The Answer: Bitcoin And The Yuan Cannot Coexist - Part 2

| About: Winklevoss Bitcoin (COIN)


There are two alternative futures for the yuan, but only one for Bitcoin.

The Chinese government can drop its obsession with the detritus of a falling yuan.

Then the Chinese government can focus on the economic fundamentals that are creating the problem.

If these changes are not made, China will follow Japan and the Eurozone into a decade in purgatory.

Either way, the Chinese will ultimately force a hard fork in Bitcoin.

The pressure's high, just to stay alive. 'Cause the heat is on.

Glenn Frey

In my last article, I predicted that Bitcoin would ultimately become three separate cryptocurrencies. But fear not, Bitcoin mavens. If my analysis is correct, you will all be better off that way, in the long run.

This article answers the question, "Is Bitcoin really a threat to the Yuan?" The answer is in two parts. First, I argue that Bitcoin is not an existential threat. That is, if the Chinese government follows a policy toward Bitcoin in the Chinese government's long run best interest, Bitcoin is not a threat of any kind.

Second, I argue whether or not China behaves rationally, the Chinese will ultimately cause a hard fork. If the Chinese act irrationally, Bitcoin will be one of the thousand cuts that eclipse the Renminbi Yuan, and the Yuan is headed for a decade-long yen- and euro-like swoon.

But in the end, even rational decisions of the Chinese government will not save Bitcoin in its current form.

Bitcoin is not an existential threat to the Yuan.

Bitcoin is no threat to the value of the Yuan if the behavior of future Bitcoin investors mirrors their behavior in the past, as demonstrated in the graph below.

The chart shows what is happening to Bitcoin/Yuan trading. What matters is that it is only Bitcoin/Yuan trading. If holders of Yuan exchange them for Bitcoin, only to exchange them later for Yuan, there is no flight of capital.

This is the Chinese equivalent of the medieval Dutch tulip bulb bubble. The key to seeing how meaningless the whole Bitcoin trading episode is to the Chinese government, suppose Chinese investors only bought and sold Bitcoin from each other. What that implies is that Bitcoin trading simply moves Yuan around the Chinese economy, reducing the demand for other Chinese assets without affecting any other national economy. When the Bitcoin sellers capitulate and now-more-valuable Bitcoin are re-exchanged for Yuan, the Bitcoin buyer benefits at the seller's expense. There is no other important effect.

Compare that to trading on the Shanghainese gold exchange, which the Chinese government apparently supports. Chinese traders are a small fraction of this market. If there is a surge of Chinese buying that affects the world price of gold positively, since most gold is in foreign hands, foreign traders will sell at the higher price, adjusting their gold holdings downward, returning gold to the world price. Capital has just fled China.

So, if China's government does nothing with the miners - that is, China does not instigate a "51% attack," (cryptocurrency parlance for a dispute between the Chinese miners, who control more than half of the Bitcoin miner's computer power, and foreign miners that the Chinese miners intend to win and the foreign miners refuse to lose) then Bitcoin is nothing but a high-tech Chinese bingo parlor.

Why there will be a hard fork.

There are two possible paths to a hard fork.

  1. The Chinese government doesn't get it.
  2. Foreign investors do get it.

The Chinese government doesn't get it. If the Chinese government's paranoia dominates its common sense, then it is possible they will do what totalitarian governments do. The government will "request" that the Chinese miners seek a change in the Bitcoin code.

The Chinese miners would accept this request with surprising equanimity. From their point of view, a strictly Chinese Bitcoin is the status quo on the user side of the business. But is not the status quo on the supply side, where the producers of Bitcoin are only about two-thirds Chinese.

Return for a moment to Bitcoin as a Chinese bingo parlor. From the point of view of a Chinese miner, Bitcoin is a much larger version of Macao, and the miners are the "house." Except the Chinese miners split the house winnings with every Tom, Dick, and Vitaly.

If I'm a Chinese miner, I ask myself, "Why not change the code in a way that will frustrate the foreign miners?" If the foreign miners cooperate with me, that's a soft fork. If the foreign miners don't cooperate, it's a hard fork. Either way, Bitcoin becomes a Chinese cryptocurrency and laisse les bon temps rouler!

Foreign investors figure it out. To date, the big dealer sharks have not identified the schools of fish, on the reef that is Bitcoin. That is highly uncharacteristic of the big dealers.

Especially under the current conditions. When the big global dealers "get" that Bitcoin is just another market, and that the demand side of the market is being driven by Chinese investors' desire to acquire something that need not appreciate, but simply needs to outperform the Yuan, their interest will rise.

While the Yuan gasps and flounders, the big dealers will realize that there are untold billions to be taken out of this market if they simply control their appetites and don't sell into the Bitcoin market to the point that Bitcoin performance becomes unattractive to Chinese citizens.

Foreign transactions will balloon, and suddenly the Chinese government will have a real currency flight to worry about. And the government request to Chinese miners to change the Bitcoin code, irrational when the market was strictly Chinese, will now be completely sane.

The hard fork. Hence, there will very likely be a hard fork. Because foreign miners, at the gut level, do not want the Chinese government to dictate to them. Many in the Bitcoin community are there to avoid government interference generally, and Chinese government interference especially. There will be a split when the first regulated block is verified by the Chinese miners, but not by most foreign miners.

A better way. Here is my suggestion. If the miners understand their different motives, there is a mutually desirable solution. The Bitcoin miners simply need to meet.

Bitcoin 1. Let Chinese Bitcoin go its own way. There is profit in the Chinese miners' strategy. But it is no other miner's business plan. The other potentates of Bitcoin may then ask if it is not desirable to further divide the currency. The answer will be yes, because the non-Chinese casino potentates among the miners are further split, by different intended uses of Bitcoin.

Bitcoin 2. There are those who favor Bitcoin as the best way forward in global transactions. These miners need a cryptocurrency that is formally governed. They will want to encourage participation from global central banks. The big "scaling" debate within the Bitcoin community (whether or not to increase the number of feasible transactions per unit of time to an industrial scale) will be settled, in Bitcoin 2, in favor of a Bitcoin code that eases scaling.

More than likely, in Bitcoin 2, the whole mining concept will be dropped. The Central Banks will be nodes that pay their own freight. There is plenty of incentive for central banks to police each other without formal payment.

How will values of fiat currencies relative to this cryptocurrency be determined? Most likely, the cryptocurrency will have no value. If the miners aren't compensated, there is no need for a value.

Bitcoin 3. There are those who see Bitcoin as an alternative to traditional stores of value - an alternative that is not sullied by craven businessmen and politicians. They will want to keep the original Bitcoin code as it is today. Valuation every ten minutes or so is fine with them. Once commercial transactions have been moved to Bitcoin 2, I imagine the governments of the world will ask for little from the management of this cryptocurrency, other than audit and taxation powers.

No. Bitcoin, as presently constituted, will not survive a very likely Chinese attack. But with honest dialog, all parties can benefit from reconstituting the cryptocurrency to meet the very different needs of its three constituencies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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