July 11, 2017    7 minute read

Will China Capital Regulation Cause a Bitcoin Crash?

On Thin Ice    July 11, 2017    7 minute read

Will China Capital Regulation Cause a Bitcoin Crash?

In recent weeks, it has seemed impossible to watch the news or open a newspaper without encountering a story regarding cryptocurrencies, the most well-known being Bitcoin (BTC). This extensive coverage of Bitcoin in recent times is not without justification.

From its humble beginnings in November 2011 where one bitcoin would only set you back $2.37, the cryptocurrency has appreciated dramatically over the subsequent six years, so much so that at the beginning of June 2017, the same Bitcoin would cost $2954.22 – an astonishing increase of over 124,000%.

Soaring Coin

In 2017 alone, Bitcoin has appreciated by over 180%, much of which has been driven by the increased coverage of all cryptocurrencies and Bitcoin in particular. But is this growth sustainable, or will cryptocurrency investors ultimately be stung when the so-called bubble bursts?

Any technical analysis on BTCUSD is nigh-on impossible as the price chart follows an almost exponential route. The majority of the slight corrections which have occurred were mainly due to certain events or news releases, and as a result, technical analysis is all but redundant when analysing Bitcoin.

In order to gain some degree of insight into possible price movements, we must focus on fundamental analysis and the economic strategies of certain countries. So what do industry professionals make of Bitcoin? How do they navigate cryptocurrencies? How do they analyse them and what are their opinions?

Trading Bitcoin allows investors to increase the liquidity of their assets in addition to making the transfer of capital both in a country and across a country’s borders much simpler.

This free movement of capital is a core component of the basic economic theory of the “impossible trinity”. This theory, in its simplest form, states that out of the three options, namely independent monetary policy, free movement of capital and a fixed exchange rate, a country’s central bank can only choose two. A good explanation of the implications of this theory can be given by analysing China which chooses to sacrifice free movement of capital.

China

If the country’s central bank decided to decrease interest rates then it would be unable to maintain a fixed exchange rate due to the outflow of capital from the country as investors search for higher yields.

As a direct result of the increase in interest rates, the yuan would depreciate in value. By using very draconian capital controls and stopping this outflow of capital, the central bank and government could prevent this, but this would limit the movement of capital across the country’s borders.

As a result, the conditions of the impossible trinity once again hold. One major application of Bitcoin is to allow for secure and discrete financial transactions without the need for an intermediate party and in so doing, mimics various cash-like features.

The Yuan

The Chinese Yuan is now the dominant currency in which Bitcoin is traded and, as reported by Business Insider, the share of Bitcoin traded via the yuan increased from less than 10% in January 2012 to almost 100% at the time of writing.

This is a huge problem for China as the transfer of capital via Bitcoin essentially creates a way to bypass the restrictions on the movement of capital in and out of the country implemented by the government and reinforced by the impossible trinity.

Due to the speed at which Bitcoin has increased not only in value but also notoriety, it appears the Chinese government has yet to implement appropriate regulation to control the flow of capital via the use of Bitcoin.

The Chinese government did begin to implement some incremental steps towards curbing this outflow of capital at the beginning of the year, which did result in the price of Bitcoin sliding 32% in little over a week. The only other major pullback occurred at the beginning of March when two bitcoin-based ETFs were rejected by the Securities and Exchange Commission (SEC), which led to a 28% decrease in the price of Bitcoin.

The Effect of Regulation

Both these events are shown on the BTCUSD price chart below, however these pullbacks, which would normally be considered substantial if they occurred in any other asset, pale into insignificance when compared to the growth experienced by the cryptocurrency afterwards.

That said, if China implements more serious regulations, then the price of Bitcoin will be seriously affected, and if another circa 30% pullback was to be seen then the nominal change will be much more serious than previous occasions.

If this were to occur, and depending on each investors’ sentiment, this could very well present a purchasing opportunity. Many believe that due to the rapid inflow of capital into cryptocurrencies, particularly Bitcoin, a bubble has formed in the market, and because of the unpredictable nature of bubbles, it is plausible that the majority of investors hold a short-term bullish view and are attempting to gain relatively small returns in the cryptocurrency markets (which may very well be substantial).

Ethereum

Ethereum is the second largest cryptocurrency in terms of market capitalisation after Bitcoin and, just like Bitcoin, it has seen dramatic appreciation in recent times.

At the beginning of 2017 Ethereum was trading at approximately $8 but was able to reach highs of $397.37 just 6 months later. The price fell from about $300 to approximately $0.10 in a matter of minutes at the end of June 2017 after a flash crash occurred, causing many traders to experience stop loss orders (also known as margin calls) and suffer severe financial losses as a result.

The price quickly rebounded back to its pre-flash-crash level, however, the flash crash of Ethereum raised major questions regarding the integrity and stability of cryptocurrencies and whether they can, in fact, replace tangible money of many different currencies and “unite” the world under one common form of exchanging wealth.

The driving factor of the flash crash was the filling of a multimillion dollar sell order at market price. This resulted in Ethereum being exchanged at any price that was being offered until the entire order was filled (regardless of whether this price was much lower than the current price of Ethereum). 

This flash crash occurred on GDAX which is a digital currency exchange, but this exchange performed exactly as it should and the in the same way any major market would react had a proportionally large market sell order been placed. 

Was it Deliberate?

The repercussions of placing a market sell order of this size in a market with a relatively small market capitalisation are well known, which suggests that either the trader was unaware of the consequences of their actions, or simply did not care about the effect it would have on the market (due to the size of the trade, the latter is more likely true). 

The fact that traders can remain anonymous while executing transactions in addition to the relatively small market capitalisation of various cryptocurrency markets raises an interesting point. 

It is currently almost impossible to prevent and punish any forms of insider trading or market manipulation in cryptocurrency markets. This further raises the likelihood of previously rare incidents such as flash crashes until strict regulations are implemented. 

The market abuse regulation (MAR) was implemented across the EU last year, and made market manipulation and insider trading civil offences which hold up to five years imprisonment and a fine up to 10x the amount involved.   

Conclusion

With multiple success stories floating around the internet, it is easy to get absorbed into the euphoria surrounding cryptocurrencies, however, it is advised that one proceed with caution when investing in them.

As shown above, the cryptocurrencies markets can be just as unforgiving, if not more, than equity markets. Having said this, finding relatively unknown cryptocurrencies which provide certain features which distinguish them from others may very well lead to major profitability.

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