Is decentralized exchange (DEX) legal in China?

Is DEX legal in China?

Blockchain technology is a technology that uses cryptography and consensus mechanisms to achieve distributed storage and verification of data. Blockchain technology has many applications, one of which is decentralized exchanges (DEX).

A decentralized exchange (DEX) is a blockchain-based digital asset trading platform that does not store user funds and personal data on servers, does not rely on third-party intermediaries, but directly achieves the trading and transfer of digital assets through smart contracts and peer-to-peer networks. On DEX, users can trade directly using their own wallets without giving control of their funds to any intermediaries or custodians. This can avoid some risks of centralized exchanges, such as hacking attacks, platform running away, and asset freezing. At the same time, DEX can also protect user privacy as they do not need to implement regulatory requirements such as KYC and AML.

01 Current Situation of DEX Industry

There are various types of DEX in the market, which can be classified according to the order book method and trading mechanism.

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According to the order book method, it can be divided into on-chain order book and off-chain order book. The on-chain order book records all orders on the blockchain, and each transaction is confirmed by miners. This method is more decentralized but also slower and more expensive. The off-chain order book hosts transaction records in a centralized entity and uses relayers to manage the order book. This method is faster and cheaper but more centralized.

According to the trading mechanism, it can be divided into Automated Market Maker (AMM) and Order Matching (OM). AMM does not require an order book but uses smart contracts to form liquidity pools and automatically execute trades based on certain parameters. This mechanism simplifies the trading process but can also result in issues such as price slippage and impermanent loss. OM requires an order book and completes transactions by matching orders from buyers and sellers. This mechanism is more flexible and efficient but requires more liquidity providers and market participants.

The most popular DEX in the market currently include Uniswap, SushiSwap, LianGuaincakeSwap, Curve, Balancer, etc. They all adopt the AMM mechanism and operate on public chains such as Ethereum or Binance Smart Chain. The ones based on the OM mechanism include 0x, Loopring, dYdX, etc. There are also those based on cross-chain technologies such as Thorchain, Ren, Polkadot, and those based on aggregator technologies such as 1inch, LianGuairaswap, Matcha, etc.

DEX solves the security, privacy, and sovereignty issues of centralized exchanges, but also has some shortcomings such as transaction speed, liquidity, and user-friendliness. Since transactions on DEX need to be confirmed on the blockchain, transaction speed is affected by blockchain network congestion and gas fees. Moreover, the number of users and transaction volume on DEX is relatively small, resulting in insufficient liquidity to meet the needs of large transactions.

First, the user experience and usability of DEX still need to be improved. Users need to connect to DApps or install standalone DEX clients and use their own blockchain wallets for operations.

Second, the liquidity and transaction speed of DEX are relatively low. Due to the small market share of DEX in total trading volume, it is difficult to carry out large or rare token transactions. At the same time, due to the need for all transactions to be confirmed on the blockchain network, delays and slippage issues may occur.

Third, DEX is not completely immune to government regulation and intervention. Although DEX itself does not have centralized servers or institutions, the underlying public chain network may be attacked or blocked. In addition, DEX may also face legal proceedings or liability if it issues or trades tokens suspected of fraud or illegal activities.

02 Legal risks of starting DEXs in China

China does not welcome virtual currencies or cryptocurrency exchanges.

In September 2017, the Chinese central bank announced a ban on all domestic ICOs and cryptocurrency trading platforms, resulting in the closure or migration of many well-known CEXs. In September 2021, China further strengthened its crackdown on cryptocurrencies, prohibiting all financial activities and services related to cryptocurrencies.

In such an environment, DEXs seem to provide an alternative solution for Chinese cryptocurrency users to bypass government scrutiny and intervention, enabling more free and decentralized transactions. After all, DEXs do not require user registration and real-name authentication, nor do they charge listing fees. Anyone can issue and trade their own cryptocurrencies without barriers. However, considering the vast market of domestic cryptocurrency players and the cost-effectiveness of technical developers, a considerable number of decentralized exchanges are still physically located in China. Therefore, for everyone, starting a decentralized exchange in China still carries high legal risks. Based on our experience as the Mann Law Firm, entrepreneurs need to pay attention to the following risks.

1. Legality of virtual currencies

According to relevant policies and judicial practices, virtual currencies do not have the attributes of legal tender in China and are not considered financial products or services. Therefore, activities such as issuing, trading, and payments involving digital currencies within China may violate relevant laws and regulations. Decentralized exchanges, as trading platforms for digital currencies, may be suspected of engaging in illegal financial activities or money laundering, and may be investigated or shut down by regulatory authorities.

2. Compliance with information disclosure

Although decentralized exchanges do not require third-party intermediaries, they still need to provide users with necessary information, such as platform basics, trading rules, risk warnings, dispute resolution methods, etc. This information should be truthfully, accurately, completely, and timely disclosed to users, otherwise it may constitute false advertising or fraudulent behavior, infringing on users’ legitimate rights and interests. Decentralized exchanges should establish a sound information disclosure system and process, comply with relevant laws, regulations, and industry standards, and safeguard users’ right to information and choice.

3. Responsibility for protecting user rights

Although decentralized exchanges do not custody users’ digital assets, they still need to provide a secure, stable, and fair trading environment for users. If the platform experiences technical failures, security vulnerabilities, malicious attacks, etc., resulting in users being unable to use the platform normally or suffering asset losses, the platform should bear the corresponding compensation responsibility or assist users in recovering their losses. Decentralized exchanges should strengthen technological research and development and maintenance, improve platform security and reliability, establish effective risk prevention and emergency response mechanisms, and safeguard user rights and market order.

4. Regulatory Issues in Cross-border Transactions.

Decentralized exchanges, due to their decentralized nature, often have cross-border characteristics, meaning that the platform can serve global users and users can also engage in transactions in different countries or regions. This poses certain difficulties for regulatory authorities because different countries or regions may have inconsistent attitudes and regulations towards digital currencies, and conflicts may even exist. When conducting cross-border transactions, decentralized exchanges should comply with the laws and regulations of the relevant countries or regions, respect local culture and customs, avoid triggering political or social sensitive issues, and also pay attention to protecting their own legitimate rights and interests to prevent unfair or unreasonable intervention or sanctions.

03. Law Firm Recommendations

Decentralized exchange (DEX) is an emerging digital asset trading model that has advantages such as security, privacy, and sovereignty, but it also faces challenges in terms of speed, liquidity, and usability. Starting a decentralized exchange business in China comes with relatively high legal risks, requiring sufficient risk awareness and compliance awareness, as well as professional legal advisors and teams. At the same time, one should also pay attention to domestic and international policy trends and market changes, adjust their development strategies and operating models in a timely manner, and seek a legal, compliant, and sustainable development path.

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