State of the Chinese Regulations and Industry Insights from the Leading Chinese Legal Practitioner

China has a long tradition of blocking unwanted foreign websites by using the so-called Great Firewall of China. This time, the country is reportedly moving to block domestic traders and investors from accessing websites that offer cryptocurrency trading services or ICOs. The move comes months after China formally banned both initial token offerings and cryptocurrency exchanges in September 2017 and appears to have an intention of closing off some channels for private trading, which continues via social-messaging apps and foreign websites.

“ICOs and virtual currency trading did not completely withdraw from China following the official ban […] Overseas transactions and regulatory evasion have resumed […] Risks are still there, fuelled by illegal issuance, and even fraud and pyramid selling,” said an article published on February 4th by the People’s Bank of China-affiliated Financial News.

Taking into account the recent news and developments in the Chinese market, Tamar Menteshashvili of lawless.tech approached David Hong, a leading legal practitioner in China with a purpose to discuss the legal perspective of blockchain technology and crypto economy as well as the latest regulations implemented by the Chinese authorities. David is a Senior Foreign Legal Consultant at King & Wood Mallesons. Being a juris doctor from Georgetown University, he mainly focuses on foreign direct investments, M&A, technology, and telecommunications.

TAMAR: As a lawyer, what potential do you see behind blockchain technology?

DAVID: I see blockchain as a revolutionary technology on par with the internet or email. I think it will disrupt many industries. What we have seen with Uber and Airbnb, where the transactions are generally peer-to-peer, but the companies serve as trusted third-party intermediaries to ensure against counterparty risk, is the beginning of what blockchain will be able to do. Instead of depending on a trusted third party, users of blockchain technology can depend on pre-programmed computer code, thereby reducing human error or bias and third party cost.

Furthermore, the idea of a decentralized immutable ledger also democratizes many networks, gives power back to consumers/users, and prevents fraud. I see the current ICO and the variations that will inevitably enter the market (e.g. Air drops, IEOs, DAICO) as a new form of early stage capital raising. Traditional startup investing generally requires large investments and certain minimum requirements for the investors, limiting the pool of possible investors, while the current ICO process allows almost anyone to participate. It seems to be the natural progression of crowd-funding, whereby consumers not only provide monetary support for projects they find interesting and worthwhile, but can also receive a benefit other than a t-shirt or a limited edition product. As the technology develops to resolve current issues, such as scalability, there really is no limit to what blockchain can accomplish.

TAMAR: The attractiveness of the technology has gathered significant attention in legal circles. How are lawyers involved in the process? What type of clients do you serve and what type of legal services are in greatest demand in the blockchain sector?

DAVID: Most lawyers are conservative in nature and are slow adopters of technology. Currently, legal work is generally limited to regulatory/licensing regimes, particularly for exchanges as many projects operate out of less regulated offshore jurisdictions, and tokenization. We are currently advising on dozens of ICOs. We generally advise on the structuring as well as the utility aspects of tokenization to ensure that the tokens would not be deemed as securities; however, in certain jurisdictions (e.g. the United States), the regulations are broad enough to determine almost any token as a security. Recently, we’ve been advising more and more on post-ICO implementation, particularly on custody of the capital raised for new projects.

As an innovative law firm, we have experts across the globe working in the blockchain space. In Greater China, Molly Su and Janet Gu are our crypto-experts on the mainland advising on the regulatory regime and marketing issues and Urszula McCormack in Hong Kong is our expert on tokenization, structuring, and post-ICO implementation.

I see significant opportunities for law firms in providing the oracle function for many projects. Given the limitations on blockchain technology, many data-intensive projects operate on an off/on chain protocol to limit the data requirements. As such, third party oracles are required to input outside information into the blockchain and will eventually be required to resolve disputes which will inevitably pop up as more complicated smart contracts arise. I believe lawyers and law firms are uniquely positioned to serve the oracle function of many such projects.

TAMAR: Do you think there is a growing need of crypto economy regulations?

DAVID: I believe the crypto/digital asset class is in dire need of regulations and protection. If you compare the recent losses due to hacking in the traditional banking space and with digital assets, the digital asset space is significantly higher with much lower market capitalization. Furthermore, investors have quite a limited recourse if exchanges are hacked and are dependent on the exchange to compensate them; however, in many cases, such as Yobit at the end of 2017, the exchange goes bankrupt. It is also nearly impossible to determine if a security breach was due to a hacker or due to an unscrupulous insider at the exchange. Most recently, the European exchange BitGrails halted withdrawals for XRB/NANO from non-EU traders and required them to be exchanged into Bitcoin for withdrawals. They blamed it on new KYC requirements, but it still doesn’t make sense that XRB owners could not just withdraw their tokens. The price of XRB tumbled during this time and shortly thereafter, it rebranded from RaiBlocks to Nano and the token bounced back significantly, leaving many investors selling at a loss to take custody of their digital assets.

Furthermore, XRB was listed as the Binance “Community Coin per Month” in January and was expected to be listed on Binance. All of this information makes the entire BitGrails ordeal quite suspicious. I do believe the exchange operators eventually gave in and allowed withdrawal of XRB after the community was up in arms; however, much of the damage was already done and had they decided not to, investors were again left with little recourse.

I think the majority of the crypto-community wants new regulations to legitimize this market. However, it is difficult for governments to keep pace with innovation and so it may fall to the community itself to take measures to protect investors. There are many new projects that focus on this area. These projects include decentralized exchanges to mitigate the risk of a single point of weakness for hacks or unscrupulous exchange operators; peer-to-peer insurance to insure crypto assets or other credit events such as a failed ICO; and even new models such as the DAICO, which allows funding over time, to limit the risk of ICO sponsors running off with all the money after a capital raise.

TAMAR: The regulations in which fields of law (if any) do you see as a necessary prerequisite for the sustainable development of the blockchain industry in 2018 on a global scale?

DAVID: I think in 2018, the two biggest challenges to the crypto-asset class are (1) stopping scam projects from proceeding and (2) ensuring the security of exchanges.

Legal protections need to be implemented to prevent such scam projects. With the ICO model as a new model for fundraising, there are many scammers trying to cash in by using buzzwords, copying entire sections of technical details, and issuing white papers to raise capital with no intention of implementing the proposed product. There are many projects on the market that have recently faced issues, and the lack of transparency in their operations is a risk to investors. Tether was supposed to be a “stablecoin” with a direct 1-to-1 backing of USD per Tether coin (USDT); however, it was subpoenaed last December by the CFTC and it has long been speculated that there was no 1-to-1 backing of USD.

There are also many pump and dump projects out there. Tron regularly claims to have announcements upcoming in order to pump up the price and these are usually non-announcements with very little value or content, which are subsequently followed by significant open market token dumps. Furthermore, the white paper provides very little technical detail or implementation and there are rumors that entire portions have been cut and pasted. With a 14 billion USD market cap at the end of last year, it has done quite well for a company with no project or launched product.

Security of exchanges is a major concern as the largest hack in crypto-history happened in January with Japanese exchange Coincheck. Coincheck was not a properly registered exchange. The Japanese regulators warned it, and shortly afterwards it lost over $500 million in a hack. Furthermore, exchanges are currently the highest revenue-generating and most active sector in the crypto space. With volumes approaching traditional equities exchanges and sizeable transaction fees, exchanges are printing money.

It’s no wonder that Coincheck claims to be willing to compensate investors to the tune of over half a billion USD — they’ve already made at least this much money running their exchange. As such, there have to be some regulations for exchanges, similar to banks which hold other people’s money. There are many security features that can be implemented, including the requirement to hold certain amounts in “cold storage” and using multisig technology for “hot wallets.” Proper capitalization, transparency, risk-management, and security auditing should be required for all exchanges on the level of banks.

I think the recent SEC/CFTC hearing was the best that the crypto-community could hope for. The regulators said this new technology is likely to become a game changer, and regulations have to be in place to protect users without stifling innovation.

TAMAR: What legal considerations should be kept in mind when operating or just now entering the blockchain industry in the Chinese market as a startup?

DAVID: China is a tricky market. In our opinion, the key issues here are foreign exchanges and illegal fundraising. The Chinese government has legitimate concerns to ensure that foreign exchange is controlled and that there are restrictions on RMB being converted to crypto — otherwise this would allow circumvention of the country’s foreign exchange regulations. Furthermore, the Chinese government will wish to protect Chinese citizens from unscrupulous people taking advantage and illegally raising funds for fake or non-viable projects.

As of now, crypto exchanges have been banned and so has promotion/marketing of ICOs. As such, you cannot undertake any promotion activities onshore in China. Even if your blockchain project is divorced from an ICO, there is still risk as the association between the same is so strong.

One new interesting thing I’ve seen that projects should be aware of is providing multi-levels of rewards in the form of bounties for investor referrals — like multi-level marketing. Under Chinese law, only one-level of commission is allowed to be paid. Anything beyond the first level of commission would be considered an illegal pyramid scheme in China. Granted, ICOs and related marketing are banned in China, this is another concern that project sponsors should be aware of when structuring their bounties.

TAMAR: How would you evaluate the regulations already in place in China?

DAVID: From a personal perspective, I believe the regulations are intended to stem the current mania around getting rich overnight in crypto. The Chinese government is taking steps to protect the Chinese people and ensure their lives are getting better.

I believe new regulations with stricter guidelines will be implemented because China is currently a hotbed for blockchain and crypto. I see this crypto-revolution as an opportunity for developing countries to usurp the established financial institutions of the West. As such, I believe the Chinese government will eventually embrace blockchain and crypto once they can work out policies that can allow the development of the technology to flourish but be balanced to ensure investors/consumers are protected from scam projects.

TAMAR: What do you think will be the role and impact of Chinese regulations on the development of the blockchain sector in 2018? Are there any upcoming regulations in China that you are aware of that needs to be kept in mind by those in the industry?

DAVID: There will always be rumors about China imposing more regulations, but I never give much credence to them. In 2015, the new draft foreign investment law was released. Many anti-China authors claimed this spelled the doom of foreign investment in China, it would kill the VIE structure, and the sky was falling. None of these things happened. The draft foreign investment law has not even been implemented nearly 3 years later. As stated in my answer above, I think China will embrace blockchain and cryptocurrency. China is a global hotbed for this technology, and it is a revolution that will upend many traditional industries, which are all to the advantage of China.

Even the rumors of mining ban are overstated in my opinion. I often use the analogy of gold mining. China, as the top Bitcoin miner in the world, is essentially utilizing its electricity to generate assets — digital gold — to sell on the global market. We believe the proposed ban fits under the current push towards anti-graft and corruption as many of these mining operations have agreements with local governments which provide access to subsidized electricity, and then some of the money will disappear and a local official will be driving a Lamborghini.

TAMAR: According to the recent reports, China has gone a step further in effectively constructing a firewall to keep domestic traders and investors from using websites of international cryptocurrency exchanges. Where is the crackdown targeted and what is the reasoning behind it?

DAVID: I think this is the natural step for the PRC government. I still believe the two main issues being controlled here continue to be foreign exchange and illegal fundraising — focusing on limiting speculation. A key issue raised about cryptocurrency, particularly Bitcoin, is that it has no intrinsic value — I would counter, and ask for the intrinsic value of a USD. The value of the asset is based purely on market demand and what people perceive its value to be (I understand some people believe it should be valued like a commodity). As such, it has unlimited speculation potential, which I believe is an issue for the Chinese government. Gambling is banned in China, and my belief is that buying cryptocurrencies is more akin to speculation than it is to investment. There aren’t fundamentals such as PE ratios or EBITDA to determine the value or health of a cryptocurrency like Bitcoin. Furthermore, many projects are at the nascent stage and are mostly an idea with no actual finished product and therefore, with no revenue generation, it’s still very much speculation.

I do not believe the crackdown is targeted towards experienced traders/investors but rather the general population, which has limited understanding of this new asset class and is easily scammed. Back in 2015, the Chinese stock market was exploding and everyone in China was throwing money at it. My maid was telling me about a Shenzhen company she invested in on the advice of one of her friends. I asked her what the company does, and she responded, “I don’t know, but it has technology in its name.” These are the types of investors that the Chinese government aims to protect because they are not sophisticated enough and are easily tricked. When the market crashed, people committed suicide because they took out loans to invest, expecting unlimited gains. The Chinese government is keen to prevent the social unrest that would come from millions of unsophisticated Chinese investors being duped by a scam project or not understanding that Bitcoin drops 40% or more not infrequently.

I think many of the regulatory moves globally are the right moves to help bring this market into legitimacy. More regulations are required to protect investors. I saw that many banks are preventing people from buying crypto with credit cards, which is great — people should not be speculating with money they don’t have. Ultimately, crypto buying is more speculation than investment, but that is the case with most early stage investments. By democratizing early stage investment, there is now a need to protect new speculators with tighter regulatory controls.

Ultimately, my Coinbase, Binance, and blockchain wallet apps still work. There have been announcements that VPNs would be banned at least a dozen times, but many VPNs still work. Should the ban be actually implemented, sophisticated traders will find ways to access offshore exchanges.

Conclusion

As it seems, there are grounds to stay very optimistic that developments in the financial technology field will, in a long run, help facilitate capital formation, providing promising investment opportunities for institutional and retail investors alike. What we are undoubtedly witnessing is the cryptocurrency and ICO markets, while new, growing rapidly, gaining greater prominence in the public conscience, and attracting significant capital from the investors.

This recent proliferation and subsequent popularity should create a question for all the market regulators on a global scale, including China, as to whether their historic approach to the regulation of sovereign currency transactions is appropriate for these new markets.


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