The billion-dollar scandal swirling around unlicensed cryptocurrency exchange JPEX has exposed gaps in Hong Kong's regulatory and legal oversight and is testing Hong Kong's drive to become a pre-eminent hub for virtual assets.

It's also reignited the debate over the city's crypto pivot and raised questions over whether retail investors will still be willing to boldly go into the world of digital assets.

Officials insist it will not deter Hong Kong from developing the alternative asset class.

But experts say scams like these are bound to happen again and retail investors will now think twice about trading in digital tokens in a blow to the city, which has been pushing to establish itself as a crypto hub since last year, leading to the launch of a new regime for cryptocurrencies in June.

JPEX, which claims to be based in Dubai, is accused of deceiving investors into forking out money on products that promise high returns but later preventing them from withdrawing funds.

Authorities say there are more than 2,500 alleged victims who have together lost over HK$1.5 billion. Twenty-eight people have so far been arrested and more than HK$100 million in assets seized, yet the mastermind remains unknown.

Securities and Futures Commission chief executive Julia Leung Fung-yee has referred to the scam as a "possible Ponzi scheme" without naming JPEX, but it's unclear how the scandal unraveled, as the platform has been in business long before the new regulatory regime was launched.

Still some say the authorities have not done enough and have been slow to act.

Now, four weeks after the SFC's first warning that prompted JPEX to jack up withdrawal fees to extortionate levels to stop outflows, the regulator has set up a task force with the police to enhance collaboration in tackling illegal crypto activity.

The celebrity factor

JPEX, which is not licensed in Hong Kong, uses influencers and celebrities to promoted products that with yields of up to 21 percent for customers who transfer their digital coins from other exchanges or convert fiat money into tokens and place them on the platform.

In addition to providing trading in bitcoin and ether - the two coins allowed to be traded by retail investors on licensed platforms under the new regime - the platform also offers other services like earning and deposits, which are strictly prohibited even by licensed outlets.

REGULATORY GAPS

The SFC says it put JPEX on its alert list in July 2022 - when it still lacked the power to regulate crypto firms - and has warned investors of dealing with unlicensed platforms nine times - without naming any companies - since then.

The new rules bar unlicensed exchanges from marketing but there is a 12-month transition period.

The SFC says it has since been investigating the platform but lawmaker Johnny Ng Kit-chong questions whether the time taken for the investigation is too long and feels the regulator should have warned investors sooner to minimize losses.

As the fallout grows, Anli Securities chairman and chief executive Andrew Wong Wai-hong says there are lessons to be learned and room for review and improvement.

For example, why was massive advertising on the platform allowed across the city including in the MTR, and why are over-the counter or OTC shops are not regulated, he asks.

OTC shops or ATMs where people exchange fiat money for digital assets are still not required to register with the SFC under the new rules, nor do they need to apply for any license from the Customs like other money changers because cryptocoins are not considered currency.

Even regulators admit they are clueless about the number of OTC shops in the city.

Since JPEX was able to widely publicize itself through ads and OTC shops, it should be a matter of concern for the SFC, says lawmaker Doreen Kong Yuk-foon.

Jeffrey Lam Kin-fung, a member of the Executive Council, also urges regulating influencers.

No going back

Despite the fallout, officials including Leung and Financial Secretary Paul Chan Mo-po have reiterated Hong Kong's determination to promote virtual assets, saying the scandal underscores the importance of regulation in the industry.

Ceajer Chan Ka-keung, the former Secretary for Financial Services and the Treasury, calls it "unfortunate" but says the scandal won't hurt market confidence.

Others are less positive.

Although the scale and impact of the scandal are not as big as other crypto fallouts in the world, Hong Kong customers might become more conservative on digital coins, says Livio Weng, chief operating officer at HashKey, one of the two licensed firms.

His views are echoed by Darwin Choi, an associate professor in the Department of Finance at the Chinese University of Hong Kong.

"There may be another JPEX in the future as it always takes some time for regulations and laws to catch up on the development of new products like crypto," he says.

The enthusiasm of crypto firms to come to the city appears to have also taken a hit with only five seeking permits from the SFC so far, in contrast to more than a dozen of them claiming to do so.

HashKey expects less than 10 exchanges to be granted licenses after the grace period.

Many may hesitate because of the limited scope of products allowed under the new rules and the uncertainty in trading volumes, Wong says, adding that the relatively high capital requirement is also a hurdle.

The bigger question is whether the SFC will eventually allow more crypto products to be traded by retail investors and, if so, how will they be protected, he adds.

Lessons from FTX

It still remains unclear why Hong Kong suddenly started to embrace digital assets that are often susceptible to crime including fraud and money laundering, after a colossal US$1.5 trillion (HK$11.7 trillion) rout in the industry last year.

Some view it as part of Chief Executive John Lee Ka-chiu's efforts to regain Hong Kong's appeal as a financial center following the social unrest of 2019 and its three-year isolation during Covid.

But ironically, despite the crypto push, the city has for the first time in more than half of a century lost its status as the world's freest economy to the rival hub Singapore, where crypto marketing for retail investors has been banned and bitcoin ATMs removed.

In fact, the collapse of exchange FTX, just days after the city announced its crypto embracement last year, had already sent early warning signals.

Sam Bankman-Fried, who founded FTX in Hong Kong in 2018, now faces charges of fraud and money laundering that could send him behind bars for more than 100 years.

The ongoing trial is expected to lay the foundation of the regulatory framework for regulators around the world and could even decide the future of digital assets.

Lawsuits against FTX's celebrity promoters may also become legal cases for other jurisdictions to take reference from.

Critics of Hong Kong's crypto push include Joseph Yam Chi-kwong, the former chief executive of the Hong Kong Monetary Authority and an ExCo member.

He has questioned why the government is actively promoting the development of crypto that "doesn't even have a balance sheet to look at" and how the "self-serving" asset class can help support the economy.

Yam has said he wouldn't buy any cryptocurrencies whose prices are driven by speculation: "If you want to speculate, you might as well go to casinos."

Former Secretary for Commerce and Economic Development Frederick Ma Si-hang also believes the SAR should not have promoted virtual assets in the first place and if it insists on doing so, strict oversight must be put in place.

"The real benefits of developing crypto to the economy may be to lend a hand to legal advisers and advertisers," Ma says.

Lawmaker Kong feels the billion-dollar lesson is too high a price to pay, saying there should be no rush to develop new investment products if the ecosystem and related regulatory framework are not adequately prepared.

Crypto's tangled web challenges HK pivot