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Bolts, Bits, & Bytes: China’s New Digital Currency And Implications For Insurers And Insurtech – Technology


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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). 

1032596b.jpg

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.

1032596c.jpg

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),
1 though this has yet
to launch and its scope is set to be much narrower than in the
scenarios described above.

1032596d.jpg

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.

Footnotes

1 In the words of Federal Reserve Bank of Cleveland
President Loretta J. Mester, this would create “digital cash
[…] just like the physical currency […] but in a digital form
and, potentially, without the anonymity of
physical currency [emphasis added].”

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