he cat-and-mouse game between the market and regulators over the virtual cryptocurrency Bitcoin continued in 2017. The price is still hovering above US$10,000, nearly 10 times what it was worth a year ago. In the US, the Securities and Exchange Commission (SEC) has repeatedly issued investment alerts for the asset, and recently required several companies to withdraw their filings because they offered Bitcoin trading products. The People’s Bank of China, along with several other regulatory agencies, made plain that Bitcoin and other virtual currencies could not be used in China as a means of real-world payment at the end of 2013. The red-hot business of initial coin offerings (ICOs), which raise funds by issuing virtual currencies, was banned by Chinese regulators in September 2017.
In contrast, blockchain, the technology that Bitcoin runs on, has been embraced warmly by both the market and regulators. It is said to improve transparency and efficiency in transactions. Financial and Internet companies are frontrunners in developing and applying the technology. In 2014, the Bank of England was the first central bank to explore the potential use of blockchain in the financial sector. The US Federal Reserve showed similar interest in a 2016 report which acknowledged the potential advantages of reducing “operational and financial frictions” in payments, settlements and clearing services.
China’s central bank has been preparing to issue a digital fiat currency (money considered to be legal tender by a government) based on blockchain since 2014. On February 26, 2018, Party newspaper the People’s Daily ran three articles on blockchain, saying China should seize the “strategic opportunity” by winning the “international competition” over blockchain technology. On Chinese social media, articles boasting “the best way to understand the blockchain trend” are widely circulated. A WeChat account with 500 well-known investors and even pop stars renamed itself “Sleepless at 3am for blockchain,” showing their eagerness to seize a gold-rush moment.
Blockchain technology is high on the agenda of key player the National Internet Finance Association of China (NIFA). Its working group on blockchain has joined with finance and tech companies, as well as following developments made in other countries in the area.
In an interview with NewsChina, Li Lihui, leader of the NIFA working group, discussed his views on some of the concepts, progress and prospects of blockchain technology in China. Li has been a member of the Financial and Economic Affairs Committee of the 12th National People’s Congress, China’s parliament, since 2014. He was president of the Bank of China from 2004 to 2014.
NewsChina: How do you define ‘blockchain’?
Li Lihui: Blockchain is a chain of blocks of data. It is a ledger maintained and shared by all participants in transactions on the basis of their consensus. The core of the blockchain involves three technologies which are based on consensus, encryption and smart contracts. There are three key concepts in the technology.
First, blockchain is a data chain based on the sequence of time and maintained via the consensus of participants. It is like a distributed ledger. Put simply, data is packed into blocks within 0.1 to one second. The more data the block includes, the longer it takes to create a block. The speed of data processing is higher when there are fewer blocks. The blocks are created in a time sequence. The blocks are trackable and tamper-proof.
Second, blockchain is a real-time system based on consensus among multiple participants. They all add data in real time using the same algorithm which they agree upon in advance.
Third, blockchains are enforced using a system of smart contracts. A conventional business contract, whether written or spoken, is reached before it is enforced. The opposite is true of blockchains: an algorithm is generated when all participants agree to the rules. It includes laws, prices and quality of goods or capital traded in the deal. During the deal, the algorithm-writing program automatically implements these rules, rejecting goods or capital which do not comply with its programming.
NC: What advantages do smart contracts have over conventional contracts?
LL: First, smart contracts must be enforced in the way they have been agreed. They cannot be tampered with and they are trackable. Conventional contracts sometimes end up not being enforced, or being twisted. For example, someone may fake a debt financing tool, [say, a commercial paper], and have it underwritten by banks. Disputes often arise later. In deals based on blockchain, every commercial paper is unique and trackable, which helps avoid fraud.
Second, rules and requirements for all participants in a deal are laid out in a smart contract. In conventional deals, regulators are unable to supervise the deal-making process in real time. They only verify the result after the deal is completed. This means regulators face the problem of information asymmetry to detect irregularities.
Third, a smart contract is enforced automatically. Deals that do not meet the terms programmed into the contract are rejected.
Fourth, it is possible to give auditors and regulators special access to the enforcement process of smart contracts so they can supervise the process.
NC: What progress has been achieved in blockchain research and development in China?
LL: Progress has been mainly in three aspects. First, blockchains to build trust between various parties in transactions are already available. Tencent, the Internet giant that operates WeChat, has launched TrustSQL, a platform that helps companies develop their blockchain applications. Ant Financial, which operates the leading online payment system Alipay, has built a blockchain-based platform to track donations.
Second, blockchain is doing well in complicated transactions involving multiple parties. For example, a trust service needs a fiduciary, trustees, auditors and consultants. Hundreds of transactions happen in a second. Such businesses can use blockchain.
Third, research on a digital fiat currency and commercial papers is progressing.
Blockchain R&D in China has three important characteristics. First, the country’s central bank is leading key projects, particularly in digital fiat currency and commercial notes. Second, finance and technology companies of all sizes are the biggest players in researching and developing new technologies, including blockchain, artificial intelligence, big data and cloud computing. Third, these stakeholders have developed different ways of cooperating among them. For example, research institutes develop and maintain systems and platforms for financial services. In return, they share the yields of their increased financial services. This is a very good match of capital, technology and business.
NC: The idea of decentralization of the blockchain has attracted huge media attention. What do you think of the idea?
LL: Whether blockchain necessarily means decentralization is disputed. Generally speaking, decentralization is not the core character of blockchain in the way many think it is.
Decentralization is a feature of blockchain technology used in Bitcoin trading. Systems of this kind are typically called public blockchains [meaning they are open to everyone]. However, private blockchains or consortium blockchains [which have limited participants, say, certain people within an institution] have already emerged. For example, WeBank, which is based in Qianhai and provides microloans to consumers and small businesses, has developed a distributed system with multi-data centers to run interbank loan loss provision. China Postal Savings Bank has also used blockchain in its asset management business [in partnership with IBM].
I believe a decentralized system works well only in transactions with limited participants, scale and frequency. In large-scale financial transactions, centralized systems are a way to ensure speed and security. In the future, such large-scale applications must be based on multi-centered systems, with decentralization reserved for small ones.
NC: Can you talk about the concept of“de-trust,” which is often discussed in regard to blockchain?
LL: Trust cannot be erased. Creditworthiness is the most important cornerstone of any market economy. The real meaning of “detrust” in blockchain refers to the possibility that a smart contract – an algorithm program–creates trust where there is very weak or no trust. Simply put, various parties can do business without knowing very much about each other.
In this sense, blockchain does not “detrust,” but strengthens trust. Trust becomes universal, and makes inclusive finance possible [since assessing risk is a large obstacle in inclusive finance for small, poorer borrowers].
NC: What do you think of the surging of interest in blockchain?
LL: It is good to see that new technologies, including blockchain, smart finance, AI and big data have attracted so much interest. There are already good examples of blockchain deployment. WeBank’s platform for loan loss provisions gives regulators special access to track trading information which is not accessible to non-traders. There are other applications on the market that track and supervise the flow of goods, information and capital. We need more analysis of them.
NC: Are there any potential risks in using blockchain?
LL: Decentralization-oriented virtual finance has to be regulated effectively. For example, Bitcoin is not backed by any sovereign credit issuer. The value of such virtual currencies is not underwritten by any real asset, but purely by the endorsement of their participants. In 2017, the price of Bitcoin soared at its peak to nearly 20 times its starting value in early 2017. Speculation was a key force behind it.
In decentralization-oriented public blockchains, besides the consensus-based operation model, virtual initial coin offerings (ICOs) play a big role. Coins carry value and are used for payment among participants in the business. They are traded with fiat currencies on trading platforms. They have become a de facto financial tool. Two things about coin offerings have caught my attention. One is that the coins are issued to raise funds. In the first half of 2017, ICOs raised US$1.27 billion. China accounted for 31.5 percent of that share, with the majority illegally purchased.
The other is the rise of so-called initial fork offerings (IFO). These involve offshoots of Bitcoin, notably Bitcoin Diamond and Super Bitcoin.
It is estimated that 40 percent of Bitcoins are held by around 1,000 accounts globally, giving big holders the power to manipulate the market. Retail investors seeking risky high returns could swarm in and trigger serious market risk.
Restrictions on Bitcoin trading by Chinese regulators are necessary. Without them, more Chinese investors would have gambled on Bitcoin and wound up with huge losses when the bubble bursts. The restrictions help ensure financial stability and protect the interests of investors.
NC: How can the blockchain market be regulated?
LL: It is necessary to regulate a tech-based business in the high-risk financial market. Loopholes in the technology can be taken advantage of if there is no effective regulatory system for the protection and supervision of market players. The purposes are to prevent systemic risks and protect consumers and investors. Regulators have to take responsibility as long as financial innovations, including blockchain, digital finance, smart finance and big data finance may inflict such risks.
In the case of blockchain, decentralized virtual finance and the real world are linked and combine numerous participants. In Internet-based finance, mobile Internet combines with technologies of big data, AI, cloud computing and blockchain to create new financial services, such as inclusive finance, smart finance and integrated finance. In these new models, a lot of stakeholders engage in financial transactions with much more direct contact between them than ever before.
There must be rules +for this new digital finance. They must include rules to govern the issuance of a digital fiat currency, supervision of virtual finance, standard setting of digital finance and international coordination on the supervision of virtual finance. Illegal trading must be stopped and legal, effective and inclusive services must be promoted.
NC: What is your attitude toward the risks that are embedded in financial innovation due to new technologies like blockchain?
LL: Any new technology brings risks. The key is to follow, assess and address the risks. Blockchain can improve efficiency and reduce cost in financial services. To realize this, the issue of security must be solved in largescale trading.
At the 3rd Global Blockchain Summit in Shanghai in September 2017, which I attended, Vitalik Buterin, co-founder of Ethereum, a world-leading blockchain platform, noted that blockchain was in its third stage, with large-scale applications as the biggest feature. This would not be possible without solutions for both the technical and systematic problems.
China leads the world in Internet finance. It is partly attributed to Chinese regulators’ inclusive attitude toward new technologies and tough handling of scams and illegal fundraising. It is important to be tolerant toward new technologies and cautious about potential risks that could be brought about by a new technology. When a technology reveals a problem too small to have systemic impact, it can be given more chances to grow. Contingent measures have to be taken once the problem shows signs of a systemic impact.
It is equally important to distinguish between the technology and problems it causes. Illegal fundraising in the guise of new technologies must be stopped. The problems are one thing, but the research and wider applications of blockchain are another.
NC: What do you think of the prospects for blockchain?
LL: There are bright prospect for the application of blockchain, and progress has already been made in this regard, as we have mentioned. The development of the technology should be encouraged and guided properly, while potential risks should be prevented.
Chinese regulators support the development of blockchain and restrict illegal speculation. A lot of effort has been made to set up a legal framework and on R&D of digital commercial papers.
Although China has been moving fast in blockchain R&D, there is a long way to go toward safe, large-scale applications in financial transactions. Blockchain needs to be integrated into other new technologies, including AI, big data and cloud computing, to realize its potential.