APREVIOUS LEXICON COLUMN discussed the phenomenon that is known as fintech (see China Business Law Journal volume 7 issue 8: Fintech and smart contracts). Reflecting the combination of “finance” and “technology”, fintech focuses on the various ways in which technology can be utilized to increase the efficiency of financial services (including payment systems) and to change the way in which financial services are structured and delivered.
As the column noted, one area of fintech that has generated a lot of attention and disruption in recent years is the use of distributed ledger technology to support digital currencies, which are also known as cryptocurrencies. The term “crypto” comes from the Greek word kryptós, which means “secret” or “hidden”. In the context of cryptocurrencies, the use of the word reflects the fact that there is no tangible form of the currency, unlike normal currencies that are issued in paper form. The Chinese term that is used is “虚拟货币”, which means “fictitious” or “virtual” currency.
The design and regulation of cryptocurrencies. Distributed ledger technology enables data concerning transactions to be recorded and shared across a network of parties. Because all the parties have access to a single database (or ledger) and because the data is held by (or distributed to) each party, the accuracy and the security of the transaction data can be guaranteed.
An integral component of distributed ledger technology is the “blockchain”. This refers to the chain of transactions that are recorded on the ledger. All the transactions on the ledger are grouped into blocks and a new block is added to the chain each time a new transaction is verified. An important application of blockchain technology is the creation of “cryptocurrencies” such as bitcoin. Cryptocurrencies use encryption technology to generate units of currency and verify the transfer of funds.
A particularly popular use of cryptocurrencies is to purchase digital coins or tokens that are issued to the public as part of initial coin offerings (ICOs). The funds raised are used to invest in various businesses. Although the issue of tokens resembles an initial public offering of shares, it is different as the investors in ICOs do not receive ownership rights but instead receive a token whose value is determined by the blockchain.
The use of blockchain technology for the above purposes gives rise to a range of legal and regulatory issues. These issues include the application of laws and regulations governing data privacy, cybersecurity, anti-money laundering and financial crimes.
One of the greatest challenges for regulators is determining how cryptocurrencies and ICOs should be classified for regulatory purposes. Are they a commodity that investors buy and sell like any other commodity? Or are they like securities and subject to the same disclosure and other requirements?
The US Securities and Exchange Commission has announced that it will treat certain ICOs as securities and will regulate them accordingly. In addition, the Securities and Futures Commission in Hong Kong issued a statement in September that, depending on the facts and circumstances of an ICO, digital tokens may be “securities” as defined in the Securities and Futures Ordinance (SFO), and subject to the securities laws of Hong Kong.
The Chinese ban
The astronomical popularity and value of bitcoin in recent times took a couple of hits in September this year. The first hit occurred when China issued a notice banning the use of cryptocurrencies to raise finance in the PRC and the trading of cryptocurrencies. Given that China is reported to be the largest cryptocurrency market in the world with about 80% of bitcoin transactions taking place in renminbi, it is not surprising that the news triggered a plunge in the value of bitcoin by more than 30%.
The second hit occurred when JPMorgan CEO Jamie Dimon warned that bitcoin was a fraud that was heading for collapse and likened it to the Tulip market bubble of the 17th century. Interestingly, China experienced its own Tulip-style mania in relation to the market for the sale of Pu-Erh Tea, which collapsed spectacularly a decade ago in 2007. The impact of these hits, however, appears to have been short-lived as the value of bitcoin recovered by more than 25% a few days later.
At least three conclusions can be drawn from these developments. Firstly, cryptocurrencies are likely to continue to experience significant volatility in their value as the global markets respond to their rise in popularity and contemplate their long-term impact and staying power. Economic and regulatory trends in China will be of critical importance because of the size of the Chinese market.
Secondly, China’s decision to ban cryptocurrencies highlights the volume of cryptocurrency transactions in China to date. The popularity of cryptocurrencies in China has been boosted by the tightening of capital and currency controls over the past two years, which has placed downward pressure on the renminbi as investors seek non-renminbi denominated assets and chase higher yields. It has also been boosted by the ease with which cryptocurrencies can be used to transfer funds offshore and circumvent the foreign exchange controls.
Thirdly, the ban reveals the extent to which cryptocurrencies are perceived to represent a threat to financial stability – and therefore social order – in China. This is particularly important at present in view of the 19th Party Congress in October this year. The use of cryptocurrencies and initial coin offerings (ICOs) to perpetrate and disguise fraudulent activities, including money-laundering and ponzi-type investment schemes, is likely to have been of serious concern to the Chinese authorities in recent times. The concerns that social unrest will occur in response to events relating to the financial markets have increased since the stock market collapse of 2015, which saw a loss of one-third of the value of the A-share market in Shanghai over a period of one month.
The crack-down against cryptocurrencies is in line with previous practice in China, where the government often adopts a wait-and-see approach in respect of activity that is largely unregulated until its magnitude becomes clear and the time arrives for the activity to be regulated. In some respects, this situation is no different from other jurisdictions that have dragged their heels in coming to terms with cryptocurrencies. After all, it was only in July this year that the US Securities Commission issued a report determining that DAO tokens were “securities” and must be regulated accordingly.
What took some by surprise was the decision on the part of the Chinese authorities to ban cryptocurrencies and ICOs altogether. Although the short-term future of cryptocurrencies in China is uncertain, experience suggests that it will be just a matter of time before China regulates the area.
In January 2016, the People’s Bank of China (PBOC) issued a notice announcing that it was working towards issuing its own digital currency soon. This would effectively result in the digitization of China’s currency, the renminbi (RMB). The notice highlighted the benefits of a sovereign-backed digital currency in terms of cost, coverage, convenience and security. The introduction of a digital currency would avoid the risks associated with privately issued cryptocurrencies and enable China to ensure that it is not used as a means of circumventing its strict capital and currency controls.
When China introduces its own cryptocurrency, the impact on the global economy will be significant. Not only will it challenge the existing global payment systems and establish China as a leading rule-maker in this area, but it will also reinforce the importance of the renminbi as a global currency, potentially eroding the position of the US dollar as the world’s leading reserve currency.
A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at www.vantageasia.com.