Chinese Innovation In E-Money And Virtual Currency Systems And Incentive Effects Of Domestic Regulations

The largest internet population on the globe, a track record of fast adoption of novel electronic payment methods in the past, and most recently the government’s crackdown on cryptocu[r]

Chinese Innovation In E-Money And Virtual Currency Systems And Incentive Effects Of Domestic Regulations

Roswitha Alexandra Trappe Directed by Dr Chen Dongmin, Peking University, Beijing, China

ABSTRACT

E-Money and virtual currency systems (VCS) have been in active use years before Satoshi Nakamoto published his ground-breaking Bitcoin paper, with exceptional popularity in China As traditional financial institutions and the central bank struggled

to keep up with the rapid development of online services and new payment channels in the late 1990s, private firms such as Tencent and Baidu were quick to fill the void in order to facilitate transactions for online purchases with their own VCS Q Coin and Baidu Coin, respectively, which paved the way for e-money systems WeChat Pay and Alipay Meanwhile, online games such as World of Warcraft saw a sizeable black market emerge on which its game-specific virtual assets were exchanged globally, often

"mined" on large scales in low-wage countries such as China as considerable secondary industries emerged Only a few years later, cryptocurrencies such as Bitcoin saw millions of private investors pour private savings into Initial Coin Offerings, with up to 80% of all cryptocurrency trades cleared against the Renminbi and an estimated 58%

of all mining pools located in China at its peak in 2017 In each of these distinct cases, Chinese regulatory intervention was uncompromising, though only after an initial laissez-faire approach This paper seeks to provide a novel taxonomy of VCS, examine the past utilisation of different VCS types on the Chinese market, and investigate whether the impact of relevant policies in the space have been instrumental in steering innovative enterprise It will utilise a largely qualitative approach, with which the model from Knut Blind’s much-cited “The Impact of Regulation on Innovation” will be analysed Findings reflect that Chinese innovation in both e-money and VCS largely filled vacuums which existing payment and settlement systems could not fill, while regulation has proven to aid and in fact embrace large-scale adoption of novel technologies so long as state control over currency flows is not threatened and industries are fully regulated

KEY WORDS: Virtual currency systems, e-money systems, electronic payment systems, cryptocurrency, innovation regulation

Glossary

BIS Bank of International Settlements

CBDC Central Bank Digital Currency

CBRC China Banking Regulatory Commission

CCCB Clearing Center for City Commercial Banks

CIRC China Insurance Regulatory Commission

CNNIC China Internet Network Information Center

CSRC China Securities Regulatory Commission

DLT Distributed Ledger Technology

ECB European Central Bank

EFT Electronic Funds Transfers

FMI Financial Market Infrastructures

GAPP General Administration of Press and Publications

ICO Initial Coin Offering

IP Intellectual Property

MIIT Ministry of Industry and Information Technology

MMORPG Massively Multiplayer Online Role-Playing Game

MOC Ministry of Culture

MOF Ministry of Finance

MOFCOM Ministry of Commerce of the People’s Republic of China NDRC National Development and Reform Commission

NUCC China Nets Union Clearing Corporation

OECD Organisation for Economic Co-operation and Development

OTC Over the Counter

PBoC People’s Bank of China

PCAC Payment and Clearing Association of China

R&D Research and Development

SAPPRFT State Administration of Publication, Press, Radio, Film and

Television SEC US Securities and Exchange Commission

VCS Virtual Currency Scheme

Table Of Contents

1 Introduction 1

1.1 Background 1

1.2 Research Objective 2

1.3 Research Question & Hypothesis 2

1.4 Theoretical Framework 2

2 Electronic Money and Virtual Currency Schemes: An Overview 4

2.1 Functions of Money 4

2.2 Traditional Versus Electronic Moneys 5

2.3 Central Bank Reserves 6

2.4 Commercial Bank Deposits 7

2.5 E-Money Systems 7

2.6 Virtual Currency Systems 9

2.6.1 Type 1: Centralised Nonconvertible Virtual Currency Scheme 10

2.6.2 Type 2: Centralised Unidirectional Virtual Currency Scheme 10

2.6.3 Type 3: Centralised Bidirectional Virtual Currency Scheme 11

2.6.4 Type 4: Decentralised Bidirectional Virtual Currency Scheme 13

2.7 Crypto-Assets: Virtual Currency Scheme Types 3 and 4 13

2.7.1 Taxonomy of Crypto-Assets 14

2.7.2 Bitcoin (Type 4 – Decentralised Bidirectional VCS) 15

2.7.3 Central Bank Cryptocurrency (Type 3 – Centralised Bidirectional VCS) 16 2.7.4 Initial Coin Offerings 19

3 Methodology 22

4 Setting the Scene: Context for Chinese E-Payment Systems Innovation 25

4.1 Internet Use in China 25

4.2 E-Payment Environment in China 26

4.3 Overview of the General Institutional Framework of Chinese Payment, Clearing and Settlement Systems 27

5 Results and Discussion 30

5.1 E-Money Systems 30

5.1.1 Alipay 30

5.1.2 Tenpay 31

5.1.3 Tencent QQ Credit and Debit Cards 32

5.1.4 Analysis 32

5.2 Non-Cryptographic Virtual Currency Systems: Types 1-3 35

5.2.1 Type 1: Centralised Nonconvertible VCS – Online Mah-Jong 35

5.2.2 Type 2: Centralised Unidirectional VCS - Q Coin 35

5.2.3 Type 2: Centralised Unidirectional VCS – Shanda Point Ticket 38

5.2.4 Type 3: Centralised Bidirectional VCS – WoW Gold 39

5.2.5 Type 3: Centralised Bidirectional VCS – Linden Dollars 40

5.2.7 Analysis 44

5.3 Cryptographic Virtual Currency Systems: Type 4 47

5.3.1 Cryptocurrency Trading 47

5.3.2 Cryptocurrency mining 49

5.3.3 Initial Coin Offerings 50

5.3.4 Analysis 50

6 Conclusion 53

6.1 Concluding Remarks 53

6.2 Limitations 53

6.3 Managerial and Regulatory Recommendations 54

7 Bibliography 56

8 Appendix 68

1 Introduction 1.1 Background

The largest internet population on the globe, a track record of fast adoption of novel electronic payment methods in the past, and most recently the government’s crackdown

on cryptocurrency trading are three interrelated phenomena which render the investigation of innovation in e-money and virtual currency systems (VCS) in China very much purposeful Year after year, e-money schemes and VCS saw rapid adoption and growth speeds in the country, which regulators usually intended to gain control over through strict clampdowns Even years before Bitcoin, private firms such as Tencent, Baidu and NetEase released their in-house VCS, which saw varying degrees

of success but equal regulatory scrutiny, though mostly after an initial laissez-faire approach Furthermore, third party payment system providers such as Alipay and WeChat Pay have irreversibly shaped the Chinese e-commerce industry, and in fact called the role of traditional financial intermediaries and regulators into question While numerous studies have been conducted on the impact of alternative payment channels and currency systems such as Bitcoin on monetary and financial stability, there remains

a lack of literature examining the grounds for their rapid adoption throughout the past

20 years in China The pace at which novel methods have become the norm has faced the government with sizeable challenges, and often prompted delayed, yet strict responses This should be investigated more closely

The impact of regulatory measures on economic development and innovation has been subject of plenty of research projects in the past, and its relevance cannot be underestimated A central function and goal of any government is to promote economic and social well-being of its population, and appropriate policies are pivotal in order to maintain and achieve this state through “policies aimed at macroeconomic stability, increased employment, improved education and training, equality of opportunity, promotion of innovation and entrepreneurship, and high standards of environmental quality, health, and safety” (OECD, 1997, p 5) Frameworks such as those of Schumpeter have had an enduring impact on subsequent research and have remained relevant (Braunerhjelm & Svensson, 2010; Cantwell, 2001; Parayil, 1991) His original

1934 model highlighted the role of entrepreneurship “and the seeking out of opportunities for novel value-generating activities which would expand (and transform) the circular flow of income” but distinguished between invention on the one hand and innovation on the other (Cantwell, 2001) Subsequent extensions postulated that, in essence, economic development is induced by technological innovation, which in turn are led by entrepreneurs in correspondence to business cycles (Parayil, 1991) The so-called Schumpeter relation thus assumed that increasing capital intensity, and thus more resources, become available for investments in research and development, which in turn

fosters innovation (Blind, 2012a) In contrast, other model such as Carlin and Soskice’s differentiate between the impact of incentives and the compliance cost of regulations, and consequently determined innovation endogenously The latter, in combination with the OECD’s regulation taxonomy, has served as the base for Knut Blind’s widely acclaimed model on the impact of regulation on innovation, which will be utilised for this paper (Blind, 2012b; Mullan, 2016)

1.2 Research Objective

This paper seeks to provide a novel taxonomy of VCS, examine the past utilisation

of different VCS types and e-money schemes on the Chinese market, and investigate whether the impact of relevant policies in the space have been instrumental in steering innovative enterprise in the private sector Knut Blind’s model from the paper “The influence of regulations on innovation: A quantitative assessment for OECD countries” will be utilised for the examination of the research question Upon the analysis of cases illustrating e-money and both cryptographic and non-cryptographic VCS, policy recommendations will be drawn, for both Chinese and foreign regulators

1.3 Research Question & Hypothesis

The analysis for this thesis has been conducted under the premise of the following research question:

To what extent was Chinese innovation in e-money and virtual currency systems influenced by regulation and initiatives by the private sector?

The following hypotheses was constructed:

Innovation in e-money and virtual currency systems in China largely emerged from the private sector, while regulators commonly did not step in until institutional voids had been filled

1.4 Theoretical Framework

In academic literature, the impact of regulation on innovation has been widely discussed and researched, as touched upon above This paper will utilise the model extracted from Knut Blind’s 2012 paper on the influence of regulations on innovation

It has proven as a significant functional addition to the research body, and as a base to numerous follow-up studies after its release Divided into three categories, economic, social and institutional regulations, each with several subcategories, it offers a satisfactory basis to which this paper can address this paper’s research question In contrast to Blind’s approach, this paper will utilise a qualitative approach, however

Drawing from policy announcements, news sources and academic journals, relevant regulation will be singled out and allocated to their respective categories in the model

2 Electronic Money and Virtual Currency Schemes: An

It is worth mentioning that there is a plurality on definitions of moneys within and between disciplines For instance, Austrian economist Hayek saw fourfold uses of money: for cash purposes, as holding reserves for future payments, as a standard of deferred payments as well as a reliable unit of account (Hayek, 1976) Another important consideration has been put forward by Viviana Zelizer in her paper titled

“The Social Meaning of Money: Special Monies”, in which she highlights the shortcomings of a strictly utilitarian approach, discusses the diverse factors affecting the social property of money and underlines the importance of considerations beyond economic models The “special monies model” thus assumes “a plurality of different kinds of monies, each ‘special money’ shaped by a particular set of cultural and social factors and […] thus qualitatively distinct” (Zelizer, 1989) Some examples of monies identified in her research include subtypes of so-called “domestic money”, with a difference in usage and perception of “women’s household money” and “husband’s allowance”, for instance (Kow, Gui, & Cheng, 2017; Zelizer, 1989)

2.2 Traditional Versus Electronic Moneys

In their 2008 paper on Virtual Money Systems, Guo and Chow distinguish several forms of traditional money, also referred to as “t-money” Firstly, commodity money was established around the eighteenth century and was based on tangible commodities such as gold or silver, whose intrinsic value it derived its worth from Examples are gold certificates, essentially pieces of paper which did not have a high intrinsic value, but could be exchanged for a set quantity of the underlying commodity (European Central Bank, 2012) Though no longer in use nowadays, commodity-based transactions were the predominant medium of exchange for over two millennia of human history, such as in the form of precious metal coins (Bech & Garratt, 2017) More recent use of a form of commodity money could also be seen in the United States

of America before the Great Depression in the 1930s, when banknotes were freely convertible (J Guo & Chow, 2008) Secondly, there is of course fiat currency, which

is issued by a national central bank, commonly in the form of currency banknotes and coins (Prasad, 2018) A common taxonomy of money applied by the Bank of International Settlements (BIS) is based on four distinct properties: form (physical or electronic), issuer (central bank or other), transfer mechanism (centralised or decentralised) and accessibility (universal or limited) (Bech & Garratt, 2017) A summary of the distinction of different physical and electronic types of money can be found in figure 3 The table was adapted from the BIS paper on Digital Currencies in which authors offered a comprehensive overview of the interplay between novel alternative currencies and the existing financial markets infrastructure (FMIs) (BIS, 2015) The highlighted areas represent the asset classes which are covered in this paper

It is also important to consider the existing types of electronic transactions of the traditional monetary system As figure 1 depicts, electronic money also includes central

bank deposits Two types can be broadly identified The most familiar forms of central bank deposits, often referred to as settlement accounts or reserves are held by commercial banks The second form is, at least in theory, deposits which are held by the general public, and is referred to as “deposited currency accounts” (DCAs), though this type has generally not been made available to the public yet (Bech & Garratt, 2017) Furthermore, electronic transmissions of money in the existing financial system are taking place in a range of forms, such as through Electronic Funds Transfers (EFT) which have been in use since the 1980s, or credit card payments which became commercialised in the 1960s Nowadays, both methods still use relatively insecure and old underlying technology, which see transactions pass a number of parties and legislations on relatively unsecure and poorly encrypted point of sales terminals, in the case of credit card transactions (European Central Bank, 2015; Godlove, 2014)

2.3 Central Bank Reserves

Electronic central bank money is issued monopolistically and its transactions are cleared through a centralised payment system Demand for reserves arises from five distinct sources: reserve requirements on banks, non-bank public demand for liquidity (e.g currency), bank demand for settlement balances, payment of tax obligations and international interbank settlements (Arnone & Bandiera, 2004) In most countries, public access to electronic central bank deposits is restricted In Switzerland, for instance, access is limited to roughly 200 financial intermediaries, which have accounts

at the Swiss National Bank, which, in turn, uses these funds for settlement purposes and

to fulfil reserve requirements (Berentsen & Schär, 2018) In England, access is limited

to high-street and commercial banks, building societies as well as a small number of systematically important financial intermediaries (Mcfarlane, Ryan-Collins, Bjerg, Nielsen, & McCann, 2018)

At the end of each business day, commercial banks borrow excess reserves from other banks in order to settle payments, which is lent at the Interbank Market Rate of Interest, with one of the most well-known being the LIBOR However, in case aggregate reserves are insufficient to settle payments between banks, commercial banks can also resort to central banks to create additional reserves (Dyson, Hodgson, & Van Lerven, 2016) This can be done through so-called open market operations in which assets are bought on the secondary market from investors, or through what is known as

a sale and repurchase agreement (repo), where a commercial bank sells a certain asset

to the central bank in exchange for fresh central bank reserves, while guaranteeing its repurchase for a higher price on a future date (Mcfarlane et al., 2018)

A key objective for any central bank, as is the case for the People’s Bank of China (PBoC), when faced with competing forms of currency, should be to retain influence

on monetary policy “In the extreme case of complete substitution of base money,

e-money represents a threat to the way monetary policy is implemented, to the ability of the central bank to carry out its monetary policy, and to the standard effect of monetary policy on output and prices” (Arnone & Bandiera, 2004, p 13) However, while some scholars argue that a growing demand for alternative currencies could reduce the demand for base money and thus central bank influence, others, such as researchers at the BIS, have pointed out that central bank influence may simply shift, namely towards financial intermediation (Arnone & Bandiera, 2004; BIS, 2018)

2.4 Commercial Bank Deposits

As opposed to central bank reserves, commercial bank deposits usually have much less restrictive access options (Berentsen & Schär, 2018) Households and firms are generally unable to open accounts at central banks, therefore commercial banks are used Also referred to as demand deposits, they are essentially a commercial bank’s electronic record of a liability representing IOUs to customers who store their funds with them (Dyson et al., 2016) Nonetheless, these funds do not legally belong to the customer, but to the bank, and in many countries are not considered a legal tender in the strict definition of the term (Mcfarlane et al., 2018) It is commonly commercial banks which create new money in an economy, rather than central banks This process

is completed in the form of bank deposits when making new loans (Dyson et al., 2016) For instance, when a customer takes out a new mortgage from a commercial bank, it creates the money electronically and credits the customer account with the additional deposits Thus, the money supply increases as banks make new loans and decreases when said loans are repaid and deposits are destroyed (Mcfarlane et al., 2018) Commercial banks in most economies currently enjoy rather favourable conditions as they account for the first source to inject money into the economy and concurrently reap profits in the form of interest (Huber & Robertson, 2000) Supporters of alternative currency systems have pointed out that such a move could democratise “a monetary system which – via seigniorage profits – gives commercial banks a major subsidy that puts them in a uniquely privileged position in the economy” (Mcfarlane et al., 2018, p 3)

2.5 E-Money Systems

The ECB originally classified electronic money (e-money) as an “electronic store

of monetary value on a technical device that may be widely used for making payments

to undertakings other than the issuer without necessarily involving bank accounts in the transaction, but acting as a prepaid bearer instrument” (European Central Bank, 1998) Distinguishing features of e-money schemes, according to a 2004 IMF working paper, are the computer and software expertise, products and liabilities recorded on the balance sheet of the issuer, transferability limited to consumer to merchant rather than peer-to-peer, and a lack of anonymity (Arnone & Bandiera, 2004) One of the earliest notable

developments in the space was started in 1980, when David Chaum “developed the concept of electronic cash under the view that for it to be useable in the real world economy it would require a token of money that would emulate physical currency, and most importantly, privacy feature to enable safely and securely anonymous payments” (Borchers, 1995; Peters & Panayi, 2015, p 4) Chaum implemented his idea through Digicash in the 1990s, which subsequently sparked an explosion of small venture capital firms developing similar e-money systems and was a key to the initial regulatory response to such systems (Peters & Panayi, 2015)

E-money inherits the three forms of traditional money to derive three categories of e-money (J Guo & Chow, 2008): Firstly, e-commodity money, which is backed by precious metals and used in supported scope A common example for this type are E-Gold, one of the earliest virtual currencies founded in 1996 in Florida, USA It was marketed under the slogans “gold itself, circulated electronically the ultimate

worldwide free market currency” and “the only monetary system which differentiates

money from credit” (E-Gold, 1998) Backed by the precious metal and made infamous due to its novel concept, it attracted millions of users at its height, for legitimate and illegitimate uses alike before it was shut down by the US Department of Justice in 2008 (Foley, 2013) The firm accumulated over 5 million account holders, held approximately 2.2 tonnes of gold in storage spaces in London, Dubai and Zurich, and saw the equivalent of 100-120 kg or USD 1.5 million being moved per day at its height (Bech & Garratt, 2017; Lakmayer, 2014; Mullan, 2016)

Secondly, e-fiat money is the bridge between fiat money and digitalised assets which has yet to find a real-world use case The ECB was the first central bank to open the discussion about the matter when it announced its proposal to embed small radio-frequency-emitting identification (RFID) tags in Euro banknotes by 2005 (J Guo & Chow, 2008) This was intended to function as a tracking mechanism for law enforcement agencies, particularly in light of the likelihood of the relatively young currency being an attractive medium for criminal transactions (Juels & Pappu, 2003) Similar plans have been made by authorities in the USA and Japan, though it remains unclear whether they have ever materialised (Ingersoll, 2013; Smart Labels Analyst, 2002)

The third type described by Guo and Chow is e-credit money, which is often fiat money denominated and sees adoption in electronic credit, debit and prepaid cards, e-accounts including PayPal, and mobile payment outlets such as eScrip (J Guo & Chow, 2008) In China, an example which could be added to this category could be mobile payment services such as WeChat Pay and Alipay in addition to less utilised services such as Tencent’s QQ debit and credit cards (M M Zhang, 2016) As “trusted third-party payment and escrow service” it has been widely adopted in the country, partly to

cope with trust issues in online transactions (Yang Wang & Mainwaring, 2008) This will be further analysed below

The terms e-money schemes and virtual currencies schemes have been used interchangeably, although the latter should rather be considered a subcategory of the former (European Central Bank, 2012) There are indeed many similarities, but also distinctions, especially in their institutional arrangements, which must be made In traditional e-money schemes there are several essential service providers in their operation: e-money issuers, network operators, vendors of required specialised hardware and software, acquirers of e-money, as well as clearers of e-money transactions (BIS, 2015) In e-money schemes, as opposed to virtual currencies, the link with fiat currency remains intact as funds are expressed in units of that currency, e.g USD

2.6 Virtual Currency Systems

The ECB first published a breakthrough report in 2012 in which it laid out a preliminary definition of virtual currencies as “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community” (European Central Bank, 2012, p 13) This definition was later amended in its follow-up report three years later The ECB saw the need to remove the word “money” as virtual currencies did not reach the level

of acceptance and liquidity commonly associated with money Furthermore, as several jurisdictions had implemented relevant legislation in the meantime, thus it could no longer be described to be unregulated Thus, a new definition was proposed: virtual currencies as a “digital representation of value, not issued by a central bank, credit institution or e-money institution, which in some circumstances can be used as an alternative to money” (European Central Bank, 2015, p 25)

Virtual money has several distinct differences compared to traditional and electronic money Firstly, it is mainly created for spending in the virtual world, though

it can later be extend to use for real-world goods and services Secondly, it is often denominated in a fictitious currency rather than fiat currency, as was the case for Yuanbao and Leidian on xunlei.com Third, the underlying money base can be diverse: either rule-based (with rules made by a virtual community), credit-based (virtual bank credit), labour-based (value creation through virtual work, such as time spent online) and commodity-based (J Guo & Chow, 2008)

Guo and Chow identify four different types of virtual money systems Categories are defined based on their convertibility to and from fiat currency as well as the possibility to purchase goods outside the virtual world Since this model was proposed before the release of the first mainstream cryptocurrencies, it is however not fully useful

Therefore, a taxonomy proposed by the European Banking Authority will be followed and expanded (European Banking Authority, 2014)

The first three types of VCS are, as the name implies, controlled by a single private entity and hence referred to as centralised Such models have been widely adopted over the years in a range of forms Another defining feature is the convertibility of funds

2.6.1 Type 1: Centralised Nonconvertible Virtual Currency Scheme

Type 1 of VCS is spendable for goods and services in the virtual world alone As the name suggests, a conversion to and from fiat money is not available, and the scheme essentially follows the same principle as frequent flyer miles (European Banking Authority, 2014) Such v-moneys are commonly issued to virtual community members based on performance, and its spending power is reserved to the consumption of virtual goods and services of the same community An example of this is can be v-money in weiqi.ch (J Guo & Chow, 2008) It was used simply as a Chinese chess community, where its virtual G currency was earned through activities including the promotion of the website using WW, MSN or forums on other platforms, or writing posts on Chinese chess Earned coins could then be used to trade virtual goods such as pets, props and the rights to read and post (J Guo, Chow, Gong, & Sun, 2009)

The second example for Type 1 VCS breaks the virtual wall and enables the purchase of goods and services in both virtual and real scenarios An example for this type can be Facebook’s AceBucks, which was once one of Facebook’s primary virtual currencies (J Guo & Chow, 2008) Modelled after the AMEX rewards system, AceBucks was deemed to be used for purchases of both virtual and physical assets through outlets on the Facebook website (O’Neill, 2007) It could be acquired by completing tasks such as friend referrals or installing certain applications, characteristics which reminded many of classic pyramid schemes (TechCrunch, 2007) While real products could be acquired with it, it was neither transferable within other virtual worlds, nor with fiat currencies (J Guo & Gong, 2011) Although AceBucks was reported to have been purchased by investors quite early on and received a USD 1.5 million founding round, the project was abandoned shortly afterwards (TechCrunch, 2007) A screenshot of the payment page at the time can be found in appendix 1 However, Facebook reinitiated a similar project a few years later, which is covered under in the following section

2.6.2 Type 2: Centralised Unidirectional Virtual Currency Scheme

Furthermore, though Facebook was mentioned above already, they made another attempt at their own virtual currency in 2009 with so-called Facebook Credits (FB Credits) This time, it was available for purchase using a variety of common payment

methods at an exchange rate of FB 1 = USD 0.10, while the reverse was not available Moreover, users could gain additional credits by participating in certain promotions, such as online purchases, and Facebook allegedly planned to pay developers in virtual credits (European Central Bank, 2012) FB Credits in particular saw numerous commentators point out the potential of currency launched by non-sovereigns like Facebook Inc to compete with the dollar, euro, yen and alike (Gans & Halaburda, 2013) With a sizeable user base of over 1 billion, the currency, if successful, could have become more popular than most state currencies Gans and Halaburda have also suggested that the release of FB Credits may have been what nudged the European Central Bank to investigate such currencies with its pioneering 2012 report “Virtual Currency Schemes” (2013) The programme was eventually scrapped in June 2012, since “most games on Facebook [had] implemented their own virtual currencies, reducing the need for a platform-wide virtual currency” since introducing FB Credits

in 2009 (Fuloria, 2012)

Another example, which will be covered in detail in a later section, is QQ’s Q Coin Introduced in 2002 by Chinese internet giant Tencent to allow the 270 million registered users of its messaging service to purchase virtual items including cell phone ringtones and online game accessories (Fowler & Qin, 2007) Coins could be purchased for one RMB each, and were also awarded for free to top-scoring players in videogames in order to encourage engagement with the platform Opportunities were plenty, as Tencent emerged as the largest online game operator in the country, with a 27% market share by revenue in 2010 (Clark & Ning, 2010) Q Coins quickly gained unexpected popularity and users began to trade it for physical goods and real-world services in place

of the RMB to an extent that onlookers feared it could impact the effectiveness of regulatory control over the effective money supply (Barboza, 2007) Q Coin trading was effectively shut down in 2009 following new regulation by the PBoC, as will be discussed later on (Gloudeman, 2014) It is worth noting that QQ and therefore Tencent’s growth has been fuelled by value-added services such as Q Coin, accounting for 77% of its RMB 12.4 billion revenue in 2010 (Clark & Ning, 2010) Other services included China’s first virtual credit card, called QQ Show Card, as well as its own debit card called QQ All-in-One Card in partnership with China Merchants Bank (X Wang

& Wang, 2006) Furthermore, Tencent launched services such as QQ Show, QQ Game, Portal QQ.com, Q Zone and Paipai’s e-commerce C2C payment system before introducing its online payment system Tenpay, otherwise known as WeChat Pay, in

2005 (Clark & Ning, 2010; Tenpay, 2019)

2.6.3 Type 3: Centralised Bidirectional Virtual Currency Scheme

The third type described by the EBA are centralised bidirectional VCS Most prominent examples include E-Gold (described above under E-money in 2.5.) as well

as Liberty Reserve Liberty reserve was a centralised platform with its own digital

currency, referred to as LR, which began to trade in 2005 In order to access LR, users had to register on Liberty Reserve’s website, though solely minimal information on user identity was demanded While traditional banks and legitimate online payment providers required official identification documents or credit card information, accounts could easily be opened using fictitious information (Trautman, 2014) Funds were never deposited on the platform directly Instead, users were required to make deposits and withdrawals through third-party exchangers, thus adding another layer of privacy protection Such exchangers purchased large amounts of LR with Liberty Reserve, which could in turn be purchased by users for a fee of roughly 5% Such exchangers were mostly located in jurisdictions with spotty financial oversight, such as Vietnam, Russia and Nigeria, while the firm itself was incorporated in Costa Rica (Diekmann, 2013)

Once funds had been converted to LR, there were no bounds to the trading with other users In 2013, shortly before the platform was shut down by regulators, it had amassed 5.5 million user accounts and a total of 78 million transactions totalling the equivalent of USD 8 billion (Spiegel Online, 2016) The platform itself could incur significant gains as well, through its 1% trading fee, as well as an additional “privacy fee” of USD 75 per transaction, which concealed the Liberty Reserve account number and thus made transfers completely untraceable (Trautman, 2014) Unsurprisingly, the platform was extensively utilised for illegal purposes, effectively functioning as the bank of choice for the criminal underworld To further enable the use of LR for criminal activity, the website offered an interface with which “merchant” websites could process

LR as a form of payment Such “merchants” included traffickers of stolen credit card data, hackers, unregulated gambling sites, and drug-dealing websites (Diekmann, 2013; Trautman, 2014)

The second example, World of Warcraft (Wow) Gold, was slightly more difficult

to allocate As an in-game currency, WoW Gold could be farmed through intensive labour and then be used as currency in the game only, without the option to convert it to fiat money or spend it on real world goods Accordingly, the ECB classified

time-it as so called “closed virtual currency schemes” or “in-game only schemes” (European Central Bank, 2012) Although buying and selling WoW Gold in the real world went against the game’s terms and conditions in an attempt to avoid legal issues, a sizeable black market for buying and selling it emerged quickly, especially in China, hence effectively rendering it a convertible VCS (European Central Bank, 2012; Peters & Panayi, 2015; Tassi, 2011) Furthermore, starting from 2015, parent company Blizzard Entertainment released WoW Tokens, which could be purchased for a set fee and then exchanged for WoW gold through in-game auction houses for prices dependent on supply and demand and dependent on the server location Nowadays, these tokens can also be acquired with in-game WoW Gold and then converted back to fiat currency (Blizzard Entertainment, 2017; WoW Token Info, 2019)

Another popular example is Linden dollars, the currency of the metaverse SecondLife.com Not only is this example open to real-world USD conversions, but also to other virtual worlds to some extent, though through the inevitable USD conversion (J Guo & Gong, 2011) While most other virtual worlds tend to restrict the use of their virtual currencies to the individual virtual economy in order to avoid any legal issues that may arise, Second Life is one of a minority of cases in which developers did not oppose the active conversion with real fiat currency (Peters & Panayi, 2015)

Finally, some retail cryptocurrencies, which will be discussed in greater detail in section 2.7., also fit in this category While the unique selling point for many of cryptocurrency projects was decentralisation, recent reports have estimated that solely 30% of all crypto-assets could be described as fully decentralised The remaining portion saw 55% centralised and 16% semi-decentralised currency schemes (CryptoCompare, 2018) A popular example in this case is Ripple Foundation’s 100 billion units of XRP prior to the start of the network (European Central Bank, 2015) Furthermore, so-called Central Bank Cryptocurrencies (CBCCs), which so far have only seen sparse adoption, can also be defined as centralised bidirectional VCS, with the central bank at its core This will be considered further in section 2.7.3

2.6.4 Type 4: Decentralised Bidirectional Virtual Currency Scheme

Lastly, one can describe decentralised bi-directional VCS as a final type virtual money systems Examples here include cryptocurrencies such as Bitcoin, which will be described in greater detail in the following section In contrast to the above, decentralised VCS users can engage in mining in order to obtain new units and have no central unit at its core (European Central Bank, 2015)

2.7 Crypto-Assets: Virtual Currency Scheme Types 3 and 4

Crypto-assets, such as cryptocurrencies, resulted from the combination of multiple disciplines including computer science (P2P networking), economics (game theory) as well as cryptography (digital signatures, cryptographic hash functions) (Rauchs & Hileman, 2017) Cryptocurrencies are digital tokens which exist within a particular cryptocurrency system generally consisting of a P2P network, public key infrastructure

as well as a consensus mechanism This underpinning technology, also named blockchain or Distributed Ledger Technology (DLT), “allows for a decentralised public verification of transactions and ensures immutability of those records” (Prasad, 2018,

p 6) In contrast to fiat currency and fiat-backed digital currencies, most cryptocurrencies are not backed by any financial asset, with the entry on public ledgers

in itself constituting the digital asset In contrast to VCS covered above,

cryptocurrencies are created in a process called mining The mining value chain according to Rauchs & Hileman is composed of several distinct activities: mining hardware manufacturing, self-mining, cloud mining services, remote hosting services and mining pools (2017)

Theoretical roots of Bitcoin and other decentralised currencies can be traced back

as far as the 1970s, including in streams of thought such as the Austrian School of economics and its criticism of the financial and monetary system of those days, which sees the grounds of exacerbated business cycles and high inflation in interventions undertaken by governments (Bjerg, 2017; European Central Bank, 2012; Hayek, 1976)

A notable area within the Austrian School has been monetary theory, with Friedrich A Hayek amongst the most influential scholars In his publication “Denationalisation of Money” he asserts that the issuance of money should not be overseen by government alone, and suggests that private banks should be given permission to issue non-interest-bearing certificates acting as currencies (Hayek, 1976) These currencies would then be open to compete on the market and traded at fluid exchange rates, with market forces eliminating currencies with instable purchasing powers over time (European Central Bank, 2012)

2.7.1 Taxonomy of Crypto-Assets

It is also important to point out that such currency tokens are only one of several types of crypto-assets defined by regulators such as the Swiss Financial Market Supervisory Authority (FINMA) or the EBA, though no international taxonomy has been proposed by standard-setting bodies (European Banking Authority, 2019; Sprenger, 2018) Both aforementioned taxonomies include three broad types of tokens, namely payment tokens, investment tokens as well as utility tokens, while FINMA sees some tokens cover attributes of two classifications at once (CryptoCompare, 2018) The first category includes payment, exchange and currency tokens and are most often referred to as cryptocurrencies They are used as a means of exchange as well as investments for the storage of value and include well-known examples such as Bitcoin and Litecoin The second classification are investment or asset tokens, which typically provide ownership rights to a project, as is the case in the context of capital raising, such as Initial Coin Offerings (ICOs) Because these tokens effectively represent debt

or equity claims on the issuer, they have been classified as securities by FINMA (Sprenger, 2018) Examples include Bankera Lastly, utility tokens enable access to a specific product or service using aforementioned DLT platforms, but are not a common means of payment for other services, as is the case for tokens issued to facilitate cloud computing projects, for instance As alluded to, Swiss FINMA has noted that numerous tokens fit two categories, so called hybrid tokens, as is the case for Ethereum, which they identified as both a payment and utility token (CryptoCompare, 2018; Sprenger, 2018)

2.7.2 Bitcoin (Type 4 – Decentralised Bidirectional VCS)

Bitcoin was launched in 2009 as an alternative electronic payment system based

on cryptographic proof instead of trust which, as a peer-to-peer version of electronic cash, would allow online payments to be sent directly from one party to another without the need for intermediation by a financial institution (Nakamoto, 2009) Under the pseudonym Satoshi Nakamoto, the paper title “Bitcoin: A Peer-to-Peer Electronic Cash System” was released in 2009 and saw adoption not long afterwards At its core, Bitcoin

is nothing more than a digital file listing each past transaction on its DLT, a network which “timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work” (Nakamoto, 2009, p 1; Rotman, 2014)

The supply of bitcoins is inelastic, and once 21 million Bitcoins have been made,

no more will be produced (CME Group, 2018) Traditional examples for goods with inelastic supply and demand could be water, food, housing and gasoline According to Blockchain.com, the supply of BTC on the network as at March 2019 was just over 17.5 million, so over 80% of the total supply theoretically available (Blockchain.com, 2019) Newly minted Bitcoins are set to have a finite lifespan as well, as their number will decrease over time However, the supply new coins is scheduled to exhaust no earlier than in the year 2140 (Blenkinsop, 2019; CME Group, 2018) Lower supply of

a currency can, in theory, lead to higher demand, increasing prices and depreciation of prices in the long term, which goes against the order of the traditional monetary system While central banks can freely pump new amounts of currency into a system in a process called Quantitative Easing, which therefore increases prices and incentivises the population to spend their savings in order to maximise purchasing power, Bitcoin evangelists see the chance for a novel consumption pattern and financial order in the limited supply (Berentsen & Schär, 2018)

In any cryptocurrency system, including Bitcoin, miners play a crucial role It is them who are responsible for grouping unconfirmed transactions into new blocks and adding them to the blockchain, therefore validating them (Rauchs & Hileman, 2017) This process occurs during a set period of time, usually every 10 minutes, when a group

of transactions is compiled into a “block” This process is competitive, as miners race against each other to be the first to solve the underlying solution which validates a block and reap the benefits (Rotman, 2014) Once a block is mined, the miner is awarded a certain number of bitcoins as a reward This number used to be 25 BTC in 2013, but has decreased since as rewards are halved every four years so that the total number of Bitcoins will never exceed the predetermined 21 million Such rewards are set to tumble over the years and even disappear once the limit is reached However, bitcoin founder

Nakamoto predicted that rewards will simply become transaction fees, as transactions will still have to be confirmed and processed quickly (Blenkinsop, 2019)

2.7.3 Central Bank Cryptocurrency (Type 3 – Centralised Bidirectional VCS)

Central bank cryptocurrencies (CBDCs) have been defined as “an electric form of central bank money that can be exchanged in a decentralised manner known as peer-to-peer, meaning that transactions occur directly between the payer and the payee without the need for a central intermediary” (Bech & Garratt, 2017, p 56) However, other authors have pointed out that centralisation might be necessary for government agents

or appointed agents to verify transactions (Prasad, 2018) Moreover, it must be distinguished from other forms of electronic central bank moneys such as reserves, which are exchanged in a centralised manner across accounts (Huber & Robertson, 2000) An overview of distinguishing features of conventional cryptocurrencies and CBCDs can be found in figure 2, where cash, commodity money, bank deposits in addition to reserves are put into context Although not considered the equivalent of fiat currency, CBDCs could potentially become a legal tender if the government were to proscribe it as such (BIS, 2018) While many policymakers have held CBDCs to be redundant in the past, the underlying technology in the payment systems has generally been held of interest After all, “it would be technically possible to implement a distributed payment system in the style of Bitcoin that nevertheless remained denominated in a traditional currency”, which could offer benefits such as greater accessibility and resiliency, but also additional costs related to the storage and synchronisation of ledgers (Barrdear & Kumhof, 2016, p 4)

A key point of contention in CBDCs is anonymity It is precisely that which many Bitcoin users had found initial appeal in, mostly in the form of counterparty and third-party anonymity (Bech & Garratt, 2017) The former can reduce the risk of identity theft, the risk of counterparties tracking them down and subsequent theft, as well as overly personalised advertising Third-party anonymity, on the other hand, seems to pose a more controversial problem Critics have stated that it could facilitate criminal activities including tax evasion, money laundering or terrorist financing It is also for that reason that central banks have removed large bank notes in the past, as was the case for the EUR 500 so-called “Bin Laden” bank note in 2016 or the US Federal Reserve discontinuing USD 500, 1,000, 5,000 and 10,000 bills in 1969 (Ewing, 2016) Nonetheless, it is important to point out anonymity has remained the single distinguishing feature of cash relative to electronic money, arguably due to convenience rather than intent from the standpoint of central banks (Bech & Garratt, 2017; Prasad, 2018) However, it remains debatable what level of anonymity, if any, CBDCs should ideally grant Models such as Davoodalhosseini’s have also pointed out the potential cost of anonymity concerns of users (2018)

A second important design feature is CBDC availability Currently, access to digital central bank money is restricted to certain opening hours, which in most cases are less than 24 hours a day and seven days a week (BIS, 2018) As are cryptocurrencies, CBDCs could potentially be available 24 hours a day and seven days a week, or during other specified times Furthermore, the lifespan of a CBDC would have to be determined It could be available permanently or for a limited duration

Thirdly, the ideal transfer mechanism for CBDC would have to be determined Cash transfers are conducted on a peer-to-peer (P2P) basis, while central bank deposits are processed with the central bank as its intermediary A CBDC could either be transferred on a P2P basis or through an intermediary, which could be a commercial bank or third-party agent in addition to the central bank itself (BIS, 2018; European Central Bank, 2012)

Other notable questions relate to interest rate policies on CBDC as well as quantitative limits on the holdings of CBDC, both of which would be instruments the central bank could utilise to steer the attractiveness for certain uses and users For instance, the payment of positive interest could likely enhance the attractiveness of CBDC as a store of value, while setting a limit on CBDC would render it less useful for wholesale payments (Bech & Garratt, 2017; BIS, 2018)

Perhaps the most widely discussed real-world CBDC proposal has been Fedcoin, which was originally proposed by Koning in 2014 and suggested that the central bank create its own cryptocurrency This concept mapped out a potential scenario in which

it could then be converted bi-directionally at par with the USD under the management

of the Federal Reserve Banks (Bech & Garratt, 2017) As opposed to bitcoin, Fedcoin would not have a predetermined supply rule, and would have a cash-like increase or decrease depending on customer demand for holding it Instead of being a private, competing “outside money”, it would instead become an alternative form of sovereign currency (Garratt & Wallace, 2018; Koning, 2016)

Tangible progress by central banks themselves in issuing their own digital currency has been rather inconsequential so far Nevertheless, a number of central banks around the world have initiated their own feasibility studies and research efforts Arguably the first country to adopt the first CBDC was Tunisia, which issued an e-Dinar as a virtual account as early as 2010 This was then superseded by a blockchain-based centralised digital currency which also functioned as a payments system Furthermore, Ecuador introduced a digital currency-backed centralised payment system in 2015, but deactivated it in 2018 due to a low number of users and volume of payments (Prasad, 2018)

Venezuela is another interesting case study, having issued the first official cryptocurrency in February 2018 The petro, as it is called, was declared to be a legal tender in April 2018, is in principle backed by Venezuela’s oil reserves and had an alleged market capitalisation of USD 5.9 billion (Ulmer & Buitrago, 2017) The issuance was intended to bolster public finances as well as evade financial sanctions imposed by countries including the USA At a time when the national currency, the bolivar, was in freefall, it brought hope of a certain level of stability to Venezuelans and crypto investors abroad It was therefore not very surprising that Bitcoin trading volumes hit a trading record following the announcement, with BTC 900 within three weeks (7Bitcoins, 2018)

Figure 2: Cryptocurrencies vs CBDCs (Bech & Garratt, 2017)

It is for similar reasons that Russia indicated interest in issuing their own CryptoRuble in the future (Prasad, 2018) Though details have been sparse, regulators first expressed their intent to explore their own CBCC in October 2017, after plans to heavily regulate Bitcoin and other existing cryptocurrencies (Investing.com, 2017) February 2019 then saw the lower house of the Federal Assembly decide to release an oil-backed cryptocurrency, and President Vladimir Putin instructed relevant authorities

to establish a relevant regulatory framework (Isinge, 2019)

Chinese regulators have taken a rather strict stance against cryptocurrencies in general in the past However, this has not kept the PBoC from allocating recognisable resources to in-house research in the field In an effort started by former governor Zhou Xiaochuan, the PBoC had registered 78 digital currency patents and 44 blockchain-related patents between 2016 and late 2018 (Bloomberg News, 2018b) However, it remains clear that this effort is still in its infancy While certain news outlets were quick

to describe the news of six job openings at its Beijing-based Digital Currency Institute

as a significant step, it will likely take several years before these efforts are realised (Huang, 2018c) Similar approaches to those examined above have also been

announced by countries including Tunisia, Ecuador, Japan, Canada, Singapore, Senegal and Sweden

2.7.4 Initial Coin Offerings

So-called ICOs or Token Sales have been addressed in previous sections and shall now be discussed in greater detail They have been defined as “open calls for funding promoted by organisations, companies, and entrepreneurs to raise money through cryptocurrencies, in exchange for a ’token’ that can be sold on the Internet or used in the future to obtain products or services and, at times, profits”, akin to Initial Public Offerings (Adhami, Giudici, & Martinazzi, 2018; NASDAQ, 2017) As mentioned under 2.7.1., this process is theoretically confined to so-called investment or asset token classifications of cryptocurrencies, though issuers often termed these differently In reality a report found that only 13% of all utility tokens had not undergone an ICO, which only makes the definitions more difficult (CryptoCompare, 2018) ICOs are a relatively new phenomenon and saw widespread adoption inside and outside the blockchain community at an explosive rate Blockchain start-ups themselves, perhaps unsurprisingly, raised their lion’s share of funding through ICOs From 2017 to early

2018, they raised over USD 7 billion through this new method, while traditional venture capital (VC) flows accounted for USD 1 billion (Catalini & Gans, 2018) For comparison, total VC invested in Europe summed to USD 4.3 billion in 2016 (Adhami

et al., 2018) Since this novel access to capital was not limited to the blockchain sector, firms from a wide range of industries jumped at the opportunity at the height of its popularity, including banking, entertainment, software, artificial intelligence, big data, health, retail, education and tourism, to name a few (ICObench, 2019) At the time of writing, the USA was the country with the highest number of ICOs with 740, and highest volume of capital raised through ICOs, at USD 7.4 billion, with other key jurisdictions being Singapore, Switzerland, the United Kingdom, the British Virgin Islands and Estonia According to varying sources, mainland China, in comparison, had been host to an estimated 60-250 ICO projects with a total value of over 350 million (EY Research, 2018; ICObench, 2019) While other protocols also saw frequent adoption, the vast majority of ICOs was conducted through the Ethereum platform, whose own ICO in 2014 raised a record-breaking USD 18 million, an immense success

at the time The DAO project was the first project to raise capital for its own token on the Ethereum platform and could collect a total USD 150 million through the process (NASDAQ, 2017)

ICOs saw advantages over traditional funding methods due to a variety of factors Firstly, the cost of raising capital could be reduced, as it avoids intermediaries such as crowdfunding platforms and payment agents such as banks and credit card providers (Adhami et al., 2018) Creating a token on top of an established platform such as Ethereum is also relatively undemanding, as it can be completed in under 100 lines of

code, thus additionally lowering the barriers of entry (Vereckey, 2018) Secondly, ICOs commonly work well with open-source project development and decentralised business models, which can allow for a build-in customer base as well as positive network effects (Adhami et al., 2018) It can also invite early adopters which give founders useful insights and customer feedback, and encourage developers to build on the platform (Vereckey, 2018) Third, the issuance of a token allows for a secondary market for their investments, in which their shares can be actively traded for prices demanded by the market By contrast, conventional methods such as equity, lending or reward-based contracts are effectively illiquid (Adhami et al., 2018)

The classification of ICOs, and lack thereof, posed a serious challenge to jurisdictions all over the globe as their popularity was skyrocketing A landmark decision was made by the US Securities and Exchange Commission (SEC) in 2017, when it defined that federal securities laws applied to virtual tokens such as the DAO’s given that “the automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S federal securities laws” (Prasad, 2018; SEC, 2017, p 2) While the Ethereum platform,

on which the majority of projects were raised, remained in the clear, it had a noticeable impact on the industry overall as it forced investors and projects to re-examine the funding models of many ICOs (NASDAQ, 2017) While the SEC’s move shed light on the darkness in which many blockchain entrepreneurs found themselves, Chinese regulators assumed a much more radical approach, and issued a ban against all domestic ICOs operations in September 2017, which will be discussed further in the coming sections (Nasdaq, 2018)

Figure 3: Taxonomy of Money and Exchange Mechanisms, Adapted from the Digital Currencies Report by the Committee on Payments and Market Infrastructures of the

Bank of International Settlements (2015)

3 Methodology

This paper follows a mostly positivistic and rationalistic methodology, predominantly dependant on notable policy documents, policy statements, economic indicators, scholarly articles as well as foreign and domestic news sources Since reliable numerical data on Chinese virtual currency use as old as 20 years are very difficult, if not impossible, to obtain, a qualitative approach has been selected (Heeks, 2010) As Slater proposed in his paper on the divergence between virtual and real worlds, such dynamics cannot be fully understood without an in-depth analysis encompassing spheres such as the political economy of access, material and symbolic power, as well as social conditions which underlie the domains of virtual worlds (2002)

There are various definitions and models on the impact of regulation on innovation The framework selected for this analysis was extracted from Knut Blind’s “The influence of regulations on innovation: A quantitative assessment for OECD countries” (2012b) It is presumed to serve as a comprehensive basis for the following analysis, as

it is built upon the OECD taxonomy on regulation, integrates existing economic analyses and its empirical analysis confirmed hypotheses derived from the conceptual theoretical framework As Blind suggested himself, his approach serves as “an appropriate starting point for the empirical analysis of the influence of different regulations on innovation” (Blind, 2012b, p 391) It must be emphasised, however, that Blind’s analysis was conducted with on a quantitative basis, and given the above factors, this paper’s scope is limited

As illustrated in table 1, Blind’s model differentiates between three classes of regulation in accordance with the OECD: economic, social and institutional (formerly

“administrative”) regulation (OECD, 1997) Regulation in the broad sense is defined as

“the implementation of rules by public authorities and governmental bodies to influence market activity and the behaviour of private actors in the economy” (Blind, 2012b, p 392)

Table 1: From Knut Blind’s “The Influence of Regulations on Innovation: A

Quantitative Assessment for OECD Countries” (2012)

Type of

regulation

Compliance cost / negative incentive effects

Positive incentive effect

Increases and secures incentives

to invest in innovation

Positive

Price regulation Price caps reduce

innovation incentives

Minimum prices secure minimum turnovers and decrease risks;

completely free prices allow monopoly pricing

Positive in case of flexible prices

Market entry

regulation

Prohibits market entry of probably innovative newcomers

Reduces competition for incumbents, e.g

for infant industries

Incentives to achieve progress

in productivity in case of rate of return regulation

Positive in case of deregulation

Creates incentives for development of new eco-friendly processes and products by creating temporary market entry barriers

Ambivalent in the short run, but positive in the long run

Labour force

protection

Restricts innovation and creates compliance costs

Creates incentives for development of processes with higher labour safety by creating temporary market entry barriers and monopoly gains

Ambivalent, slightly negative

Product and

consumer safety

Restricts innovation and creates compliance costs

Increases the acceptance of new products among consumers and promotes their diffusion creating innovation incentives

Ambivalent, slightly positive

Product liability Too high liability

risks reduce the incentives to develop and market innovative products

Increases the acceptance of new products among consumers and promotes their diffusion creating innovation incentives

Ambivalent, slightly positive

Intellectual

property rights

Restrict development (e.g

via patent thickets) and diffusion of new technologies and products and the option to develop

Create additional incentives to invest in R&D by appropriating temporary monopoly rights (plus increasing R&D efficiency by disclosure of technological knowhow)

positive

4 Setting the Scene: Context for Chinese E-Payment

Systems Innovation 4.1 Internet Use in China

Before delving into the case for virtual currencies in China, it is necessary to contextualise these developments in the history of Chinese internet usage Though the first email was sent from China as early as in 1987, it was not until 1994 the first cable connection to the World Wide Web was established, marking the official beginning of Chinese internet history At that time, China’s digital starting point was low and slow,

as only about 2,000 personal computers existed in the country First internet cafés opened in Shanghai in 1996, granting a growing number of users access to the web (FlorCruz & Seu, 2014) As local internet companies such as Tencent, Sina, Sohu and NetEase opened for business in the years from 1996 to 2000, the stage was set for what would become the world’s largest internet population by 2005 (K Zhang, Tian, Zhang,

& Ying, 2007) The same can also be identified as the starting point for China’s electronic payment chronicles, as e-payments had reached a significant market penetration by that point

Figure 4: Internet Penetration in China 2012-2018 (CNNIC, 2018)

By December 2017, the number of internet users in China had reached 772 million, which equates to an internet penetration of 55.8%, as is depicted in figure 4 Of the total number of internet users, 97.5% were mobile users Over the years, Chinese mobile use has grown to touch almost all aspects of daily life From 2016 to 2017, mobile payment options and usage saw significant market penetration, with new use cases such as bike sharing, meal ordering, offline bill payments and loan applications attracted millions of

0 10 20 30 40 50 60

new users Growth rates were remarkable: 64.6% for online meal ordering, 40.6% for online car-hailing services, 25.6% for mobile travel booking services and an immediate 28.6% market share for bike sharing applications (CNNIC, 2018) By 2018, a further milestone was passed as the 800 million mark was reached and thus over 57.7% of the population had been linked to the world wide web By comparison, the internet population of the USA amounted to an estimated 300 million around the same time frame (McCarthy, 2018) Accordingly, the volume of Chinese online gamers has skyrocketed as well The number of Chinese online gamers was estimated at around 66 million in 2009, with more than half of them having spent money in online games (X Zhang, 2011) In 2018, market research firm Niko Partners estimated that the total number will surpass 768 million gamers and USD 42 billion in revenue by 2022 and stated that presently, China was already the world’s largest games market (Niko Partners, 2018)

In the rapid development of the country’s IT sector, it was both state and market actors which played an essential role Neo-liberal economic policies of regulators which prioritised the sector as a key driver for modernisation allowed for the allocation of significant resources and leeway to private firms, while those, in turn, introduced popular network services (Yang, 2012) In its 41st Statistical Report on Internet Development in China, the China Internet Network Information Centre (CNNIC) summarised it as follows: “as the Internet serves as an important driving force for the national development, the Internet-driven poverty alleviation, online education and e-government have boosted the dividends of Internet development shared by the people” (2018)

4.2 E-Payment Environment in China

The first Chinese credit card was launched as early as in 1985 by the Bank of China, which became a member of VISA and Mastercard in 1987 (Bank of China, 2019) The example of the Bank of China was rapidly followed by other banks, including the remaining three “big four” banks in addition to fast-growing Tier-2 banks and city commercial banks By 2001, a total of 330 million payment cards had been issued in the country However, the vast majority of those were debit cards, and solely 2.7% of retail purchases were completed with such cash-alternatives (Worthington, 2005) Citibank was the first foreign bank to issue a credit card in China in 2004, which was considered a high-risk move at the time (Baglole, 2004) By 2008, there were a total of

110 banking card issuers in the country (Sappideen, 2008) As card issuance and usage was on the increase and the payment system greatly improved, China’s credit card business was developing rapidly Nonetheless, there were significant hurdles in the way

of more widespread usage Firstly, there was a lack of a national credit bureau which could provide credit information for banks in support of individual loan applications It was not until 2004 that the PBoC established the so-called Credit Reference Center

involving various financial players, which was commissioned in 2006 and constitutes the largest of its kind in the world today (Credit Reference Center PBoC, 2019) In order to drive the interoperability of existing payment cards and as a protectionist measure to keep Chinese banks from adopting international brands such as Mastercard and Visa, the Chinese government established the China UnionPay Corporation in 2002 with the contribution of 84 domestic financial institutions (BIS, 2012; Worthington, 2005) Furthermore, Chinese credit card providers could not maximise their network externalities, as there was still a remarkable lack of merchant acceptance and patchy infrastructure for card processing In 2008, solely 2% of Chinese merchants were said

to be equipped appropriately to handle card transactions, though that number was as high as 30% in major cities such as Shanghai (Sappideen, 2008; Worthington, 2005)

Online payments and electronic payment methods have been available in China since 2000, yet most people preferred using cash in its early days, which was partly due

to above reasons (Worthington, 2005) The willingness to use bank cards in online transaction was low due to worries about sensitive information being exposed on the internet Furthermore, online companies were reliant on banks for customer payment settlements (BIS, 2012; Sappideen, 2008) Lastly, traditional bank cards were not available to the entire market of potential customers, as many of them were underage and did not have access to such methods themselves (Tian & Zhang, 2007) Unsurprisingly, issues in the Chinese online payment market were plentiful at the time Settlement periods were too long, transaction fees were too high and thus unsuitable for micropayments, traditional payment methods such as credit cards had not been devised for online payments and lacked compatibility, and overall standards for online payments were absent (Tian & Zhang, 2007) Internet firms took a series of steps to counter such issues Some offered free transactions to allure customers, charged by year

or month, completed agreements with telecommunication providers such as China Mobile to clear transactions, or through third party payment providers such as Alipay Innovation in the space largely happened bottom-up, with the government often playing catch-up with challenges posed by private ventures (University of Pennsylvania, 2017)

It was not until 2005, a decade after commercial internet service was launched in China, and the same year the Chinese internet population became the largest in the world, that e-payments reached a breakthrough (K Zhang et al., 2007)

4.3 Overview of the General Institutional Framework of Chinese Payment, Clearing and Settlement Systems

In order to ensure a comprehensive analysis and comparison of private and regulatory moves in the realm of electronic payments, the principal institutional framework must be considered The basic legal framework of the PBoC was promulgated in 1995 and amended in 2003 and stipulated that the PBoC’s responsibilities include the formulation and implementation of monetary policies in

accordance with law, the issuance of RMB and control of its circulation, the supervision

of the inter-bank lending and bond markets, control over foreign exchange markets, supervision of the gold market, the maintenance of normal operations of the payments and settlement accounts, and the fight against money laundering, among others (BIS, 2012; China’s National People’s Congress, 2007b) The Law of the People’s Republic

of China on the People’s Bank of China has laid the groundwork of subsequent regulation until today Payment and settlement rules derived from aforementioned laws are laid down jointly with the State Council’s banking regulator The Law of the People’s Republic of China on Commercial Banks came into effect and saw amendment

in 1995 and 2003 as well, and stipulates that the PBoC has the right to regulate and supervise the commercial banking system in accordance with the Law on the People’s Bank of China (China’s National People’s Congress, 2007a) Furthermore, they shall only engage in payment and settlement transactions pending approval of the State Council’s banking regulator (BIS, 2012)

Securities registration and settlement activities have been governed by China’s Securities Law, which was promulgated in 1998 and amended in 2005 and has served

as the highest legal governance over these products since It also defined the responsibilities of the China Securities Regulatory Commission (CSRC) as the controller of relevant institutions and organisations in the securities market (BIS, 2012) The CSRC is also in charge of distributing Fund Sales Licenses, which platforms such

as Alipay have been making use of (Lu, 2018) Other relevant regulatory bodies, particularly for the interbank bond market, include the Ministry of Finance (MOF) and China Banking Regulatory Commission (CBRC) The PBoC has established a comprehensive financial supervision coordination mechanism with the aforementioned CBRC, CSRC in addition to the China Insurance Regulatory Commission (CIRC), which has reinforced the cooperation in creating and implementing regulatory and monetary policies

Payment service providers can be divided into two categories: banking institutions and non-bank financial institutions The former includes commercial banks in addition

to other financial institutions which accept deposits from the public They are the predominant providers in the payment services market and offer a range of solutions to users through their networks The latter category, non-bank financial institutions, are established through corporations in order to improve financial management services within the firms and make funds more efficient In accordance with measures promulgated under the CBRC, such companies may collect and pay money, accept bills and provide related services to their members, while PBoC approval is necessary to engage in payment and settlement services (BIS, 2012) Non-financial institutions were have been required to hold a Payment Business Permit since 2010 in order to operate

an electronic payment system (Kow et al., 2017; Lu, 2018)

Institutions which provide clearing and settlement service in China include aforementioned China UnionPay, the Clearing Center for City Commercial Banks (CCCB), local clearing houses as well as the China Securities Depository and Clearing Corporation, among others UnionPay was jointly established by domestic banks and approved by the PBoC in 2002, and provides clearing services and monitors bank card transactions (BIS, 2012) As novel non-bankcard payment systems saw funds circulate within respective mobile systems, they evaded the PBoC’s clearing systems and created difficulties regarding anti-money laundering policies, data analysis and monetary policy adjustments As a result, PBoC instructed the Payment and Clearing Association

of China (PCAC) to inaugurate the China Nets Union Clearing Corporation (NUCC) in June 2017 and called all mobile payment operators to connect and route transactions through the new clearing house by June 2018 (Lu, 2018; NUCC, 2019; M Zhang, 2017)

In 2015, regulators released the new Internet Finance Guidelines which defined different business categories of the industry Seven main types were distinguished: third party payment service, P2P lending, equity crowdfunding, online fund sales, online insurance, online trust and online consumer finance The main regulatory bodies in charge of each category can be found in Table below (Jun, 2017) The providers and currency systems discussed in the following section often cover more than one category, hence are also subject to more than one regulatory body

Table 2: Chinese Internet Finance Business Categories and Relevant Regulators

Business category Regulator

Third party payment service PBoC

Equity crowdfunding CSRC

Online consumer finance CBRC

5 Results and Discussion

Having set the scene for a comprehensive analysis of the Chinese e-payment infrastructure and building upon the taxonomy of non-cryptographic and cryptographic VCS in addition to e-money systems, the following section shall now examine how regulation has affected innovation in the sector Firstly, e-money schemes will be discussed through Alibaba and Tencent, followed by examples covering non-cryptographic VCS types 1-3, and lastly through the discussion of cryptographic VCS type 4 in the absence of cases which could address type 3 Each section shall first introduce the selected cases in detail and provide an overview of relevant regulatory responses before diving into the application of Blind’s innovation regulation model

5.1 E-Money Systems

Although a number of other schemes have emerged in the country, Alibaba and Tenpay have been selected as case studies due to their palpable dominance in the e-money market

5.1.1 Alipay

In China, an intriguing case study for e-money providers is Alipay Alipay is an online payment platform initially launched by Alibaba Group in October 2003 as a payment service for its online shopping platform Taobao (Kow et al., 2017) It spun off from the shopping platform in 2004, and operated under Zhejiang Alipay Technology Company thereafter, until it was renamed as Alipay (China) Internet Technology Co Ltd in 2008 (Lerong, 2017) It was not until February 2005 that it could officially launch its online escrow system in partnership with the “big four” Chinese banks In the respective announcement, Alibaba’s founder Jack Ma proclaimed the following: “2005 will be the year online payment becomes a reality in China With the help of our 10 million members, we expect Alipay will become the industry standard for safe online payments in China […] Today marks a new milestone for e-commerce in China and a fundamental breakthrough for online payment systems serving buyers and sellers” (Alibaba Group, 2005) Indeed, his vision materialised soon after Amid the rapid expansion of China’s e-commerce market, Alipay was at the front row With Taobao occupying a 80% market share in 2010, and with most transactions on the platform handled through Alibaba, Alipay embarked on an exponential trajectory (Lerong, 2017) Aside from B2C payments, Alipay also supported a number of other related functions, such as transfers between end users, quick pay through Quick Response Codes (QR Codes), paying for utility bills, mobile top ups, e-government services as well as in-app payments in third party apps (CNNIC, 2018) While it is free to use for consumers, it charges a 0.6% fee per transaction to most merchants except those belonging to

industries such as gaming, computing and the lottery business, in which case the fee charged is twice as high (Kow et al., 2017)

E-money transaction numbers and volumes have since skyrocketed: the total transaction value recorded through Alipay grew from USD 70 billion in 2012 to USD 1.7 trillion in 2016 alone, while WeChat Pay saw an increase from USD 11.6 billion to USD 1.2 trillion, respectively (SWIFT, 2018) The Chinese mobile payment sector saw

an increase of 28% from Q3 2016 to Q3 2017, to a total of USD 4.7 trillion, of which Alibaba and Tencent held a 53% and 40% market share, respectively (Yue Wang, 2018)

By 2018, official data reported that the two competitors held a combined total of almost RMB 1 trillion in customer provisions in 2018, or around 90% of total reserve funds (Jia, 2018)

Alipay also began cooperating with traditional financial to provide services for the provision of e-money cards, as was the case with the China Merchants Bank Alipay Card The service allowed customers to tie their Alipay accounts to their bank accounts, thus skipping a step in the online banking process and facilitating the transfer to and from Alipay accounts Default payment limits were at RMB 200, and maximum limits

at RMB 10,000 (China Merchants Bank, 2019)

5.1.2 Tenpay

As mentioned, Alipay’s fiercest competitor has been Tenpay, commonly known as WeChat Pay, which will now be discussed Owned by internet giant Tencent Holdings, one of the top ten largest public corporations by market cap as at March 2019, WeChat emerged as the most popular instant messaging app in China with a monthly user base

of over 1 billion people (HKSE, 2019; Kharpal, 2019) It provides similar services to other instant messaging providers, including group chats, voice chats and video calls, but also feature a civic service platform providing online services such as taxation, education, healthcare and social security payments (CNNIC, 2018; Kow et al., 2017) Tencent launched its WeChat Wallet in 2014 following Alipay’s successful moves in the mobile payment sector, and integrated it seamlessly into its instant messaging platform Payments were still conducted under its Tenpay brand, which settled most of Tencent’s transactions (Clark & Ning, 2010; Tenpay, 2019) Similarly to Alipay, WeChat Pay completes payments through the scanning or QR codes or in-app purchases through third parties WeChat Wallet’s merchant transaction fee is 0.6% per transaction, while industries such as online gaming pay up to 2% (Kow et al., 2017) Before March 2016, users were free to withdraw funds without fees However, beyond that date, a 0.1% withdrawal fee was charged for withdrawals above a cumulative amount of 1,000 yuan

Although Tencent was lagging behind Alibaba and its first mover advantage for years, recent numbers have seen the differences shrinking While Alipay’s mobile payment market share was 70% in 2014, it shrunk to 53% in 2017, with WeChat at an impressive 40% (Yue Wang, 2018) Aside from those mentioned above, one of WeChat Pay’s breakthrough functions have been its electronic Red Packets, which capitalised

on the Chinese tradition of gifting cash-filled envelopes on special occasions such as Lunar New Year festivities After debuting the function in 2014, it was utilised for around 16 million transactions on Chinese New Year’s Eve of the same year Just one year later, the number jumped to 1 billion, and in 2017 it had reached a total of more than 14 billion (Xiao, 2017) Following this success, the red packet market has seen an influx of competitors, with Alipay and Baidu taking up an increasingly large market share in following years Baidu, for instance, saw immense success in its first year of offering the service in 2019, as it processed almost 21 billion transactions on its app after becoming official partner of the state television’s official Spring Festival Gala (Jing, 2019; H Zhang, 2019)

5.1.3 Tencent QQ Credit and Debit Cards

Though its use volume is dwarfed by mainstream e-money channels such as Alipay and its own WeChat Pay, another interesting case study are Tencent’s attempts at e-money cards In 2005, the company launched their first debit card called QQ All-in-One Card in partnership with China Merchants Bank In a process similar to that with Alipay cards, the bank account was bound with a QQ number and had flexible payment limits It could be used to purchase Q Coins and Q cards as well as the extension of monthly service packages (China Merchants Bank, 2019) Shortly after, in November

2006, Tencent announced its cooperation with China Industrial Bank for the launch of China’s first virtual credit card, which could be used to prepay for value-added services

on its QQ platform once connected with a user’s QQ number (China Industrial Bank, 2006; X Wang & Wang, 2006) Called QQ Show Card, it enabled repayment through Tencent’s Tenpay channels, payment on online applications, electronic account statements and instant messaging reminders (China Industrial Bank, 2006)

5.1.4 Analysis

Firstly, the impact of economic regulation will be considered As was the case with other VCS, Chinese regulations often slightly lagged behind the fast-moving trends in the sphere The PBoC started actively commenting on and reacting to third-party payment institutions after 2010 In a presentation on retail payment services, the central bank outlined five goals for the supervision of such providers: safeguarding client funds, conducting general planning of supervision over different legal entities and their subsidiaries, consolidating a solid legal basis, duly performing research, as well as encouraging legitimate innovation (Chen, 2013) In the PBoC’s order on