China’s ban on digital tokens underscores dilemma of regulating fintech

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5 September 2017. By Tsering Namgyal.

The Chinese government's decision to ban the issuance of digital tokens highlights the challenges of regulating financial technology and how regulators may launch pre-emptive strikes against anything that could potentially disrupt the status quo.

The People's Bank of China's move to completely prohibit initial coin offerings is far more draconian than developments in other jurisdictions, but Chinese authorities have reason to be worried, analysts told MLex. 

The clampdown was prompted by the extent to which the new form of financing was being manipulated and misused as a form of crowdfunding capital in China. Some experts told MLex that nearly 90 percent of ICOs in China could be fraudulent.

But that has not stopped Chinese investors from rushing to exchange cryptocurrencies such as Bitcoin and Ether, a digital token powered by blockchain protocol Ethereum, for new tokens issued by start-ups.

The latest measures must be seen in the context of the Chinese policy on cryptocurrencies such as Bitcoin, on which it has conferred the status of a "virtual commodity."

China has yet to come out with a regulatory framework and remains more skeptical towards cryptocurrencies than countries such as Japan, which has legalized Bitcoin as a form of payment, and South Korea, which has approved it for international remittances. 

China's approach towards Bitcoin has been marked by volatility.

In late 2013, when the People's Bank of China banned financial institutions from using bitcoins, the cryptocurrency's unit price fell by 40 percent over the following couple of weeks to $400. 

Seen in that light, the Chinese approach towards ICOs, which have so far raised nearly $2 billion for blockchain-based start-ups worldwide, is not altogether shocking. Digital token fans have been warned, most recently by the state-backed National Internet Finance Association, which has called for caution while dealing with ICOs. 

Even before that, reports abounded that some ICOs entrepreneurs had also been "invited for tea" — a euphemism for questioning — by regulators, MLex was told, in the same way that some Bitcoin exchange operators had been addressed by the authorities before the crackdown in Spring.

The tough stance towards ICOs by Chinese regulators will put an immediate end to all financing activity related to digital tokens — through which Chinese blockchain firms have raised nearly $600 million so far this year.

Much ICO financing activity will now likely take place outside China. And it will likely do to the ICO industry what the decision by Chinese authorities to carry out a four-month freeze on withdrawals did to the Bitcoin industry.

After Chinese authorities placed a ban on withdrawing Bitcoin in February amid money-laundering concerns, China quickly began to lose its dominance as a major trading venue for Bitcoin. Jurisdictions such as Japan and South Korea quickly began more popular as key players in the industry, helped partly by their more friendly approach towards Bitcoin. 

The US is also seen as largely off-limits due to a tough approach to ICOs by the Securities and Exchange Commission, which has been playing a cat-and-mouse game with digital token operators.

Whether the latest decision by Chinese authorities will have a major impact on China's efforts to take a leadership position in the rapidly growing field of blockchain, also known as distributed ledger technology, remains to be seen.

At least two high-profile blockchain summits to be held in the Chinese capital this month have been canceled. A blockchain conference supposed to be held later this month in Beijing told MLex that it had been postponed until further notice due to a "upgrade requirement for public security."

There are reasons for Chinese regulators to be concerned, most notably the stability of the Chinese currency, experts told MLex. Cryptocurrencies not only compete with the yuan, but also offer a clever method of bypassing Chinese capital controls and moving money overseas.

Furthermore, digital tokens are also competing directly with regulated financial intermediaries such as venture capitalists, investment banks and stock exchanges, which have traditionally been involved in channeling capital to start-ups.

The rise of ICOs is beginning to disrupt the entire food chain in the capital markets, giving regulators pause for thought.

Yet the rapid pace with which the technology has been racing ahead has given authorities little time to respond in a thoughtful manner, or to devise any meaningful regulatory frameworks. Hence the decision by Chinese authorities to announce a blanket ban on the new financing method.

Now, the question is whether the ban is just a manifestation of Chinese authorities buying time to come to grips with the technology and contain the emerging risks before gradually legalizing ICOs — by granting exemption after exemption — once they think the ICO beast has been tamed.

It could be China's way, as one Hong Kong-based analyst told MLex, of "putting the brakes on until they could figure something out."

Such speculation is not entirely misplaced; similar developments have been seen before with bans in fields such as telecoms and finance. They could yet happen with ICOs.