DeFi: Can decentralized finance defy China’s crypto controls?

Every morning, for two years, Madao rode the metro to a bustling artery of downtown San Francisco for his coding job at Flexport, a freight-shipping logistics startup. Like many bright young coders in the Bay Area, the 27-year-old worked by day and bought bitcoin by night. Then one day, a friend invited him to join a WeChat group that was building an app in a new technology sector called “decentralized finance” — DeFi for short. The app allowed users to borrow and lend their cryptocurrencies with interest like a traditional bank, but without the need for a centralized service.

“That was the great thing about DeFi,” said Madao, who asked not to be identified by his real name. “Any programmer could learn how to make a [DeFi] app in a few weeks.”

The DeFi world is made up of hundreds of such apps, called protocols, built atop blockchains, which facilitate the movement of billions of dollars in cryptocurrency transactions a day. Skilled programmers who contribute to its development can make millions in cryptocurrency tokens and transaction fees. “For my first app, the amount of capital flow reached $100 million,” Madao told me. “It only took me three days to make that.” He was hooked.

Madao now works in a Defi unit called a “DAO,” a decentralized autonomous organization, out of Shenzhen. Already a multimillionaire (by his own account), he is one of many Chinese with finance or tech experience who have moved back to China to pursue a career in the DeFi sector. “I know a few Chinese who work a day job, then run a multibillion-dollar protocol at night,” he told me. 

But this is all very new: Madao’s protocol operators still have their day jobs, although perhaps they won’t need them for much longer: The DeFi industry is growing rapidly globally, and also in China despite the government’s crackdown on cryptocurrencies. Last June, the DeFi platform Compound Finance (COMP) broke a valuation of $1 billion, the largest for the industry, just a day after its public listing. The COMP listing frenzy has “spread magic to the rest of DeFi,” said Camilla Russo, the editor of The DeFiant, a cryptocurrency news site.

China, too, caught the DeFi bug. According to Chainalysis, from June 2020 to June 2021, China logged $256 billion in cryptocurrency activity, the highest in Asia. DeFi platforms made up close to half those transactions with Uniswap, the leading DeFi exchange, now the second biggest in East Asia by transaction volume. “Two years ago, nobody even knew what DeFi was,” said Genio Miao, founder of Quantiex, a DeFi protocol. “Now, the change is just incredible. Everything that was once just in your imagination, all those expectations of user behavior, they all came true.” 

A dramatic crackdown on cryptocurrency — which has intensified under China’s sweeping economic restructuring program — leveled centralized cryptocurrency exchanges. So more and more of China’s crypto-enthusiasts and investors are turning to decentralized finance options instead.

From the ashes of centralized exchanges

China’s affinity for cryptocurrencies is a decade old. Five years after bitcoin was invented by a mysterious programmer named Satoshi Nakamoto in 2008, the country was home to the world’s largest bitcoin exchange, BTC China. It boasted some of the largest bitcoin mining operations and had more downloads of bitcoin wallets than the rest of the world combined. In May 2013, China’s flagship state television, CCTV, issued its tacit support with a glowing documentary on the bitcoin boom. When a 7.0 earthquake razed Sichuan Province that same year, an organizer of a disaster relief fund reported that he had curiously received 230 donations of a “virtual currency.”

Bitcoin’s popularity grew in China, in part, from its value proposition as a decentralized currency: Its value and circulation did not rely on the actions of a centralized authority. But over time, users needed easy ways to exchange, buy, and sell cryptocurrencies, and centralization reemerged to meet that demand. That left centralized exchanges such as BTC China vulnerable to regulations. In 2013, China banned commercial banks from handling bitcoin transactions. At first, exchanges found workarounds. “The exchanges came up with some creative ways to skirt the regulations,” said Zennon Kapron, the founder of Kapronasia, a fintech consultant firm. “Back then, you had a couple of third-party middlemen; you would deposit 10,000 yuan to Mr. Joe’s account, then you would receive a voucher that you would then enter into the bitcoin exchange website, then get credited the 10,000 yuan.” From 2017 to 2019, China continued to tussle with its bitcoin hobbyists. It banned initial coin offerings and crypto exchanges, yet citizens still largely skirted the bans through offshore exchanges and peer-to-peer trading.

Now, with the boom in crypto markets, the expected rollout of China’s state-backed digital yuan, and a new resolve from those in the highest office to right “financial speculation,” Beijing came back with heavier artillery. After a brutal mining crackdown in the spring, which had reduced mining activity in the country to zero, China issued a blanket ban in September on trading and exchanging crypto into fiat money. In a statement, the People’s Bank of China stated that all cryptocurrency business activities are “illegal.” 

“That’s fairly strong language that we haven’t seen before,” said Kapron. “Effectively, this could mean that you’re arrested for doing something around crypto, whereas previously you’d just have your account shut down or fined.” 

The consequences for central exchanges were drastic and sudden. The day prior, Huobi, the world’s second-largest exchange, ceased account registration for new users in China and announced it would remove Chinese users by the end of the year. Other smaller exchanges followed suit. “In the past, we had been communicating with regulators to see if there are still ways to legally operate in China,” the co-founder, Du Jun, told Bloomberg. “But this time, there’s no room for discussion.” Binance, the world’s largest exchange, had exited China in 2017 due to government pressure, but last week, it shut down its peer-to-peer trading of the yuan, the last workaround for China’s crypto users.

Can you know your DeFi customer?  

By effectively banning its crypto industry, Beijing may have unwittingly caused a kind of creative destruction: As the easy-to-target centralized exchanges died, a more resilient, decentralized variant rose from the ashes. After the birth of decentralized currency like bitcoin, DeFi now promises to extend that decentralization to financial services. “The recent regulations have actually been good for the DeFi sector because it has hit the centralized exchanges the hardest,” said a DeFi startup founder who asked to remain anonymous. “We still haven’t hit up against any real legal barriers.”

China’s rules have not seemed to deter investors in the crypto sector. “U.S. investors are still bullish,” said Miao. He mentioned that most of his investors, who are from the U.S., remain eager to invest in the DeFi sector. “In China, investors scrutinize every bit of your business plan, but in the U.S., it’s just ‘What’s your long-term vision?’ and the next is ‘How are you all dealing with the regulators?’” 

The DeFi world could pose serious challenges to China’s regulatory system. It consists of anonymous coders writing financial products on blockchains for anonymous users. Financial transactions occur at the user’s discretion, so there is no one on the receiving end of a state prohibition. China’s DeFi users, in other words, are like users of virtual private networks (VPNs): Both are doing something illegal in theory, but the action is difficult to stop. Meanwhile on the supply side, the services cannot be terminated. “In a normal company, if you shut down the server, it’s over,” said Madao. “But the fascinating thing about DeFi is that to really shut down the company, you need to shut down Ethereum [the blockchain that runs many DeFi apps], and Ethereum can’t be shut down.”

“You cannot control blockchain abroad, so what you can control is access to the ‘front end,’” said Chris Powers, who writes the Dose of DeFi newsletter. So as long as DeFi entrepreneurs do not establish a “front end” — an exchange or store front where users can move money from the broader economy onto the blockchain — they are going to be difficult to control. 

Nonetheless, China is trying. Beijing is reportedly considering demanding a “know your customer” (KYC) protocol, a form of user identification that financial institutions require. But Madao says many DeFi companies are already incorporated elsewhere — his is in Singapore — and so abiding by regulations has become more a “choice based on development trade-offs” rather than an immovable wall. “The nature of these companies is such that they’re largely virtual,” said Kapron. “The people operating these companies could be sitting in Indonesia, the U.S., anywhere. It’s almost like flipping a switch for them to shift to a different market.”  

For now, the DeFi industry remains inchoate and a relatively low user base means it does not pose significant threats to the state. “We’re like the World Wide Web in 1992,” said Madao, “most of the infrastructure is not mature yet.” But when it does, the sector could have an appeal well beyond Chinese users. “I don’t think about it as a ‘Chinese DeFi,’ it’s much more broad than that,” said Miao. “I think about the DeFi industry as incorporating the entire Asia-Pacific Region, including China, Taiwan, Singapore, and so on.” 

The long-term goal of the DeFi sector, Madao told me, is to reach a point where the industry can offer a secure, easily accessible alternative to the traditional finance system, but total replacement is unlikely. “There’s too much money moving through it and they already have a super complex system in place,” he said. “So there’s no chance decentralized finance will 100% replace it.”

What does China want from blockchain? 

China sees cryptocurrency — which has become a highly volatile asset that is completely outside the control of the state — as antithetical to its new “Common Prosperity” agenda, which, alongside seeking a more even distribution of wealth, aims to crack down on financial instability. A similar rationale can be seen behind China’s curbs on real estate speculation, the online tutoring bubble, and gambling, all of which signal a new development path stripped of excess financial risk. In a speech at the Fifth Plenum last fall, Xi Jinping called for a “New Development Concept,” one that could pivot China away from such “fictitious growth drivers” and more toward “innovative growth drivers” and the “real economy.” 

That makes the DeFi sector a potential target. “The regulatory crackdown is directed at all tokens [short for cryptocurrencies],” one investor told me, who asked not to be named, “and DeFi products still require tokens.” The DeFi sector, like the crypto industry more broadly, has had its share of fraud cases: Between January and April, $156 million was stolen in DeFi-related hacks. 

Cryptocurrencies could also compromise the public’s confidence of China’s state-backed digital yuan, now one of the country’s major state priorities. “Right or not, people associate the CBDC [central bank digital currency] with cryptocurrency,” said Kapron. “And so all the government needs is a couple of stories of people losing their life savings in bitcoin or Ethereum or whatever it is, and then all of a sudden people are wary of using the e-renminbi.”

But the government may be saying one thing and doing another. In a move that baffled many in the DeFi sector, a Shanghai-based blockchain startup called Conflux received a $5 million investment from the Shanghai government. The startup works in DeFi and issues its own tokens (ostensibly illegal). “The only way this could have worked is if Conflux lied to them,” Madao told me. (Conflux was co-founded by Yáo Qīzhì 姚期智, an award-winning computer scientist and professor at Tsinghua University.)

Close observers of China’s DeFi sector have interpreted the Conflux investment as China’s attempt to build its own, competing version of DeFi — a concession that the sector is immune to regulation. “We believe China will have to move into the DeFi space,” said James Gillingham, the CEO of a DeFi investment firm, to Forkast, a crypto news site. He posits a “new Chinese DeFi network” that “will ensure the amount of capital leaving China.”

The Conflux problem is symptomatic of China’s broader ham-fisted approach to crypto. For years, China has denigrated cryptocurrencies but extolled blockchain, the technology infrastructure that powers digital currencies. At a virtual United Nations Conference last week, Xi Jinping called for the promotion of “blockchain” within the transportation industry. Last year, a city in Hebei Province became the first blockchain-enhanced city, with the technology helping to pay resettlement compensation and salaries for migrant workers, and to purchase construction material.  

“The technology of blockchain has a lot of fundamental value, so China sees it a bit like it sees 5G, augmented reality, IoT, and the internet,” said Frank Li, an investor at the crypto fund SNZ Capital. “Blockchain can provide data tracking and verification, and it can also guarantee the safety of data. There’s a lot that it can do.”

Among the government’s favorites are blockchain consortiums — private networks of blockchains that connect data between enterprises — that have been developed in major tech companies like Tencent and Alibaba since at least 2019, with government backing.  

“The government right now is mostly focused on blockchain consortiums and other non-currency blockchains that serve businesses and local governments,” said Li. “Every major internet company has its own blockchain group, and some are supported by the government.”

China may have sundered crypto and blockchain by fiat, but they are inseparable in practice. “The best part of blockchain are the tokens, which ensure that people can get involved in it with some incentive,” said Madao, “but the government doesn’t allow tokens because it thinks they will mess up the financial system. So people can only make blockchain without tokens — that makes things weird.”

The weirdness has already begun. NFTs, another sector of blockchain that the government seems to support, stands for “non-fungible token,” but Chinese companies are now omitting the term “token” in order to protect themselves from regulatory attention. Some have even moved away from the Ethereum blockchain altogether. Regulatory obstacles are undercutting the development of the blockchain sector writ large. China can’t have its cake and eat it, too. 

China’s lack of coherence with regards to its blockchain sector is an indication of how the digital tides may be turning. After confronting this century’s major risks — the pandemic, the internet, AI, climate change — with ever-greater centralization, China may have sparked, in its citizens, a yearning for something else. “The world is trending toward ever-greater decentralization,” the anonymous DeFi founder told me. “People prefer it more.” And now a technology promises to make it happen, one that might not be subject to governments. Madao agreed. “The only law that works in crypto is code.”