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Why China Has a Love-Hate Relationship with Cryptocurrency

Summary

China has a love-hate relationship with crypto. It loves the technology but hates the illicit activity. While blockchain will play a vital role as a strategic technology highlighted in national development goals, its ties to cryptocurrency challenge industry development. This has led to harsher regulation of the cryptocurrency space in the hopes that, by separating cryptocurrency and blockchain technology, policymakers can hasten the maturity of the blockchain industry without fear of the social or financial instability associated with crypto.

The headline “Bitcoin Banned in China” is expected during nearly each cryptocurrency cycle. Cryptocurrencies, also known as digital currencies or virtual currencies, are investment and payment tools that have been steadily increasing in popularity since the release of Bitcoin in 2009. The adoption of cryptocurrency has forced many governments to consider the economic and financial implications of their rise. For example, El Salvador has recently embraced cryptocurrency as a form of legal tender. On the other hand, the United States considers them a security or commodity bound to the rules and regulations associated with those designations. China’s feelings, however, are more ambivalent.

Blockchain technology forms the technological basis for decentralized cryptocurrencies. Blockchain, which has its roots in the 1990s, has been designated as critical to China’s strategic goals. Central support for the nascent technology is well represented in the 13th and 14th five-year plans, yet the same cannot be said for blockchain’s most well known application – cryptocurrency.

As cryptocurrency commands increasingly larger headlines, Chinese officials have deemed the risk it presents to domestic financial and social stability too large to ignore. The promise of “get rich quick” schemes has misled investors and exposed the market to widespread fraud and scams. As a result, the People’s Bank of China (PBOC) has instructed Chinese banks and financial institutions to crack down on cryptocurrency speculation and trading activity. Chinese traders and investors, who held a controlling amount of market liquidity, have consequently been compelled to liquidate their assets – the sudden action of which triggered a significant decline in the 2021 cryptocurrency market cycle.

China’s Relationship With Cryptocurrency

The First Two Crypto Cycles

The first Chinese regulation on cryptocurrency was released in December of 2013 with the PBOC’s “Notice on Preventing Bitcoin Risks.” This announcement defined Bitcoin – and all cryptocurrencies by extension – as a virtual commodity which carries with it certain regulatory implications. Despite the country’s initial resistance to cryptocurrencies, policymakers nevertheless began to explore the strategic use cases for the blockchain technology unpinning Bitcoin.

Later, in 2016, China announced its 13th Five-Year Plan for the development of information technology, which aimed to develop industries that Beijing deemed to be of strategic importance in the upcoming technological revolution. Technologies such as artificial intelligence, machine deep learning, Internet of Things, cloud computing, big data, and blockchain technology were stated as pivotal technologies that would “drive the evolution of cyberspace” to which China wished to help develop. In other words, Beijing was aiming to construct a “Digital China” by 2020.

Following the cryptocurrency bull run of 2017, China enacted its ban on initial coin offerings (ICOs), citing the risk of unregulated fundraising activity to its financial sector through the potential for rampant fraud and pyramid schemes. Regulators also moved to shutdown domestic cryptocurrency exchanges due to the prevalence of illicit market activity as well as the losses that individual investors suffered due to rampant speculation amid strong price volatility. As major Chinese exchanges such as Huobi and Binance relocated away from the mainland, China’s blockchain strategists began exploring areas in which its technical application could be harnessed to improve daily life. In particular, Beijing sought to apply this technology to administrative functions in government and business.

Why Has China Declared War on Crypto in 2021?

From December 2020 to May 2021, the cryptocurrency market once again found itself in another bull run. However, a subsequent boom in speculative activity, low-efficiency high energy consumption, cyber theft, money laundering, pyramid and Ponzi schemes, DeFi rug pulls, and more triggered renewed regulatory scrutiny. Notably, concerns over crypto assets warranted an international response, and the Financial Action Task Force is in the process of drafting a resolution to create regulatory standards for virtual assets.

Extreme price volatility has led other countries such as Turkey and India to ban the use of cryptocurrencies within their own borders due the individual and societal risks involved with market participation. In China, policymakers turned to financial institutions – the gatekeepers from traditional fiat to cryptocurrency markets – as the main enforcers of existing domestic bans. Policymakers instructed participating financial institutions to “thoroughly investigate and identify virtual currency exchanges and OTC dealers’ capital accounts” in order to sever links between investors and cryptocurrency exchanges. This cut off a critical pipeline between the investor and crypto-trading platforms, and then led to a nearly 40% decline in Bitcoin’s market price while inspiring fears of another “crypto winter.”

Bitcoin’s 2021 Market Correction

Sources: Investing.com, The China Guys

At the same time, China called for a crackdown on all domestic bitcoin mining and trading operations throughout its provinces. This new policy led to the sudden shutdown of the bitcoin mining operations that accounted for nearly 65% of total bitcoin network power in April 2021. Global bitcoin hashrates sharply dropped by nearly 50% as mining operations shuttered across the country. While some of these operations have since relocated overseas and set up shop in areas which offer favorable regulation and cheap electricity, many have not.

Bitcoin’s Declining Mining Activities

Sources: Coindesk, The China Guys

Beijing’s Stance on Blockchain and Crypto

For many, it is difficult to decouple blockchain technology from cryptocurrency. Many falsely equate Beijing’s support for blockchain technology as embracing cryptocurrency. However, while cryptocurrencies rely on blockchain technology to function, blockchain also has real-world application outside of cryptocurrency. Many blockchain-based projects do not use cryptocurrencies – and many more employ digital tokens that have no investment application and are used instead as tools for governance and smart contract functionalities.

What’s Allowed?

As mentioned earlier, Chinese blockchain companies that are allowed to operate within mainland China are those who offer services and technology solutions to the real economy. Each year, China’s Cyberspace Administration produces a list of newly authorized blockchain companies in areas that range from environmental protection, supply chain management, education, vaccine distribution, and finance. By whitelisting blockchain firms, policymakers aim to form partnerships with projects that provide significant value to the country.

While various blockchain projects may include tokenization in their designs, these tokens are not tradable. An example would be Shanghai Netban Education Company’s “Education Credit System,” in which the system tokenizes academic credits as a form of record-keeping for students, utilizing an ERC-20 smart contract. These tokens are not tradable on any exchange in any market; however, students are given vouchers in relation to their academic credits which can be used for tuition or registration purposes. Below are a few other notable whitelisted firms:

NEO

Neo is regarded as China’s first smart contract platform. It is a layer-1 multi-use blockchain project that utilizes a dual token system for system functionality. Though Neo’s native token, NEO, is traded on cryptocurrency markets, it neither serves as a currency nor a security. Instead, it is used solely for governance purposes on the blockchain. GAS, another token produced by Neo, is a utility token used for smart contract and transaction purposes within its network. This structure has been replicated by others operating in China.

VeChain

VeChain uses a similar structure for its mainland operations wherein VeChainThor (VeThor) is a utility token used to enable its smart contracts and record keeping and VeChain Token (VET) is used for blockchain governance. It utilizes a proof of authority (PoA) governance model. This technology has been applied to various sectors that VeChain is involved in, namely supply chain management, environmental protection, and healthcare. This approach allows the company to stay compliant with existing laws governing cryptocurrencies.

In the cases of both NEO and VeChain, though their governance tokens are traded in cryptocurrency markets, neither token is used for capital raising or as a virtual currency. Rather, these tokens are necessary components of their blockchains to keep their ecosystems functioning and self-governing. Meanwhile, the technology produced from these blockchain projects may very well later serve China’s technology goals as stated in both the 13th and 14th Five-Year Plans.

TRON

TRON is a Singapore-based decentralized web platform that provides public blockchain support. It uses a delegated proof-of-stake (POS) model for its governance system that determines the overall maintenance of the platform. Its TRC-10 and TRC-20 utility tokens are tokens created specifically for the development of the platform, similar to Ethereum’s ERC-20 standard. TRON’s Founder and CEO, Justin Sun, is a member of China’s National Development and Reform Commission, to which Sun and his foundation provides guidance for China’s blockchain industry development.

What’s Not Allowed?

There are two governing regulations pertaining to cryptocurrencies in China today: “Notice on Preventing Bitcoin Risks” and “Preventing Token Issuance Financing Risks.” Both serve as a foundation for cryptocurrency regulatory enforcement. With these regulations, financial institutions and payment providers are both barred from setting prices for products or services in bitcoin, cannot buy or sell bitcoin as a central party, and cannot provide any form of services in relation to bitcoin. It is also illegal to operate bitcoin exchanges with RMB and other foreign currencies.

Prior to the bitcoin mining and trading ban in 2021, any sites that provided bitcoin transactions needed to satisfy money laundering obligations as well as institute KYC (Know-Your-Customer) requirements. The 2017 ban on initial coin offerings (ICOs) and cryptocurrency exchanges were later included in China’s cryptocurrency regulatory framework, which was in response to the prevalence of scams that had emerged in the ICO phase

Following China’s hawkish regulation, many cryptocurrency operators have since moved abroad. Well known exchanges such as Binance and Huobi have relocated offshores and bitcoin miners are now fleeing to friendlier shores. Additionally, Chinese cryptocurrency traders have historically used OTC vendors or trusted third-parties to circumvent regulation and onboard their funds on trading platforms. However, on June 21st, China announced that participating financial institutions will actively investigate and sever payment links to known cryptocurrency service providers in order to prevent money laundering and cryptocurrency speculation. China has also announced it will crackdown on promotional materials relating to cryptocurrencies, which coincides with stricter censorship of cryptocurrency-related posts on the Chinese social media platform, Weibo.

After the 51st meeting of the State Council Financial Stability and Development Committee, China had announced it will begin cracking down on bitcoin mining and trading activities. This announcement was followed by a re-emphasis on existing cryptocurrency regulation. These approaches are not without reason nor motive. Scams such as Ponzi schemes, pyramid schemes, and DeFi (Decentralized Finance) rug pulls plague the cryptocurrency space. These scams occur almost daily on less regulated platforms and have defrauded investors out of billions of dollars. Additionally, the cryptocurrency space has been a useful tool by criminals to launder ill-gotten gains. Below are a few noteworthy scams that have elicited a Chinese government response.

PlusToken Ponzi Scheme

This scheme involved six Chinese nationals who had defrauded investors out of 2 billion dollars in cryptocurrency. According to People’s Daily, PlusToken falsely advertised that their platform had technology that could arbitrage their trades among different cryptocurrency trading platforms and collect the difference. However, this capability was never developed, and those who paid for these services were scammed out of their money. After being arrested in Vanuatu, Cambodia, Vietnam, and other jurisdictions, the schemers were extradited and tried in a court in Jiangsu in which 14 people were sentenced between 2 and 11 years in prison.

‘Hostages in Turkey’ Scam

The ‘hostages in Turkey’ scam highlights the potential for criminal elements inherent in cryptocurrencies that the Chinese government is wary of. This particular scam involved a fake cryptocurrency investment consultancy that promised to double investments. However, those who were lured into this fake company were forced to relinquish their passports, con other Chinese investors, and held against their will within the complex in which the organizing gang resided. After the Chinese consulate was notified of the hostage situation, Turkish police moved in to apprehend the suspects and break up the operation.

The Future of Blockchain and Crypto in China

Chinese policymakers have deemed the cultivation of its blockchain industry vital to national goals. The level of support for the technology can be seen in Beijing’s “Government Services + Blockchain” policy in which it promotes the implementation of blockchain technology in government services, allowing the digitization of certificates, licenses, and other government services to build a more efficient business environment. Governmental bureaus have been active in seeking partnerships with blockchain companies that boast complementary synergies, such as VeChain’s recent partnership with the Chinese government in creating a blockchain-based COVID-19 risk assessment tool dubbed “VeTrust.” Similarly, other recent projects have focused on monitoring, controlling, or incentivizing the reduction of carbon emissions.

While it has been widely speculated that Chinese policymakers have ulterior motives in banning cryptocurrencies – such as to shore up threats to its strict capital control regime or to promote the impending release of its digital yuan, the reality is that regulators must address the significant social and individual damages from rampant illicit activity in the industry. The severing of the fiat-to-cryptocurrency pipeline is an important step in cracking down on this behavior and called more attention to the risks inherent in cryptocurrency speculation. While centralized institutions will face considerable headwinds due to the new regulation, P2P decentralized exchanges that are not bound to the traditional financial system will likely become a de facto alternative for stakeholders within the Chinese cryptocurrency market. However, this means that industry players will need to find new onramps for initial fiat-to-cryptocurrency exchange, which could prove increasingly difficult should China’s ban on cryptocurrency spark similar action abroad. One thing is certain – until the risk of illicit behavior in the cryptocurrency market is sufficiently snuffed out, there is likely to be a domino effect of harsh regulation that will take its toll on the industry as regulators across the globe move to keep investors safe.

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