By Mark Schaub and Molly Su King & Wood Mallesons‘ Shanghai office.
For much of its short history, Bitcoin’s turbulent growth has remained relatively unbridled by regulations or laws. The past 12 months have been no less explosive—investors in Bitcoin have enjoyed the cryptocurrency’s greatest period of growth since its inception in 2009. At its peak on the 11th of August this year, 1 BTC reached 4425.30 USD, a sevenfold increase on the same day the previous year. 1 BTC has since dropped to 4,210.94 USD at the time of writing.
Many jurisdictions are now establishing regulatory frameworks to deal with the risks of cryptocurrency, and these have the potential to significantly limit the way cryptocurrencies are purchased and traded. This regulatory reform, ranges in intrusiveness, from simple record-keeping requirements to strict licensing regimes, like the BitLicense scheme implemented in New York. Recently, China is looking to more tightly regulate Bitcoin; however, as of now, the only Bitcoin related regulation in China is the Circular of the People’s Bank of China, Ministry of Industry and Information Technology, China Banking Regulatory Commission, China Securities Regulatory Commission, and China Insurance Regulatory Commission on the Prevention of Risks from Bitcoin (《中国人民银行、工业和信息化部、中国银行业监督管理委员会、中国证券监督管理委员会、中国保险监督管理委员会关于防范比特币风险的通知》) (“2013 Circular“) promulgated in 3 December 2013.
In many ways, these new laws are beneficial to the development of the technology. But they also stand to radically change the way Bitcoin is used. Changing rules call for a changing approach by Bitcoin investors, particularly for those based or interested in China.
Regulation so far has largely come in either one of two forms. The first of these, and more widely implemented, is aimed at reducing the risks arising from Bitcoin’s anonymity: record-keeping and licensing requirements for Bitcoin exchanges. This was spearheaded in 2014 by the Monetary Authority of Singapore (MAS). It introduced regulations requiring Bitcoin exchanges and vending machines to verify customer identities and to report suspicious use, in line with rules that are already in places for traditional currency exchanges. Last year, MAS proposed rules requiring Bitcoin exchanges to register, though such rules are yet to be enacted.
In Japan, in February of this year, 3 years after the collapse of the world’s then-largest Bitcoin exchange, Mt. Gox, regulations were passed imposing significant requirements on Bitcoin exchanges, including registration with the Prime Minister and possessing collateral of at least 10 million yen.
The state of New York has implemented the harshest example of licensing requirements so far. In New York, all businesses carrying out ‘virtual currency business activity’ must obtain a so-called BitLicense. The move saw many Bitcoin companies cease operations in New York altogether. Only three BitLicenses have been awarded so far, to Circle, Ripple and Coinbase.
The second category of regulation has been the issue of whether cryptocurrencies constitute securities, and are therefore subject to their rules. This has been the central focus of the United States. Weeks ago, the Security and Exchanges Commission decided that DAO tokens, tokens purchased in a specific Initial Coin Offering (ICO), were securities for regulatory purposes. The decision was made on the basis of the ‘Howey Test’ which, at its simplest, says that where investors invest money in a product with a reasonable expectation of profit arising from the managerial efforts of others, the product constitutes a security, and is thus subject to regulation. As a proposed cryptocurrency venture capital fund, DAO was a special case, and whether the SEC ruling extends to other ICO tokens depends on the nature of the individual ICO. Tokens purchased in an ICO for a proposed video game, for instance, would likely not qualify, since profits would arise from increase in market value as opposed to direct management. MAS seems to be moving towards the same view of regulation, stating on 1 August 2017 that the offer or issue of digital tokens in Singapore will be regulated by MAS if the digital tokens constitute products regulated under the Securities and Futures Act.
Regulation in China
A significant share, once the vast majority, of Bitcoin is traded in Chinese Renminbi. In recent times, Bitcoin has acted as a reflection of Chinese market sentiment amidst continued intervention by the government in the Renminbi exchange rate and capital controls. As an asset with very high liquidity, this reflection was amplified on Bitcoin trading charts. Indeed, shortly after the State Administration for Foreign Exchange (SAFE) imposed new reporting requirements on owning foreign currency, making it harder to exceed the annual quota of 50,000 USD per person, there was a significant rally in the Bitcoin price. There is no doubt that the value of Bitcoin was closely tied to goings-on in Chinese finance (and still is, though to a lesser extent).
2013 Circular states that Bitcoin should be regarded as a specific virtual commodity, does not have the legal status of currency, and all financial institutions as well as payment institutions are prohibited from providing services including clearing and exchange relating to transactions involving Bitcoin. 2013 circular also emphasizes the importance of anti-money laundering risk, and the platforms providing Bitcoin registration and trading service shall be subject to the anti-money laundering regulations. However, it is important to note that China has not taken steps to explicitly prohibit PRC citizens or institutions from owning Bitcoin. In fact, there are rumors that the People’s Bank of China (PBOC) is testing and in development of its own cryptocurrency.
This highly liquid, highly volatile financial market, which offered a potential shortcut to Chinese capital controls, was the impetus for China to begin regulating Bitcoin. In early February of this year, China’s three major Bitcoin exchanges, Huobi, OKCoin and BTCC, froze all Bitcoin withdrawals, pursuant to an investigation by the PBOC for an indefinite period. They only unfroze three months later, on the 1st of June, having updated internal compliance systems.
Prior to the investigations, the exchanges enjoyed success charging zero fees on transactions. It was recently revealed that, during this period, the companies were investing idle funds into wealth management products. In retrospect, this was a high-risk strategy that could have caused losses of Mt. Gox proportions.
Now, these services limit cash withdrawal amounts, require registration with Resident Identity Cards and charge a flat rate of 0.2% on all exchanges, in line with guidelines from the PBOC.
It seems likely that the PBOC will impose anti-money laundering and so-called KYC requirements, following in the footsteps of the likes of Singapore and Japan. Indeed, Xinhua recently published an article urging regulators to keep pace with new developments in cryptocurrency and to shut down questionable Bitcoin exchanges. Evading foreign exchange administration in China is another risk arising from Bitcoin trading and may be placed under the scrutiny of PBOC and/or SAFE.
The opportunities with Bitcoin remain ample, as is demonstrated by its sustained growth. (Some of the most optimistic commentators have stated the value will rise above 6,000 USD.) This is occurring alongside the continuous creation of new and derived cryptocurrencies, as was recently demonstrated by Bitcoin’s hard fork, which created ‘Bitcoin Cash’. Moreover, developers are continuing to find novel uses for blockchain technology as a whole.
Regulation should be seen as an opportunity, too. More stringent rules translate to lower investment risk and increased legitimacy. Investors in cryptocurrencies, particularly ICO tokens, will likely be afforded some level of legal protection on their investment in certain jurisdictions. Start-ups, too, stand to gain from regulation as a means to build trust amongst an increasingly skeptical pool of investors. Indeed, the perceived legitimacy of the blockchain system as a whole seems to be on the rise, earning clout with institutions as large as the Bank of England, which signed up to participate in the Hyperledger project in March.
Regulation should also be seen as a way to stabilize the extreme volatility of the currency by making it harder for speculators to instantaneously purchase and liquidate Bitcoin on a whim. This will also open the door to more risk-averse investors.
On top of these, there are opportunities specific to China, which looks poised to continue its role as a global hub for Bitcoin. Between Hong Kong and the mainland, it hosts some of the world’s most established Bitcoin exchanges as well as significant infrastructure for Bitcoin mining, which generates 70% of the world’s Bitcoins. Moreover, the trend of China-based cryptocurrency startups is only going to increase, as the government continues to incentivise a burgeoning ‘Silicon Valley in China’. Recommendations have also been made by PBOC officials to foster a ‘regulatory sandbox’ for blockchain innovation. That is, an ICO-inclusive market with minimal intervention bounded by some basic regulations such as Singapore-style KYC rules.
Cryptocurrencies continue to bring a variety of risks to investors. The sheer variety of potential uses for blockchain technology is a double-edged sword. Increasingly, businesses are turning to blockchain as a panacea to a variety of database issues, or as a part of a marketing strategy to appear more modern. In reality, blockchain technology is a system with high energy costs and a narrow scope of uses. Lacking the need for a single database with multiple writers and no trusted intermediary, many companies are better off employing a traditional relational database. Investors should beware of start-ups touting the use of blockchain where, in fact, it adds cost and does not increase efficiency.
Furthermore, companies looking to maintain environmentally-friendly policies should also be aware of the significant energy costs of maintaining a blockchain system, as well as increasing public awareness of it.
The volatility of Bitcoin and other, smaller cryptocurrencies continues to be a risk. Even with regulation, the digital nature of cryptocurrencies means they will also be more liquid than physical currencies or ‘real’ assets.
Also, the new rules concerning Bitcoin stand to limit its uses. One focus of regulation, particularly in the Unites States, appears to be cryptocurrency products that seek to incorporate elements of traditional financial assets. These include the DAO token, which aimed to be a cryptocurrency venture capital fund, as well as the attempt by Winklevoss Capital to list an Exchange Traded Fund on the NYSE that tracked the price of Bitcoin, which was blocked by the SEC. Investors should be wary of these.
Considering risks unique to China, some commentators have suggested that the newly-created ‘Bitcoin Cash’ is an attempt to create a Chinese version of Bitcoin. The larger block sizes of Bitcoin Cash pose a significant advantage to industrial-scale mining operations. Indeed, Jihan Wu, the creator of Bitcoin Cash is also the manufacturer of the ‘AntMiner’ mining device. At any rate, a pivot by the Chinese market to Bitcoin Cash may result in the loss of a significant driving factor for the growth of Bitcoin.
Moreover, Bitcoin in China remains largely unregulated, at least for the time being. The nearly-catastrophic move by Huobi and OKCoin to invest idle client funds into wealth management products should be closely considered as an example of the potential losses to be incurred in the Chinese Bitcoin market.
Regulation in China has started, however, and will continue. This poses risks for investors. For instance, Bitcoin was once seen as a potential “golden ticket” to bypass China’s increasingly harsh capital controls on getting money out of the country. Following the PBOC investigation earlier this year, using Bitcoin as a means of repatriating funds will be throttled, at best. Users and investors in China must consider the very high possibility of the PBOC imposing further regulations on cryptocurrencies, both expected and otherwise. Financial laws in China are strict, and penalties are harsh. Another factor that may affect Bitcoin investors is further restriction on Bitcoin trading that may be imposed by the Chinese regulators. During the NPC & CPPCC in 2017, Mr. Zhou Xuedong, the Director of Business Administration of PBOC, proposed a bill for establishing a negative list with respect to the business activities that should not be conducted by a Bitcoin trading platform. Furthermore, the Legal Affairs Office of the State Council issued the draft regulation on the penalty of illegal fund-raising activities, stating in its Article 15 that the department dealing with illegal fundraising shall conduct an illegal fundraising administrative investigation when any such acts are found and explicitly mentioning virtual currencies in this draft regulation. As such, there is the risk that issuing or trading in Bitcoins (particularly relevant to the ICO market) may be deemed and sanctioned as illegal fundraising.
 24 August, 2017