What are the legal compliance issues of virtual currency exchange financial products?

Author: Liu Honglin, Huang Wenying; Source: Lawyer Liu Honglin

Virtual currency exchanges should be one of the first ways for most newcomers to the cryptocurrency circle to enter Web3. In addition to daily buying and selling of virtual currencies, most virtual currency exchanges have also launched a variety of financial services, some of which claim to be low-risk and guaranteed returns, while others have set up complex gameplay and mechanisms. Among them, simple earning coins is often recommended by the platform to new users because of its user-friendliness.

Yesterday, a certain exchange's simple earning coin financial product attracted much attention due to the soaring interest rate of USDT current financial management. Generally, the interest rate of this product is 6%. At 23:00 yesterday, the interest rate soared to 44%.

*Source: Screenshot of the interest rate on a financial management page of an exchange

Today, Lawyer Mankiw will take the user agreement of the exchange's "Simple Earning Coin Service" as an example to talk to you briefly about what this type of financial management product is all about.

Overview of Simple Earning Coin Service

The simple earning coin service (Earn) of the virtual currency exchange provides a convenient way for digital asset holders to increase their value. Users can deposit their virtual currencies into the platform and choose current or fixed-term financial management products to obtain returns based on their liquidity needs and return expectations.

From the perspective of the use of funds, this type of simple coin earning service is a service based on lending, that is, users deposit their own virtual currencies on the exchange platform, and the exchange lends these virtual currencies to people in need, and charges a certain fee, which is distributed to users in proportion as financial management profits. At present, most exchanges support mainstream currencies for investment and financial management, such as the subscription of USDT, USDC, BTC and ETH for current or regular simple coin earning products.

After the user deposits the token, if his lending demand is successfully matched with the lending demand of other users, he can earn income by the hour before the end of the order period. Not only that, users can also choose to enable the automatic renewal function. In this way, at the end of the period, the order will be automatically matched again and continue to generate income.

Financial attributes and legal definitions

If we compare the simple coin earning service with the products and services of the traditional financial industry, we can find that the simple coin earning service is similar to the deposit or financial management in traditional finance, and the virtual currency earned is equivalent to interest or investment return. However, compared with traditional financial products, the simple coin earning service of virtual currency exchanges relies on blockchain technology, has the characteristics of decentralization and globality, has stronger capital liquidity, and relatively higher returns.

However, if you want to provide such services, the compliance and licensing of the platform is the first step. There are significant differences in the regulatory provisions and qualification requirements of virtual currency exchanges in different countries and regions. Taking Hong Kong as an example, virtual currency exchanges need to apply for Type 1 (Securities Trading) and Type 7 (Automated Trading Services) licenses from the Securities and Futures Commission (SFC) of Hong Kong.

*Source: Hong Kong SFC official website

In addition, different countries and regions have different legal positioning of virtual currencies, which directly affects the legal attributes of financial services based on virtual currencies. In my country, regulators have taken a strict stance on virtual currencies. In the "Announcement on Preventing the Risks of Token Issuance and Financing" issued in 2017 by the People's Bank of China and seven other ministries and commissions, it was clearly pointed out that token issuance and financing activities are essentially an act of unauthorized illegal public financing. In addition, my country has clearly prohibited financial institutions and payment institutions from conducting business related to virtual currencies.

In such a regulatory environment, simple currency earning services, as an unauthorized financial activity, may be deemed illegal. For investors, if they know or should know that the service may be suspected of being illegal and still accept and establish a legal relationship with the exchange, the legal relationship may be deemed invalid. When a dispute occurs, it will be difficult for investors to obtain effective legal protection.

Legal risks and suggestions

For this reason, when investors use the simple coin-earning service of a virtual currency exchange to manage virtual assets, they should fully understand the compliance of the exchange and correctly assess the transaction risks based on the user agreement to avoid unnecessary property losses during the investment process. Specific methods and approaches that can be taken are:

* Image source: "Simple Earning Coin User Agreement" of a certain exchange

• Pay attention to changes in regulatory policies.Regulators in various countries may implement stricter regulatory measures on virtual currency exchanges for a variety of reasons, such as requiring exchanges to comply with specific registration and reporting requirements, restricting the operation of exchanges, and even completely stopping related services in some extreme cases. Investors will face liquidity risks, which will affect the recovery of investment principal and the expected returns. For example, the once-popular FTX exchange disclosed a debt of tens of billions of US dollars when it filed for bankruptcy, which not only caused millions of retail investors to lose all their money, but also affected well-known investment institutions such as Sequoia and Temasek. Therefore, when participating in the simple money-making service, investors should pay close attention to regulatory developments and evaluate the impact of potential policy changes on investment.

• Pay attention to risk and equity assessment. In the traditional financial field, regulators usually require financial service providers to ensure that investors are fully protected. However, in the field of virtual currency investment, most service providers will minimize their risks through the terms of the agreement. Therefore, when participating in the simple money-making service, investors should fully understand the terms of service, risk disclosure and their own risk tolerance.

• Pay attention to dispute resolution clauses. These clauses usually appear in the user agreement in the form of standard clauses, and the platform party often sets the dispute resolution method from the perspective of maximizing its own interests. For example, it agrees to arbitrate abroad. Users may not pay enough attention to the jurisdiction clause during the registration process. When a dispute occurs, such dispute resolution clauses often bring additional time and economic costs to users.

• Some jurisdictions require that when using standard clauses, platforms or service providers must reasonably remind users of these clauses, especially those that may be disadvantageous to users. If the provider of the standard clauses fails to take reasonable measures to remind the other party, or the content of the clauses is obviously unfair, the court may determine that the clause is invalid. But even if such claims are supported, it usually requires a long process of negotiation, consultation, or even litigation, which is not conducive to the efficient resolution of disputes.

Attorney Mankiw's Summary

The low risk and stable rate of return promised by the simple money-making service are particularly attractive in the risky Web3 field, but such promises often require investors to treat them with caution.

Before participating in such services, investors should fully understand the relevant regulatory policies, assess the risks, and pay attention to the relevant provisions in the user agreement. The legal status and regulatory requirements of virtual currencies vary significantly in different countries and regions. Investors need to pay close attention to policy changes to avoid unnecessary legal risks and property losses.