Cryptocurrencies

APREVIOUS LEXICON COLUMN discussed the phenomenon that is known as fintech (see China Business Law Journal volume 7 issue 8: Fintech and smart contracts). Reflecting the combination of “finance” and “technology”, fintech focuses on the various ways in which technology can be utilized to increase the efficiency of financial services (including payment systems) and to change the way in which financial services are structured and delivered.

As the column noted, one area of fintech that has generated a lot of attention and disruption in recent years is the use of distributed ledger technology to support digital currencies, which are also known as cryptocurrencies. The term “crypto” comes from the Greek word kryptós, which means “secret” or “hidden”. In the context of cryptocurrencies, the use of the word reflects the fact that there is no tangible form of the currency, unlike normal currencies that are issued in paper form. The Chinese term that is used is “虚拟货币”, which means “fictitious” or “virtual” currency.

The design and regulation of cryptocurrencies. Distributed ledger technology enables data concerning transactions to be recorded and shared across a network of parties. Because all the parties have access to a single database (or ledger) and because the data is held by (or distributed to) each party, the accuracy and the security of the transaction data can be guaranteed.

An integral component of distributed ledger technology is the “blockchain”. This refers to the chain of transactions that are recorded on the ledger. All the transactions on the ledger are grouped into blocks and a new block is added to the chain each time a new transaction is verified. An important application of blockchain technology is the creation of “cryptocurrencies” such as bitcoin. Cryptocurrencies use encryption technology to generate units of currency and verify the transfer of funds.

A particularly popular use of cryptocurrencies is to purchase digital coins or tokens that are issued to the public as part of initial coin offerings (ICOs). The funds raised are used to invest in various businesses. Although the issue of tokens resembles an initial public offering of shares, it is different as the investors in ICOs do not receive ownership rights but instead receive a token whose value is determined by the blockchain.

The use of blockchain technology for the above purposes gives rise to a range of legal and regulatory issues. These issues include the application of laws and regulations governing data privacy, cybersecurity, anti-money laundering and financial crimes.

One of the greatest challenges for regulators is determining how cryptocurrencies and ICOs should be classified for regulatory purposes. Are they a commodity that investors buy and sell like any other commodity? Or are they like securities and subject to the same disclosure and other requirements?

The US Securities and Exchange Commission has announced that it will treat certain ICOs as securities and will regulate them accordingly. In addition, the Securities and Futures Commission in Hong Kong issued a statement in September that, depending on the facts and circumstances of an ICO, digital tokens may be “securities” as defined in the Securities and Futures Ordinance (SFO), and subject to the securities laws of Hong Kong.

A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.