He Fei: Six major risks behind this surge in Bitcoin prices

The author is a senior researcher at the Financial Research Center of Bank of Communications. This article represents only his personal views and does not necessarily represent the opinions of his organization.

On August 17, 2017, according to data from Huobi.com, the price of Bitcoin in China exceeded the 30,000 yuan mark, setting a record of a 58% increase in 17 days. There is no doubt that Bitcoin has become a hot investment target under the background of declining economic growth expectations, narrowing investment channels, and declining investment returns. However, everything has two sides, and there are huge risks behind the "sky-high" price of Bitcoin. If we cannot prevent it early and take effective measures, the "tulip bubble" is likely to reappear.

Before warning about the risks of Bitcoin, it is necessary to focus on three questions: First, can Bitcoin be called a currency? Second, compared with previous rounds, what are the different characteristics of this round of price increases? Third, what are the main factors driving this round of price increases?

Regarding the first question, at present, Bitcoin is still a long way from realizing its currency function. On the one hand, the price of Bitcoin is seriously unstable, which is very different from mainstream currencies. On the other hand, compared with legal tender, Bitcoin does not have the credit endorsement of a sovereign state, its payment function is still not accepted by the public, and the scope of payment is still quite limited. In addition, compared with the universality of mainstream currencies, the number of people who own Bitcoin is small, and it is impossible to form a high-frequency and continuous trading atmosphere. It can be seen that instead of calling Bitcoin a virtual currency, it is better to call it a virtual asset, that is, the investment (speculation) attribute of Bitcoin is far greater than its currency attribute.

Regarding the second question, as early as the end of 2013, the price of Bitcoin experienced a phased rise and exceeded the price of gold per ounce for the first time. However, that round of rise lasted less than two months. This round of Bitcoin price rise can be traced back to 2016. Unlike the previous "one-man show" in the Chinese Bitcoin market, many countries including Japan, the United States, South Korea, and Europe have participated in it. Among them, Japan has surpassed China and the United States to become the country with the largest Bitcoin trading volume. At the same time, top investment banks including Goldman Sachs and Citi, and governments and regulatory authorities including Japan, the US Securities and Exchange Commission, and the People's Bank of China are closely watching the trend of Bitcoin prices. In addition, whether it is institutional investors or retail investors, each party is gearing up and eager to try, for fear of missing this round of feast. It should be said that globality, explosiveness, and intensity are the main characteristics of this round of Bitcoin price increases.

Regarding the third question, the main factors driving the current round of Bitcoin price increases include fundamentals, technology, policy and capital. In terms of fundamentals, after July 9, 2016, the daily number of new Bitcoins was halved, which was determined by the operating mechanism of Bitcoin's "halving every four years". Affected by the halving of supply, the trading price of Bitcoin is expected to rise. In terms of technology, the blockchain technology behind Bitcoin has received increasing attention and has become one of the mainstream technologies in the development of financial technology, which has ignited the bullish sentiment of Bitcoin. In terms of policy, some countries including the United States and Japan have successively introduced favorable policies, which has accelerated the upward momentum of Bitcoin. In terms of capital, a series of events such as the Trump administration taking office, North Korea's frequent nuclear tests, South Korea's accelerated deployment of THAAD, and the UK's promotion of Brexit negotiations have intensified the global situation. Under this circumstance, Bitcoin is generally regarded as a safe-haven asset equivalent to gold and is favored by many parties.

Nevertheless, since many factors that boost the price of Bitcoin are highly uncertain, the rise in Bitcoin prices is not sustainable. In fact, the current Bitcoin risks are gathering and showing signs of an outbreak, which deserves close attention from regulators and investors. Specifically, Bitcoin faces the following six risks:

The first is the risk of manipulation. According to statistics, as of the end of May 2017, the number of bitcoins mined was 16 million. Based on this, on the one hand, the scale of bitcoins currently entering the trading market is limited, and it is easy to be manipulated by large institutions and consortiums. On the other hand, the current bitcoin price fluctuates violently, and it is likely to be controlled by institutional investors. Therefore, Bitcoin faces the risk of manipulation.

The second is the risk of public opinion. It is observed that every leap in the price of Bitcoin is related to good news. These so-called "good news" are difficult to distinguish between true and false. Even if they are true, many "good news" on the technical level are difficult to implement in a short period of time. At present, the price of Bitcoin overreacts to the "good news" in the market, bubbles accumulate, and public opinion risks are intensified.

The third is arbitrage risk. Globally, governments' regulatory attitudes towards Bitcoin have gradually diverged, with varying degrees of support and suppression. For example, the Chinese government has always been concerned about Bitcoin and has repeatedly interviewed the heads of Bitcoin trading platforms, demanding strict control of Bitcoin risks. Unlike China, in April this year, Japan passed the Payment Services Amendment Act, officially recognizing the legal status of Bitcoin payments. It can be expected that under different regulatory environments, Bitcoin transactions are likely to produce a clustering effect, Bitcoin arbitrage space will increase, and arbitrage risks will emerge.

Fourth, policy risk. In China, every time the price of Bitcoin soars, the central bank will issue risk warnings in a timely manner. At present, the atmosphere of Bitcoin "speculation" is strong. At the same time, the control of RMB capital outflow has been strengthened, and the probability of money laundering through virtual currencies such as Bitcoin has increased sharply. Under this circumstance, the central bank is likely to introduce a more stringent Bitcoin regulatory policy than before, and the Bitcoin market faces huge policy risks.

The fifth is technical risk. Currently, the blockchain technology behind Bitcoin is popular, and the rise in Bitcoin prices is also related to it. However, the security of the blockchain itself cannot be fully verified. At the same time, with the rapid increase in trading volume, the risk resistance of trading platforms is challenged. Bitcoin faces dual technical risks from both itself and the platform.

Sixth, the greater fool risk. At present, the reason why Bitcoin investors are "full of confidence" is largely because they are optimistic about the "scarcity" of Bitcoin, that is, the total amount of Bitcoin is limited. However, on the one hand, Bitcoin is driven by algorithms, and its total amount is not absolutely immutable. On the other hand, even if the total amount of Bitcoin is fixed, its pricing unit can be extended downward, that is, revalued according to units such as 0.1 and 0.01. In addition, many "Bitcoin-like" virtual currencies have appeared around the world, and these virtual currencies will pose a challenge to the price of Bitcoin. It can be seen that if the "limited total amount of Bitcoin" is used as the basis for investment, there is a "greater fool risk". If you rashly enter the Bitcoin market, you may become the last "taker".

In order to prevent Bitcoin risks, the author recommends that regulators take the following specific measures:

First, we should once again warn of Bitcoin risks through the publication of documents. In December 2013, the central bank and five other ministries and commissions issued the "Notice on Preventing Bitcoin Risks" (hereinafter referred to as the "Notice"), stating that Bitcoin is not a real currency, but a virtual commodity. When ordinary people trade Bitcoin on the Internet, they should assume the risk themselves. After the issuance of the "Notice", the domestic Bitcoin market experienced a downturn for more than two years. However, in 2016, the price of Bitcoin rose again, with an annual increase of 200%. In 2017, the Bitcoin market was almost "crazy", with the highest increase of 202% in half a year. In this case, the author suggests that the central bank and other regulatory authorities once again issue a document to warn of Bitcoin risks, and focus on explaining the properties of Bitcoin, its relationship with blockchain, and specific risk types.

The second is to indirectly regulate Bitcoin through regulating trading platforms. The Notice clearly states that Bitcoin trading platform websites should be registered with telecommunications management agencies in accordance with regulations and laws, and should fulfill anti-money laundering obligations such as identifying customer identities and reporting suspicious transactions. At the beginning of this year, the central bank's Shanghai headquarters, Beijing Business Management Department and other regulatory departments interviewed the person in charge of the Bitcoin trading platform to understand the specific operation of the platform, and further pointed out possible risks, requiring the platform to conduct self-inspection and self-correction. In this sense, it is recommended that the regulatory authorities accelerate the promotion of the Bitcoin trading platform management methods and anti-money laundering regulatory documents.

The third is to accelerate the development and application of the central bank's digital currency. Legal digital currency is the mainstream development direction, and it will play an important role in reducing transaction costs, preventing inflation, improving transaction efficiency, and curbing money laundering. In this sense, it may not be Bitcoin that will replace gold in the future, but digital currency led by the central bank. In fact, in recent years, the central bank has spared no effort in promoting the development and application of legal digital currency. As early as 2014, the central bank established a special research group for legal digital currency. In early 2016, the central bank announced its digital currency issuance target for the first time. Around the Spring Festival this year, the Central Bank Digital Currency Research Institute was officially listed, and the blockchain-based digital bill trading platform it led was successfully tested. Based on this, it is recommended that the central bank further accelerate the development and application of digital currency. On the one hand, the launch of legal digital currency will prompt the public to look at virtual currencies such as Bitcoin more rationally. On the other hand, the legitimacy and stability of legal digital currency determine its widespread circulation, thereby reducing the improper trading space of virtual currencies such as Bitcoin, and the Bitcoin trading market will be further regulated.