Recently, social media in China is abuzz with Wannacry, which has successfully made bitcoin known to those who have never heard of it before.

Sun Tzu, a Chinese military strategist, author of the art of war, says that he who knows his enemy and himself well will not be defeated easily. Bad guys use bitcoin as a method of ransom for its pseudonymity, transparency and global payment. And what’s behind these advantages is the blockchain technology, which is shining in areas like copyright protection, healthcare, energy and philanthropy. As such, we could say that bitcoin is only a successful experiment of blockchain and I believe blockchain will lead to more regulatory challenges. Therefore, I am writing to analyze possible risks of blockchain in its three phases and how to handle them.

Blockchain 1.0: Digital Currency

The age of blockchain 1.0 has witnessed the inception of bitcoin and other cryptocurrencies. With the help of cryptography, game theory and consensus mechanism, a brand new decentralized digital payment system has evolved into a global low-cost real time clearing and settlement system that enables cross-border payment. And in this phase, blockchain faces challenges concerning anti money laundering, payment settlement and monetary system.

• To crack down money laundering, financial institutions must know your customer. However, as digital currencies are not dependent on financial institutions, regulators must innovate in their regulation methods. In 2016, the EU called for tighter restrictions and released the Fourth Anti-Money Laundering Directive (4MLD), under which virtual currency exchange platforms and custodian wallet providers will fall under the scope of 4MLD and will be required to perform customer due diligence for all relationships.
• Second, with the payment and settlement of digital currency, it will weaken the market demand for the central bank and thus shake up the central bank-based payment and settlement system, which is likely to endanger the implementation of monetary policy. Meanwhile, both capital projects and cross-border payments under the current account are based on authenticity. But when it comes to real time digital currency payment, no one knows how to supervise.
• Finally, the biggest problem with digital money is its incompatibility with current monetary systems. At present, only several countries have accepted bitcoin as a legal currency. In most cases, it is either being banned or restricted. Japan has officially recognized bitcoin as a legal currency, but says that it cannot be treated as important as legal tender and should be taxed. Overall, China has remained unsupportive of bitcoin. At the end of 2013, the PBOC People’s Bank of China and five associated ministries released “Notice on the Prevention of the Risk of Bitcoin” and defined bitcoin as virtual commodity and prohibited any financial institution or third party payment institution from engaging in the bitcoin business. Since 2017, the PBOC is mobilizing to ensure that tighter restrictions and surveillance can be possible within bitcoin exchanges. On the other hand, the central bank is working on its own digital currency.
• Will Chinese all switch to their national digital currency?

Blockchain 2.0: Digital Assets and Smart Contracts

• If blockchain 1.0 is meant to decentralize means of payment, then blockchain 2.0 is born to decentralize the whole financial market.
• At this stage, digital asset becomes the most serious legal issue. Digital asset can be divided into two categories, one is the Internet-based virtual asset like online game accounts and the other is physical asset being mapped on the Internet like electronic bills, securities, equity. In the case of virtual property, it has been included in the newly released General Principles of Civil Law, but remains controversial and uncertain in its legal attribute. On the mapped property, records on blockchain are irreversible, but this cannot guarantee the authenticity of underlying assets, which undermines the credibility of blockchain.
• Smart contracts are another big headache. Should it be considered as the contract under the terms of China’s “Contract Law“? If the answer is yes, then does the code belong to the legal form of expressing content contained in a contract? Can everyone involved have the ability to identify and understand the meaning of the code? In other words, can the code reflect what does a party want? If “code is law”, how to make sure the party with technical advantages will not abuse its advantages? In addition, the inherent irrevocable and automatic implementation of smart contracts comes into conflict with the Contract Law where contract can be changed, cancelled and invalidated.
• Blockchain 2.0 will experience a hard time with lack of relative laws and policies. It is well-said when ETF was roundly rejected.

Blockchain 3.0 RegTech

In this phase, with the combination of regulation and technology, RegTech will be used as a brand new tool for effective governance. But it faces two concerns.

First, as data recorded on blockchain are open, transparent and accessible to regulators, which would be like living in the Truman’s Show. Plus, data recorded cannot be revised or deleted and in rare cases, some unfavorable records would become lifelong burdens. Second, RegTech wishes to transfer literal rules into rules on blockchain. The thought of “law is code” greatly underestimates the difficulty of doing so.

The world is now moving from the age of blockchain 1.0 to the age of blockchain 2.0. And regulators should not block its future by releasing rules once and for all. Let’s wait and see what would be the future of blockchain.