Central Finance Professor: Establish a Long-term Mechanism to Regulate the Chaos of Virtual Currency Trading

Original Title: "Research on the Legal Regulation of the Chaos in Virtual Currency Trading" Author: Deng Jianpeng, Professor at the Law School of Central University of Finance and Economics, Co-Director of the Financial Technology Rule of Law Research Center Source: People's Forum

The issuance and trading of virtual currencies are important applications in the field of blockchain finance. However, relying on the underlying technology of blockchain, they have issues such as anonymity, no entry barriers, and lack of scrutiny on the legal source of funds, which pose significant compliance risks. Decentralized financial application projects based on blockchain lack clear legal entities, creating obstacles for regulation. Therefore, regulatory agencies should strictly enforce the law based on the spirit of the rule of law and promote compliance construction in blockchain finance on one hand, while on the other hand, they should assess how to enhance the regulatory capacity of decentralized finance in the future, effectively constraining code development teams and venture capital institutions.

Blockchain is a new technology supported by distributed databases, peer-to-peer transmission networks, and asymmetric encryption algorithms. The issuance and trading of virtual currencies are significant applications in the blockchain finance sector, and virtual currencies issued based on blockchain technology have attracted considerable attention in recent years. Particularly since the second half of 2020, due to the halving effect, the market price of virtual currencies, represented by Bitcoin, has rapidly increased. At the same time, decentralized finance (commonly referred to as "DeFi") has launched various "liquidity mining" projects claiming high returns; concerns over the devaluation of the dollar due to the massive issuance of dollars by the Federal Reserve in response to the pandemic have led some investment institutions in Europe and the United States to heavily invest in mainstream virtual currencies; and some well-known figures in the high-tech sector abroad have promoted specific virtual currencies, all of which have contributed to the further surge in the prices of mainstream virtual currencies in the first half of 2021. The rapid wealth effect has led many domestic "retail investors" to rush into the market, resulting in a high concentration of financial risks.

In recent years, various investment and wealth management products based on virtual currencies launched by some trading platforms have often lacked appropriate investor control. Virtual currencies are not anchored to real-world assets, and their price fluctuations are closely related to investor consensus, future expectations, and emotions. Therefore, the dramatic rise and fall of virtual currency prices are often the norm. Moreover, many virtual currency exchanges are foreign legal entities, far removed from Chinese financial regulatory agencies, and these exchanges often provide high-leverage spot and futures trading to a large number of investors lacking risk tolerance, allowing them to go long or short in the virtual currency market. However, virtual currency prices can easily fluctuate dramatically due to various news events, especially smaller market cap coins that are particularly susceptible to manipulation by large players, who can easily control the trading prices of certain virtual currencies or even the entire contract trading market, turning many uninformed retail investors into "leeks" harvested by large players and trading platforms. During the dramatic price fluctuations of virtual currencies, many retail investors have repeatedly faced liquidation. For retail investors lacking extensive high-risk investment experience, "rushing into the market" can easily turn into a nightmare. Since the first half of 2021, several extreme risk events have occurred domestically, resulting in individuals losing everything due to engaging in high-leverage virtual currency futures trading. The frequent liquidation risks in the virtual currency trading market may impact traditional financial markets, undermine the stability of China's financial market, and subsequently affect national financial security.

Furthermore, prior to the first half of 2021, China's Bitcoin mining machines accounted for over 70% of the global computing power, bringing enormous wealth to "miners." "Mining" refers to the process of using dedicated computer nodes to compute the correct answer to a random hash function for the Bitcoin system to compete for the bookkeeping rights of blocks, thereby earning Bitcoin rewards. The Bitcoin system utilizes human self-interest (obtaining Bitcoin as an economic incentive) to achieve altruism (operating and maintaining the Bitcoin system, enhancing system security). Individuals or institutions running these network nodes are commonly referred to as "miners," and these computing nodes are "mining machines." To increase computing power and enhance the probability of competing for Bitcoin block bookkeeping rights, thousands of "mining machines" have clustered together in recent years, forming super-large "mining pools." However, Bitcoin "mining machines" consume vast amounts of electricity, and many mining pools relying on thermal power generation cause significant carbon emissions and air pollution. Against the backdrop of carbon peaking and carbon neutrality policies, China's regulatory authorities are deeply concerned about the high energy consumption issues brought about by Bitcoin "mining."

Regulatory Responses and Legal Reflections

Central financial regulatory authorities and local governments have taken strong measures to combat the chaos in virtual currency trading. In the short term, the virtual currency trading market has "cooled down," achieving some expected results. Of course, in the era of rule of law, the long-term mechanism for regulating the chaos in virtual currency trading should be a key consideration for future policy formulation. To this end, the author believes there are two issues worth pondering: first, to promote "good laws and good governance," clarifying the "clear" and "turbid" in the blockchain finance field, and strictly enforcing the law to combat illegal activities; second, in the face of the rapid development of cutting-edge technology and the blockchain industry, regulatory methods should be forward-looking, making predictions about new forms of chaos in virtual currencies and researching and deploying effective regulatory measures.

"Good laws and good governance" is the core connotation of the rule of law. "Good laws" mean that through scientific and democratic legislation, good laws and regulations express the will to promote the healthy development of the industry, provide stable operational expectations for legitimate market entities, prevent financial risks, sanction illegal actors, and effectively protect investors' property rights. Specifically, in various sub-industries related to blockchain, the chaos in virtual currency trading easily infringes on investors' rights and interests, and in extreme cases, can even trigger financial risks. However, other subfields of blockchain may have positive value for enhancing social welfare, such as blockchain judicial evidence storage, which provides low-cost and high-efficiency value for parties to obtain evidence and for courts to authenticate evidence. The blockchain-based judicial evidence storage system—Tianping Chain—has already been applied by the Beijing Internet Court and others. Operating on Ethereum and regulated stablecoin USDC, these systems offer good payment convenience and are favored by traders. Regulated stablecoins may provide a reference for the internationalization practice of China's central bank digital currency. Therefore, it is essential to cautiously distinguish between the "positive" and "negative" aspects of the blockchain field, avoiding a "one-size-fits-all" approach to legislation. When formulating policies, regulators can enforce laws based on major meeting decisions, fully absorbing market entities' participation in discussions, and striving to formulate "good laws," restraining individual regulatory intentions from becoming the sole guiding principle for policy formulation.

"Good governance" means that regulatory agencies strictly enforce the law and implement rule-based regulation while preventing excessive leaps in specific administrative actions that deviate from the spirit of the rule of law, avoiding bringing operational risks to legitimate market entities. Implementing the spirit of the rule of law in the blockchain industry should provide relevant enterprises with certainty in industry development and predictability in the market. Rule-based regulation means that regulators should ensure the universal enforcement of existing laws and regulations, relying on good legislation and policies rather than making decisions based on momentary will. Therefore, whether combating the chaos in virtual currency trading or effectively regulating the application of blockchain in other financial fields, it is necessary to consider the introduction of long-term regulatory rules, changing the mindset of simple responses to extreme risk events.

The chaos in virtual currency trading also brings challenges such as breaking foreign exchange controls, money laundering, and terrorist financing, which can currently be addressed by controlling fiat currency exchange channels. However, China currently does not prohibit individuals from holding virtual currencies or trading them among themselves. Financial regulatory agencies explicitly prohibit virtual currency trading platforms from providing exchange services to the public and prohibit the use of virtual currencies as a means of payment for goods and services. The legal status of virtual currencies is unclear, and issues related to the buying, selling, pricing, payment, and exchange of virtual currencies, as well as related litigation, bring much confusion to judicial institutions regarding the nature of cases and judgments. For example, is it compliant if virtual currency transactions between individuals are priced in RMB? Should personal loans of virtual currencies or stablecoins be protected by the judiciary? These questions currently lack clear answers within the existing legal framework. In the future, China's legislative bodies may further consider clarifying the legal status of virtual currencies, incorporating them into a more comprehensive financial regulatory legal system, effectively safeguarding the legitimate rights and interests of holders from an institutional perspective, while also providing a legal basis for combating illegal activities arising from virtual currency trading.

Compliance Construction and References for Blockchain Finance

Unlike the internet, blockchain technology inherently leans towards financial applications. However, the financial applications of blockchain often lack compliance, and as blockchain financial applications become more widespread, compliance has become a severe issue in the development of blockchain finance. To further curb the financial and compliance risks brought about by virtual currency trading, it is essential to encourage the application of consortium chains in the financial sector and to focus on strengthening the compliance construction of public blockchains in the financial field. Promoting self-controlled consortium chains is a result of strengthening regulatory policy choices in recent years. The network nodes of consortium chains are limited, and the system is relatively closed, requiring permission from the consortium to access nodes, usually demanding strict user identity verification, thus generally making financial risks controllable. Given the complex requirements of the financial regulatory legal system, most traditional financial businesses (such as some large state-owned banks' blockchain business pilots) are currently conducted only on consortium chains.

The core difference between consortium chains and public chains is that the former requires network authorization to enter and is only open to consortium members. Since the consortium itself resembles super authority, it has actual control over traders' accounts. Therefore, it primarily promotes compliance construction through the following two aspects: only allowing traders approved by the consortium to join the blockchain system; and only permitting nodes approved by the consortium to maintain the network. Of course, due to its certain closed nature, consortium chains sacrifice many advantages of blockchain, such as openness, flexibility, and the freedom of programming various financial application projects brought about by openness, allowing for compatibility and diversified flexible combinations, greatly enhancing the efficiency of capital utilization, etc. However, although consortium chains are relatively closed, they enhance security and compliance.

Public blockchains are completely open and free systems, and the issuance of virtual currencies and some trading businesses rely on public chains, which pose challenges to financial regulation and compliance requirements. Therefore, compliance construction based on public blockchains should become a key focus of current regulators. In accordance with the baseline requirements of the financial regulatory legal system, the compliance construction of blockchain finance should include real-name registration for traders, compliance reviews based on transactions, and financial intermediaries participating in payment audits. The compliance construction of blockchain finance involves promoting the integration of decentralized digital identities at the underlying level of public chains, setting smart contract execution permissions, and identifying user identities as regulatory solutions. The author believes that the following industry practices can provide references for compliance construction in China.

First, taking the public blockchain Stellar as an example. Stellar provides a cross-border payment network for the banking industry, and its compliance protocol layer mainly includes real-name registration and authentication of accounts, with user transactions needing to be reviewed by trusted nodes (banks), making user addresses easy to identify. The compliance construction idea of the Stellar technical solution is to abandon the peer-to-peer nature between network nodes, with trusted nodes possessing super authority reviewing account transaction information. Stellar maintains partial openness, allowing users who have undergone identity verification to freely join the network.

Second, the Lightning Network provides another approach to compliance construction in blockchain finance. The Lightning Network is similar to a second-layer settlement protocol based on the Bitcoin system, allowing two users to create off-chain payment channels, undertaking the bookkeeping of off-chain transactions, and automatically executing through smart contracts. However, the Lightning Network requires service provider roles similar to financial intermediaries to act as transfer stations for payment channels, reducing the cost for users to create payment channels directly with counterparties. Therefore, the roles in the Lightning Network are suitable for compliance construction: maintaining the openness of the blockchain while having some nodes act as liquidity providers to create off-chain payment channels for various traders, without affecting the equal power of the "bookkeeping" nodes that maintain the system. The Lightning Network has the foundation for implementing real-name registration for traders—the service provider nodes creating off-chain payment channels can complete identity verification for traders. However, the legal qualification review of the service providers themselves requires the involvement of financial regulatory agencies.

Finally, since September 4, 2017, when China's financial regulatory authorities issued a ban on the establishment of virtual currency exchanges domestically, platforms providing virtual currency trading services to Chinese citizens mainly originate from abroad, and these foreign platforms are outside the scope of Chinese regulatory agencies. Virtual currency trading has financial or "quasi-financial" attributes, and such trading completely lacks oversight from Chinese authorities, becoming a significant reason for various trading chaos, including inflated trading volumes, artificial price manipulation (or suppression) of virtual currencies, insider trading, and market manipulation. Therefore, on one hand, Chinese financial regulatory agencies can issue letters warning foreign platforms to raise their trading entry thresholds, requiring them to implement mechanisms for trader identity verification, anti-money laundering, and investor suitability control for the record and review of Chinese financial regulatory agencies; on the other hand, for foreign trading platforms that infringe on the legitimate property rights of Chinese citizens, regulatory agencies can explore the possibility of a "long-arm jurisdiction" mechanism. For foreign trading platforms with actual domestic controllers or affiliated companies, Chinese judicial institutions can "pierce the corporate veil" of foreign companies to enforce the requirements of the financial regulatory legal system through litigation.

Promoting the "Regulatory Capacity" of Decentralized Finance in Blockchain

Since 2020, with the explosion of various applications in decentralized finance, the chaos in virtual currency trading has gradually spread. Promoting the "regulatory capacity" of decentralized finance should become an important task for regulatory agencies to anticipate their next steps. Decentralized finance applications transform virtual currency trading and related "quasi-financial products" into business models that can operate without centralized intermediary institutions (such as virtual currency trading platforms). Decentralized finance is a global financial service accessible to anyone through the internet, and this new business model, along with automatically executed trading protocols, is typically deployed on permissionless blockchains (represented by Ethereum).

Decentralized finance projects have created new financial service models. Such application projects provide unlicensed mechanisms for lending, trading virtual currencies, and investment and wealth management based on virtual currencies. In recent years, various staking and lending products, savings and wealth management products, options investment products, and various financial derivatives based on virtual currencies have rapidly diversified, with the user base continuously expanding. Currently, the decentralized finance industry mainly consists of three areas: stablecoins, decentralized lending markets, and decentralized exchanges. Compared to traditional financial industries, decentralized exchanges do not require physical office spaces or offline entities, can provide continuous trading without regard to holidays, and operate automatically through smart contracts and code, offering low-cost advantages. However, at present, the virtual assets in blockchain finance are mostly used for "speculating on coins" or so-called "liquidity mining," lacking genuine value creation and falling short of the national goal of serving the real economy. More importantly, decentralized finance directly challenges the enforcement capabilities of regulatory agencies. Unlike centralized virtual currency exchanges, these new business models are not controlled by specific legal entities. Traditional financial industries are all subject to regulation, where regulatory agencies issue scarce financial licenses, requiring financial institutions to meet corresponding standards for service levels and risk control capabilities, thereby increasing the "violation costs" for financial institutions and ensuring that they provide trustworthy services to financial consumers. On the other hand, regulatory agencies require financial institutions to implement investor suitability controls to reduce social risks arising from financial risks and maintain social stability.

However, decentralized finance based on virtual currencies, stablecoins, smart contracts, and public blockchains represents a new financial system that is free and open. The risks of this financial system mainly lie in: the absence of any entry barriers (such as licensing controls) and exit permissions, no identity verification mechanisms for traders, and no scrutiny of the legality of fund sources. These financial application projects are merely programs deployed on the blockchain, not specific legal entities. Once the development team deploys decentralized finance application projects on-chain, it is almost impossible for anyone to shut them down. This new form of finance makes legal regulation lack clear targets. To mitigate its risks, it is essential to enhance the regulatory capacity of decentralized finance, establishing specific entities that can bear legal responsibilities, thereby effectively implementing the requirements of the financial regulatory legal system.

The author believes that it is necessary to clarify the core influential entities in decentralized exchanges, which is a prerequisite for making decentralized exchanges regulatory. First, the core code development team shapes the basic architecture, business model, and economic incentives of decentralized exchanges, making them identifiable responsible entities. Second, many well-known decentralized exchanges are often backed by prominent venture capital institutions. The substantial funds or networking resources provided by these venture capital institutions directly influence the project's development process. Finally, in recent years, the iteration or parameter changes of decentralized exchange projects are often determined by community voting, adopting a so-called "decentralized" governance (DAO) model. The number of governance tokens held in decentralized projects determines the weight of voting rights. However, the power of governance tokens is primarily concentrated in the hands of the code development team and venture capital institutions. Therefore, decentralized finance in blockchain essentially has typical centralized characteristics. Regulatory agencies can use the code development team and venture capital institutions as important leverage to strengthen the regulatory capacity of decentralized finance and fulfill legal requirements.

With the promotion of regulatory agencies, blockchain may drive some changes in the compliant financial system, such as partially replacing licensing trust and personal credit trust with technological trust (consensus algorithms, asymmetric encryption, etc.), and through blockchain's technical "self-governance" (such as automatic execution of code and smart contracts) and community self-governance (voting by blockchain community participants), partially substituting the legal governance of real society, enhancing social governance efficiency, and ultimately reducing the overall cost of financial operations. Therefore, blockchain finance generally has positive value. However, it cannot be denied that in recent years, blockchain finance in China has been more characterized by speculation on virtual currencies, forcing regulators to implement stringent control measures.

Typically, financial regulation sets rules for relatively mature financial industries, but financial innovation implies that certain financial products or services have not previously existed. If excessive regulation is simultaneously implemented on financial innovation, it may hinder the emergence and growth of new financial products, negatively impacting the enhancement of financial efficiency. Therefore, appropriately encouraging financial innovation and loosening financial markets will help deepen the construction of China's financial market. In the long run, through careful assessment of the development trends of blockchain finance, the introduction of more flexible and intelligent regulatory policies will effectively promote the compliance construction of blockchain finance and strengthen the regulatory capacity of decentralized finance.

Note: This article is supported by the Emerging Interdisciplinary Construction Project "Financial System Security and Blockchain Regulatory Technology" of Central University of Finance and Economics.

References

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