Senior central bank official: How to regulate digital currency

This article is from China Finance magazine. The authors include Wen Xinxiang, Secretary-General of the Monetary Policy Committee of the People's Bank of China, and Chen Xi of China Financial Electronicization Company. The original title is "How to Regulate Digital Currency"

In the 1980s, cryptographer David Chaum first proposed the concept of digital currency. In the 1990s, Chaum created Digicash, one of the earliest digital currencies, which can ensure the anonymity of transactions. Bitcoin (BTC), which came out in 2009, is the first decentralized digital currency, realizing a series of properties previously envisioned by cryptographers - anonymity, decentralization, and immutability.

According to the report on digital currency issued by the Bank for International Settlements in November 2015, digital currency is a digital asset with certain currency characteristics. Digital currency can be denominated in legal currency, issued by the issuer and responsible for redemption. According to the definition of the European Central Bank, virtual currency is issued by non-central banks, credit institutions, and electronic money institutions, and can be used as a digital representation of the value of currency substitutes in some cases. In the report of the European Central Bank in 2012, "virtual currency" was defined as a digital currency. In China, the "Notice on Preventing Bitcoin Risks" issued on December 5, 2013 clearly defined Bitcoin as a "network virtual commodity" rather than a currency.

The Phantom of Digital Currency

The development of information technology has led to rapid changes in financial technology. Bitcoin, based on blockchain, provides important technical and application support for the innovation of financial technology, and has been valued and sought after by more and more people. Driven by factors such as the limited total amount of Bitcoin, slowing output, rising market risk aversion, and investors' profit-seeking nature, the price of Bitcoin has been pushed up again and again, soaring more than 5 million times in just eight years. As of June 10, 2017, the total market value of digital currencies represented by Bitcoin has reached a milestone of over $100 billion. Asian investors have made a huge "contribution" to the skyrocketing prices of digital currencies such as Bitcoin. The tens of millions of new registered users of Bitcoin wallet platforms in the past year are mainly concentrated in China, South Korea and Japan. In 2016, China's Bitcoin trading volume accounted for 93% of the global trading volume; in 2017, due to the recognition of Bitcoin by the Japanese Financial Services Agency, Japan surpassed the United States to become the country with the largest Bitcoin trading volume, accounting for 40%; South Korea's Ethereum trading volume exceeded Bitcoin trading volume, and Ethereum won trading volume exceeded 30% of the global Ethereum total trading volume.

A large amount of funds continue to pour into the digital currency market, and the ICO project market related to it continues to be hot. ICO (Initial Coin Offering) refers to the first public offering of coins based on blockchain technology. It is the process by which startups bypass venture capital or banks that require strict regulations to raise funds for new digital encryption token projects. In ICO activities, a portion of tokens are sold to early supporters of the project in exchange for legal currency or other digital currencies, usually Bitcoin. ICO projects have a low threshold for participation and lack of supervision, providing a quick way for startups to raise funds; investors have expectations that the digital currencies involved in the project will appreciate in the future.

The ICO market is booming. In terms of the amount of money raised, the total amount of ICO financing in 2017 exceeded the funds that start-ups obtained through traditional venture capital companies. In China, according to data released by the National Internet Financial Risk Analysis Technology Platform, there were 43 related platforms in China providing ICO services in the first half of 2017, with a total financing of 2.616 billion yuan and a total of 105,000 participants. In terms of the speed of fundraising, ICO projects are also enjoying the "bonus" brought by wild growth. In June 2017, the BAT project of web browser startup Brave raised $35 million in its token ICO within tens of seconds. Later, even the relatively unknown project Bancor raised $153 million worth of Ethereum in a few hours, setting a new record for ICOs.

Digital currency chaos

Digital currencies continue to gain favor among investors and are also attractive to criminals. Currently popular digital currencies are not issued by central banks and are theoretically not subject to government intervention; their anonymity gives them the ability to hide transactions like cash, which allows digital currencies to evade regulatory policies.

Criminals use digital currencies for various crimes. According to a risk assessment report by the UK Treasury in 2015, most criminals use digital currencies to conduct traditional criminal transactions in online markets. Digital currency exchanges can easily become criminal platforms for money laundering, terrorism, etc. On July 28, 2017, the US government filed charges against Russian businessman Alexander Vinnik, including money laundering and using Bitcoin transactions on the BTC-e exchange for illegal activities. The BTC-e exchange is one of the largest and earliest virtual currency exchanges in the world, and is suspected of using Bitcoin to launder more than $4 billion for criminal organizations.

Ordinary investors generally face two types of risks when investing in digital currencies: one is the speculative risk of digital currencies themselves; the other is the risk brought by unregulated digital currency trading platforms. If a digital currency purchased by an investor does not technically have the characteristics of a digital currency, but is merely an illegal fundraising in the name of a digital currency, then the risk is even greater.

Digital currency has speculative risks. Investing in digital currency is more like a speculative behavior. Due to the lack of actual exchange value and the fact that its own value is not based on the "currency anchor", it is easily affected by changes in regulatory policies. The price of digital currency is prone to huge fluctuations, and ordinary investors who blindly follow the trend are likely to suffer heavy losses.

Digital currency exchanges lack protection for consumers' legitimate rights and interests. When illegal operations occur and operators abscond with funds, investors suffer heavy losses. In 2013, the domestic Bitcoin trading platform GBL suddenly "ran away" on the grounds of being hacked, causing users to suffer direct losses of more than 20 million yuan. In addition, the security of the trading platform itself is questionable, and network security precautions are not in place, making it vulnerable to hacker attacks, resulting in the theft of stored digital assets. In 2016, nearly 120,000 Bitcoins worth about 72 million US dollars were stolen from the Hong Kong Bitcoin exchange Bitfinex. The final solution was to let users share 36% of the losses. In 2017, Bithumb, the largest Bitcoin exchange in South Korea, was hacked, and users lost billions of won. It is expected that about 100 victims will file a class action lawsuit against Bithumb. Due to the lack of laws and unclear regulatory provisions, even if the damage is proven, it is difficult for the trading platform to determine the legal responsibility and pay compensation for the lost funds.

In recent years, anonymous digital currencies have become the latest criminal tool for extortion attacks. The emergence of digital currencies such as Bitcoin has, to a certain extent, contributed to the spread of ransomware. Data from the cybersecurity company Malwarebytes shows that the proportion of extortion cases in cyberattacks increased from 17% in 2015 to 61% in 2016, of which the proportion of Bitcoin extortion in hacker attack patterns increased by nearly 50% in 2016. The spread of ransomware has caused great damage to the global Internet. On May 12, 2017, the global outbreak of the ransomware "WanaCrypt0r 2.0" infected 75,000 computers in at least 99 countries. Hackers demanded a Bitcoin ransom, otherwise they would delete all data. The harm of Bitcoin extortion is not only reflected in the direct economic losses, but also in the interruption of public services in the medical, health, education, finance and other industries due to extortion attacks, which harms the public interest and even endangers national cybersecurity.

The continued hype of digital currencies such as Bitcoin has allowed criminals at home and abroad to seize people's desire to get rich quickly and use the concept of digital currency to concoct pyramid schemes. The "Risk Warning on the Issuance or Promotion of Digital Currency in the Name of the People's Bank of China" issued by the Currency, Gold and Silver Bureau of the People's Bank of China has attracted people's attention to digital currency pyramid schemes and fraud. Digital currency pyramid schemes use "new concepts" to hype, attract people by offering heavy rewards, and develop downlines layer by layer. Under the guise of innovation, they do not change the essence of pyramid schemes; by imitating Bitcoin to build a platform system, they manipulate the generation and trading of copycat coins to attract investors to buy, and then sell them in large quantities when the time is right; investors suffer heavy losses. The original Bitcoin is generated by decentralized "mining" and is not manipulated by anyone. The "Internet MLM Identification Guide" (2017 edition) issued by the Jiangsu Internet Finance Association has exposed 26 illegal digital currency pyramid schemes. Among them, OneCoin has been confirmed to be a global pyramid scheme scam. In Germany and India, OneCoin has been severely cracked down by the government, and many countries around the world have issued warnings against OneCoin's pyramid schemes.

As the popularity of ICOs skyrocketed and the scope of investors continued to expand, problems such as over-hyping, price gouging, and fraud were gradually exposed. Due to the lack of knowledge about blockchain technology and the high technical threshold of ICO projects, even if investors have a full set of white papers and open source codes, it is difficult to predict the actual operation and profit prospects of the projects; many ICO projects do not strictly comply with KYC (know your customer) and AML (anti-money laundering) standards, project developers are anonymous, and funds do not have escrow wallets, which cannot prevent malicious project developers from taking away funds; these ICO projects are in a regulatory gray area, and investors' rights and interests are not protected, making them easy victims of ICO money-making.

International regulatory response

More and more governments and central banks are incorporating digital currencies such as Bitcoin into their national regulatory systems, but the progress and attitudes of regulation vary. The United States, Singapore, and Japan are at the forefront of the world in regulating digital currencies. Countries such as the United Kingdom, Canada, Australia, and Switzerland are friendly to Bitcoin, recognize its positive significance, and are working on or have already formulated regulatory bills to regulate the development of the Bitcoin industry. In order to reduce the risk of money laundering and protect financial technology innovation, Russia and Thailand have shifted from completely banning the use of Bitcoin to relaxing Bitcoin regulation.

Regulatory agencies in various countries mainly regulate digital currency start-ups and digital currency trading platforms, with anti-money laundering and protection of investors' legitimate rights and interests as their main goals. There are four main forms of regulation. First , based on the traditional money transfer law, a regulatory bill specifically targeting virtual currency is issued. For example, the Digital Currency Regulatory Act issued by New York State, the Virtual Currency Business Uniform Regulatory Act passed by California, and the Virtual Currency Act implemented by Japan. Second, legal interpretations are issued to include virtual currency in traditional bills. For example, in 2017, the European Parliament (EP) issued the fourth draft amendment to the Anti-Money Laundering Act, which included anti-money laundering control in the field of digital currency. In 2017, Vermont passed a new bill to define virtual currency, update the state's currency transaction rules, and supplement it to the state's money transfer service law. Third, regulatory technology is used to solve regulatory issues in the field of digital currency. For example, in 2017, the European Union invested 5 million euros to support the digital asset monitoring project "Tools for the Investigation of Transactions in Underground Markets", which aims to provide technical solutions for investigating or reducing crimes and terrorism related to digital currency and underground market transactions. Fourth, separate regulatory rules and documents are issued. For example, in 2013, the People's Bank of China and five other ministries jointly issued the "Notice on Preventing Bitcoin Risks", prohibiting financial institutions and payment institutions from conducting Bitcoin business and treating Bitcoin only as a specific commodity.

The supervision contents mainly include the following five aspects.

First, classify the legal nature of digital currency and establish its legal status. The identification of the nature of digital currency has always been a core issue of legal supervision. More than 20 countries and regions have identified the legal status of digital currencies such as Bitcoin. Different regulatory agencies have different identifications of its legal attributes. The UK's HM Revenue and Customs (HMRC) defines Bitcoin as private property; the US Internal Revenue Service (IRS) classifies Bitcoin as a taxable asset; in Japan, Bitcoin is defined as a new payment method; and Australia "allows digital currency to be considered as a currency subject to consumption tax."

The second is to regulate ICO and protect the rights and interests of investors. The progress of ICO supervision does not match the development of ICO. The United States and Singapore have successively determined that ICO tokens belong to the category of securities in ICO supervision and included them in the scope of supervision. In Switzerland, digital currency companies do not need any specific licenses or approvals. The Financial Conduct Authority (FCA) of the United Kingdom discussed blockchain and digital currency in its paper in April 2017. China and other countries are paying close attention to the issue of ICO supervision. Relevant personnel have called for the supervision of ICO to be put on the agenda, but no clear regulatory bill has been introduced yet.

The third is to adopt a licensing system to regulate the legal qualifications of digital currency start-ups. The New York State Department of Financial Services (NYDFS) released the "BitLicense Regulatory Framework" in June 2015, making New York the first state in the United States to officially launch customized Bitcoin and digital currency regulation, setting a benchmark for other states in the United States and other countries to regulate virtual currencies. Subsequently, Washington State in the United States, Japan, and other countries also introduced similar licensing systems to protect consumer rights. These licensing systems regulate companies operating in the field of digital currencies such as Bitcoin, and include various compliance policies, such as the need to comply with KYC and AML regulatory regulations.

Fourth, include digital currency trading platforms and private users in anti-money laundering regulations to prevent money laundering activities. Most transactions, such as the exchange of digital currency and legal currency, are completed through trading platforms, and the supervision of platforms is less difficult than that of private users. Therefore, most governments focus on trading platforms for anti-money laundering supervision. In order to improve regulatory efficiency, the United States and Japan focus on intermediary service agencies such as digital currency trading platforms and payment companies for anti-money laundering supervision. Anti-money laundering measures for private users of digital currency mainly focus on solving the anonymity of digital currency. The draft amendment to the fourth edition of the EU Anti-Money Laundering Law supervises the use of digital currency by real-name registration of digital currency users.

Fifth, reduce or exempt Bitcoin transaction taxes or establish regulatory exemption privileges to relax regulation of the digital currency industry. In order to encourage financial innovation, some governments have relaxed regulation on Bitcoin and other products. Australia abolished the Bitcoin goods and services tax; the European Union exempted digital currency transactions from value-added tax; North Carolina and New Hampshire in the United States established regulatory exemption privileges for some digital currency merchants.

Regulatory recommendations

As a new thing in the field of financial technology, the regulation of digital currency should not only help entrepreneurship and innovation, but also grasp the timing and degree of regulation; it should not only focus on preventing risks, but also establish a legal, compliant, and innovation-friendly regulatory environment. Combining my country's specific national conditions and drawing on international experience, we give some suggestions on the regulation of digital currency.

First, establish and improve the regulatory framework for digital currencies. First, in terms of regulatory attitude, grasp the relationship between financial regulation, financial innovation and financial risks, and moderately regulate digital currencies. Second, in terms of regulatory subjects, clarify the digital currency regulatory departments and functions; in terms of regulatory objects, clarify the different roles in the digital currency market, such as digital currency trading platforms, digital currency startups and investors. Finally, in terms of regulatory methods, according to the development and changes of digital currencies, choose targeted regulatory measures, such as establishing digital currency industry standards to reduce industry risk hazards from the source; amend the Anti-Money Laundering Law to include digital currencies in the scope of anti-money laundering supervision.

Second, a licensing system is adopted for digital currency trading platforms to protect the rights and interests of investors and prevent fraud, money laundering, terrorist financing and other activities. A licensing system is adopted for the supervision of trading platforms; specific provisions are made for filing management, licensing access, anti-money laundering responsibilities and processes, user real names, and large-value transaction restrictions. Necessary risk protection barriers are established between Bitcoin transactions and banking institutions and payment institutions.

Third, the introduction of a "regulatory sandbox" for digital currency start-ups will protect the rights and interests of investors and support financial innovation. In light of China's current financial environment, the introduction of a "regulatory sandbox" in the digital currency industry requires consideration of the expected goals and subjects of the digital currency "regulatory sandbox", that is, which type of regulatory agency is responsible; select the specific model of the "regulatory sandbox" based on the innovation risk, risk control ability, and investor rights protection of the regulated institution; and build a specific system for the digital currency "regulatory sandbox", such as the access system for digital currency start-ups, the period of entry, operational responsibilities, and the protection mechanism for the rights and interests of digital currency users and investors in the "sandbox".

Fourth, we should do a good job in regulating ICO, focusing on protecting the rights and interests of investors. We should clarify the legal regulation of ICO, a new financing method, and issue normative guidance, policy recommendations and mandatory regulations for digital currency trading platforms participating in ICO projects, implement continuous information disclosure and anti-fraud liability clauses for issuers, and improve basic legal norms such as investor rights protection. For ICO, we can also introduce a "regulatory sandbox" to solve the problem of relatively lagging ICO supervision. At the same time, we should increase the popularization of relevant knowledge such as digital currency and blockchain, so that investors can understand the ICO industry and investment risks, treat the financing needs of ICO projects rationally, and reduce irrational investment and speculative behaviors.

Fifth, multiple measures are taken to prevent pyramid schemes and fraud in digital currencies. For pyramid schemes in the name of digital currencies, it is recommended to revise or strengthen the judicial interpretation of the regulations prohibiting pyramid schemes; further regulate digital currency trading platforms to clarify whether they have the obligation to supervise the trading currencies; establish a regular mechanism for issuing potential risk warnings for digital currency transactions to the public and a digital currency complaint handling mechanism to further improve the protection of investor rights and interests.

Sixth, develop regulatory technology. Use technologies such as big data, cloud computing, artificial intelligence, machine learning, and blockchain to conduct compliance supervision on anti-money laundering, digital currency trading platforms, and ICOs to improve regulatory efficiency.

Seventh, strengthen international regulatory cooperation. The decentralized nature of digital currency requires regulatory agencies in various countries to coordinate supervision. Member countries should formulate principled regulatory laws and regulations, establish a unified international dispute resolution mechanism for digital currency, strengthen information sharing and exchanges, and jointly combat cross-border digital currency crimes. (This article is the author's personal opinion and does not represent the opinion of the employer)