We have written recently at AIER about how blockchain – and bitcoin, the cryptocurrency that is one early and prominent application of blockchain technology – may be important to the future of money and exchange. In this article, I discuss how in the past few years, the center of gravity of the bitcoin world moved to China and the lessons we can draw from the resulting cycle of consolidation and regulation. This may have important implications for the future of bitcoin, as well as a being a potential challenge to the decentralization that is part of the fundamental appeal of cryptocurrencies.
Bitcoin goes to China
Until a few years ago, almost all bitcoin trading was in dollars. Around the end of 2013, the balance began to shift to the Chinese yuan. By 2016, over 90 percent of bitcoin trading volume was in yuan, where it remained until early 2017, although recent regulations that I will discuss shortly are beginning to reverse this trend. Business Insider in January published a striking chart showing the change in bitcoin’s trading volume by currency.
There are two main reasons for this reversal. First, Chinese investors became interested in bitcoin, in part because of laws in their country restricting the movement of traditional currency. Secondly, there were until recently no trading fees on major Chinese exchanges, which means once investors became interested, the no-fee structure invited a higher volume of trading. Related to the fee and regulation structure, bitcoin was traded as an asset and subject to capital gains taxes in both China and the U.S., but because bitcoin took off earlier in the U.S., the Internal Revenue Service may have been quicker to monitor these transactions than Chinese regulators.
Why does this matter? It is important because while bitcoin is not governed by any central bank, its development can be affected by its user base – especially if a large percentage of that base is working and making decisions as a unified group. The migration of bitcoin trading and creation to China is important not only because Chinese investors may have different priorities than Americans, but because a lot of the Chinese activity is dominated by a small number of agents, both in the exchange and production of new bitcoins.
The network of computers running bitcoin software uses a blockchain database. New “blocks” of transactions are added all the time and are linked to existing blocks. Each new block requires a computing power-intensive “proof of work” to be accepted by the network. One important feature of bitcoin is that new bitcoins are given to users who add these blocks. This is known as bitcoin “mining” and is an important way to ensure that the bitcoin network maintains significant computing power.
This system also resists manipulation because it relies on many different computers running bitcoin software. Any important changes to the system must be adopted by essentially the whole network, which allows, for example, generally accepted security patches or updates to be adopted but resists manipulation by individual actors. However, this safeguard depends on the breadth of the network.
According to a June 2016 New York Times article, by April of 2016 over 70 percent of bitcoin transactions were going through four Chinese companies. Almost half of newly mined bitcoins were produced by just two mining pools, or groups that pool resources and share the successfully mined bitcoins. This creates the potential for market power, in which a small group could unilaterally impose changes on the network. In the worst case, this could create a “hard fork,” in which competing protocols would each create new blocks recognized as valid by a substantial fraction of the bitcoin network. Other users would have to gamble on which transactions would count, which could cripple bitcoin’s usefulness as a store of value or medium of exchange, two essential properties of money.
This power is more than a theoretical possibility. The Times article also described an American delegation that came to China early in 2016 to discuss a bitcoin software proposal designed to alleviate congestion and transaction delays. While there was significant debate about the merits of the proposal, there was no doubt the Chinese companies had the ability to tip the scales by choosing to endorse or reject the proposal.
This can be a dangerous precedent if the short-term incentives of a mining pool are at odds with the overall health of the system. The Times interviewed Bobby Lee, an executive of one of the Chinese companies. Although Lee dismissed both these concerns and the idea that the major Chinese bitcoin companies were a single bloc, other observers have warned about this possibility. As a recent article on NASDAQ.com said, “Bitcoin, the currency, and bitcoin, the system and underlying technology, are two separate things, as shown by the current emphasis to separate the technology that underlies the bitcoin blockchain from the currency. What is good for the currency is not necessarily good for the system, and vice versa.” The article also quoted a former director of MIT’s Digital Currency Initiative, Brian Forde, “as governments and large corporations start to adopt the bitcoin blockchain infrastructure around the world, they will have to think through the concentration of bitcoin mining that is happening in China, and maybe they will have to put up speed in doing bitcoin mining in their countries, to start to decentralize even further and increase the security.”
It is clear that by 2016, China had become the center of the bitcoin world. However, the balance may be shifting away from China, in large part because of the actions of China’s own central bank.
In 2017, Chinese regulators have taken a stronger interest in bitcoin, and there have been significant restrictions on the flow of bitcoins in China. In late January, the Wall Street Journal reported that the three largest bitcoin exchanges in China each instituted a 0.2 percent transaction fee. The article cited statements on each exchange’s website indicating the change was “to further curb market manipulation and extreme volatility,” and it further noted that the Chinese central bank had begun investigating the exchanges earlier in January.
In early February, it became clear that regulators were not satisfied. Many observers suggested that regulators are interested not only in curbing speculation, but in restricting the flow of money out of China. The Business Insider piece cited earlier pointed out that China’s foreign reserves fell by 8 percent in 2016. If so, any crackdown on bitcoin exchanges is either symbolic or pre-emptive. The Wall Street Journal cited an estimate by Chainalysis, a start-up specializing in monitoring and protecting bitcoin transactions, that the value of bitcoins removed from China in 2016 was only about $2 billion, a drop in the bucket of the nation’s roughly $3 trillion in total reserves.
According to multiple reports, regulators met with major bitcoin exchanges on Wed., Feb. 8, and warned them not to violate regulations related to issues such as money laundering and foreign exchanges. The next day, two of the three largest exchanges announced a one-month freeze on withdrawal of bitcoins, and the third announced that withdrawals would be permitted but would require 72 hours to process. (The third also halted withdrawals the following week.) All three cited concerns about illegal transactions. The market responded swiftly, and the ban was quickly followed by a 10 percent decline in bitcoin prices, to $960 from about $1,060. However, prices recovered rapidly and passed the $1,060 mark by Feb. 20. Bitcoin continued to rise and was trading at nearly $1,200 just one week after that.
The future of bitcoin—money, trailblazer or both?
Some observers believe that these regulations are to bitcoin’s long-term benefit, due to engendering trust among people who may worry about bitcoin’s legitimacy. This is one possible reason for the rise in prices after the initial drop. A CNBC article quoted the CEO of a bitcoin research company saying on Feb. 10, “These marketplace changes will inevitably slow nefarious activity and open channels to more and more institutional investors. In my opinion the 'PBoC [People’s Bank of China] clean-up' is the best thing that could have happened to bitcoin this year.” This is obviously speculative but is consistent with the sharp appreciation in bitcoin’s value in late February. As the quote suggests, the potential benefits apply to use of bitcoin as money – or more generally as a financial asset.
Indeed, both regulators and bitcoin’s users in the marketplace invite the question of whether bitcoin is actually money at all. The FAQ section on bitcoin.org is very clear in describing bitcoin as digital money. In the U.S., the IRS declared in 2014 that virtual currencies such as bitcoin would instead be considered property.
However, the status of money is determined not only by lawmakers but by users. Bobby Lee was quoted by Business Insider calling bitcoin “a very ripe opportunity for day trading to make money,” but he also noted that bitcoin “has not taken off in China as a form of payment.” Overall, as shown in the New York Times article, only a small proportion of bitcoin transactions put bitcoins into individual wallets to be exchanged directly for goods and services. The vast majority of activity is on the market exchanges – people buy and sell bitcoins on the exchanges, but they spend traditional currency. Most people do not own bitcoins, and it seems many of those who do use bitcoin to store value, but not as a primary medium of exchange or unit of account.
Even some of bitcoin’s most fervent supporters are hesitant to pin its future on its potential to circulate as money. In January, Wired quoted Olaf Carlson-Wee of Polychain Capital, “it was a big mistake that any of this was ever compared to currency.” Carlson-Wee instead focused on the conceptual framework of blockchain’s ability to decentralize other processes, as Max Gulker has written about for AIER recently.
This long-term view has been around for some time. In a 2014 paper, written during the period when Chinese mining pools and exchanges were becoming a large share of bitcoin mining and transactions, Stephanie Lo and J. Christina Wang discussed “the convergence toward concentrated processing, both on and off the blockchain,” and said that this concentration is a predictable consequence of the increasing computing power necessary to maintain the blockchain and mine new bitcoins. As others have before and since, they especially praised bitcoin’s role in developing blockchain technology. They wrote, “the lasting legacy of bitcoin most likely lies in the technological advances made possible by its protocol for computation and communication that facilitates payments and transfers.”
It may be that bitcoin will continue to evolve, retain its current dominant position among cryptocurrencies, and even gain wider acceptance as money. It is as likely to remain a niche financial asset and be remembered as people my age remember the search engine AltaVista: an early implementation of a revolutionary idea, but not the brand name destined to gain ubiquitous acceptance. In either case, economies of scale suggest that the cycle of consolidation and regulatory attention are likely to be seen again with future cryptocurrencies or other nations in which bitcoin trading volume spikes.