3 February 2021
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Let's talk tech and Chinese money.
Since antiquity, China had led the world with its adoption of cutting-edge currency
Today, there is an immense amount of interest surrounding China's new digital yuan (“DCEP” – Digital Currency Electronic Payment).
However, China's history of currency innovation goes back to ancient times. Unlike Roman coins, ancient Chinese coins are marked by a square hole in the middle, allowing the bearer to efficiently string large amounts together for ease of transport.
A "开元通宝", kāiyuán tōng bǎo; 'Circulating treasure from the inauguration of a new epoch'. Attribution: Unknown.
Another innovation was the use of bolts of silk. In ancient times, silk was issued to garrisoned troops along the silk road as a form of payment, because it was lighter than coins and easier to transport overland from the then-imperial capital of Chang'An (present-day Xi'an).
A plain, basket-weave (one thread over, one thread under) bolt of silk from the 3rd or 4th century CE and currently housed at the British Museum. Before it snapped in half, this bolt was sent as payment to garrisoned Chinese troops in the silk road city of Krorän (also known as Loulan). Attribution: Valerie Henson, The Silk Road, Colour Plate 5A.
Promissory bank notes appeared a few hundred years after silk bolts were used, in Tang dynasty China. These promissory notes allowed merchants to conclude large transactions without needing to carry heavy loads of metal coins (Tiě qián, 贴钱) on their person. Another few hundred years later, real paper currency (Jiāo zi, 交子) appeared in Song dynasty China (although Chinese paper already existed when silk was used as payment, it was mostly for wrapping and it took some time for paper currency Jiāo zi to emerge).
China is starting a new chapter in its currency innovations
Fast forward to today: with the proliferation of Wechat Pay and Alipay during the 2010s, China has, more than a millennium after inventing paper bank notes, become the first major economy to transform into a cashless society. In this regard, China is already miles ahead of other developed markets.
In line with its history of currency innovation, China is again writing a new chapter. However this time, there is one major difference. Past Chinese improvements on money were usually incremental. Paper and silk are lighter than copper, and digital wallets weigh no more than the smartphone they're carried. That latter also bring some additional record-keeping features, like a basic receipt for the parties' reference.
Unlike these incremental evolutions, the DCEP is a revolutionary advance in currency. Allowing near-instant foreign exchange settlement and built on blockchain, the DCEP is perfectly traceable and allows the People’s Bank of China ("PBOC", Chinese Central Bank) and state owned banks to collect data not only on transactions between users (the parties, the date, and the amount exchanged, among other details) but also on each subsequent transaction using DCEP. There is immense potential for using this ledger data to fuel the growth of fintech in China.
To better understand this, imagine for a moment if every transaction for every US Dollar in circulation — for the lifetime of each dollar — were recorded by the Federal Reserve on a ledger. These dollars are stored and exchanged in digital wallets, each of which has an "address" (like a bank account number) tied to a person or company.
Whether in New York, Paris, or Shanghai, the Federal Reserve now knows the name, timestamp, and amount exchanged for every transaction completed in USD. Now imagine that the Federal Reserve makes this data available to tech giants, either to help detect crime, encourage innovation, or even to help the government raise money. Imagine also that they share this information with law enforcement to help them identify and catch criminals, and fight money laundering and tax evasion.
Obviously, the Federal Reserve won't be able to realize these scenarios for legal and political reasons. It is very limited in what it can do with a digital dollar. It would be illegal for it to sell user data without user consent and privacy concerns in the US would quickly lead to public backlash against sharing data with law enforcement programs. It should be noted that the US Federal Reserve is considering a Central Bank Digital Currency (CBDC), though this has yet to launch and its scope is set to be much narrower than in the scenarios described above.
The PBOC, on the other hand, is more than ready to push a digital currency to its fullest potential, from government departments to beyond China's borders. As of January 2, 2020, the PBOC had already filed 84 patent applications for the DCEP, and the DCEP is scheduled to be in use in time for the 2022 Winter Olympics in Beijing. The plan is to first implement its use across government institutions, then large Chinese companies, and then finally to help forge a path along the new land, maritime, and "digital" silk roads as a settlement layer in the Belt and Road Initiative ("BRI"). Former PBOC Governor Zhou Xiaochuan recently spoke at length on the potential for the DCEP to transform cross-border trade.
There are plans to share DCEP data to fight crime. According to Yao Qian, founder of the PBOC's Digital Currency Research Lab, the DCEP's data will also be shared with law enforcement. Of course, as suggested in a report by the Bank of International Settlements, the benefits to law enforcement could be minimal because ordinary criminals will tend to avoid a fully traceable currency. That said, it could be used to great effect to fight white-collar crime and corruption. For example, after government treasuries convert all Yuan to the DCEP, their spending (and the spending of government contractors) could be tightly monitored. This may lead to much greater transparency in areas like government product procurement, construction, and other public tenders, which are particularly vulnerable to bad actors. Similarly, once large companies convert to DCEP, it follows that their staff payroll and a funds paid to suppliers will also be traceable.
Moreover, there are already plans in place for the mass-commoditization of data in China, which may enable marketing DCEP data. This year, it was revealed that Shenzhen will establish a “data trading market” and “take the lead” in exploring new mechanisms for data property rights protection and utilisation (see 2020 Implementation Plan for the Pilot Comprehensive Reform of Building a Pilot Demonstration Zone of Socialism with Chinese Characteristics in Shenzhen). To be clear so far, there is no indication this this is intended to market DCEP data, but it does open very interesting opportunities should the government decide to do so.
Implications of China's DCEP for Insurtech & Insurers
In terms of creating Insurtech products for end-users, the DCEP's implications for Insurtech depend in part on whether and to what extent the DCEP will enable or support smart contracts. Smart contracts are already featured on other crypto tokens, most notably the Ethereum Virtual Machine ("ERC-20") which supports developing smart contracts by using the Solidity programming language, a combination of Javascript and C++.
While initially a cause for alarm in some jurisdictions, blockchain smart contracts hold great potential that is increasingly well-understood by regulators. In addition to powering the telematics behind Insurtech products (for more on the potential for telematics in China see our past article, "Can Foreign Investors Capitalize on Insurtech’s Growth in China?"), smart contracts enable automating transfers of rights in exchange for funds and lowering transaction costs (especially for multi-party agreements).
This technology forms the basis of Initial Coin Offerings ("ICO"). Through ICOs, smart contracts allow a fundraising venture to execute only after sufficient investors have agreed to the financing terms. In exchange for funding the venture, the investors receive a token, a kind of digital share certificate recorded on blockchain.
Although ICOs provide an innovative and potentially important vehicle to support fundraising for new ventures and ideas, lack of regulation and rampant fraud raised serious regulatory concerns when they became popular a few years ago. For more on this, see Zetzsche et al., “The ICO gold rush: It’s a scam, it’s a bubble, it’s a super challenge for regulators”, Harvard International Law Journal, vol. 60, no. 2, 2019. ICOs have been banned in the PRC Mainland since September 2017 (PBOC, CAC, MIIT, SAIC, CBRC, CSRC, and CIRC Announcement on Preventing Financial Risks from Initial Coin Offerings).
While ICOs remain restricted in the PRC, they are now legally regulated in Hong Kong and Taiwan as Security Token Offerings ("STO"). STOs combine the power of an ICO with the stringent regulations of the securities market.
Integrating the digital Yuan with an eventual STO regime would be revolutionary in a couple of different ways. First, allowing STOs — whether in Hong Kong or in the PRC assuming they are legalized — to be denominated in DCEP would greatly benefit fundraising for this innovative space. This would be a win for both private investors and the government: investors gain access to a powerful new fundraising tool, while the government can monitor and regulate STOs under its financial exchanges by bringing them within the fold of Chinese securities laws. This would allow regulators to implement mandatory disclosure rules to protect investors from the risks of fraud associated with ICOs, and further displace unofficial cryptocurrencies by channeling existing ICO action into the legitimate STO system. Together, these changes would make institutional investors more likely to treat STOs as serious investment opportunities. As a result, enabling the DCEP to support STOs would cement the DCEP's appeal for fundraisers and institutional investors while helping the government keep tabs on this new activity in public exchanges.
Legalizing STOs and allowing them to be denominated in DCEP also opens up major new underwriting opportunities for property insurers. Say, for example, that an opportunity presents itself for a new insurance line of business — a new Chinese rocket company wants to launch missions into space to replenish the International Space Station, or launch a new satellite. Given the risks, it cannot find an insurer willing to underwrite and sell such an insurance policy.
With a DCEP-denominated STO, an insurer could decide to underwrite such a policy on the condition that an STO attracts an adequate number of co-insurers and reinsurers, and then exchange the tokens as financial assets. If there's adequate market interest after the STO is listed, then the policy would launch (as would the rocket ship!), be divided into token shares, and then be distributed into each insurer and reinsurer's book of business in exchange for their DCEP payments. After the STO is written, all of these subsequent steps would happen automatically and significantly reduce transaction costs. Innovations like this are already occurring, for example Nexus Mutual, a blockchain company providing a decentralized financial alternative to insurance cover. Depending on how innovative the regulators wish to be, such "policy tokens" could then be resold as securities to investors on the Shanghai, Shenzhen, or Hong Kong stock exchange. In an interview with Sergey Nazarov, co-founder of Chainlink (a company developing "oracles" for smart contracts), one possibility under discussion is for the revenue from such policies to even become tokenized, and then bought and sold as a fixed-income investment asset.
Due to its instant settlement capability, denominating these investments in DCEP would also open the door for participation from foreign insurers provided that they satisfy market access requirements (for more on this, see our past articles, WFOE Shopping — How Do Beijing, Shanghai, And Shenzhen Compare For Establishing An Insurance WFOE In China?; and China, GATS, Trump: Do Non-US Insurers Get A Piece Of The China-US Trade Deal?).
Second, integrating the DCEP with an STO regime would be particularly welcome for insurance investors, for whom restrictions on equity investments were recently relaxed in November 2020. Coming into effect on November 12, the Notice on Matters Related to Insurance Fund Financial Equity Investment (the “Notice") lifts a significant number of prohibitions on equity investments by insurers. In particular, it divides permissible investments into a positive and a negative list. Generally, as long as an equity investment prospect is safe, liquid (stable cash flow and a track record of dividends), profitable, legally registered and not engaged in serious legal disputes, is led by an honest team, presents no risk of related-party transactions, is not involved in real estate, is not a serious environmental polluter, and is not on the NDRC's negative list, then an insurer is free to invest in it. Although in practice a significant number of ICOs were risky, failed, and would not meet these criteria for investment, in theory this opens the door for lucrative new investment opportunities if the government opens the door to PRC STOs with sufficient securities regulations in place.
While this DCEP/STO revolution is far from a reality, the government is already moving towards an "internet of blockchains" that would allow the DCEP to work far better with existing smart contract ecosystems. One government initiative, the Blockchain Services Network ("BSN", 区块链服务网络, qū kuài liàn fúwù wǎngluò) is designed to allow cross-platform compatibility and support popular Western frameworks such as "Hyperledger Fabric (already supported), Ethereum, EOS and Digital Asset’s DAML" (Forbes). The BSN is aimed at "providing a robust, low-cost, high-availability, multi-cloud, internet-of-blockchains infrastructure", and was launched in collaboration with large Chinese enterprises including UnionPay, China Mobile Communications Corporation, Design Institute, and China Mobile Communications Corporation Government (ibid).
As for personal insurance, this would depend in large part whether and to what extent DCEP data will be turned over to the private sector. Realistically, most personal data would be off-limits — absent user consent, we most likely will not enter a dystopian future where central banks sell data on personal lifestyle habits to insurers in order to adjust health policy rates. However, as discussed above, it would be feasible for the PBOC to make some personal data available to some financial institutions in order to help fight financial crimes, and this may including combating risks such as insurance fraud. It would also be feasible for new insurance contracts to stipulate that some benefits will only be paid out in DCEP. While insurers would not collect DCEP data, they may thereafter be able to request production of such data in the event of a lawsuit disputing the claim, and detect suspicious activity after the benefits are paid with the help of forensic experts.
Besides fraud prevention, one form of data that would be particularly helpful is data on insurance disputes. Insurtech smart-contracts could feasibly house not only insurance policies, but also dispute resolution provisions which connect to mediation, arbitration, or even Chinese internet courts. One example, SageWise, already provides a dispute resolution clause to be integrated within smart contracts. The data generated from disputes, i.e. the nature of the disputed claim, the amount, and the party which prevails, could help regulators identify and take action against standard clauses showing a high-frequency of disputes, while allowing insurance companies to better allocate resources in drafting and communicating sensitive policies to their clients. This would allow not only resolution of disputes, but also prevention of future disputes.
If allowed to be used by the private sector, we can expect there to be strict guardrails in place for how DCEP data is used, which would make it especially difficult for foreign insurers seeking to enter China's Insurtech market to satisfy local requirements. Under Article 37 of China’s Cybersecurity Law (2017) ("CSL"), Chinese citizens’ personal data, together with critical business data collected in China, must be stored within mainland China, and companies must undergo a security assessment before exporting such data across the border. Thus although possible to make visible from an insurer's headquarters in London or New York, this would almost certainly require a local Chinese partner or subsidiary that can pass the CSL's security assessment prior to sending such data to a foreign server.
Conclusion
From bolts of silk to blockchain bits and bytes, China has a rich history of currency innovation that continues to the present day.
This time, China is implementing a currency innovation so revolutionary that it will take years to fully grasp its potential. The DCEP allows near-instant settlement and will play a significant role in the land, maritime, and digital silk roads, with the potential to transform cross-border trade.
Legalizing STOs and allowing them to be denominated in DCEP would unleash a wide range of new investment and underwriting opportunities for insurers. The DCEP would be especially powerful if it can support smart contracts. As for data, the DCEP may present great advantages to insurers in terms of risk and fraud detection, though this depends in large part on the extent to which PBOC data is shared with other financial institutions.
In light of the DCEP's untapped potential, the 2022 Winter Olympics in Beijing will — just like the 2008 Beijing Summer Olympics — display to the world a modern, dynamic China with its sight set on even further horizons.
