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Decoding Cryptocurrency in China

Chinese cryptocurrency exchanges saw a significant drop in Bitcoin trading volume and local prices due to a regulatory halt on withdrawals. The suspension has been lifted, but forthcoming regulation is set to diminish opportunities for capital outflows, financial speculation, and currency arbitrage. China’s biggest potential impact on the cryptocurrency market may be in development of digital currency applications, including for its own digital fiat currency.

With the conclusion of the PBOC’s months-long inspections of major Chinese Bitcoin exchanges, new regulations rumored to launch in June on digital currency trading in China have now been pushed back, with no stated timeline. Regulatory concerns to date have focused more on anti-money laundering, foreign exchange management, and compliance with financial and scope-of-business regulations, while authorities have sought to deemphasize Bitcoin’s utility in circumventing capital controls or hedging yuan depreciation.

From Domination to Regulation

Given China’s historical domination of the global Bitcoin market, it’s easy to assume some event in China was responsible for the recent explosive growth to record high after record high, rounding $3000 in June. In reality, the 200% price surge over the first five months of 2017 had little to nothing to do with China, as Bitcoin trading in China was effectively suspended from February to May. Within one month after PBOC announced inspections of major Chinese Bitcoin exchanges, drawing concerns of a regulatory crackdown, the share of trading on China’s three big exchanges (shown in shades of red in Figure 1) fell from 98% of global daily trading volume to below 20% in February.

As we wrote early this year (Jan 12, “The RMB and Bitcoin’s Boom-Bust”), the major bitcoin price moves in 2013 and in Q4 2016 to January 2017 levels were largely influenced by speculative investment, asset diversification, and rumors of a regulatory crackdown within China. In addition, Chinese miners dominate new bitcoin creation, allowing a degree of influence over market developments. By contrast, the price surge in the first five months of 2017 occurred at a time when activity on major Chinese exchanges accounted for an average of only 20% of daily trades.

As was widely reported, China fell from market dominance shortly after the PBOC started conducting spot checks on three main Chinese Bitcoin exchanges on January 11 amid intense capital outflows and pressure on the yuan to depreciate. In February, all three announced a temporary halt to bitcoin and litecoin withdrawals. For average traders, the suspension was minimally disruptive as it did not hinder sales of bitcoins or RMB withdrawals from exchanges, but effectively prohibited taking profits in bitcoins or shifting bitcoin to digital wallets. The following month, most Chinese platforms also halted margin trading after discussions with the central bank. One side effect was the shift from spot trading on exchanges to OTC trading at Chinese Bitcoin platforms in larger transaction volumes.

The impact on prices is clear in Figure 2. The withdrawal suspension caused the yuan-denominated price of bitcoin to fall 14% lower than the USD-denominated price on average over the month of April, while trading in Korea led the recent price surge, trading 20% above the USD price on average in May. Bitcoin-fiat arbitrage opportunities exist due to market frictions, like transaction fees, verification and transaction confirmation time lags, lack of liquidity, regulatory uncertainty, threat of cyber theft, trustworthiness of exchanges, and capital controls.

Chinese exchanges explained they suspended withdrawals in order to upgrade compliance with anti-money laundering, foreign exchange, and other regulations, but a PBOC document leaked on WeChat and reported on Chinese industry site in April suggests the suspension was a direct order from officials to extend until certain issues could be “rectified.” While not dated, the document did reference a State Council implementation plan on internet finance risks from October 2016 and a joint notice issued by PBOC and 17 other ministries in December 2016. The guidance prohibited zero transaction fees, money laundering, violation of foreign exchange management regulations, engagement in illegal payments, offering leverage or margin trades, and fiat or bitcoin lending. The lack of transaction fees up to that point contributed to automated bot trading across Chinese platforms, which in turn inflated transaction volumes and drove price speculation.

In a March interview with Caixin, Zhou Xuedong—National People’s Congress (NPC) member and head of the PBOC’s Business Management Department, which conducted the bank’s inspections of trading platforms—explained that while the PBOC can “forgive” and even embrace innovations from Bitcoin like blockchain technology, a certain level of regulation is necessary to prevent speculative asset bubbles. He acknowledged that Bitcoin had been used in small volumes for money laundering and capital control evasion in China, but emphasized financial risks as the main target of regulation. Other measures in forthcoming regulations could include licensing of trading platforms, in-person account verification, and controlling withdrawal of digital assets.

New Coin Offerings

In late May to early June, the withdrawal suspension was lifted for most major platforms and other smaller operators, reawakening Chinese trading activity relative to its four-year lows. Yuan-denominated daily trading volume in May and June averaged more than 75% higher than in March and April, and in late June bitcoin reached its all-time high RMB price of nearly 20,000 yuan. However, yuan-denominated trading volume is still only around 20% of the global total in May and June, compared with 15% in March and 18% in April.

As of June 1, Ethereum is also supported at several major Chinese platforms, in addition to Bitcoin and Litecoin. Like Bitcoin, Ethereum runs on the blockchain, a public ledger on which all completed transactions are confirmed cryptographically and recorded. Unlike Bitcoin, Ethereum is not a digital currency; it is a highly programmable software platform that was created to enable decentralized applications (“Dapps”) and conditional transactions (“smart contracts”), without fraud, delay, or intervention. Ether (ETH), the native digital currency that powers Ethereum, has gained rapid popularity in the last year, and its mid-June market cap of $30.7 billion is only $15 billion short of Bitcoin’s.

Chinese regulators are already cautious about the potential of digital currency applications to exacerbate financial risks. In a May 13 essay, Yao Qian, head of the PBOC Fintech Commission’s digital currency research arm, discussed at length initial coin offerings (“ICOs”, like IPOs for coins), which are tradable digital assets (“tokens”) built on platforms like Ethereum used to fund specific projects. ICOs are relatively new in the cryptocurrency world, and therefore largely unregulated, with mounting venture capital interest looking for the next big payoff. In the last month, one token raised $30 million in seconds, and another raised $20 million in 15 minutes. Yao recommended a “regulatory sandbox” approach be taken to ICO investment in China, imagining its application for regional Chinese businesses in crowdfunding.

Digital Fiat Currency and Applications

Chinese authorities are approaching Bitcoin and digital currency more broadly as an opportunity for financial system development, rather than a threat. Since 2013, Bitcoin has been classified as a commodity and not a currency in China, while Yao clarified its status as a “quasi-” digital currency in May. Chinese authorities don’t seek to ban trading or owning Bitcoin, but primarily seek to isolate the financial system from risks associated with digital currency. For that reason, Chinese banks and financial services companies have been banned from conducting Bitcoin transactions for years, so many buyers typically invest through a third party like a broker, who then sends the asset to the investor’s digital wallet.

Chinese central bank officials seem to believe that digital currency innovations like the blockchain can improve regulation of monetary conditions, anti-money laundering, and know-your-customer policies domestically, through the creation of a digital fiat currency. Since the establishment of its digital currency research team in 2014, the PBOC has invested R&D into ledger technologies—like the blockchain, but private rather than public—and conditional transactions like smart contracts.

In a different May 2017 essay on the relationship between commercial banks, the central bank, and digital currency, Yao Qian proposed incorporating digital currency wallet attributes into the existing commercial bank account system so that electronic currency (online funds) and digital currency can be managed by banks under the same account. By leveraging the existing central bank-commercial bank infrastructure, digital currency ownership can be directly verified by the issuing bank (i.e. the central bank or authorized commercial banks, as with the Hong Kong dollar) and users can transact peer-to-peer while still maintaining their commercial bank accounts. This model is only hypothetical at this early stage, according to Yao.

Major Chinese banks are already advancing fintech initiatives, many of which integrate blockchain technology. In the last three months alone, Bank of China, Agriculture Bank of China, and ICBC announced partnerships with Tencent, Baidu, and, respectively, focusing on initiatives including cloud computing, artificial intelligence, and blockchain applications. Other major firms are using blockchain technology to improve supply chain management, including ZhongAn Insurance for tracking chicken provenance, and Walmart, IBM, and Tsinghua University for tracing China’s pork supply chain.

While deeper integration of a blockchain and smart contracts and creation of a digital fiat currency are still hypotheticals in China, top leadership has indicated support for these initiatives. PBOC governor Zhou has commented that a blockchain-based digital fiat currency can operate differently in China at different levels, while vice governor Fan Yifei has argued digital currency should play a role in replacing traditional currency. In its Five-Year Plan for fintech development, released in June, the PBOC identified development of blockchain technology to strengthen financial services, regulation, and compliance. These movements show China’s digital currency aspirations and plans for regulating fintech, though practical implementation is still taking shape.