Saturday, 30 May 2020

Bubbles and Opportunities

What follows are edited excerpts from the English translation of a paper that Chuanwei Zou originally wrote in Chinese, “Bubbles and Opportunities: An Economic Analysis of Cryptocurrencies and Blockchain Technology.” 

China has emerged as a dominant hub in global cryptocurrency networks. Chinese hardware, computing power, and exchanges are at the center of the Bitcoin market. The Chinese government has also taken an increasingly aggressive stance toward regulating cryptocurrencies in a cat-and-mouse game with companies, exchanges, and investors, while openly exploring the potential of official central-bank digital currencies. With remarkable speed, it’s become clear that Chinese entrepreneurs, experts, and regulators are shaping the future of cryptocurrencies both in China and around the world. What will that future look like?

There’s no person better positioned to answer that question than Chuanwei Zou, who is currently the chief economist of Bitmain, the world’s largest producer of Bitcoin mining hardware, and a prize-winning economist.

He begins his paper by bemoaning that “markets are flooded with specious ideas about cryptocurrencies and blockchain.” His goal is to dispel those “specious ideas” from the distinctive perspective of a Chinese economist and to offer a way forward based on deep technical and economic expertise. It is a unique perspective from a leading Chinese expert on the economic risks and opportunities of cryptocurrencies, as well as a vivid tour through a future in which Chinese voices will take the lead in shaping how the world understands major technological shifts.

Since 2017, the speculation in cryptocurrencies has swept the world, and the innovation in blockchain technology has been very active. Markets are flooded with specious ideas about cryptocurrencies and blockchain. In order to clarify popular misunderstandings, make financial innovations beneficial to society, and introduce required regulations, it is necessary to study cryptocurrencies and blockchain technology from an economic perspective.

How do pricing and volatility affect the utility of Bitcoin?

Cryptocurrencies represented by Bitcoin have become the first asset bubble on a global scale and many irrational behaviors of individuals and groups can be observed. There are two popular misunderstandings about Bitcoin price. The first viewpoint is that the demand from the underground economy has pushed up Bitcoin price. There are certain reasonable elements in this viewpoint. Bitcoin has the characteristics of anonymity and decentralization, and exists in an electronic form, which makes it suitable for the underground economy. However, there are no reliable data regarding the volume of Bitcoins used in underground economic activities.

The second viewpoint is that the cost of Bitcoin "mining" supports Bitcoin price. As the "mining" cost increases, Bitcoin price shall rise too. However, this viewpoint is hard to hold. At any given time, the supply of Bitcoin is determined by a prespecified algorithm and has nothing to do with how much computation power (measured by hashrate or the number of hash operations per second) is engaged in "mining.” If the price of Bitcoin goes up, the hashrate will be higher, but the supply of Bitcoin will not increase correspondingly, and the price of Bitcoin will not be held back.

Bitcoin’s volatility is too high for it to be an effective medium of exchange, nor is it economically feasible to develop Bitcoin-denominated financial transactions. Price stability is a necessary condition for Bitcoin to become an effective medium of exchange.

What are the prospects for stable tokens?

Some practitioners are experimenting with stable tokens. There are two representative methods. The first category, represented by Tether (which converts cash into digital currency), issues a “USDT” token pegged 1:1 to the US dollar and with a reserve rate of 100%. The second category, represented by Basecoin, is still in a state of development, but claims that it will mimic the open-market operations of central banks. I think the success of the second category is very difficult. These stable tokens try to implement monetary policy operations through algorithms, which is equivalent to giving up discretion in monetary policy. From the perspective of human history, it is the first time that a fixed exchange rate has been pursued solely through algorithms.

What are the benefits of the “token economy”?

The “token economy” represents a category of promising blockchain application projects. In these projects, there are transactions with real needs, but these transactions were previously constrained by incentives, transaction costs, or payment tools. By introducing tokens, these projects not only solve the problem of fundraising, but also ease the constraints of incentive mechanisms, transaction costs, and payment tools. However, successful projects in this area remain to be seen.

What are the unsolved problems of initial coin offerings?

At present, a highly controversial issue is that, although a token economy project has not yet been successful, the tokens issued by the project may be hyped up to a very high price through initial coin offerings and cryptocurrency exchanges.

Blockchain projects generally have two financing channels: equity financing and initial coin offerings. These offerings are chaotic and risky all around the world, which is reflected in the following three aspects.

First, the economic functions and intrinsic value of the tokens given to investors by initial coin offerings are often ambiguous. Many tokens combine multiple characteristics and it is difficult to value them. Nevertheless, they become the objects of considerable hype even before their intrinsic value is fully revealed or discussed.

Second, speculation in tokens after initial coin offerings is widespread. Tokens can be traded in the secondary market, especially in cryptocurrency exchanges. In theory, if the token is a certificate of equity, goods, or services, its valuation should be "anchored" to some fundamental factors. But in reality, many token prices are being hyped up to levels far above the fundamentals.

Third, initial coin offerings distort the incentive mechanism for blockchain startups. The secondary market of tokens provides the startup an easy way to “cash out” even when the blockchain venture projects remain in the white paper stage. In contrast to the fast “cash out” mechanism of the initial coin offering, the time from startups getting investment from venture capital firms to an IPO is much longer.

Finally, in the field of cryptocurrencies, initial coin offerings have formed a positive feedback loop between "central currencies" such as Bitcoin and Ether, and other tokens. Initial coin offerings generally collect Bitcoin and Ether, which increase the demand for Bitcoin and Ether and push up their prices. And the prices of Bitcoin and Ether serve as the valuation benchmark for the tokens issued by the offering. In this way, a mutually reinforcing feedback mechanism has been formed between Bitcoin, Ether, and other tokens. This is a key driver behind the spectacular rise in the cryptocurrency market in 2017. However, if the prices of Bitcoin and Ether enter a downward path, this positive feedback mechanism will also cause the prices of other tokens to fall faster.

What are the prospects of a central bank digital currency (CBDC)?

First, when it comes to its economic function, central bank digital currency (CBDC) is a replacement for cash. CBDC is issued directly by the central bank to the public and consists of the liability of the central bank. It is a form of fiat money and can pay interest to its holders.

Second, technically CBDC is not necessarily based on blockchain. CBDC tends to take the form of a consortium blockchain, and the distributed ledgers are maintained by the central bank and certain pre-authorized institutions.

Third, CBDC would be a new kind of monetary policy instrument. Specifically, CBDC can pay negative interest, thus helping the central bank to break through the zero lower bound of nominal interest rates and magnifying monetary policy stimulus during economic crises. In contrast, when cash is still in circulation, negative nominal interest rates are impossible, because people will withdraw their bank deposits and change them into cash.

Finally, when it comes to financial stability, CBDC will have a major impact on the payment and settlement system. Payment and settlement will not necessarily go through commercial banks and can be carried out directly on the balance sheet of the central bank. Therefore, CBDC helps get rid of the special position of commercial banks in the payment and settlement system and the accompanying "too big to fail" problem. But this could also cause instability in bank deposits, as people may withdraw bank deposits and change them into CBDC.

What principles should guide the regulation of cryptocurrencies?

Speculation in cryptocurrencies directs limited social resources into unproductive areas. Once the speculative bubble bursts, it will have a negative impact on wealth distribution. Speculation is also accompanied by fraud, scams, and even illegal conduct. Therefore, there is no doubt that regulation of cryptocurrencies should be strengthened. In addition, cryptocurrencies move across borders and the speculation is global. Therefore, global regulatory coordination should be strengthened.

(I) Regulation of the production and issuance of cryptocurrencies

Cryptocurrency production consumes lots of electricity, especially for cryptocurrencies with proof-of-work consensus mechanisms. According to the website Digiconomist, the annual electricity consumption by the Bitcoin blockchain is equivalent to that of Peru and is still growing rapidly. Considering the pollution caused by thermal power generation, the Bitcoin blockchain is actually causing serious environmental problems.

(II) Regulation of the circulation and transaction of cryptocurrencies

Cryptocurrency exchanges are widely distributed around the world. Exchanges provide liquidity for cryptocurrencies. Once a cryptocurrency is listed on an exchange, its price usually rises significantly. Essentially this shows the effect of the liquidity premium. Cryptocurrency exchanges have fueled speculation and have also taken on high risks themselves.

First, cryptocurrency exchanges have little proper checks on account holders, and many exchanges allow anonymous accounts.

Second, leverage-based speculation exists because some cryptocurrency exchanges offer leverage to investors, which amplifies the price fluctuations in cryptocurrencies. But if the cryptocurrency market enters a system-wide and large decline, high leverage will amplify the downward trend.

Third, many cryptocurrencies are held in a concentrated way. Also, the cryptocurrency exchanges do not have the same information disclosure requirements as stock exchanges, making market manipulation possible. A typical manipulation strategy is the so-called "pump and dump,” where a number of large cryptocurrency holders conspire to push up prices and attract retail investors, and then suddenly sell their holdings.

Fourth, some cryptocurrency exchanges have opened the door to fraudulent ICO projects, actually colluding with them to deceive retail investors.

Fifth, incidents like the cryptocurrency exchanges being attacked by hackers, leading to customers’ assets stolen and exchanges even bankrupted, have occurred many times.

Finally, cryptocurrencies, because of their anonymity, are associated with illegal transactions or activities in the underground economy. The former website Silk Road is a typical example. Cryptocurrencies even help the Islamic State get access to funding. Cryptocurrencies are also used to circumvent capital controls.To handle the above problems, regulators all around the world should implement the following measures:

1. "Know Your Customer" (KYC) requirements, and rules against money laundering and terrorism financing, especially for cryptocurrency wallet providers and exchanges.
2. A tax on cryptocurrency transactions.
3. Requirements for investor suitability.
4. Rules to combat fraud and market manipulation.
5. Policies that govern the exchange between cryptocurrencies and fiat currencies, which is the area where regulators are best able to strengthen regulation.

What is China’s role in the cryptocurrency market?

China has a large presence in the cryptocurrency market. The three largest Bitcoin mining hardware companies—Bitmain, Canaan Creative, and Ebang—are all in China. By some estimates, Chinese mining pools control more than 70 percent of the computational power of the Bitcoin network. Three of the largest cryptocurrency exchanges in the world, namely Binance, OKEx, and Huobi, are Chinese-run.

However, since 2013, the Chinese government has become more negative towards cryptocurrencies. In 2013, the Chinese government warned domestic financial institutions about the risks of Bitcoin. From late 2016 to early 2017, the Chinese government investigated major cryptocurrency exchanges, especially on their role in money laundering and capital outflow. In September 2017, the Chinese government banned initial coin offerings and centralized cryptocurrency trading. Many cryptocurrency exchanges moved abroad but still offered trading services to domestic investors. In January 2018, the Chinese government blocked online access to overseas cryptocurrency exchanges. Since August 2018, the Chinese government has clamped down on online platforms promoting initial coin offerings projects and cryptocurrencies trading. It has also introduced more restrictions on over-the-counter cryptocurrency trading.

It is worth noting that the Chinese government is, in different domains, very positive on the potential of blockchain technology. For example, China’s central bank, the People’s Bank of China, has a dedicated team for CBDC. This team has conducted extensive research and experiments on the application of blockchain technology in the financial sector.

However, due to the restrictions of China’s Securities Law, initial coin offerings and cryptocurrency exchanges won’t be legal in China for the foreseeable future. In China, only certain categories of financial instruments are considered securities. Security tokens aren’t covered by the Securities Law. Therefore, fundraising via token issuance is considered illegal and subject to severe punishment. As a consequence, cryptocurrency exchanges facilitating trading in those tokens are illegal too.

This situation won’t change without revising the Securities Law. By comparison, the Chinese government is neutral towards mining pools as long as they purchase electricity legally and pay tax. However, mining hardware companies are viewed as high-tech companies—and the Chinese government encourages them to apply their microchip design skills to areas more relevant to the real economy such as artificial intelligence.

Chuanwei "David" Zou is the chief economist of Bitmain. In 2015, he won the Sun Yefang Prize for Financial Innovation, China's top prize for economists.

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