Private digital currency, represented by bitcoin, should be more accurately defined as "quasi-digital currency" as it neither effectively performs the basic functions of currency nor is it qualified to become real currency. The emergence of ICO is inevitable and a legal definition of it should be given as soon as possible. One possible way is to start with a regulatory sandbox and to gradually build a complete regulatory framework, which will be very important to the healthy development of the entire blockchain industry. We need to restrain from defining digital currency simply as bitcoin and should approach digital currency from the perspective of digital fiat currency (DFC) rather than private digital currency. The competitiveness of central bank digital currency (CBDC) comes from two sources: one is to draw upon advanced and mature digital technology and the other is to inherit the reasonable connotations of traditional currency that come as a result of long-term evolution.

Bitcoin as quasi-digital currency

Digital currency, a current hotspot topic, is regarded by most people as represented wholly by bitcoin. In fact, it is more appropriate to define bitcoin as “quasi-” or “pre-” digital currency. The prospect of bitcoin, Ethercoin and others are favored by investors as they apply the blockchain technology to address the trust issue of digitized payment from a technical perspective and the emergence of smart contracts in Ethercoin has the potential to embark on a new business application model. However, cutting-edge technologies cannot provide trust backed by asset value.

As pointed out by BIS and IMF, bitcoin is lack of strong asset support, which is a fatal defect. Some may joke that “mining is the biggest flaw of bitcoin”, though from a technical perspective this is an innovative design. Because of such an inherent defect, bitcoin is faced with volatile value, weak credibility, limited public acceptance and vulnerable to negative externalities. Therefore to be precise, although bitcoin is called “currency” nominally, it is by nature just a kind of non-currency digital asset. Just like the word “virtual” in virtual currency, which I would like to interpret as “not qualified yet”.

Currency is asset, while asset is not necessarily currency. Digital assets represented by bitcoin, due to low liquidity and high risk, cannot perform the three basic functions of money, i.e. medium of exchange, unit of account and store of value. As a result, they are not qualified to become real money, let alone replacing fiat currency that is endorsed by sovereign credit and supported with strongest trust in value.

Treating ICO with rational mind

Some think that quasi-digital currency represents the right to use technological infrastructure or the prepayment for open source project service. But so far, instead of being used for transaction payment, quasi-digital currency is held by individuals for investment or speculative purposes in most cases. Statistics and expert assessment show that only a small proportion (less than 20%) of bitcoins is used for transaction purpose. Most people just simply hold it. In terms of the structure of the holders, early holders of bitcoins are mostly tech-lovers, but since 2013 institutions and individuals outside of technological communities have started to hold bitcoins. It is also shown by relevant experience that those new comers invest in bitcoin as a kind of asset rather than use it as medium of exchange.

ICO has become a very important way to fund blockchain projects and it may sometimes raise more than twice as much capital than do venture capital. In its earliest time ICO was interpreted as Initial Coin Offering, which is quite similar to IPO. Having taken into account the sensitivity of privately issued quasi-digital currency and the dispute over whether coins should be regarded as currency, some literatures start to use the term Initial Crypto Token Offering, which means raising capital by issuing encrypted token. The author of this paper regards this as a more accurate interpretation. The term token is usually referred to as some kind of certificate for using alternative currencies within certain scope. It can be considered as encrypted equity issued and circulated on blockchain. Although so far many ICO projects do not have much value, their emergence is beneficial to the development of blockchain industry.

Take Ethereum as an example, it was started by raising over 30,000 bitcoins via ICO with the aim to develop an unstoppable, anti-screening and self-maintaining decentralized smart contract platform. In the development process of blockchain, smart contract is a good direction. Another example can be found in the data layer. The Zcash issued through ICO has facilitated the development of full anonymity of transaction information, and as a result the token was priced extremely high the moment it came into being. The capital raised for NextCoin through ICO is used to develop PoS-based blockchain. Similar cases abound, including various kinds of decentralized application projects based on payment, digital wallet, asset transaction, fund management, deposit, gambling and games on the application level.

The burgeoning of ICO is inevitable. Its pricing mechanism is worth studying. No matter what purpose ICO serves, be it investment or speculation, it manages to offer very high returns. Ten years ago, 10,000 bitcoins could not afford a piece of pizza, but now one bitcoin is worth more than an ounce of gold. Currently China holds a rather strict attitude to bitcoin. But in a sense, is it possible to give green lights to the largest 10 ICO companies on a cautious basis? On one hand, this will offer more investment opportunities (unintended investment in dark technology is possible, but still better than buying junk stocks). And on the other hand, it is worth our attention that neighboring countries including Japan, South Korea, and Singapore are encouraging the development of bitcoin and they even think that bitcoin might become high quality asset.

There is a notion in currency theory that is very similar to ICO encrypted equity—cash or currency is by nature the central bank’s liability to the public and it can also be regarded as equity assets held by the public against sovereign country because it has features of contingent claims[ D. Gray, R. Merton, Z. Bodie, 2008. New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability. ]. In this sense, quasi-digital currency is encrypted equity issued and circulated on blockchain and is highly analogous to liability or equity asset issued by a sovereign country to the public. Therefore, it is understandable that monetary authorities can get so alerted to speculations on those currencies. However, an indiscriminate treatment towards all quasi-digital currencies is not advocated. We should keep an open mind while tighten regulation.

Regulatory sandbox for ICO

So far, ICO business mainly exists in communities and token exchanges which are two separate places, leading to discontinuous regulation. Moreover, speculation on tokens at the exchanges will cause severe deviation of price of ICO token from the project’s intrinsic value. Theoretically, the price of the token is determined by the intrinsic value of the ICO project. If an ICO project does not have any real value and an investor buys a token just so he/she can sell it later at a higher price, then the situation is more like a “passing the parcel” game or a Ponzi scheme. This is worth our attention

Since ICO is at the edge of laws and regulation, it is necessary to legally define ICO as soon as possible. A complete regulatory framework is very important to the healthy development of the blockchain industry. Implementing regulatory sandbox for ICO might be an effective way. A few solutions could be considered.

One is to establish an ICO platform similar to crowdfunding platforms which assumes responsibilities such as investor education, risk alert, ICO project examination, qualification check, funds custody, information disclosure, monitoring of funds usage and anti-money laundering. The other way is to supervise exchanges of encrypted tokens, which bears the defect that a regulated exchange may still engage in transactions through decentralized means. There is also suggestion that we could draw upon management ideas of VC funds by allowing professionals to make investment choices and support ICO project operation, which will promote innovation while making the projects more transparent. As technologies supporting decentralized exchanges become increasingly mature, token exchanges may also be decentralized in the future. By then regulatory action of a single country will not suffice, and international regulatory cooperation and coordination will be especially important.

The UK and Australia have already accumulated some experience on regulatory sandbox, and they have a very clear financial regulation model to control ICO projects. China adopts a separate regulatory system which is prone to regulatory vacuum, regulatory arbitrage and regulatory chaos and is not very much in line with the diversified and innovative nature of ICO projects and testing needs. Thus, further enhancing the coordination mechanism of financial regulation is significant to the implementation of regulatory sandbox.

Investor education is critical to ICO regulation. Mature market requires mature investors. Looking back into the history, it is found that all the asset bubble bursts and financial crisis are, to some extent, reflection of human weaknesses. Currently ICO token is still an emerging item with high technicality, and people hold divergent views on how to define its attributes and value. Protection of ICO investors requires actions from regulators. But in the long run, the fundamental solution lies in the maturity of investors who possess professional knowledge, emotional stability and rational cognition.

Interaction between Ethereum and smart contract

Among discussions about blockchain, some have proposed an inspiring time-based decentralized payment solution to address the performance issues of traditional blockchain[ P. Xie, W. G. Shi, 2017.]. But this is more like a solution on a private chain instead of a public one. There are two problems of the abovementioned solution that can be solved on private chain but not on public chain. The first is that the solution requires a unified time base becasue the operation of the system depends on a trustable and reliable time base service and all the nodes should be able to guarantee absolute synchronization of time. But time on a public chain is relative—various nodes have different local time and receive data packets at different times and even in different orders due to communication delay. As a result, what matters to public chain is the order of data arrival rather than the absolute time of events, meaning there is no such concept of absolute space time. The second problem is that the solution only describes system operation under normal conditions. On a public chain, the system operates in an open space and the environment is uncontrollable, so the biggest difficulty is to respond to all kinds of emergencies including packet loss, time delay, occurrence of “bad guys” etc. Therefore the design of public chain should be focused on the mechanism to respond to abnormal situations under non-conventional conditions.

For the time being, research on blockchain has not made any significant breakthrough in consensus algorithm. On the contrary, thanks to Ethereum, smart contracts have witnessed rapid development—given the upward momentum of Ethercoin, it may one day surpass bitcoin. In terms of application, components of blockchain are not developing on an equal footing, with current focus mostly on smart contract. Is this some sort of AI on blockchain that may lead to the initiation of real intelligent commercial application model? As a result, the technology of smart contract is developing rapidly despite of setbacks caused by security incidents like “The DAO”. Only by tackling the problem head-on can innovation be realized—an idea that is quite in line with what guides the development of Ethereum.

Two “untying”

Is it feasible to untie digital currency from bitcoin? And is it feasible to untie digital currency from blockchain?

Untying digital currency from bitcoin

Digital currency should not be narrowly interpreted as bitcoin and it should be approached from the perspective of DFC rather than private digital currency. We should define digital currency in China’s context which is a brand new field by itself, and therefore it is not necessary to copy existing definition. This may make it easier to understand digital currency from the perspective of public economics.

According to Hartmut Picht (1992), services provided by currency include “liquidating” and “stabilizing value of unit-of-account”. The former has attributes of quasi-public goods and the latter has attributes of public goods.

Generally speaking, certain conditions should be met for the private sector to provide public goods. First, public goods provided by the private sector should be quasi-public goods. Second, such quasi-public goods usually have small size and narrow coverage, involving only a limited number of consumers. Third, there should be exclusive technologies to ensure consumption of quasi-public goods. Finally and most importantly, a series of institutional arrangements should be in place for the private sector to provide public goods successfully[ E. T. Ma, 2003.].

The weaknesses of private quasi-digital currency are obvious. Cases occur quite often where the leakage of private key leads to the digital asset getting stolen and not getting back. At bitcoin exchanges, which are the most critical part to the circulation of bitcoins, there are no institutional arrangements (e.g. deposit insurance for the banking system and central bank as lender of last resort) to ensure the security of bitcoin transactions, withdrawals and storage. On 7th February 2014, Mt.Gox, the world’s largest bitcoin exchange suspended withdrawal service due to cyber attack, which caused trading chaos. Later Mt.Gox declared bankruptcy. Apparently, private quasi-digital currency does not have the capacity to offer the service of liquidation and the service of stabilizing value of unit-of-account. DFC is the only one that can play this role and has the potential to become the cornerstone for a new generation of financial infrastructure and for the development of digital economy in the future.

Untying digital currency from blockchain

Can’t traditional distributed architecture be used to develop digital currency? Of course it can. Digital currency as a branch of cryptography emerged long before bitcoin. Why do we have to rely so much on blockchain technology? Is blockchain mature enough? Can it be used on a large scale? There are still plenty of concerns about it, so why should we tie up blockchain with digital currency? Blockchain is only one of the options. How it should be used is quite flexible—it is just a tool and should be used in the way it should be. If it fails to work well, we can always choose to abandon it.

But of course, blockchain technology is indeed inspiring. When developing a system, how could it occur to us that high value data should not be allowed to change? We have to keep such idea in mind when building new systems. Abnormalities are rarely considered in the consensus algorithm of traditional distributed architecture. When transforming exclusive-purpose systems into open systems, we have to take into account all kinds of potential attacks and extreme abnormalities. In this regard, blockchain has offered many inspiring ideas, for example using Byzantine generals agreement to avoid the emergence of traitors, which is an improvement to traditional distributed systems. We can learn from such ideas but it does not mean we have do it in the exact same way. In another example, smart contract requires CBDC to have higher quality, which is an issue that is worth some serious thinking. The user experience of existing payment products is very good already, so new payment tools have to become better to attract more users.

Competitiveness of digital fiat currency

The competitiveness of DFC comes from two sources. From a technical perspective, DFC has to draw upon advanced and mature digital technology—this is very important and the private quasi-digital currency is in a advantageous position to do this. And from an economic perspective, DFC should inherit the reasonable connotations of traditional currency that come as a result of long-term evolution.

It is important to keep in mind the similarities and differences between DFC, which is a new type of currency, and traditional currencies and private quasi-digital currency. But no matter how DFC evolves, the intrinsic value supporting DFC should remain the same. Things that do change are the form of currency (i.e. digitized form) and the issuance technology. In the conventional issuance process, things appear on the banknotes include face value, issuer, year of issuance, serial number, etc. But new technologies will allow the currency to contain more information, including for example the information of the currency holder and the whole lifecycle information during its circulation process. Of course, to realize this requires not only a technological system of higher quality but also changes of mindset on the part of central banks and currency users.

At present, there are two ways to issue and create DFC. One is to allow exhange for DFC according to one’s needs. For example, it is proposed in a recent ECB report to allow non-banking participants to transform bank deposits into digital base currency on a 1:1 ratio, because the purpose of non-banking participants to hold digital base currency is to replace cash rather than bank deposits. The report argues that the negative effects of digital base currency could be ignored as long as the purpose of its usage is to replace cash. In the starting period, CBDC can be positioned as a supplement or replacement to cash until more experience is gained. Such a step-by-step approach to promote digital currency is inspiring to all central banks.

Another way is to expand central bank’s balance sheet, namely the central bank issues digital currency by purchasing assets from the market in accordance with monetary policy targets. Of course, the premise of doing so is to clearly define what types of assets are qualified to be purchased and at what quantities and prices. The second way is rather complicated. In a sense, the first approach proposed by the ECB offers an easier start and is easier for us to reach consensus on.

It is worth notice that although DFC is legal tender by nature, meaning that anyone or any institution cannot refuse to accept it in a circulating environment, it is still possible for it to lose attraction to citizens of the issuing country under circumstances of sovereign debt monetization, excessive external debts and rising default risks because as mentioned above, cash or currency is by nature debts or equity issued by a sovereign country to the public. It is no exaggeration that in extreme cases a country’s cash (including DFC) may no longer be qualified as currency. Therefore, the question of how to determine and control the issuance volume of digital currency and ensure price stability is not only the most critical consideration of central banks that issue CBDC but also the key for monetary authorities to win the competition of digital currencies in an era of digitized economy.

The author is the Vice Director-General of the Technology Department and the Head of the Institute of Digital Money of the People’s Bank of China. This article only represents academic views of the author.