(Yicai Global) Sept. 13 -- China last week unveiled hefty measures aimed at supervising virtual currency issuance and trading, making it the first country to completely ban initial coin offerings (ICOs) and terminate virtual currency trading, which will undoubtedly affect the direction of worldwide regulatory policies.
Six major government agencies, including the central bank, issued the Notice on Preventing Risks in Token Issuance Financing on Sept. 4, giving early indication that virtual currency exchanges could be shut down. According to the notice, the tokens or virtual currencies used in token issuance financing are not issued by monetary authorities and do not have monetary attributes, meaning they are not legal tender and should not be circulated as currencies.
It also states that from the date of issue, any token financing platform should not engage in the conversion of legal currency and tokens or virtual currencies, nor shall they buy or sell tokens or virtual currencies for their own benefit or as a counterparty of the central bank. They may also not provide services, such as pricing, for tokens or virtual currencies.
With the policy in place, Chinese regulators need to actively follow up and provide solutions for a number of problems. The first is to find a safe way out of this difficult situation, i.e. figuring out how to phase out tokens and properly handle trading platforms and investors. The second, which this article discusses, is to work out how to utilize global economic financial governance platforms to push coordination for worldwide regulation.
What Is a Virtual Currency?
On June 12, Yicai Global published an article titled Why Is Supervision Over Digital Currency Necessary?, which became a big topic for discussion. Perhaps the definition of a “digital currency” (of which a virtual currency is one type) was still being discussed in academic circles at that time.
However, now the ICO regulatory policy is in full swing, it’s important to define the nature of virtual currencies and clarify regulation direction accordingly. Different countries have different policies over such currencies, so it’s necessary for us to push for the establishment of a set of regulation principles, or best practices, on a global level to prevent regulatory arbitrages between countries. This is a contribution that China should make to global financial governance.
So how should we define a virtual currency? A paper by the International Monetary Fund suggests that it is one type of digital currency. At present, the value of virtual currencies relies on a consensus agreed to by users. Such currencies are issued by private institutions and use their own accounting units. Examples include cryptocurrencies, the best known being bitcoin, and other asset-backed currencies, as well as e-coupons, air miles, etc., with which we are quite familiar. The definition for digital currencies is even broad, and includes e-money, such as electronic payment mechanisms for legal tender.
In terms of characteristics, virtual currencies share some properties with currencies, commodities, assets and payment systems. Based on Yicai Global’s June 12 article, judge four functions of currency -- a medium of exchange, accounting units, a stored value, a standard for deferred payment -- which means virtual currencies are not ‘real currencies.’ At present, virtual currencies are partly qualified as a medium of exchange (often in illegal trading), but perform poorly in terms of accounting units. In trade, they are used more for payment than for pricing (which is again true in illegal trading). With regard to the stored value, sharp rises and hasty declines are very common. There are also no major debt contracts that use virtual currencies as a repayment model, meaning there is no standard for deferred payments.
However, not every country looks at virtual currencies the same way. The UK considers virtual currencies as private currencies, whereas Japan and some American states define them as legal currencies. Other US states deem them digital currencies or bulk commodities, Switzerland sees them as non-securities assets and Singapore defines them as assets.
Huge Risks and Potential Threats
Not all countries may agree on how to define a virtual currency, but the ICO chaos in China has clearly revealed the vast size of the market and the social risks of such currencies.
The first risk is the bubble and social risks. Economist Robert Shiller used behavioral finance to analyze bitcoin’s surge in a recent interview, and believes this is a bubble typical of the digital era.
Second comes the risk of breeding large-scale networked crimes. In our earlier article, we described at great length the uncontrollable dark web, where crimes, drugs and terrorist transactions take place with bitcoin used as a payment method. The Federal Bureau of Investigation shut down Silk Road, a notorious black market, in June 2013. The website had turned over more than USD1.2 billion in bitcoin, at its then value, with more than 150,000 anonymous users and around 4,000 suppliers. Four years on, the number of undiscovered dark markets online is still unknown.
The third significant risk concerns money laundering and terrorist financing. Service providers and users are anonymous in the virtual currency system, and an opaque trading chain enables criminals to easily cover up sources of funding and investment, which the IMF believes facilitates money laundering, terrorist financing and the evasion of sanctions. This can boost the cross-border movement of illegal funds through virtual currencies, challenging efforts to reduce money laundering and terrorism funding.
There are also many potential risks and threats related to macro-policy. As virtual currency does not have intrinsic value or the endorsement of a central bank, its price is highly vulnerable to market expectations and subsequently highly volatile. Its market liquidity is hard to guarantee and based on distributed ledger technology, this decentralized virtual currency system features anonymous transactions, multinational free flow of funds, a relatively fixed currency supply and irreversible transactions. These present risks for market participants and the entire financial system. The IMF paper identified the following risk categories:
Risks faced by consumers (investors) stemming from the lack of transparency and the absence of regulation in the system. These include risks related to settlement price, intermediaries and fraud.
There are also risks financial stability-related risks. With the expansion of the scope and scale of virtual currency use, the possibility of systemic risks developing in a single virtual currency system also increase. Given that the various virtual currency systems do not exhibit characteristics of a stable monetary mechanism, near-rigid supply rules may result in structural deflation. When this is coupled with a lack of a final lender to provide protection for monetary stability, it can lead to a run on virtual currency money changers and impact financial stability when there is a risk event.
From a financial point of view, tax evasion is also a major risk facing the macro-sector.
Lastly, there are risks in terms of cross-border capital flow management and monetary policy effectiveness, impacts from virtual currency will be self-evident once the scope and size of its use reach a certain extent nationally and globally.
Many countries have tried to regulate the virtual currency system in view of these risks. The regulatory attributes can be divided into several categories: risk warning, registration permits, legislative regulation, and prohibition by official order.
How Can the World Coordinate Regulatory Efforts?
Current regulatory measures taken by each country (see table 1) are far from sufficient to combat the associated risks. One key challenge of such policies is the difficulty of defining a virtual currency, which makes it hard to determine applicable laws. It is also difficult for regulators to collect statistical data and monitor the operations as virtual currency transactions are conducted anonymously. All countries lack effective means to regulate cross-border virtual currency transactions, while a non-centralized cryptocurrency conflicts with the current centralized regulatory framework, and the designation of a specific regulator remains a problem.
Nonetheless, global coordination for virtual currency regulation is set to happen in the near future, and China should work actively to drive regulatory reform globally. China's stringent measures may not apply to other countries, as there are diverse national conditions and market impacts globally, but it is still a top priority to establish supervisory measures or best practices for global collaboration. China should vigorously promote an international platform to reach a consensus in the following regulatory aspects:
The G20 and organizations related to international standards (IMF, Bank for International Settlements, Financial Stability Board) should accelerate the development of guidelines or best practices since the virtual currency extends beyond national borders.
It is crucial that efforts made to combat risks related to virtual currency-based money laundry and terrorism are designated a standard practice for regulation among all countries.
The promulgation of a defined tax system is also necessary in order to avoid regulatory arbitrage, and it should be followed by all countries.
The promotion of traceability and transparency should be high on the regulatory agenda as part of counter measures against the use of virtual currency as a medium of exchange within the Dark Web. The EU has already set out non-anonymous transactions as a regulation target for all countries in the future.
Virtual currency-based cross-border transactions are becoming an effective measure to circumvent foreign exchange regulation. Countries and economies with partially opened capital accounts should prohibit anonymous transactions, and strengthen regulations on the use of the virtual currency.
The G20 should encourage each country to establish a unified licensing system for virtual currency exchange, and achieve global coordination in terms of regulation. The G20 could even prohibit trading or close the exchanges in extraordinary circumstances.
Finally, regulation should not lead to restrictions on the development of blockchain technology, which is based on distributed ledger and has its own technical advantages. It is expected that distributed accounts will be widely applied in the future in applications such as bill exchanges, stock trading and property rights transactions. Blockchain is still its infancy stage of experimentation and exploration. It is not as versatile as originally thought and has no clear advantage for block trading, netting and risk measurement. Problems such as capacity scalability and ex-post status without recourse restrict it from reaching further popularization and applications.
Regulation on virtual currencies is beneficial to the healthy growth of blockchain technology in the financial sector, not the other way around.
(The writer is the deputy editor-in-chief of Yicai Media Group.)
Annex. Policy Responses to Virtual Currencies— Selected Countries
Jurisdictions have taken different approaches towards mitigating the potential risks of VCs and regulating VC-related activities. Following the Regulatory and Policy Challenges section, this Annex considers responses by selected jurisdictions that illustrate this divergence in approaches.
The information gathered in the Annex includes readily available information from public sources and does not necessarily reflect all actions taken by any given jurisdiction.