Author: Ding Anhua, Chief Economist, China Merchants Bank
Introduction: May’s Cryptocurrency Circle
On May 11, Tesla boss Elon Musk announced the suspension of his plan to accept bitcoin payments for car purchases, and the price of bitcoin and other cryptocurrencies plunged by 30% in a week. On May 21, the Golden Stability Committee of the State Council held its fifty-first meeting to further clarify the “crackdown on bitcoin mining and trading”. The cryptocurrency world has changed since then, with the price of bitcoin falling by up to 50% from its all-time high in April.
In May, the cryptocurrency world once again brought us back to a few classic questions about cryptocurrencies: Is Bitcoin a real currency or not? Is Bitcoin, as a virtual asset, a risky asset or a safe-haven asset? Where will the cryptocurrencies represented by Bitcoin go from here? These are all questions we should ponder.
Bitcoin as Currency: Utopia
According to the cryptocurrency community, the original intention of Bitcoin’s creation was to provide a cryptographic digital currency that does not require central bank endorsement or bank intermediation, and to completely solve the trust problem of money through blockchain technology. This ambitious design has generated widespread and intense curiosity. So, what is cryptocurrency? Why do we need cryptocurrencies?
Money exists because it serves a fundamental economic purpose: to facilitate the exchange of goods and services. Without money, people would have to engage in barter, exchanging goods and services for other goods and services. In a barter economy, each exchange requires an exact match of needs between the two parties. A butcher in need of rice and a farmer in need of pork must seek exact agreement in time, space, quantity, and consideration in order to reach a deal, which greatly constrains economic development. To solve this dilemma, money emerged. If all members of society agree to accept some commonly accepted representation of value (money) as a medium of exchange, payments can be made quickly, people’s needs can be met effectively, and economic efficiency is enhanced. Therefore, the primary function of money is to serve as a medium of exchange. What can be used as a medium of exchange? This leads to two other subtleties of money: first, money is used as a unit of account to express prices, which requires money to have relatively stable price characteristics; second, in order to express prices, money needs to reflect the function of value storage, that is, money needs to carry the trust of value, gold is In Gold We Trust, the U.S. banknotes written on the In God We In Gold We Trust, and In God We Trust, which is written on the US banknotes, also means this.
Bitcoin is named “coin”, does it really have the characteristics of a currency? The answer is clear: no. On the surface, Bitcoin seems to fit the bill as a medium of exchange, otherwise Musk would not have announced in March this year that he was considering accepting Bitcoin payments. However, the reality of bitcoin as a medium of exchange presents many insurmountable challenges, most notably a lack of liquidity. We know that cash is fully liquid and can be used for payments at any time; treasury bonds are the next most liquid; and stocks again. Bitcoin, as a virtual digital currency, is constrained by the system’s storage space and security confirmation requirements, which limit the size of the blocks used to store transaction records and the speed of generation, which fundamentally limits the speed at which Bitcoin can process transactions. Currently, the number of transactions processed by the Bitcoin network is around 300,000 per day, which is a drop in the ocean compared to the processing power of other electronic payment systems (e.g., credit cards, WeChat Pay, and Alipay). The user experience of Bitcoin as a medium of exchange is extremely poor, and the capacity and depth of the entire cryptocurrency market remains very limited.
Similarly, Bitcoin cannot meet the requirements of being a unit of account and a store of value. Its price fluctuates too much to be a useful unit of account; nor is it a credible store of value, as it has no real value and is not backed by the credit of governments or central banks. However, the view in the cryptocurrency community is that governments and central banks are not credible, with governments running the money printing presses to deflate money in a big way and inflation constantly eroding the purchasing power of legal tender. The debate continues, and from an official perspective, challenging the dictatorial power of a sovereign state to issue currency does not stand a good chance of winning. So, to date, no country has endorsed bitcoin as a true currency.
Nevertheless, as a medium of exchange, Bitcoin and other cryptocurrencies demonstrate unique possibilities in the cross-border payments space. Due to its decentralized, anonymous, borderless and portable nature, coupled with the capital controls and anti-money laundering compliance review requirements faced by cross-border payments, Bitcoin is widely used for blackmail, drug trafficking, gambling, pornography, money laundering, tax evasion and other illegal cross-border transactions. Some studies estimate that the percentage of bitcoin users engaged in illegal activities is about 1/4, and the percentage of bitcoin transactions related to illegal activities is 46%. It is foreseeable that cross-border payments of Bitcoin will face an increasingly stringent regulatory and enforcement environment.
Bitcoin as an Asset: High Risk
Unlike as a currency, bitcoin is still gaining wider market acceptance as a tradable asset class. The CFTC treats bitcoin as a commodity, and China defines bitcoin as a “virtual commodity”, as opposed to a physical commodity. As with all financial assets, bitcoin’s trading price is ultimately determined by supply and demand.
According to our friends in the cryptocurrency community, there is a clear upper limit to the supply of bitcoin. This is different from all fiat currencies and is therefore inflation-proof. The supply of bitcoins is generated by what is often referred to as the “mining” process, which provides the incentive to maintain the entire bitcoin system, and the “miners” are at the heart of the entire bitcoin system, issuing, maintaining, verifying, and record transactions throughout the network. Mining is the process of solving mathematical puzzles through computer operations, with successful solutions resulting in the mining of a certain number of bitcoins. The reward for mining was initially 50 bitcoins per block, and has been halved every 4 years to the current level of 6.25 bitcoins per block. The mechanism of halving the mining reward (bitcoin halving) has resulted in a fixed supply rhythm and a gradual decay of incremental bitcoin supply. The final number of bitcoins is limited to 21 million, which is expected to be mined out by 2040, and the current number of bitcoins that have been mined is about 18.7 million. In fact, given the number of “lost” bitcoins, the number of bitcoins in circulation is significantly smaller than the theoretical value, which means that bitcoin is even a deflationary system in terms of supply.
This reminds us of gold. A few years ago, archaeologists found a large amount of gold, over 120 kilograms, in the tomb of Liu He, the Marquis of Haihang. More than 2,000 years ago, the Marquis of Haihang took this gold underground, which at the time may have caused severe deflation in the Western Han economy. Today, many investors in the cryptocurrency world believe that bitcoin is the “digital gold” that could potentially replace gold. Between March of last year and April of this year, the price of bitcoin has skyrocketed 12 times. And this year, with the vaccine economy recovering and inflation expected to rise, bitcoin is considered by many investors to be an effective hedge against inflation. Millennial investors, in particular, seem to prefer bitcoin to gold.
Bitcoin has attracted the attention and favor of an increasing number of institutional investors over the past year, a significant departure from the retail-led bitcoin bull market of 2017. Some institutions believe that bitcoin can serve as a store of value/wealth as well as an inflation hedge in portfolios, and expect that “digital gold” could eventually replace traditional gold. Gold currently holds about $2.7 trillion in private wealth, more than three times the total market value of bitcoin. Some foreign research reports suggest that if Bitcoin’s market capitalization reaches the level of gold, its price will exceed $140,000 per coin.
The term “digital gold” seems to me to be more of a marketing term and deserves some consideration. While gold has practical uses as a precious metal, such as making jewelry and chips, bitcoin has no intrinsic value. Even as an investment asset, gold has proven to be a safe-haven asset in times of high uncertainty due to its high market value, good liquidity, low volatility, and lack of correlation with stock movements. Bitcoin, on the other hand, has behaved more like a risk asset, and the market volatility in May is ample proof that it is really no risk to avoid. On a longer time series, bitcoin price action is highly similar to that of fellow risky asset stocks (especially small-cap stocks).
Even as a hedge against inflation, bitcoin’s role may be overstated, or at least not empirically tested. Cryptocurrency enthusiasts often emphasize that the supply of bitcoins will not exceed 21 million at most, thereby proving that bitcoins will not keep depreciating in value as inflation goes up, like fiat currencies do. This argument remains flawed. This is because cryptocurrencies like Bitcoin are springing up all over the place. A small team of ten programmers can develop some sort of cryptocurrency with no more than a master’s level of expertise. In fact, we are seeing all types of “coins” popping up, and the technical design is even more novel. Therefore, there is no upper limit to the number of cryptocurrencies, just as there is no upper limit to the number of fiat currencies. An accurate count of how many cryptocurrencies there are is difficult, with a less outrageous estimate of more than 6,000, of which at least 1,600 are dead. With the emergence of various cryptocurrencies, Bitcoin’s market share has dropped from 90% before 2017 to near about 50% today.
My conclusion is that Bitcoin, as a tradable virtual asset, is characterized by high risk. It is similar to gold in that it is a hedge against inflation, although this conclusion remains dubious; the difference is that it is not a safe-haven asset, but a high-risk asset. So, the argument for replacing gold is not necessarily valid, at least in times of high uncertainty. the divergence between bitcoin and gold since late May illustrates just that.
Bitcoin and China: Bigger than Half the Sky
When I visited the U.S. in 2015, I heard a professor at a prestigious university say that Bitcoin was on fire thanks to the enthusiasm of the Chinese people. He wasn’t kidding. In fact, Chinese miners and investors have, for more than a decade of Bitcoin’s development, and especially in its early stages, supported a large part of the Bitcoin world. According to estimates from the University of Cambridge Centre for Alternative Finance, China controls 65% of the world’s bitcoin mining capacity (in terms of computing power) (2 out of every 3 bitcoins are mined in China), and five years ago it was 75% (3 out of every 4 bitcoins are mined in China). From 2013 to 2017, RMB-denominated bitcoin transactions accounted for more than 80% of the volume, and at one point accounted for 95% of transactions, so it’s not too much to say that it was all Chinese speculation in bitcoin. After the government cracked down on bitcoin trading in 2017, the current number of nodes dropped to 3%. Most investors either open accounts to trade offshore or trade peer-to-peer OTC domestically. Four of the world’s five largest cryptocurrency exchanges now have Chinese investors as their primary users.
As a result of this development, bitcoin has had a degree of “negative externality” on China’s social welfare. First, Bitcoin as a financial innovation has not improved financial efficiency, and decentralized payment systems are nowhere to be found in China’s mobile payment sector. It is estimated that carbon emissions due to bitcoin mining in China can rank ninth among all cities in the country. Without regulation, carbon emissions from bitcoin mining will peak at 130 million tons by 2024, surpassing the carbon emissions of the Czech Republic (which ranks 39th globally). This is contrary to our policy goal of “carbon peaking and carbon neutrality”. Bitcoin’s negative externalities may also be the reason why Elon Musk has gone back on his word, after all, Tesla Electric Vehicles is an innovative company that boasts of being environmentally friendly.
At the same time, the expansion of bitcoin trading poses a certain threat to our financial stability and investor protection. As the price of bitcoin continues to reach new highs, the level of leverage in the bitcoin market continues to climb. More and more individuals and investors are getting involved in unregulated bitcoin trading, expanding the correlation between bitcoin prices and other financial markets and further escalating the strength and scope of the impact on financial stability. While few investors are said to have lost their positions in May, the opaque and irrevocable nature of bitcoin trading has made it more difficult for investors to claim their legitimate rights.
The Future of Bitcoin: Capital Never Sleeps
The understanding of Bitcoin has evolved since its introduction. While we still have doubts about Bitcoin, the future is showing a clearer picture. In my opinion, at least three things are now conclusive.
First, there is zero chance that Bitcoin and other cryptocurrencies will replace sovereign fiat currencies, while the process of launching digital currencies by central banks accelerates. The decentralized payment mechanism built by Bitcoin is not necessarily more efficient than existing mobile payments, even in technical terms. However, the anonymous and trusted mechanism of Bitcoin payments is likely to become an alternative tool for cross-border payments that is evolving towards dark web transactions and underground economic activities. Against this backdrop, governments are bound to start cracking down on the illegal transactions that Bitcoin may be involved in.
Second, Bitcoin, as a new risk asset, will gain more institutional investors and take a place in the market portfolio. The trend is to clarify Bitcoin’s characteristics as a risk asset, and thus to properly regulate Bitcoin investments and transactions. In fact, increased regulation is beneficial to the health of the market for trading Bitcoin and other cryptocurrency assets. Regulation is not the biggest risk facing Bitcoin, but rather the opportunity for Bitcoin to survive in the long run. Bitcoin itself is not a demon. Two big bubbles in history burst and Bitcoin’s price had dropped 90%, but it survived and lived a wonderful, heart-stopping life.
Third, the blockchain technology that Bitcoin relies on has a promising future. However, the key to understanding this is to remove the mystery, sanctity, and charm of the blockchain, and give up the illusion of anarchy and centerlessness. If the object of decentralization is the government and financial intermediaries, it can only be a utopian imagination. Moreover, in terms of economic logic, financial intermediaries emerge precisely to solve the trust problem and reduce transaction costs, and while blockchain technology has proven that decentralization can solve the trust problem, it cannot reduce transaction costs.
Looking to the future of Bitcoin is like a youthful paradise lost. Come on, welcome to the real world.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/paradise-lost-the-future-of-bitcoin/
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