Research and discussion on central bank digital currency: virtual currency and its regulatory response

In recent years, virtual currencies born in the Internet world have attracted attention from all parties. In particular, virtual currencies represented by Bitcoin have developed rapidly, and their scope of use has penetrated from the Internet to the real world. Based on relevant reports from international organizations and representative central banks, the author has studied the concept of virtual currencies, potential risks, and regulatory countermeasures of various countries.

The concept, characteristics and classification of virtual currency

The International Monetary Fund (IMF) pointed out in a recent report that virtual currencies are digital representations of value, issued by private institutions and using their own accounting units, including common electronic coupons, airline miles, encrypted digital currencies and certain asset-backed currencies. The IMF report believes that virtual currencies are a type of digital currencies. The concept of digital currency is broader, and it also includes e-money, which is an electronic payment mechanism expressed in legal currency. The Bank of England believes that unlike traditional sovereign currencies, virtual currencies are not a claim, but should be regarded as a commodity. The difference from physical commodities such as gold is that virtual currencies are an intangible asset or electronic commodity, and their value depends on the users to reach a consensus on the value they represent. From the perspective of the three functions of currency, all countries currently believe that virtual currencies are still difficult to call currency in the usual sense.

Other institutions have some subtle differences with the IMF in the use of the term virtual currency. The report of the Bank for International Settlements (BIS) believes that there is no essential difference between the two terms "virtual currency" and "digital currency". In two reports in 2012 and 2015, the BIS Committee on Payments and Market Infrastructures (CPMI) used the two different terms virtual currencies and digital currencies respectively. In a 2015 report on digital currency, the Australian Senate Economic Advisory Committee held the same view as the IMF, that is, the concept of digital currency is relatively broader, but in the specific use of terms, digital currency and virtual currency can be interchangeable. The reports of the European Central Bank (ECB) and the European Banking Authority (EBA) have always used the term virtual currency and defined virtual currency as a digital representation of value, emphasizing that this value is not endorsed by a central bank or public institution, and is not necessarily linked to legal currency.

At present, the virtual currencies based on distributed ledgers, represented by Bitcoin, have attracted the attention of various countries. This type of virtual currency has three main characteristics. First, virtual currency can be regarded as an asset, similar to gold as a commodity, and its value is determined by supply and demand. However, unlike legal currency, it is not the debt of an individual or institution, nor is it endorsed by an official institution. Second, in terms of value transfer, the value transfer of electronic currency needs to rely on centralized financial clearing institutions. The innovation of virtual currency (such as Bitcoin) lies in the use of distributed ledgers to complete point-to-point value transfer without a trusted intermediary. Third, virtual currency is not operated by any specific institution, but some intermediaries can provide services to virtual currency users, but the services provided by these intermediaries are essentially different from the transaction and clearing services provided by electronic currency issuers.

In the classification of virtual currencies, the IMF, BIS and ECB all believe that the convertibility with currencies of various countries can be used as a classification standard for virtual currencies. Based on this, virtual currencies can be divided into closed, semi-closed and open types. Closed virtual currencies are only used to purchase virtual goods and services within the virtual community and cannot be traded outside the virtual community. Semi-closed virtual currencies can be purchased with legal currency at a certain "exchange rate", but this process is irreversible. Open virtual currencies can be bought or sold at a certain "exchange rate". In this case, virtual currencies are like some real-world currencies, and can be used to purchase both virtual goods and real-world goods and services.

The IMF's recent report also uses "decentralization" as a classification standard for virtual currencies. Decentralized virtual currencies are also called encrypted digital currencies. This type of virtual currency has no centralized issuing and management agency. It is generated through a large amount of calculation based on a specific algorithm, and uses a distributed database composed of many nodes in the entire P2P network to confirm and record all transaction behaviors, and uses cryptographic design to ensure the security of each link in the currency circulation.

Potential risks of the virtual currency system

Virtual currencies have no intrinsic value and are not backed by the central bank. Their prices are easily affected by market expectations, with extremely high volatility and difficult to guarantee market liquidity. The decentralized virtual currency system is based on distributed ledger technology, and has features such as anonymous transactions, free cross-border capital flow, relatively fixed money supply and irreversible transactions, which may bring risks to market participants and the entire financial system. International organizations, central banks and regulators of various countries are generally concerned about this.

The first is the risk of money laundering and terrorist financing . In the virtual currency system, service providers and users are anonymous, and the ambiguous transaction chain makes it easy for criminals to conceal the source and destination of their funds, which facilitates money laundering, terrorist financing and evasion of sanctions. International organizations such as the IMF, BIS, and OECD, as well as regulatory agencies such as the Bank of England, the Reserve Bank of Australia, and the Monetary Authority of Singapore have expressed great concern about the risks of money laundering and terrorist financing related to virtual currencies. A recent IMF report pointed out that the virtual currency system is likely to be used as a channel to evade capital controls, and illegal funds can be used to achieve cross-border flows through the virtual currency system, which poses a challenge to anti-money laundering and anti-terrorist financing.

Second, the risks faced by consumers . The virtual currency system lacks transparency and supervision, which brings a variety of risks to consumers, including but not limited to the following: Settlement risk. The virtual currency system is difficult to manage liquidity. When the exchanger has problems with liquidity management, users may not be able to exchange virtual currency for legal currency. Price risk. Many regulators have pointed out that when the price of virtual currency fluctuates sharply, holders are likely to suffer value losses. System risk. Operational risks such as system failure are borne by financial institutions in traditional payment systems, but in the virtual currency system, they must be borne by users. Intermediary risk. Market participants in the virtual currency system are almost unregulated, and the security of user funds is not guaranteed. Fraud risk. Due to the opacity of transactions, fraudsters set up fake e-commerce transaction websites and exchange the collected virtual currency for the currency of any country without leaving any transaction traces. Legal risk. Transactions in the decentralized virtual currency system are irreversible, and there is no legal framework to clarify the rights and obligations between the parties to the transaction. When fraud, theft, counterfeiting and other incidents occur, it is difficult to determine which party should be responsible for the incident, and consumer rights are not guaranteed.

The third is the risk related to financial stability . Major international organizations and national regulators generally believe that the current market value and transaction volume of virtual currencies are small, and financial institutions rarely participate, and do not pose a systemic threat to financial stability. However, the recent IMF report emphasizes that as the scope and scale of virtual currency use expand, the probability of a single virtual currency system risk evolving into a systemic risk will also increase. In addition, due to the lack of a lender of last resort to provide guarantees for currency stability, once a risk event occurs, virtual currency exchangers are easily subject to a run, which will have an impact on financial stability. The Bank of England pointed out that if virtual currency develops into an important payment system, the individual risks faced by consumers in the system may evolve into systemic risks.

Fourth, risks related to currency stability . The IMF pointed out that the current virtual currency systems do not have the characteristics of a stable currency mechanism. The nearly rigid supply rules of virtual currencies (especially encrypted digital currencies) may cause structural deflation, and there is no public institution in the virtual currency system that can assume the role of the lender of last resort, making it difficult to cope with financial crises. Both the BIS and the ECB believe that if virtual currencies develop to a stage where the user group is wide and transactions are frequent, the central bank's balance sheet may be significantly reduced, and the monetary policy transmission mechanism and policy effectiveness will be weakened.

International Experience in Virtual Currency Regulation

In response to the possible risks of virtual currencies, many international organizations and central banks have publicly responded to the regulatory issues of the virtual currency system. These responses can be roughly divided into four categories: warnings and risk reminders, supervision and registration licenses, legislative regulations, and explicit prohibitions.

Warnings and risk reminders. Some central banks and regulators have issued risk warnings about Bitcoin and the virtual currency system. Germany's Federal Financial Supervisory Authority, the Bank of France, the Netherlands and the Belgian central banks have issued public warnings about the money laundering and terrorist financing that may be caused by the use of Bitcoin. In a report released at the end of 2013, the European Banking Authority (EBA) warned consumers of the many risks of virtual currencies, such as exchange losses, electronic wallet theft, unprotected payments, price fluctuations, etc. Although Spain did not have similar risk warnings, it issued information bulletins related to virtual currencies in a timely manner.

Regulation and registration license. In general, international organizations believe that the regulation of virtual currencies should find a balance between preventing risks and promoting innovation. Sweden has required that transactions related to virtual currencies must be registered with financial regulators since 2012. Other countries focus on qualification supervision, which indirectly meets prudential supervision requirements. Some countries' supervision is mainly aimed at the business model of virtual currency transactions. The French Financial Prudential Supervision Authority regards the provision of Bitcoin circulation and trading services and the act of earning money in the process as a payment service and requires government authorization. Other countries focus their supervision on intermediaries related to virtual currencies. The German Federal Financial Supervisory Authority and the Danish regulator believe that authorization is required to provide intermediary services for virtual currencies.

Legislative norms. At present, some countries have proposed to legislate to regulate virtual currency transactions. Canada is proposing legislation to allow the government to regulate Bitcoin transactions and include transactions with an amount greater than $10,000 in the scope of suspicious supervision. The United States hopes to adjust the relevant legal structure to cope with the development of Bitcoin. In order to make the Bank Secrecy Act (BSA) applicable in the context of the Internet, the Financial Crimes Enforcement Network (FinCEN) of the U.S. Treasury Department issued interpretative guidance on the behavior and subject definition of private generation, holding, distribution, trading, acceptance and transmission of virtual currency in 2013. The European Central Bank emphasizes that international cooperation under the existing legal framework should be strengthened, and virtual currency should be regulated under the existing legal system framework at the European and global levels. More countries believe that Bitcoin is not a circulating currency, has no legal status, and does not meet the definition of a financial instrument, such as Finland, Sweden, Malaysia and Indonesia.

Explicitly prohibited. In some countries, transactions related to Bitcoin are prohibited. In December 2013, the People's Bank of China banned financial institutions from conducting Bitcoin transactions, and the above ban was subsequently extended to payment service providers. The central banks of Thailand and Indonesia also hold the same attitude. The circulation of anonymous online currencies (including Bitcoin) is regarded as a substitute for currency by the Russian judicial inspection department and is prohibited. The Central Bank of Russia has already included the provision of Bitcoin services in the scope of monitoring suspicious transactions. The U.S. Securities and Exchange Commission (SEC) prohibits the issuance of unregistered stocks in exchange for Bitcoin and prohibits unregistered online securities trading activities denominated in virtual currencies.

Author: Wang Xin (President of Nanchang Central Branch of the People's Bank of China)