17 October 2017

China Bitcoin Dominance Wanes As Communist Party Meet

While the People's Bank of China (PBoC) have banned Initial Coin Offerings (ICOs), around 70-80% of Bitcoin mining is still concentrated in China. The Chinese Communist Party meeting taking place in Beijing on 18 October 2017 could see new guidelines on Bitcoin emerge on the back of capital flight fears.

China is known to discuss sensitive areas at the congress, which takes place once every five years. It could potentially be the forum where the future of Bitcoin in China is discussed. Early Bitcoin adopters in the People’s Republic enjoyed zero trading fees on exchanges leading to massive trading growth. However, the PBoC has implemented regulation on exchanges due to concerns of capital flight and within just nine months into 2017, Bitcoin’s future in China has become uncertain.

China has been involved in the Bitcoin community almost immediately after its start in 2009 and became a leading force in both bitcoin trading and mining. Chinese exchanges dominated the trading volume due to the lack of trading fees; instead they charged for withdrawals out of the exchange. The absence of trading fees enabled high frequency trading strategies on Chinese exchanges, which allowed traders to profit from price discrepancies on an imperfect immature market. Bloomberg estimated that as much as 80% of bitcoin trading in China was automated.

Since 2014, China has been battling high capital outflows along with decreasing forex reserves. In February of 2017, China’s forex reserves hit a 5-year low (See Graph 1). The Chinese government has stepped in and started regulating the bitcoin exchanges citing the risk of capital flight. In theory, it was possible to avoid the country’s limits of the amount of Renminbi converted to other currencies by buying bitcoin on the Chinese exchanges and then selling it anonymously for a different currency on a non-Chinese exchange. In fact, there was an intriguing inverse relationship between Bitcoin and Renminbi in 2016 (See Graph 2), which could only further the suspicions of the Central Bank (PBoC) that Bitcoin was being used to facilitate capital flight.

Bitcoin and other cryptocurrencies weakened China’s control over money flows. To combat the problem, China’s first step was that, starting from January 2017, all financial institutions were required to notify the Central Bank of any transactions over 50,000 Renminbi down from a ceiling of 200,000 Renminbi (Approx. 30,000 USD).

Subsequently, China also started inspecting the big three exchanges. BTC China, Huobi and OKCoin soon announced that they will begin charging trading fees of 0.2% per transaction.

Overnight, high frequency trading was made unprofitable and China lost its biggest competitive advantage. As a result, the share in bitcoin trading in China has declined from 90% to about 27% in just a matter of days. In early February, the PBoC temporarily halted withdrawals of any bitcoins and stated that normal operation can resume after the regulators approve the internal compliance upgrades. China's share in trading further continued to decline.

In July, three months after the Central Bank’s probe started, the exchanges were finally allowed to resume Bitcoin withdrawals. At Central Bank’s request, they have updated their verifications systems to satisfy the anti-money laundering (AML) and know your customer (KYC) regulations.

The withdrawal ban put a downward pressure on bitcoin price for months as the price of bitcoin was lower by around 25% on Chinese exchanges because of the inability to withdraw funds. This created an arbitrage opportunity and further pressured the prices on the other markets lower. With the resumption of withdrawals, the demand for bitcoin increased and prices of bitcoin normalized across the global markets, which eased the pressure and price of bitcoin started to grow. The price continued to grow until September when it doubled from when the withdrawals were resumed and crossed the $5,000 mark.

1: China Foreign Reserves Increasing  After Record Low (Mn USD)

2: The Inverse Relationship Between Bitcoin and Renminbi

In September, the PBoC officially declared ICOs to be illegal. They stated that “ICO is essentially a form of non-approved illegal public financing behavior and raises suspicions of illegal selling of notes and bills, illegal securities issuance, illegal deposit-taking, financial fraud, illegal direct marketing and related criminal activity".

The Wall Street Journal reported that the Chinese authorities are preparing to shut down the country’s bitcoin exchanges citing a focus on preventing capital flight. Starting from the time when China started inspecting the exchanges in January, the Chinese forex reserves have increased for seven straight months and are currently the highest since October 2016 (See Graph 1).

The capital outflows have also started to decrease as China instituted stricter rules on moving capital outside the country. It is quite logical that China would want to continue this exercise. The three largest Chinese bitcoin exchanges announced that they will indeed stop offering local trading.

BTC China announced that they will stop all trading by the end of September while OKCoin and Huobi said that they will only cease the Yuan trading by the end of October. Bitcoin’s price has tumbled by about 35% from its $5,000 mark following both the ICO ban and the announcements from exchanges. However, despite all the negative shocks, investors remain optimistic and the price has since not only recovered, but hit a new all time high.

China has not made it illegal to own bitcoin, yet. Chinese investors can still utilize the local over-the-counter (OTC) trading platforms such as LocalBitcoins.com to trade bitcoins but the liquidity is much lower than at online exchanges. Investors can technically still use foreign exchanges but only in a very limited way because of the strict capital control rules. Investing in bitcoin therefore has become very impractical for investors in China. And mining Bitcoin in China remains unregulated but there are speculations that China is planning to ban the miners too. Whether or not the Chinese Communist Party meeting will reveal new regulation and guidelines is to be seen.

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