China Might Lose Its Pricing Power On Digital Assets


It’s official. All Chinese cryptocurrency exchanges announced their plan to cease all trading operation.

With the assumption that the condition would persist for a prolonged period, this article aims to evaluate the possible price dynamic changes on digital assets after such drastic measures.

To begin, I strongly agree that most domestic cryptocurrency exchanges should improve their corporate governance, investor protection, set forth a proper code of conduct and increase their transparency of policy on client money. ICOs is a bubble and it shall be heavily scrutinized by an accredited third party before they start soliciting public investors. While at the same time, China’s regulator should take into serious consideration on how cryptocurrency trading can be tamped by putting into proper regulatory framework — rather than a complete halt.

Bear in mind that China is NOT banning bitcoin and digital assets itself. Regulators in China essentially suspended the operation of centralized matching services provider exchanges which facilitates buy and sell by way of an automatic auction process.

In order to understand the dynamics between the market and its pricing power on cryptocurrency of a nation, you have to understand how price is eventually formed and how market price is affected by a variety of market mechanism.

Market Mechanism

For a market to work well and healthy, the structure should accommodate the needs of fundamental users (of the asset), investors, dealers and speculators.

Markets are generally quote-driven, order-driven or a hybrid of the two.

Quote-driven market means participants must transact with a dealer (or market maker). Dealer would quote prices at which they will buy and sell in a given quantity. Peer-to-peer, over-the-counter-type of market is generally being categorized as quote-driven market.

Order-driven markets allows all traders to place orders on a centralized order book. Orders are then matched using a consistent set of rules (continuous auction process, for instance) so to allow all traders to participant into the market equally. All regular stock exchange and all major cryptocurrency exchange such as OKCoin & OKEx are categorized as order-driven market.

Price Formation Process

Asset Price is formed based on supply and demand because investors tend to have varying level of information and views on the future value of an asset. The nature of quote-driven markets relies on market-maker to quote price. And its bid offer spread represents the costs for which market maker prepared to trade. Market maker would take into consideration their current inventory (or positions) in order to determine an appropriate bid-ask spread.

While order-driven markets are mostly based on a central limit order book, their transparency of a market depth has a substantially positive effect on improving price formation. Comparing with quote-driven, over-the-counter-type of market, its lack of transparency nature on liquidity would add a degree of uncertainty to traders and could lead to orders being priced more aggressively than is necessary.

Forgotten value of quote-driven price discovery process

Transaction costs are unavoidable, they are incurred each time an asset is bought or sold. While transaction is categorized into explicit costs (commission, fees, insurance, & taxes) which are clearly defined and easily measured with implicit costs (eg. Market impact & slippage). These normally require scientific approach to identify and measure.

An absent of a consolidate order book that facilitate continuous price auctioning would undoubtedly drive up the cost of transaction — traders would have to engage with unknown dealers or market makers and negotiate a price and quantity. Regardless how advance and robust the design of OTC matching platform is, it is still a peer-to-peer transaction and traders have to take into account of the counterparty risk — every time traders engage with a new counterpart. Market itself would price-in such risk and hence everybody has to pay more for finishing a transaction — comparing with a consolidated order-driven trading mechanism. The asymmetric of information between buyer and seller would imply a wider bid-ask spread and hence the explicit costs between both sides would be expectedly increase.

Trading volume of cryptocurrency in China alone accounted for 15–30% of the global crypto-market share through major exchanges such as OKCoin. On the other hand, suspension of order-driven exchange would push Chinese traders to OTC platforms like Localbitcoin.

1-d6733jzwjkev601QU2t-gwChina’s weekly volume on Localbitcoins spike exponentially after domestic exchange announced closing trading operations.

Yet, it is not hard to imagine a much wider bid-ask spread quoted on Localbitcoins than other Chinese exchanges, despite its huge volume after China’s regulatory crackdown.

Snapshot Best-Bid Quoted @ LocalBitcoin China

Snapshot Best-Ask Quoted @ LocalBitcoin China

Chinese traders might have to bear extra costs for a while.

Tradable Tokens play crucial role in blockchain-powered economy

Imagine in a foreseeable future, where global ICO and its blockchain application become a lot more regulated, transparent, promising and mainstream.

Token plays a crucial part in future blockchain-powered economy and helps create incentive for project supporters by assigning them a protocol-defined cryptocurrency (eg. Block rewards). At the same time, it is also a form of penalty — by destroying or reducing the deemed token — if the participant did something bad.

For a form of economic system to thrive long term, allocation of scarce resources (or asset) should be voted by all participants in the system in a fair and transparent manner. Essentially, the best and most pragmatic way is to price the asset (project) efficiently by way of the price discovery process in a fair and orderly market place.

Centralized order book is without doubt the best candidate and it has been a proven mechanism for years. Such marketplace is a fundamental element in a blockchain-powered ecosystem.

Pricing Power is a form of national competitiveness

Bitcoin is NOT a currency, yet. There are still 2 major hurdles for Bitcoin to be seen as a currency: prize volatility and its transaction processing speed.

May be Bitcoin can never be qualified as currency, yet it is becoming a commodity with similar characteristic as Gold or Silver. At the same time it is looking to become a solid complementary asset class to provide an investable asset with low correlation with traditional financial asset class. And its common use case is gradually becoming a “base currency” in crypto-world — despite its highly volatile characteristics.

Bitcoin, aside from its “digital gold” nature, is gradually becoming the base currency of all cryptocurrency. Almost all of tokens circulating in the market is available to be bought by bitcoin.

China has all the ingredients to become the world’s largest blockchain-powered economy. PBOC is reportedly close to the release of a government-backed digital RMB. And government officials of PBOC is well equipped on decentralized technology and its beauty on reducing operating cost, optimizing efficiency, and better measurement on monetary policy. Also the Chinese Ethereum community has put a lot of energy and devotion towards blockchain.

While China announced a complete ban on cryptocurrency exchange, it does not look very likely that other countries will follow China’s lead. While tightening regulation and increasing scrutiny on crypto-economy globally, China might lose its global pricing power over base digital currency like bitcoin — for the fact that there is no efficient price formation process in China.

While at the same time I strongly agree that most of the domestic cryptocurrency exchange should improve its governance, investor protection, set forth a proper code of conduct and increase its transparency of policy on client money, China’s regulator should take a serious thought on how it is going to put in a proper regulatory framework rather than enforcing a complete halt on all cryptocurrency trading.

Lesson should be learned from global oil market. China is currently the world’s largest net oil importer, but also a major victim on oil price volatility due to the lack of pricing power in the global oil market. Same thing happened in global iron ore. After years of struggling, China aims to gain its pricing power in launching yuan-denominated crude oil futures listed in Shanghai and hopefully the contract would attract oil users, refiners, traders and investors to participate and eventually a create a price benchmark. Lots of works still need to be done.

Lennix Lai

Director of Financial Market
Tel: +852 5808 5768
Sep 21, 2017

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