How a money laundering crackdown in China is ensnaring crypto OTC trading

From the outside looking in, it may appear that China is cracking down on over-the-counter cryptocurrency trading.

But the reality is more complicated, and Chinese law enforcement's recent efforts are, in fact, broader in scope.

So far this year, Chinese courts have convicted more than 100 people in 33 criminal cases involving the use of Tether’s USDT, over-the-counter (OTC) crypto trading, or both, according to an analysis by The Block of China’s court database, Judgements Online. The convictions are for crimes that occurred as far back as 2018.

But only nine of those cases, in which 17 individuals were convicted of “concealing and hiding criminal proceeds” by a process in which they knowingly facilitated the laundering of criminal proceeds via USDT through their Huobi and OKEx accounts, pertained directly to cryptocurrency exchanges.

The rest were not directly about crypto. They were aimed more broadly at illegal economic activities — Ponzi schemes, investment scams, telecommunication frauds, and other crimes. In those cases, the perpetrators also happened to use crypto-assets either to defraud victims or launder fiat currency proceeds. 

What’s going on? Lately, Chinese law enforcement has been ramping up its so-called “Internet cleansing movement” — a systematic crackdown on internet-enabled criminal activities. 

A current priority of the initiative is to eliminate cross-border gambling operations. China’s Public Security Ministry said as of September, it has arrested over 60,000 suspects from more than 1,700 gambling sites that involved over one trillion yuan of proceeds ($150 billion). Caixin magazine described the massive situation in detail in a recent cover story.

As part of the larger effort, law enforcement officials have intensified their scrutiny of Chinese crypto OTC desks suspected to have either knowingly or unknowingly facilitated the laundering of illegally obtained funds.

Of the 33 criminal cases in which convicted individuals used USDT, 20 involved the use of OTC desks to buy or sell crypto-assets. In 15 of those, the courts specified that OTC merchants on Huobi and OKEx were involved. And in multiple cases, the crypto exchanges assisted law enforcement by providing user or transaction information.

This state of affairs has had a chilling effect. Third-party OTC merchants who cater to Chinese users are still active on crypto exchanges such as Huobi, OKEx, Binance and Gate.io. But the increasing police scrutiny has led to a widespread fear among OTC merchants and users that they could unwittingly receive tainted yuan and have their bank accounts frozen.

The unique role of OTC

To understand the effect that the money laundering crackdown has had on crypto trading in China, it’s important to keep in mind the large role that OTC desks play in the country.

In September 2017, the People’s Bank of China began prohibiting crypto exchanges from offering fiat-to-crypto trading pairs in centralized order books. That meant Chinese users could no longer deposit yuan in the exchanges’ custodian bank accounts. 

Since then, they’ve had to go through OTC merchants to buy crypto assets, using yuan, in a peer-to-peer fashion. Then, they can begin trading on various crypto-to-crypto exchange platforms. When a user wants to cash out, they have to return to an OTC desk to exchange crypto for yuan, which they then receive from their counterparties via bank wires.

But if that counterparty sends them money that is somehow associated with criminal activity, law enforcement might freeze their bank account.

This risk is especially pronounced for Chinese crypto miners. They can still sell their mined coins via crypto-to-crypto trading pairs at any centralized exchange’s order books. But when it comes to cashing out into fiat money via OTC desks to pay utility bills, they may have to consider minimizing the frequency and taking extra precautions when choosing their counterparties.

While bank account freezing has not been uncommon historically, the situation has worsened this year. In June, OTC merchants and users reported a wider bank account freeze as a result of law enforcement’s crackdown on illegal activities. Some estimated that over 1,000 accounts might have been affected at the time.

In response, most OTC merchants on Huobi and Binance have started requiring buyers and sellers to complete the highest level of KYC. That means providing photocopies of a national ID will not suffice any more. Now, a user must submit to facial recognition and record a video while reading a preset script and holding their ID card. 

The purpose of this is to have a record of a user attesting to the exchange that the KYC information provided is authentically associated with that user, since it’s not difficult to obtain someone else’s ID card or a fake. 

Clouds of uncertainty

The uncertainty around OTC trading intensified in July when Zhao Dong, a well-known OTC trader and minor Bitfinex shareholder, as well as some other OTC traders, were taken into police custody to “assist investigations.”

It has been nearly five months since then. So far, there’s been no arrest notice for Zhao and his whereabouts remain unknown. 

Then, in October, crypto exchange OKEx suspended asset withdrawals after one of its private key holders, who later was identified as founder Star Xu, was taken away by Chinese police — also to “assist investigations.” 

Most recently, on November 2, Huobi’s chief operating officer Robin Zhu was taken away from a hotel in Zunyi in China’s Guizhou province by what may have been plainclothes police, one person that witnessed the scene at the hotel lobby told The Block.

Huobi had been hosting a private hiking event with VIP guests and partners during the weekend of October 31 in Zunyi. The person, who spoke on the condition of anonymity given the sensitivity of the issue, said the people who detained Zhu did not wear police uniforms and that it was not clear why Zhu was taken away.

Hours after the alleged incident, Huobi denied that any of its senior management was detained or arrested.

OKEx said on November 19 that it will resume the withdrawals within eight days but did not clarify the nature of the investigation.