Galaxy Digital Research Report: Bitcoin's Correction is Beneficial for Market Development in the Long Run

This article was published on Mars Finance, author: Galaxy Digital Research, translated by: Bite.

On May 21, the high-level committee of the Chinese government proposed the goal of "cracking down on Bitcoin mining and trading" in its policy outline, bringing additional uncertainty to the cryptocurrency market after significant adjustments.

Key Points

1. The Chinese government's Financial Supervision Committee stated in a recent policy meeting notification that "cracking down on Bitcoin mining and trading" is imminent.

2. Miners are taking this news seriously, and we have already seen various reactions from miners accelerating their migration to full capitulation.

3. As miners migrate annually to regions with cheap hydroelectric power, the hash rate will decline in the short term.

4. China's cryptocurrency ecosystem will continue to survive, but it will become smaller, with stricter regulations as the government seeks a new balance.

5. As the government imposes more restrictions, the hash rate will primarily shift to Kazakhstan, Russia, and Pakistan, but North America will also benefit from the migration.

6. The likelihood of a complete ban on Bitcoin is low, but restrictions and government scrutiny are imminent.

7. As the hash rate becomes more decentralized, the Bitcoin network will actually become more robust, which is beneficial for Bitcoin in the long run.

I. What Happened in China?

On May 21, during a meeting of the Financial Stability Development Committee of the State Council of China (the "Financial Committee" or "FSDC") chaired by the Vice Premier of China, a new government policy was announced to restrict Bitcoin mining and trading. At 10 PM Beijing time on Friday, the committee released a statement detailing several goals for the financial system. The second part outlined the need for the country to "prevent and control financial risks," listing "cracking down on Bitcoin mining and trading" as a specific priority.

"Second, resolutely prevent and control financial risks. Adhere to bottom-line thinking, strengthen comprehensive scanning and early warning of financial risks, promote the reform of small and medium-sized financial institutions, focus on reducing credit risks, strengthen supervision of financial activities of platform enterprises, and severely crack down on Bitcoin mining and trading activities, firmly preventing individual risks from transmitting to the social field. Maintain the stable operation of the stock market, bond market, and foreign exchange market, severely crack down on illegal securities activities, and impose severe penalties on illegal financial activities. Strictly guard against external risk shocks, effectively respond to imported inflation, strengthen expectation management, enhance market supervision, and prepare response plans and policy reserves."

The Financial Development Committee was established in November 2017 as a high-level government body coordinating financial regulation, with members including Liu He (Vice Premier), Yi Gang (Governor of the People's Bank of China), and Ding Xuedong (Deputy Secretary-General of the State Council), as well as chairs from securities, foreign exchange, economic affairs, and national development regulatory agencies.

In fact, this is not the first time the Chinese government has imposed restrictions on Bitcoin. In 2013, the People's Bank of China banned financial institutions from cooperating with cryptocurrencies, and since this ban, over-the-counter trading has been the main fiat channel for entering the cryptocurrency market. Additionally, ICOs and exchanges faced restrictions in 2017, with Huobi and OKEx suspending trading and establishing offshore entities to cope with the measures, while Binance had already exited the Chinese market before the ban.

In 2020, executives from Huobi and OKEx were summoned for talks, and OTC desks were temporarily shut down. OKEx was the first to face scrutiny, and the exchange was forced to suspend withdrawals.

As the situation began to normalize, China's cryptocurrency ecosystem was in an unstable equilibrium, but still an equilibrium. Fiat-to-cryptocurrency trading remained banned, but over-the-counter trading continued to be a channel for entering the asset class. Exchanges typically traded in USDT to avoid interaction with the banking system but were able to provide referral services for OTC trading, ensuring a relatively smooth user experience. Exchanges continued to operate, and some even maintained close ties with the government. China remains the primary location for most hardware manufacturers and mining pools, as well as the geographical center of the mining industry.

These policies share similarities with the government's latest announcement, but there are also differences. The main differences lie in two aspects: this policy targets miners more than traders, and it is shared by a high-level government committee with significant influence. Although the policy's impact is still unfolding, conversations with local sources suggest that the latest announcement may lead local governments to closely follow central government policies and take regulatory actions.

China is not a monolithic entity: the central government operates separately from provincial governments, and provincial governments differ from companies registered in China. Restrictions in various provinces have been implemented until 2021, with Inner Mongolia recently banning Bitcoin mining as part of a series of restrictions on energy-intensive industries. Following the announcement of central government policy, other provinces may also follow suit. Central government policies are typically promulgated slowly; restrictions on cryptocurrency trading and mining are almost certain to come, but a complete ban on both activities seems unlikely.

Due to policy restrictions, we will see Chinese miners leaving, especially those relying on coal power. The initial decline in hash rate is due to seasonal migration, but it will later migrate permanently abroad. The hash rate will primarily move to Kazakhstan, Russia, and Pakistan, but will also migrate to North America and other regions. As the situation develops, ongoing volatility may continue. China's cryptocurrency ecosystem will survive, but it will become smaller, with stricter regulations as the government seeks a new balance.

II. How Did the Market React?

As we wrote in our May 20 report "Assessing the Correction in Cryptocurrency," the market has been in a tense trading state after significant corrections over the past two weeks. The uncertainty surrounding the Chinese policy news has further suppressed the market.

The announcement from the Financial Stability Development Committee was made at 10 PM China Standard Time (GMT+8) on Friday, May 21, or 10 AM Eastern Standard Time (GMT-5). BTC dropped 12.5% in the first hour and had fallen 20% by 2 PM Eastern Time. Bitcoin prices continued to decline over the weekend, bottoming around $31,100.

Due to the late announcement, there was little information from regulators, and more clarifications are expected next week. According to our sources, some miners are liquidating their machine inventories and panic-selling their Bitcoin. On-chain data shows an increase in outflows from miner wallets, indicating that miner sell-offs have played a role in the volatility, which has been confirmed.

III. Dynamics of Mining in China

1. Distribution of Hash Rate

Bitcoin is permissionless, allowing anyone to join as a user, validator, or miner. Because of this, Bitcoin is a global industry. Since anyone can join and there is no centralized directory of participants, estimating the detailed distribution of hash rate is very difficult.

Miners tend to operate in areas with cheap electricity. As a result, the mining industry has concentrated in regions with low-cost electricity, such as China, Russia, and North America, but it is challenging to estimate the locations of miners.

The heavy representation of Chinese miners in Bitcoin's hash rate is often a point of debate. Traditionally, Chinese companies have been at the forefront of the mining industry, not only due to their ingenuity but also because of cheap electricity and the network effects generated by the presence of ASIC manufacturers and mining pools.

2. Cheap Electricity

China's power grid is centered around the Sichuan Three Gorges Dam, which provides hydroelectric power. From May to October, the Sichuan region experiences the rainy season, reducing the cost of hydroelectric power.

In northern and western China, the annual power generation is economically competitive by global standards; the electricity prices in the Sichuan basin are particularly favorable during the rainy season. To take advantage of this, Chinese miners implement seasonal mining, moving machines annually between Inner Mongolia/Xinjiang and the Sichuan river valley to optimize for the lowest electricity costs. The mass migration of miners typically manifests as a decline in hash rate during the transportation of machines.

The rainy season has already begun this year, and we will continue to see the hash rate decline in the coming weeks. Due to the method of estimating hash rate, there is about a seven-day lag for accurate observation, making real-time estimates less reliable and accurate. Miners pay their electricity bills monthly in advance, so we expect the decline in hash rate to be most severe near the end of the month, with accurate data observable in early next month.

As miners in the Sichuan basin come back online, there may be some recovery in the hash rate decline. However, miners temporarily sidelined due to government regulation will take time to come back online in other jurisdictions, so the hash rate may continue to decline. Given the scale of China's mining industry compared to other countries, capacity becomes an important bottleneck. Unlike the past year or so, the limiting factor for hash rate growth is the severe shortage of machines.

3. ASIC Market

Almost all competitive Application-Specific Integrated Circuit (ASIC) manufacturers are in China, providing Chinese miners with faster access to machines. There is little publicly available data on the scale of manufacturers' machines, largely due to market opacity leading to more severe price discrimination.

The traces left by miners on the blockchain provide some clues. Based on data analysis, we can estimate the hash rate proportions provided by certain types of hardware. Today, this technology is most notably applied in Bitmain's first two generations of flagship Antminer S9 products.

At its peak in June 2018, when it dominated the market, Antminer S9s and related hardware accounted for about 75% of the network's computing power. Even today, two generations of hardware later, S9s and related hardware still contribute about 31% of the network's hash rate.

Data derived from nonce analysis has been corroborated at various points in time by CoinShares and Cambridge. In the future, this technology may be used to identify other types of hardware, including new models of miners from Bitmain and other manufacturers, thereby better estimating network health and decentralization at the hardware level.

In light of last week's policy impact, ASIC resellers are leaving China. Reseller B.top, associated with mining pool BTC.top, announced it would stop servicing Chinese customers, as did Huobi Pool. We expect a large number of machines to be sold on the secondary market, which, as Chinese miners clear their inventories, may lead to a misalignment in the markets for mining platforms in China and overseas.

IV. What Does This Mean for Bitcoin?

Bitcoin is resilient and not subject to the regulatory influence of any single country. In the short term, as miners continue to migrate their machines or even shut them down, we will see the hash rate continue to decline.

The government's ban on value storage is not new. In 1933, President Roosevelt signed Executive Order 6102, prohibiting private entities in the U.S. from owning gold, a ban that did not last, and private ownership of gold did not cease. As of 2021, gold continues to hold its value. The censorship-resistant nature of Bitcoin makes it increasingly difficult for governments to effectively suppress ownership of this asset globally.

In the long run, this is beneficial for Bitcoin. Essentially, the Bitcoin network will emerge stronger and more decentralized from these events. From a public relations perspective, this ban should also be a significant positive: as Bitcoin survives under policy restrictions, the narrative of it being controlled by China will be dispelled.