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China’s moves against cryptocurrencies could affect blockchain growth

As China clamps down on the use of bitcoin, other nations and businesses are also seeking to more heavily regulate cryptocurencies and, more generally, blockchain-based networks.

Lucas Mearian Jan 12th 2018

While the hype around bitcoin and other cryptocurrencies has sent their prices  skyrocketing, some governments and companies are restricting activity to head off potential money laundering and protect consumers from a credit meltdown.

Cryptocurrencies have begun to exit once-friendly China for more open nations and other regions and businesses are beginning to impose restrictions on how – or even whether – they can be used.

Open blockchains, such as bitcoin, are only the first to be affected by increased regulatory oversight. Depending on how they're used, permissioned blockchains, or those that are centrally administered and used for general transactions, could also be affected by the push to reign in the cryptocurrency technology.

With cheap electricity, China was once a haven for vast, power-hungry server complexes that perform the algorithmic processing for bitcoin and other blockchain-based virtual currency networks. In recent years, however, China has gradually  clamped down.

China moves to clamp down

Last year, China outright banned initial coin offerings, a form of crowdfunding for cryptocurrencies, and later put the kibosh on trading in electronic currencies. More recently, the government began shutting off the power faucet for bitcoin mining pools, or large server farms that perform cryptocurrency processing.

"The market is very entrepreneurial and we'll see the bitcoin transaction processing move elsewhere pretty quickly," said Paul Brody, Global Innovation Leader for Blockchain at EY (formerly Ernst & Young). "It may well boost other cryptocurrencies,  especially those with a lower carbon footprint in the transaction processing work and more business and IT applications like Ethereum."

The company running two of China's biggest bitcoin mining pools, Bitmain and BTC.Top, the third largest mining pool, have set up mining operations in the U.S. and Canada. And ViaBTC, the fourth largest mining pool operation, has opened facilities in Iceland and the U.S., according to Bloomberg News.

There are various "good" reasons China and other countries hope to take a more hands-on regulatory approach to cryptocurrencies, which to date have existed in an oversight Wild West, according to Martha Bennett, a principal analyst at Forrester Research.

Dangers of cryptocurrencies

There is a growing concern that cryptocurrency could be a threat to the current financial system through unbridled speculation and unsecured borrowing by consumers looking to purchase the virtual money.

"We have seen increasing evidence that people are borrowing to invest in cryptocurrencies, and in some cases borrowing on credit cards to invest in it," Bennett said. "That could lead to a credit collapse."

The price of the leading cryptocurrency, bitcoin, has skyrocketed to nearly $20,000 in recent weeks only to plunge to under $13,000 before recoverying to about $14,500. The second most popular cryptocurrency, Ethereum's Ether, also saw its price skyrocket over the past month from $481 to more than $1,300.

Ripple, a blockchain-based financial settlement and currency exchange system, also has its own form of cryptocurrency: XRP, which banks on the network can chose to use as an intermediary between cross border currencies or not. Because of the recent investment fervor around virtual currencies, XRP's market price has also risen dramatically.

"If you have a situation like that, even with a permissioned network, if there’s a token associated with it where its value has been driven up, that could have implications," Bennett said.

Investors can purchase digital currencies like bitcoin, Ethereum and Litecoin on exchanges such as Coinbase, which was founded in 2011. More venerated, traditional exchanges have also opened futures trading in bitcoins, including the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE), which opened bitcoin trading in December. The Nasdaq OMX Group is also considering opening a bitcoin exchange.

Unlike bitcoin, Ethereum's open-source blockchain technology has been developed for use by enterprises as a peer-to-peer, transaction network, and it is being deployed in pilot projects for everything from cross-border payments to the tracking of international shipments. Ethereum's Ether token was developed as a way to fund development, but it has been "hijacked" by investors, Bennett said.

Other nations tighten oversight

As the use of cryptocurrencies expands, regulators worldwide are considering more oversight.

"This isn't just about China and regulators but the wider ecosystem is really clamping down," Bennett added.

This week, Israel declared bitcoin not an actual currency, calling it instead a financial asset that remains difficult to regulate for the purposes of mitigating risk for banks and consumers.

"Beyond the risks to the customer there are also compliance risks to the bank," Israel's Deputy Governor, Nadine Baudot-Trajtenberg, told a meeting of the parliamentary finance committee.

In the U.S., various state agencies have also reacted to what they see as fraudulent activities by cryptocurrency companies by ordering them to cease sales of bitcoin. One Nebraska lawmaker filed three bills to amend the state's money-laundering laws to cover cryptocurrencies and, more broadly, blockchain applications.

The Securities and Exchange Commission (SEC) has ordered the suspension of cryptocurrency trading by one company due to "unusual and unexplained market activity." More generally, SEC regulators around the country have regularly tweeted out warnings about cryptocurrencies.

Last week, Visa suddenly terminated its relationship with WaveCrest, a company that converted cryptocurrencies into cash on a prepaid Visa debit card for common transactions. Beyond saying WaveCrest violated its "operating regulations," Visa didn't explain its decision; Bennett however, speculated there may have been a concern the pre-paid cards would be used for money laundering.

"Where you have money laundering concerns, you have regulatory issues," she said. "If you have bitcoin and can turn that into dollars... even if it's only $1,000 a time, then you just go and get another debit card."

As a virtual, electronic currency, bitcoin, Ethereum and others allow anyone to exchange money on a blockchain-based peer-to-peer network in real time, anywhere in the world – and without a central governing authority such as a bank or credit card company.

Cryptocurrencies have existed in a gray area that allows for cross-border transactions that are far more efficient than traditional fiat-based currencies, such as dollars or euros.

Blockchain can offer transparency

There is virtually no risk of identity theft on a blockchain because every participant is anonymous; the only thing being verified through a cryptographic hash is the digital wallet used to send and receive virtual currencies.

Most financial networks built on blockchains, such as Ethereum, are operating within strong regulatory frameworks often between banks, such as the R3 consortium.

"Those networks are already subject to pretty careful regulatory scrutiny and are unlikely to be affected by clampdowns on bitcoin," Brody said.

Governments have been slow to regulate cryptocurrencies because, while they could be used for nefarious purposes, they are also capable of establishing transparent, efficient and trustless virtual currencies that can bolster business efficiency.

While nations may one day unify on common cross-border regulations, that will likely be a slow and complex process compared to hammering out domestic regulations, Brody said.

"The choke-point in bitcoin is becoming the exchange where people can move value between cryptocurrencies and to and from classical fiat currencies," Brody said. "Subjecting those exchanges to audit and know-your-customer requirements should do a great deal to help structure and normalize the market."

In fact, China is considering creating its own blockchain-based cryptocurrency as online transactions have surged there.

Clamping down on bitcoin currencies could actually help promote more nefarious activity by newer blockchain-based cryptocurrencies. While bitcoin is highly traceable due to its platform being an open, immutable electronic record, some of the new cryptocurrencies are making use of new techniques that make it very hard or nearly impossible to trace transactions, Brody said.

"Clamping down on bitcoin could result in a shift towards those currencies, so it's not something that financial authorities should do without considering the consequences," he said.