Bitcoin and other cryptocurrencies are unlikely to replace sovereign fiat currencies, and their cross-border payments will face an increasingly stringent regulatory and law enforcement environment.
Original title: “Ding Anhua | Paradise Lost: The Future of Bitcoin”
Author: Ding Anhua, Chief Economist of China Merchants Bank Source: New Fortune Magazine
Coin Circle in May
Entering May, Bitcoin, which has been advancing all the way this year, has crashed. On May 11th, Tesla boss Elon Musk announced the suspension of accepting bitcoin for car purchase payment plans. The prices of bitcoin and other cryptocurrencies plummeted and fell by 30% within a week; due to the currency circle (coin mining, currency speculation) It is extremely active in China. In order to protect the interests of investors, three industry associations including the China Internet Finance Association issued a document on May 18, requiring member institutions not to carry out virtual currency-related business; on May 21, the 50th A meeting further clarified “combating Bitcoin mining and trading behavior.” So far, the currency circle has undergone a sudden change, and the price of Bitcoin has fallen by as much as 50% from its historical high in April.
Figure 1: Bitcoin price dropped by nearly 50% from its peak (Source: Macrobond, China Merchants Bank Research Institute)
In the currency circle in May, let us once again return to a few classic questions about cryptocurrencies: Is Bitcoin a real currency? Bitcoin as a virtual asset, is it a risk asset or a safe-haven asset? Where will the cryptocurrency represented by Bitcoin go? These issues are worthy of our deep consideration.
Bitcoin as currency: Utopia
According to the currency circle, the original intention of Bitcoin was to provide an encrypted digital currency that does not require the endorsement of the central bank and bank intermediaries, and to completely solve the problem of currency trust through blockchain technology. This grand design has aroused people’s extensive and strong curiosity. So, what is currency? Why do you need cryptocurrency?
The reason currency exists is because it serves a basic economic purpose: to promote the exchange of goods and services. Without currency, people will have to engage in barter transactions, exchanging goods and services for other goods and services. In the barter economy system, every exchange needs to match the needs of both parties. The butcher who needs rice and the farmer who needs pork must seek complete agreement in time, space, quantity and consideration to reach a transaction, which greatly restricts economic development. In order to solve this problem, currency appeared. If all members of the society agree to accept a certain commonly recognized value representative (currency) as a transaction medium, payment can be quickly achieved, people’s needs can be effectively met, and economic efficiency can be improved. Therefore, the primary function of currency is to act as a medium of exchange. What can be used as a medium of exchange? This leads to two other subtleties of currency: First, currency is used as a unit of account to express prices, which requires currency to have relatively stable price characteristics; second, in order to express prices, currency needs to reflect the function of value storage. In other words, currency needs to carry trust in value. Gold is In Gold We Trust, and the In God We Trust written on the dollar bill also means this.
Bitcoin is named “coin”, does it really have the characteristics of currency? More than ten years of practice has given a clear answer: no. On the surface, Bitcoin seems to meet the requirements of the transaction medium, otherwise Musk will not announce in March this year that he will consider accepting Bitcoin payments. However, Bitcoin, as a trading medium, encounters many insurmountable problems in reality, the most important of which is lack of liquidity. We know that cash is fully liquid and can be used for payment at any time; the liquidity of treasury bonds is second; stocks are again. Bitcoin, as a virtual digital currency, is subject to system storage space and security confirmation requirements, and the block size and generation speed used to store transaction records are restricted, which fundamentally restricts the speed of Bitcoin processing transactions. Currently, the number of transactions processed by the Bitcoin network per day is around 300,000. Compared with the processing power of other electronic payment systems (such as credit cards, WeChat Pay, and Alipay), it is a drop in the ocean. The user experience of Bitcoin as a trading medium is extremely poor, and the capacity and depth of the entire cryptocurrency market is still very limited.
Figure 2: The efficiency of cryptocurrency processing transactions is extremely low (Source: public information, China Merchants Bank Research Institute)
Figure 3: The daily average transaction volume of Bitcoin is much smaller than other major assets (Source: BIS, CBOE, SIFMA, China Merchants Bank Research Institute)
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 accounting unit; it is also not a credible stored-value product, because it has no actual value and no credit endorsement by the government and the central bank. However, the view of the currency circle is that the government and the central bank are not credible, the government has launched the money printing press to release water, and inflation continues to erode the purchasing power of legal tender. This controversy continues. From an official point of view, challenging the sovereignty of sovereign state currency issuance is unlikely to win. So, so far, no country has recognized Bitcoin as a real currency.
Nevertheless, as a medium of exchange, Bitcoin and other cryptocurrencies have demonstrated unique possibilities in the field of cross-border payments. Due to its decentralization, anonymity, and portability without borders, combined with the capital control and anti-money laundering compliance review requirements faced by cross-border payments, Bitcoin is widely used for extortion, drug trafficking, gambling, pornography, money laundering, tax evasion, etc. Illegal transactions across the border. Studies have estimated that Bitcoin users engaged in illegal activities accounted for about 1/4, and Bitcoin transactions related to illegal activities accounted for 46%. It is foreseeable that Bitcoin’s cross-border payments will face an increasingly stringent regulatory and law enforcement environment.
Bitcoin as an asset: high risk
Different from being a currency, Bitcoin, as a tradable asset class, has been increasingly recognized by the market. The US Commodity Futures Commission (CFTC) regards Bitcoin as a commodity (commodity), and my country defines Bitcoin as a “virtual commodity” to distinguish it from physical commodities. Like all financial assets, the transaction price of Bitcoin is ultimately determined by supply and demand.
Friends in the currency circle believe that the supply of Bitcoin has a clear upper limit. This is different from all legal currencies, so it can withstand inflation. The supply of Bitcoin is produced by the process of “mining” that people often say. Mining provides an incentive mechanism that the entire Bitcoin system depends on. “Miners” are issued and maintained in the entire Bitcoin system. , Verify and record the core position of the entire network transaction. Mining refers to the process of solving mathematical problems through computer operations. The result of successful problem solving is reflected in the mining of a certain amount of Bitcoin. The reward for mining was initially 50 bitcoins per block, and then halved every 4 years. Currently, it is 6.25 bitcoins per block. The mechanism of halving mining rewards (bitcoin halving) makes the supply of Bitcoin a fixed rhythm, and the increase gradually decays. In the end, the number of bitcoins is limited to 21 million, and it is expected that the mining will not be completed until 2040. At present, about 18.7 million bitcoins have been dug up. In fact, considering that there are many “lost” Bitcoins, the number of Bitcoins in circulation is significantly less than the theoretical value, which means that Bitcoin is even a deflationary system in terms of supply.
This reminds us of gold. In the past few years, archaeologists discovered a large amount of gold in the tomb of Haihuhou Liu He, over 120 kilograms. More than two thousand years ago, Haiwuhou brought these gold underground, which might have caused severe deflation of the Western Han Dynasty’s economy at that time. Today, many investors in the currency circle believe that Bitcoin is a “digital gold” that may replace gold. From March last year to April this year, the price of Bitcoin skyrocketed 12 times. Since the beginning of this year, in the context of the vaccine economic recovery and rising inflation expectations, Bitcoin has been considered by many investors as an effective hedge against inflation. In particular, millennial investors seem to prefer Bitcoin over gold.
Bitcoin has attracted the attention and favor of more and more institutional investors in the past year, which is significantly different from the 2017 Bitcoin bull market dominated by retail investors. Some institutions believe that Bitcoin can play the role of value/wealth storage and inflation hedging in investment portfolios, and hope that “digital gold” can eventually replace traditional gold. The current value of private wealth stored in gold is approximately US$2.7 trillion, more than three times the total market value of Bitcoin. Research reports by some foreign institutions believe that if the market value of Bitcoin reaches the level of gold, its price will exceed $140,000 per coin.
The term “digital gold” seems to me more like a marketing term and is worthy of consideration. As a precious metal, gold has practical uses, such as making jewelry and chips, while Bitcoin has no intrinsic value. Even as an investment asset, gold has proved to be a safe-haven asset in a period of high uncertainty due to its high market value, good liquidity, low volatility, and not much correlation with stock trends. Bitcoin’s performance is more like a risky asset. The market volatility in May fully proved that Bitcoin is indeed inevitable. From a longer time series, Bitcoin price trends are highly similar to stocks that are also risky assets (especially stocks with small market capitalization) (Figure 4).
Figure 4: Bitcoin shows more high-risk asset characteristics (Source: Macrobond, China Merchants Bank Research Institute)
Even if it is a hedge against inflation, the role of Bitcoin may be exaggerated, at least not empirically tested. Enthusiasts in the currency circle often emphasize that the supply of Bitcoin will not exceed 21 million at most, which proves that Bitcoin will not continue to depreciate with rising inflation like legal tender. There are still loopholes in this argument. Because cryptocurrencies similar to Bitcoin have sprung up like bamboo shoots after a rain. A small team of ten programmers can develop a certain cryptocurrency, and the professional requirements will not be higher than the master’s level. In fact, we have seen an endless stream of various types of “coins”, and the technical design is even more novel. Therefore, there is no upper limit for the number of cryptocurrencies, just as there is no upper limit for fiat currencies. It is difficult to accurately count how many types of cryptocurrencies there are. A not too outrageous estimate is that there are more than 6,000, of which at least 1,600 have died. With the emergence of various cryptocurrencies, Bitcoin’s market share has dropped from 90% before 2017 to around 50% today.
Figure 5: Bitcoin’s market capitalization share in cryptocurrencies declines (Source: Macrobond, China Merchants Bank Research Institute)
My conclusion is that Bitcoin, as a tradable virtual asset, has the characteristics of high risk. The similarity between it and gold is that it hedges against inflation, although this conclusion is still suspicious; the difference is that it is not a safe-haven asset, but a high-risk asset. Therefore, the argument to replace gold is not necessarily true, at least in a period of high uncertainty. Since late May, the trend of Bitcoin and gold has diverged, which illustrates this point.
Bitcoin and China: more than half the sky
When I visited the United States in 2015, I heard a professor from a prestigious school said: Bitcoin’s popularity is due to the enthusiasm of the Chinese people. He was not joking. In fact, in the development of Bitcoin for more than ten years, especially in the early stages, Chinese miners and investors have supported most of the sky in the Bitcoin world. According to estimates by the University of Cambridge Centre for Alternative Finance, China controls 65% of global Bitcoin mining capacity (in terms of computing power) (2 out of every 3 Bitcoins are mined in China) , It reached 75% 5 years ago (3 out of every 4 bitcoins were mined in China). From 2013 to 2017, RMB-denominated bitcoin transactions accounted for more than 80% of the transaction volume. At one time, it accounted for 95% of the transaction volume. It is not too much to say that all Chinese people are speculating in bitcoin. At that time, the nodes of the Bitcoin network located in the mainland accounted for more than half of the global share. After the government took action to suppress Bitcoin transactions in 2017, the current number of nodes has dropped to 3%. Most investors either open accounts overseas or conduct peer-to-peer over-the-counter transactions in China. Currently, four of the world’s five largest cryptocurrency exchanges use Chinese investors as their main users.
The result of this development is that Bitcoin has had a certain degree of “negative externality” impact on China’s social welfare. First of all, Bitcoin as a financial innovation has not improved financial efficiency, and the decentralized payment system has disappeared in China’s mobile payment field; secondly, the energy consumption of Bitcoin mining continues to rise. It is estimated that the carbon emission caused by Bitcoin mining in my country ranks ninth among all domestic cities. Without regulation, the carbon emissions from Bitcoin mining will reach a peak of 130 million tons in 2024, exceeding the carbon emissions of the Czech Republic (ranked 39th in the world). This is contrary to my country’s policy goal of “carbon peak and carbon neutrality”. The negative externalities of Bitcoin may also be the reason why Elon Musk has turned back. After all, Tesla electric vehicles are innovative companies that promote environmental protection.
At the same time, the expansion of Bitcoin trading poses a certain threat to my country’s financial stability and investor protection. As the price of Bitcoin continues to hit new highs, the level of leverage in the Bitcoin market also continues to rise. More and more individuals and investors are participating in irregular Bitcoin transactions, expanding the relationship between Bitcoin prices and other financial markets, and further escalating the impact and scope of the impact on financial stability. It is said that there are not a few investors in the currency circle in May. Although these people rarely petition to make trouble, the opaque and irreversible characteristics of Bitcoin transactions make it more difficult for investors to claim legitimate rights and interests.
The future of Bitcoin: capital never sleeps
Since the advent of Bitcoin, people’s understanding of it has continued to evolve. Although we are still full of doubts about Bitcoin, the future is showing an increasingly clear picture. In my opinion, at least the following three points can be concluded.
- Bitcoin and other cryptocurrencies are unlikely to replace sovereign fiat currencies, and the process of launching digital currencies by central banks is accelerating. The decentralized payment mechanism built by Bitcoin, even technically, is not necessarily more efficient than the existing mobile payment. However, the anonymous and credible mechanism of Bitcoin payment is likely to become an alternative tool for cross-border payments, evolving towards dark web transactions and underground economic activities. In this context, governments of all countries will definitely start to crack down on illegal transactions that may be involved in Bitcoin.
- As a new type of risky asset, Bitcoin will gain the favor of more institutional investors and occupy a place in the market investment portfolio. It is the general trend to clarify the characteristics of Bitcoin’s risky assets, and then to properly supervise Bitcoin investment and transactions. In fact, strengthening supervision is conducive to the healthy development of Bitcoin and other cryptocurrency asset trading markets. Regulation is not the biggest risk Bitcoin faces, but Bitcoin’s long-term survival opportunity. Bitcoin itself is not a demon. Two major bubbles burst in history, and the price of Bitcoin fell by 90%, but it still survived, and it was a wonderful and exciting life.
- The blockchain technology on which Bitcoin relies has broad development prospects. However, the key to understanding this is to “disenchant”, remove the mystery, sacredness, and charm of the blockchain, and abandon the anarchy and centerless fantasy. If the target of decentralization is the government and financial intermediaries, it can only be a utopian imagination. Moreover, in economic logic, the emergence of financial intermediaries is precisely to solve the trust problem and reduce transaction costs. Although blockchain technology has proven that decentralization can solve the trust problem, it cannot reduce transaction costs.
Looking forward to the future of Bitcoin is like a paradise lost in youth. Come on, welcome to the real world.
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