A ‘black box’ can be described as a system in which the observable elements entail inputs and outputs, but without any understanding of its internal workings. In other words, the black box is opaque. The observer has no knowledge of the process through which the inputs enter the system and the outputs emerge at the other end. Machine learning algorithms are often described as black boxes. The making of laws and policies can also be viewed as a black box, a metaphor that I draw on to depict China’s approach to regulating cryptocurrencies in recent years. I conclude by exploring the possibility of introducing a ‘sandbox’ for FinTech innovation in China, which has been promoted in a growing number of jurisdictions.

The Regulation of Cryptocurrencies in China

Among the more controversial FinTech innovations in recent years has been the rise of cryptocurrencies such as Bitcoin and Ethereum on the back of ever-expanding possibilities offered by distributed ledger technology, such as blockchain. Peer-to-peer transactions involving cryptocurrencies operate on a decentralised, distributed ledger which does not require any intermediaries, such as banks or money transmitters.

As the value of Bitcoin skyrocketed in 2017, Initial Coin Offerings (ICOs) also became a popular financing method for start-ups. ICOs entail the offering of digital coins or tokens, usually denominated in a cryptocurrency, to investors in return for cash. The tokens give investors a prescribed interest in the start-up, which in principle should gain value with the success of the business’ product/venture (sometimes the tokens can be used to purchase the product itself).

Growing popularity in the use and trading of cryptocurrencies, especially among speculators, and the lack of clarity on how they fit into existing regulatory frameworks, has attracted significant attention of late from regulators around the world. In China, the country with the largest exchanges of cryptocurrencies, authorities stepped up regulatory controls in 2017 by issuing a complete ban on exchanges and ICOs.

The first official regulatory intervention took place in 2013 when the People’s Bank of China (PBoC) and four government departments jointly issued a circular declaring that Bitcoin was not issued by official monetary authorities and did not have the status or attributes of a fiat currency. Instead, the document stated that Bitcoin was a special ‘virtual commodity’ and may not be circulated and used as currency in the market. It prohibited financial services companies from dealing with Bitcoin exchanges.

The latest regulatory move from the Chinese authorities, in September 2017, involves the immediate ban of all types of ‘token financing’ activities and related businesses. According to the relevant Circular issued by the PBoC and six other national regulators, ‘token financing’ involves the raising of Bitcoin, Ethereum, and other ‘virtual currencies’ from investors through the illegal sale and circulation of coins. ICOs are deemed ‘a form of unauthorised illegal public financing’, which possibly involves the illegal sale of coins/tokens, illegal issuance of securities, illegal fundraising, financial fraud, pyramid schemes, and other illegal and criminal activities.

The ban prohibits all digital token financing and trading platforms from engaging in the exchange of ‘fiat currency’ and ‘virtual currency’, trading in virtual currencies, and providing pricing, information and intermediary services in relation to virtual currencies. Furthermore, ICOs are required to cease immediately and refund any money raised to investors. Financial institutions and non-banking payment institutions are also prohibited from, directly or indirectly, providing services or products relating to ICO financing and virtual currencies, such as setting up accounts, registration, trading, settlement, clearing and insurance.

The preamble of the Circular states: ‘speculation prevails, and suspected illegal financial activities have seriously disrupted the economic and financial order’. Regulators have cited various reasons for the latest crackdown, such as the use of cryptocurrencies in criminal activities such as money-laundering and trafficking, the protection of investors’ rights and interests, and financial stability risks associated with capital flight.

Innovation without authorisation?

The inner workings of China’s regulatory model are not immediately observable or available for inspection. As such, the regulation of cryptocurrency in China to date can be aptly described as a ‘black box’. Cryptocurrency exchanges in China were operating in a legally ‘grey’ area from as early as 2013. Given the potential risks, why did regulators allow such platforms and attendant activities to continue (and grow) instead of imposing stringent rules earlier on?

There have been rumours that the latest ‘ban’ on cryptocurrency trading and ICOs is only an interim measure until regulators figure out a better approach. Some observers are even speculating that the government will re-open cryptocurrency exchanges that it will run and control. Indeed, the possibility of an official digital fiat currency issued by the PBoC cannot be ruled out. The PBoC has its own digital currency research institute, and there have been numerous statements made by its officials regarding piloting a prototype. It is not clear if/when a digital currency under the control of China’s central bank will be introduced. However, it could have significant implications for the Chinese economy as well as the global financial system.

It is likely that the outcome of China’s regulatory black box will be ‘innovation without authorisation’, in the absence of clear rules. A lack of transparency associated with the ‘black box’ also entails regulatory fragmentation and competition among different authorities at various levels. The division of labour is often not clear, and given the possibilities for conflicting interests and ‘power struggles’ between these bodies, the door for regulatory arbitrage is left open. It remains to be seen if regulators can support FinTech innovation while managing market risks and preventing wrongdoing.

From Black Box to Sandbox?

‘Regulatory sandboxes’ in the context of FinTech innovations are in vogue. The UK Financial Conduct Authority has described the concept as providing ‘a “safe space” in which businesses can develop and test innovative products, services, business models and delivery mechanisms without immediately incurring all the normal regulatory consequences of engaging in the activity in question’. Supporters of the approach maintain that sandboxes enable firms to try out new innovations in a live market. The experimentation takes place within certain regulatory parameters (such as safeguards for consumers) but is not subject to the restrictive or complex rules of the wider system which may stifle innovation.

Regulators engage in ongoing supervision of, and interaction with, sandbox participants in a controlled testing environment so that all actors involved can better understand the regulatory implications of the innovation and improve the management of risks. In a growing number of jurisdictions including the UK, Singapore, Hong Kong, South Korea, Canada, Denmark, Switzerland, United Arab Emirates, and Australia, regulatory sandboxes have been heralded as a new and effective form of regulatory engagement with innovation and experimentation. A larger number of jurisdictions, including the EU, are currently considering the introduction of sandboxes.

Nevertheless, there is a concern that sandboxes may leave markets vulnerable to considerable risks, which highlights the challenge of defining appropriate regulatory parameters for the sandbox’s operation. In doing so, a number of important questions need to be asked. Which participants should be permitted to enter the sandbox? What rules should be applied? How long should the experimental period be? What constitutes a successful innovation? Will the test experimentation within the sandbox reflect the actual regulatory risks if/when the project scales up? Overall, how should one evaluate the effectiveness of the sandbox?

Getting the parameters wrong can increase the risk of regulatory arbitrage, as regulators give the ‘green light’ to underdeveloped innovations that are not adequately tested. This risk is accentuated with the different parameters of sandboxes that can vary considerably between jurisdictions. Most sandboxes are still in an embryonic stage of development. Pressures arising from competition between countries to be the ‘first-mover’ in developing and bringing innovations to the market could also heighten the risk of regulatory capture in the implementation of sandboxes.

There have been growing discussions of regulatory sandboxes among Chinese policymakers, FinTech players, and academics in China. One may argue that China’s system of financial regulation is not equipped to deal with any ‘loosening’ of regulation, given the government’s general reluctance to tolerate risky experimentation and its need to preserve stability above all other goals. Indeed, the country’s leadership is only too wary of growing signs of systemic instability in light of the spectacular 2015 stock market plunge, unprecedented levels of capital flight, and rapid accumulation of debt in recent years. On the other hand, major reforms have taken place in China based on localised experimentation involving pilot projects, trial/interim rules, and special zones within tightly defined regulatory parameters.

A regulatory sandbox for FinTech with ‘Chinese characteristics’ may well emerge in the future. Given the tight control the state at the central level seeks to exercise over the official financial system, the formal parameters of such a sandbox are likely to be much more restrictive than those in other jurisdictions in terms of eligibility criteria and rules of operation. Such a sandbox is also likely to encompass a top-down, command-and-control, centrally-driven model of reform that maintains the appearance of a tightly controlled regulatory system. At the same time, the system leaves room for bottom-up innovation from a range of entrepreneurial activities at the local level by investors, local government authorities, banks, and non-bank financial institutions that lead to new products and services outside the formal regulated system. An illustrative phenomenon has been the rise of shadow banking in China.

A pervasive feature of financial regulation and supervision in China has been institutional fragmentation. There are at least half a dozen different regulators at the central (national) level. A newly formed Financial Stability and Development Commission under the auspices of the State Council is hoping to address ongoing regulatory coordination problems. If China adopts a sandbox approach, such a body (given the appropriate regulatory powers) could be in the ideal position to oversee its implementation. However, the real danger is perhaps related to another pervasive characteristic of the system. A serious lack of transparency could very well mean that any regulatory sandboxes will end up being “black boxes”.

Mimi Zou is the Fangda Career Development Fellow in Chinese Commercial Law at St Hugh's College, University of Oxford.