Yao Qian of the Central Bank: Focus on the development and regulation of digital currency

Observer: Bitcoin is a phenomenon of ICO (initial coin offering) in the online world. Bitcoin is only a quasi-digital currency, and cannot be a digital currency in the legal sense. Bitcoin is nominally called a currency, but in essence it is a non-monetary digital asset. Bitcoin may be a niche asset class with certain collection value; however, looking back at history, various asset bubbles and financial crises are, to some extent, manifestations of human weakness.

By Yao Qian, Director of the Digital Currency Research Institute of the People's Bank of China

Digital assets represented by Bitcoin cannot effectively perform the three basic functions of currency: medium of exchange, unit of account, and store of value. They do not yet have the conditions to become real currency, let alone replace legal tender that is backed by national credit and has the highest value and trust. Therefore, it is more accurate to define it as a "quasi" digital currency.

The ICO (Initial Coin Offering) phenomenon cannot be avoided. From the perspective of institutional construction, we should give ICO a legal explanation as soon as possible. A complete regulatory framework is very important for promoting the healthy development of the entire blockchain industry. A regulatory sandbox approach can be adopted. The intrinsic value support of legal digital currency cannot change in any way. The change lies in the digitization of currency form and digital issuance technology.

Analyzing digital currency from multiple perspectives

First, the report keenly observed the forward-looking proposition of "currency innovation" under the conditions of the Internet economy. In this context, the discussion of digital currency is of high purpose.

Secondly, the report comprehensively combed through recent research literature, refined some reports from the IMF, BIS, and central banks, summarized the main viewpoints and conclusions, reflected them in the definition, and laid a good foundation for subsequent research.

Thirdly, the report establishes the connection between the innovative form of digital currency and the basic theoretical research of currency, and attempts to use new monetary economics methods such as new monetary economics and money market theory to explain and analyze the field of digital currency. It is commendable that the report analyzes from two dimensions, economics and technology, and proposes a time-based blockchain decentralization solution. Although the solution is debatable, it is a good attempt.

Finally, the report combines theory with practice, proposes the impact of digital currency innovation on monetary policy and financial stability, the two core functions of central banks, and explores the compliance and regulatory innovation issues brought about by this. It also raises the question of whether DLT (distributed ledger technology) can support future financial infrastructure, which provides inspiration for further research.

It is more accurate to define Bitcoin as a "quasi" digital currency

Nowadays, the topic of digital currency is very hot, and most people think that Bitcoin represents digital currency. In fact, it is more appropriate to call Bitcoin a "quasi" or "quasi" digital currency. Bitcoin, Ethereum, etc. use blockchain technology to solve the technical trust problem of digital payment. Ethereum's smart contract technology can also open up new business application models. Therefore, the prospects are generally optimistic among investors, but advanced technology cannot solve the trust problem of the asset value behind it.

Both BIS and IMF pointed out that Bitcoin lacks strong asset support, and this weakness is fatal. Some people also joked that "mining is the biggest failure of Bitcoin", although from a technical point of view, it is an innovation. This inherent defect leads to the instability of Bitcoin's value, weak credibility, limited acceptance range, and easy to generate large negative externalities. So to be precise, although Bitcoin is nominally called "currency", it is actually just a non-monetary digital asset. The definition of the well-known "virtual currency", the so-called "virtual" qualifier, in my personal understanding, means that it is not qualified.

Money is an asset, but an asset is not necessarily money. Digital assets represented by Bitcoin cannot effectively perform the three basic functions of currency as a medium of exchange, unit of account, and store of value due to their low liquidity levels and high liquidity risks. They do not yet have the conditions to become a real currency, let alone replace legal tender that is backed by national credit and has the highest value trust.

A rational view of ICO

Some people believe that quasi-digital currencies represent the right to use technology infrastructure or prepaid fees for using open source project services. However, at present, private quasi-digital currencies are held more for investment or speculation rather than for transaction payments. Statistics and expert evaluations show that the proportion of Bitcoin used for transactions is not high. Most holders simply hold it, and the proportion of transactions is less than 20%. From the perspective of the holder structure, most of the early Bitcoin holders were technology enthusiasts, but since 2013, some non-technical personnel and institutions have begun to hold Bitcoin. Relevant experience also shows that new participants use it as an asset to invest rather than as a medium of exchange.

ICO is now a very important financing method for blockchain projects, and the amount of funds that can be raised is more than twice that of VC investment. ICO was first interpreted as Initial Coin Offering, which is very similar to IPO. Considering the sensitivity of private issuance of quasi-digital currencies and the controversy over whether "Coin is currency", some literature calls it Initial Crypto Token Offering. This statement is more accurate and refers to financing through the issuance of crypto tokens. The so-called token, in reality, usually refers to a certain certificate that uses alternative currencies within a certain range. It can be regarded as a kind of encrypted equity issued and circulated on the blockchain. Although many ICOs do not have much value at present, their emergence is still beneficial to the development of the blockchain industry.

For example, Ethereum started by raising more than 30,000 bitcoins through ICO, and is committed to developing an unstoppable, anti-shielding and self-maintaining decentralized smart contract platform - in the development of blockchain, smart contracts are a good direction. Another example is the data layer, Zcash (Zerocoin) issued by ICO, which has promoted the development of the technology of complete anonymity of transaction information, and it is a real advancement. The price of this token was extremely high when it came out. Another example is NextCoin, the funds raised by ICO are used to develop a blockchain based on PoS (Proof of Stake). There are many similar examples, including various decentralized application projects based on payment, digital wallets, asset transactions, fund management, storage, gambling, games, etc. at the application level. Although I do not approve of currency speculation, the ICO phenomenon cannot be avoided and is worth studying, such as how to price it?

At present, whether you say ICO is an investment or speculation, in short, its rate of return is very high. 10 years ago, the market value of 10,000 bitcoins could not buy a pizza, but now the price of one bitcoin exceeds one unit of gold. At present, the country has a very strict attitude towards Bitcoin, but in a sense, we also need to be lenient to the top ten companies in the ICO market value on the basis of caution. On the one hand, it provides everyone with an investment opportunity - maybe investing in black technology is better than buying some junk stocks. On the other hand, from the perspective of the country, neighboring countries, including Japan, South Korea, and Singapore, encourage the development of Bitcoin. They believe that it may be a high-quality asset. Not to mention that this can promote innovation in the financial technology industry, at least holding high-quality assets is in the national interest.

There is also a statement in monetary theory that is very similar to ICO crypto-equity: cash or currency is essentially a debt issued by the central bank to the public, or because of its contingent claims, it can also be regarded as the equity assets held by the public to the sovereign state. Because private quasi-digital currency is a kind of encrypted equity issued and circulated on the blockchain, it is highly similar to the debt or equity assets issued by the sovereign state to the public. Therefore, it is understandable that the monetary authorities are wary. Especially now that the trend of currency speculation is very popular, we need to treat it differently instead of killing it with one stick - rushing in and denying it all are common mistakes.

A “regulatory sandbox” approach can be implemented for ICOs

ICOs must be properly regulated. We can be prudent and tolerant of them, but we must not allow them to prevail. Currently, ICO business exists in the environment of community plus token exchange. The community and token exchange are separated, which will lead to discontinuity of supervision. Moreover, the hype of tokens in exchanges will cause the price of tokens issued by ICO to deviate seriously from the intrinsic value of the project. In theory, the price of tokens should be determined by the intrinsic quality of the ICO project. If the ICO project itself has no real value, and the upper party buys the token only in the expectation that the lower party can take over at a higher price, then this kind of hype and speculation is a typical Ponzi scheme. We should pay enough attention to this.

At present, ICO is on the edge of legal regulation. From the perspective of system construction, ICO should be given a legal explanation as soon as possible. A complete regulatory framework is very important for promoting the healthy development of the entire blockchain industry. In line with the report's point of view, I also suggest that a regulatory sandbox approach can be implemented.

There are several options for reference. One is to establish an ICO platform similar to a crowdfunding platform, which will undertake relevant duties such as investor education, risk warning, ICO project review, qualification certification, fund custody, urging information disclosure, supervising the use of funds, and anti-money laundering. Another is to use encrypted token exchanges as a regulatory method, but the disadvantage of this method is that even if the token exchange is controlled, it can still be traded in a decentralized manner. There are also suggestions to introduce venture capital (VC) management ideas, allowing professional managers to choose investment directions, assist in the operation of ICO projects, promote innovation, and improve the transparency of ICO projects. With the development and maturity of decentralized exchange technology, token exchanges may also be decentralized in the future. At that time, the regulatory actions of a single country will lose their grip, and international regulatory cooperation and coordination are particularly important.

The UK and Australia have some experience in sandbox supervision, and they have a very clear financial regulatory model to control. my country implements a separate regulatory system, under which it is easy to produce regulatory arbitrage and regulatory chaos, and it does not meet the diversified innovation characteristics and testing needs of ICO projects. Therefore, further strengthening the financial regulatory coordination mechanism and elevating it to a more effective level is of great significance for the development of regulatory sandboxes.

In ICO supervision, it is particularly important to strengthen investor education. A mature market requires mature investors. Looking back at history, various asset bubbles and financial crises are, to some extent, manifestations of human weakness. At present, ICO tokens are still a new thing, highly technical, and there are still great disputes and differences in the definition of their attributes and value cognition. ICO investor protection requires supervision to make some progress, but in the long run, it fundamentally requires the maturity of investors themselves, including professional knowledge, stable emotions and rational cognition.

Ethereum and smart contracts promote each other

The time-based decentralized payment solution proposed in the report is very interesting. However, this is more like a solution under a private chain rather than a public chain. There are two problems that can be solved in a private chain but cannot be achieved in a public chain.

First, the technical solution requires a unified time base. The operation of the system depends on a trusted and reliable time base service, and each node can guarantee absolute time synchronization. The time of the public chain is relative - not only the local time of the node is different, but also because of communication delays, the time when the node receives the data packet is different, and even the order may not be the same. Therefore, the public chain only cares about the order, not the absolute time of the event, and has no concept of absolute time and space.

Second, the technical solution only describes the system operation under normal conditions. Under the public chain, the system is in an open space and the environment is uncontrollable, so the biggest difficulty lies in various exception handling, including packet loss, delay, the appearance of "bad guys", etc. Therefore, the design focus of the public chain should be how to handle exceptions under abnormal conditions. At present, there has been no major breakthrough in consensus algorithms in blockchain research. On the contrary, because of Ethereum, breakthroughs in smart contracts are relatively fast - considering that

Ethereum is on the rise, and it is possible that it will surpass Bitcoin. In terms of application prospects, the components in the blockchain are not developing evenly. Currently, they are basically focused on smart contracts. Is this artificial intelligence on the blockchain? Because it can open up a truly intelligent business application model. For this reason, the technology in smart contracts is developing rapidly, despite major security incidents such as "The DAO". Only by overcoming difficulties can there be innovation, and Ethereum's efforts are in line with this direction.

“Two loosenings”

Can we propose "two loosenings"? One is to loosen the binding between digital currency and Bitcoin; the other is to loosen the binding between digital currency and blockchain.

Don’t narrowly understand digital currency as Bitcoin. We should examine the issue from the perspective of private digital currency to legal digital currency. We should define digital currency in a Chinese way - this is a new field and we don’t have to copy existing definitions. From the perspective of public economics, it may help to understand quasi-digital currency and digital currency.

According to Hartmut Picht (1992), monetary services consist of "liquidation services" and "accounting unit value stabilization services", among which "liquidation services" (i.e., broad solvency) have the attributes of quasi-public products, while the "accounting unit value stabilization services" of currency have the attributes of public products.

Generally speaking, if the private sector wants to successfully provide public goods, a series of conditions must be met: first, the public goods provided by the private sector should generally be quasi-public goods. Second, the scale and scope of quasi-public goods are generally small, and the number of consumers involved is limited. Third, there must be exclusive technology in the consumption of quasi-public goods. Finally, and most importantly, if the private sector wants to successfully provide public goods, a series of institutional conditions must be guaranteed.

In contrast, the weaknesses of private quasi-digital currencies are obvious. For example, we often see situations where digital assets are stolen due to private key leakage but are difficult to recover; at the level of Bitcoin exchanges, which is the most critical for maintaining Bitcoin liquidity, there is no relevant institutional guarantee (bank system deposit insurance, central bank lender of last resort and other institutional arrangements) to ensure the security of Bitcoin transactions, withdrawals and storage. On February 7, 2014, due to a cyber attack, Mt.Gox, the world's largest Bitcoin exchange, stopped Bitcoin withdrawal business, causing trading chaos, and then Mt.Gox declared bankruptcy. Obviously, private quasi-digital currencies do not have the ability to provide public product services such as "liquidation services" and "accounting unit value stabilization services". Only legal digital currencies can be competent and play this role. Only legal digital currencies can become the cornerstone of the new generation of financial infrastructure and the future development of the digital economy.

This is how I understand the second loosening mentioned above. If we adopt the traditional distributed architecture, can we not carry out the research and development of digital currency? Of course not. Digital currency is originally a branch of cryptography and existed long before Bitcoin. Why do we rely so much on blockchain technology? Is blockchain technology mature? Can it really be used on a large scale? There are many concerns about this. Why do we have to tie blockchain and digital currency together? This is an optional technology, but how to use it is very flexible - it is a tool, use it as you want, and if it doesn't work, giving it up is also an option.

Of course, blockchain technology is indeed inspiring to us. When we were building the system, how could we have thought that high-value data should not be allowed to be modified? Such a concept must be embedded in the construction of new systems. The consensus algorithm in the traditional distributed architecture rarely considers abnormal situations. Because in the process of moving from the original proprietary system to the open, it is necessary to consider various possibilities of being attacked and damaged as well as extreme abnormal phenomena. In this regard, blockchain provides a lot of reference, such as using the Byzantine protocol to deal with the situation of "traitors", which is an improvement on the traditional distributed system. We can learn from such concepts, but the methods can be diverse.

For example, smart contracts put forward higher quality requirements for central bank digital currencies, which I think needs to be considered. Existing payment products are already very good to use, and new payment tools must have better quality to increase their appeal to customers.

What is the competitiveness of legal digital currency?

The competitiveness of legal digital currency is reflected in two aspects. First, from a technical perspective, it is very important to absorb and learn from advanced and mature digital technologies - and this is precisely the strength of private quasi-digital currency. Second, from an economic perspective, it must inherit the reasonable connotations of the long-term evolution of traditional currency.

As a new type of currency, legal digital currency must consider its similarities and differences with traditional currency and private quasi-digital currency, that is, what to change, including what to change and what not to change, why to change, what to abandon and what to inherit, etc. It is very important to clarify these issues. The intrinsic value support of legal digital currency cannot change in any way. The change lies in the digitization of currency form and digital issuance technology. Originally, in the process of issuance, banknotes could only have information such as denomination and issuing institution, but new technologies can try to make adjustments in this regard. For example, recording the information of the holder of each digital currency and the information of the entire life cycle during the circulation process is the result of technological progress, which of course will also put high demands on the technical system in turn. A new concept is needed, and the implementation of this concept still needs to be explored in practice.

The European Central Bank recently issued an assessment report. The ECB recommends that non-bank entities be allowed to convert bank deposits into digital base currency at a 1:1 ratio, based on the fact that the main purpose of non-bank entities using digital base currency is to replace cash, not bank deposits. The ECB believes that as long as the main purpose is to replace cash, the negative effects of digital base currency can be ignored. In the initial stage, the central bank's digital currency can be positioned as a supplement or substitute for cash until more experience is gained. This step-by-step approach should become the consensus of most central banks.

The report is consistent with our thinking. There are currently two ways to generate legal digital currency. Another way is to expand the balance sheet - the central bank issues digital currency to the market through asset purchases according to the needs of monetary policy goals, thereby expanding the central bank's balance sheet. Of course, there will be other problems, provided that the qualified asset types are defined and purchased at appropriate quantities and prices. This method is more complicated. In a sense, the ECB provides a solution that is easy to start and easy to reach consensus.

It should be noted that although legal digital currency is naturally legal tender and cannot be rejected by anyone or any institution under the condition of a circulation environment, as mentioned above, cash or currency is essentially a debt or equity asset issued by a sovereign state to the public. Therefore, when sovereign state debt is monetized, foreign debt levels are too high, and default risks rise, domestic residents will also lose interest in their own currency. In extreme cases, domestic cash (including legal digital currency) may also lose its currency qualifications, which is not alarmist. On the other hand, how to scientifically determine and regulate the issuance of digital currency to ensure currency stability should be the most important consideration for the central bank to issue legal digital currency, and it will also be the key to the competition between different monetary authorities in digital currency in the digital economy era. ■

This article is a review article written by the author on Xie Ping’s “Digital Currency Research” at the Finance 40 Forum on “The Theoretical Basis of Digital Currency and China’s Innovation” on May 13, 2017.

The author is Deputy Director of the Science and Technology Department of the People's Bank of China and Director of the Digital Currency Research Institute of the People's Bank of China