BNP AM

The official blog of BNP Paribas Asset Management

The inherent risks of crypto currencies – When bitcoin meets China’s CBDC

Increasing regulatory control, due to central banks protecting their economic policy sovereignty and national governments seeking to control climate change, is an imminent risk for cryptocurrencies. In particular, China’s official digital currency is 'anti-cryptos'.

Cryptocurrency anonymity, notably in the case of bitcoin, comes without any recourse to or protection against theft, loss or other forms of financial crime. This creates an inherent risk which the crypto market is trying to fix. Ironically, the potential solutions bode ill for cryptos by destroying their untraceable anonymity.

Longer-term, the bitcoin 'protest' may force sovereign states to improve their macroeconomic management and strengthen the framework of their institutions. Cryptos could be marginalised by the rise of central bank digital currencies characterised by 'controllable anonymity', as per the Chinese model.

Bitcoin - A new type of institutional arrangement

The cryptocurrency fever has made financial headlines, with bitcoin's price surging and a debate raging over the emergence of cryptocurrency technology. These may, however, be a sideshow within a major, developing trend of China’s digitalisation, including renminbi digitisation[1].

China’s central bank digital currency (CBDC), officially called Digital Currency Electronic Payment (DCEP or 'e-CNY' in the markets), also highlights the cryptos’ inherent risks. These could lead to their demise when public trust in government institutions can be re-established.

The starting point for bitcoin, and cryptos in general, is the loss of trust in government institutions behind money in the developed world since the 2007-08 Great Financial Crisis. Bitcoin has emerged as a new type of institutional arrangement where participants agree on the value of money without the backing of public institutions such as central banks.

Bitcoin’s environmental cost

However, bitcoin’s 'mining' process, which determines its finite supply of 21 million bitcoins by 2040, comes at a significant environmental cost in terms of massive electricity consumption. This has undergone a ballistic rise over the years (Exhibit 1). The Cambridge Centre for Alternative Finance estimated that the bitcoin mining industry burned through about 143 terawatt-hours of electricity a year as of May 2021[2], or 0.6% of the world’s total energy consumption.

By way of comparison, Australia's main electric grid uses less than 200 terawatt-hours a year and the whole of Argentina uses just 125 terawatt-hours annually. Under the global initiatives for climate change control, bitcoin mining faces an imminent risk of a global regulatory crackdown.

This risk is especially prominent in China, where coal is the main source of energy, accounting for almost 60% of the total, and power generation (accounting for 51% of China’s carbon emission in 2018)[3]. In its 14th Five-Year Plan, China set goals for carbon emissions to peak by 2030 and for carbon neutrality by 2060. The heavy emissions from bitcoin mining could undermine these carbon reduction efforts.

China’s anti-bitcoin move

The Chinese government is starting to rein in bitcoin mining as it implements the climate targets. Even renewable energy-rich provinces do not want to accept bitcoin mining projects. They would rather favour energy-intensive projects that fit with Beijing’s development targets. Bitcoin mining is definitely not one of them.

In April 2021, Inner Mongolia shut down all cryptocurrency mining to meet its energy-saving targets. Other provinces are following this example. With China currently the largest bitcoin mining country in the world (Exhibit 2), its crackdown on mining is certainly a negative for the fate of the cryptocurrency in China.

Already in 2013, the People’s Bank of China (PBoC) banned banks and retailers from dealing in bitcoin. In 2017, it shut down all domestic exchanges and banned initial coin offerings (ICOs) that created bitcoins to fund new ventures. One may argue that under these circumstances, the bitcoin industry would just move from China to somewhere else.

From a climate-control perspective, however, the regulatory risk now seen in China is likely to also emerge in other countries. So, bitcoin/crypto mining will have nowhere to go in the longer term. The short-term impact on supply could squeeze bitcoin’s price higher, thus, inflating and prolonging the bubble.

Despite China’s ban, millions of Chinese still trade bitcoin through overseas exchanges, or through local brokers arranging peer-to-peer trades without an exchange and/or use Tether[4]  as a trading conduit. This has prompted the PBoC to start exploring issuance of an official digital currency, the DCEP. Testing and experimenting with its circulation began in 2017. Beijing even plans to use its e-CNY as a means of payments at the 2022 Winter Olympics in China.

Central bank digital currencies are coming

The trend is for global central banks to develop and offer CBDCs for both economic and political reasons. In my view, this could marginalise cryptocurrencies. Economically, they want to protect their monetary systems and currencies to safeguard sovereignty of economic management. China’s stance is clearly anti-bitcoin, with the PBoC aiming at replacing cash with a centrally controlled e-CNY that will give it 'controllable anonymity'. This is a direct attack on cryptos’ untraceable anonymity.

The fixed supply of bitcoin (and cryptos) is the big potential 'economic apocalypse' that central banks want to avoid. A 'bitcoin-ised' economy (i.e. with the fixed-supplied bitcoin replacing all fiat money) would deprive the central bank of the ability to conduct a countercyclical policy. It is simple economics: If you fix nominal variables (bitcoin, in our case), real output has to adjust violently to absorb any economic shocks.

So, in the case of an economic recession, when bitcoin supply cannot expand, economic output would go into free fall. It was this problem of rigid money supply that led to the demise of the Gold Standard and the Bretton Woods system. These both deprived governments of the ability to counteract large negative economic shocks, financial crises and asset price deflation. Does anyone still think bitcoin’s fixed supply is a sure-fire benefit?

The environmental damage bitcoin mining causes is an additional reason for global authorities to tighten regulatory control of cryptos. China’s example shows vividly how quickly regulators could destroy the decentralised crypto market.

Politically, CBDCs will inject a new dimension of competing sovereign interests in wielding global influence into a future currency war. When a CBDC is generally accepted by the global community, it will boost the issuing country’s currency dominance in the global reserves pool. In this way, it helps advance a sovereign’s foreign policy claims.

Currencies are prized as reserve assets when they meet two conditions:

1) When they are stable, liquid and widely used in international transactions

2) When they are backed by a country that has important linkages to the global system.

China’s digital revolution is putting it on a path to satisfy these criteria, albeit in the long-term. China is also inspiring emulation, putting pressure on other countries to explore CBDC development.

Crypto shooting itself in the foot

The crypro community is fighting back by addressing bitcoin’s security and huge energy consumption problems. New types of intermediaries such as custodian wallets have emerged. They allow holders to keep their cryptocurrencies in centralised wallets – giving them the familiar, password-recovery and access-protection features common in online banking.

To reduce energy consumption, crypto developers are exploring different incentive systems and technological solutions to replace wasteful computation with more energy-efficient models. Notably, systems based on proof-of-stake can establish a consensus faster, thus solving the transaction puzzle more quickly, by giving more weight to information presented by large coin-holders.

However, this also means that the integrity of this system relies on the majority of a crypto-coin’s holding remaining in the hands of honest players. It does not really solve the problem of bitcoin/cryptos being misused by criminals. Furthermore, the information weights that the proof-of-stake systems rely on depend in turn on the coin balances being easily verifiable on a digital ledger without the need for external information. A holder’s identity is inevitably required for verification. Who has the legal identity of coin holders? The government!

It is obvious that these solutions replicate some of the features of the conventional financial system. They require government involvement and the disclosure of holder identity, both of which bitcoin is supposed to eschew. The crypto community is shooting itself in the foot. This highlights another key issue: trust, which cryptocurrencies focus on attacking.

Weak versus strong institutions

The trust issue argues that the social contract supporting cryptos would be less compelling in domiciliations with strong institutions. When the public enjoys sound legal and economic systems, with an effective government, good consumer protection laws, sound monetary policy and government guarantees such as deposit insurance against bank failure, bitcoin’s decentralised and untraceable anonymous design has little to offer.

Essentially, cryptos thrive in a weak institutional environment. So, when a strong democratic system deteriorates and the public’s trust in its state institutions is diminished, cryptos emerge, as seen in the rise of bitcoin in the wake of the GFC when crypto promoters capitalised on the fear and distrust of fiat money. More than anything else, the strength of demand for bitcoin in advanced rich democratic economies reflects sheer speculation on a possible breakdown of the system or a Ponzi scheme where the objective is to get out before the collapse[6].

This, in turn, argues that if governments and their agencies want to safeguard their economic policy sovereignty, they need to get their act together to regain public trust. Viewing this positively, the 'crypto protest' is a wake-up call for governments to change their economic management behaviour and become more responsible so as to regain credibility and public confidence.

Crypto has not won the day

The digital currency exchange Coinbase went public in April 2021 with great fanfare. Crypto supporters argued that its successful listing established cryptocurrencies as a force to be reckoned with on Wall Street. I am sceptical, to say the least.

Why do people still want this exchange and why are its shares still priced in US dollars rather than in bitcoin? Blockchains should enable the world to eliminate the middleman and allow smooth direct trading. However, somewhat ironically, Coinbase is the biggest crypto-trading middleman. Its successful listing and pricing in US dollars demonstrate that the crypto community has failed to abandon the traditional state-controlled fiat money system and its middleman/intermediary.

Worse still, Coinbase’s 56 million users do not care that most of their transactions are not even settled through any blockchain at all[7]. This is evidence of speculation, with the speculators only interested in using bitcoin to obtain more US dollars (the fiat currency that it is supposed to do away with). Hence, the Ponzi scheme and bitcoin bubble: Buyers pile into bitcoin based on a captivating, but fictitious story, hoping to sell it on at higher prices. When the story crumbles, the whole pyramid collapses.

If the success of Coinbase’s listing tells us anything, it is that the state, not crypto, has won the battle and retained control of the financial system of fiat money.

For more on bitcoin's challenge to gold’s standing as the one supra-currency, the asset to own when fiat currencies are being debased, read What is the problem with cryptocurrency (bitcoin)?

[1] Digitisation is the act of changing a process from analog to digital form without any different-in-kind changes to the process itself. Digitalisation is the use of digital technologies and digitised data to make a fundamental change to the entire work process or business model. In essence, digitalisation cannot occur without digitisation.

[2] Cambridge Centre for Alternative Finance: https://cbeci.org/

[3] Most Bitcoin mines in China are located in resource-rich provinces, such as Inner Mongolia, Sichuan, Yunnan and Xinjiang, where electricity prices are low.

[4] Tether is a stablecoin that pegs one-for-one to the USD.

[5] See “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition”, by Barry Eichengreen, Working paper 11336, National Bureau of Economic Research, May 2005.

[6] For example, see “Is Bitcoin A Ponzi Scheme? Point By Point Analysis”, by Lyn Alden Schwartzer, Seeking Alpha, February 9, 2021 https://seekingalpha.com/article/4404419-is-bitcoin-ponzi-scheme-point-point-analysis

“’Black Swan’ Author calls Bitcoin a ‘Gimmick’ and a ‘game’, Says It Resembles a Ponzi Scheme”, by Kevin Stankiewicz, CNBC, April 23, 2021 https://www.cnbc.com/2021/04/23/bitcoin-a-gimmick-and-resembles-a-ponzi-scheme-black-swan-author-.html

[7] See “Coinbase Listing is a Lament for Some Bitcoin Believers”, by Izabella Kaminska, The Financial Times, April 18, 2021.


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

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