What’s the deal with DAOs?

[Disclaimer: I do not own any cryptocurrencies nor have I participated in any DAO crowdfunding.]

This post will look at the difference between a decentralized autonomous organization (DAO) and a project called The DAO.

Brief explanation

The wikipedia entry on DAOs is not very helpful.  However, Chapters 2 through 5 may be of some use (although it is dated information).

In terms of the uber hyped blockchain world, at its most basic kernel, a DAO is a bit of code — sometimes called a “smart contract” (a wretched name) — that enables a multitude of parties including other DAOs to send cryptographically verifiable instructions (such as a digitally signed vote) in order to execute the terms and conditions of the cloud-based code in a manner that is difficult to censor.

One way to think of a simple DAO: it is an automated escrow agent that lives on a decentralized cloud where it can only distribute funds (e.g., issue a dividend, disperse payroll) upon on receiving or even not receiving a digital signal that a task has been completed or is incomplete.

For instance, let us assume that a small non-profit aid organization whose staff primarily work in economically and politically unstable regions with strict capital controls, set up a DAO — an escrow agent — on a decentralized cloud to distribute payroll each month.

This cloud-based escrow agent was coded such that it would only distribute the funds once a threshold of digital signatures had signed an on-chain contract — not just by staff members — but also from independent on-the-ground individuals who observed that the staff members were indeed doing their job.  Some might call these independent observers as oracles, but that is a topic for a different post.1

Once enough signatures had been used to sign an on-chain contract, the escrow agent would automatically release the funds to the appropriate individuals (or rather, to a public address that an individual controls via private key).  The terms in which the agent operated could also be amended with a predetermined number of votes, just like corporate board’s and shareholder’s vote to change charters and contracts today.

The purported utility that decentralization brings to this situation is that it makes censoring transactions by third parties more difficult than if the funds flowed through a centralized rail.  There are trade-offs to these logistics but that is beyond the scope of this post.

The reason the DAO acronym includes the “organization” part is that the end-goal by its promoters is for it to provide services beyond these simple escrow characteristics such as handling most if not all administrative tasks such as hiring and firing.

Watch out Zenefits, the cryptocurrency world is going to eat your lunch!  Oh wait.

A short history

It is really easy to get caught up in the euphoria of a shiny new toy.  And the original goal of a DAO sounds like something out of science fiction —  but these undertones probably do it a disservice.

Prior to 2014 there had been several small discussions around the topic of autonomous “agents” as it related to Bitcoin.

For instance, in August 2013, Mike Hearn gave a presentation at Turing Festival (see above), describing what was effectively a series of decentralized agents that operated logistical companies such as an autonomous car service.

Several months later, Vitalik Buterin published the Ethereum white paper which dove into the details of how to build a network — in this case a public blockchain — which natively supported code that could perform complex on-chain tasks: or what he dubbed as a decentralized autonomous organization.


The impetus and timing for this post is based on an ongoing crowdsale / crowdfunding activity for the confusingly named “The DAO” that has drawn a lot of media attention.

Over the past year, a group of developers, some of whom are affiliated with the Ethereum Foundation and others affiliated with a company called Slock.it have created what is marketed as the first living and breathing DAO on the Ethereum network.

The organizers kicked off a month long token sale and at the time of this writing just over 10 million ether (the native currency of the Ethereum blockchain) — or approximately 13% of all mined ether — has been sent to The DAO.  This is roughly equivalent to over $100 million based on the current market price of ether (ETH).

In return for sending ether to The DAO, users receive an asset called a DAO Token which can be used in the future to vote on projects that The DAO wants to fund.2 It is a process that Swarm failed at doing.

An investment fund or a Kickstarter project?

I would argue that, while from a technical standpoint it is possible to successfully set up a DAO in the manner that The DAO team did, that there really isn’t much utility to do so in an environment in which censorship or the theft of funds by third parties will probably not occur.

That is to say, just as I have argued before that permissioned-on-permissionless is a shortsighted idea, The DAO as it is currently set up, is probably a solution to a problem that no one really has.3

Or in short, if you “invested” in The DAO crowdsale thinking you’re going to make money back from the projects via dividends, you might be better off investing in Disney dollars.


Putting aside securities regulations and regulators such as the SEC for a moment, most of the crowdsale “investors” probably don’t realize that:

  1. crowdfunding in general has a checkered track record of return-on-investment4
  2. crowdfunding in the cryptocurrency world almost always relies on the future appreciation of token prices in order to break-even and not through the actual creation of new features or tools (e.g., see Mastercoin/Omni which effectively flopped)
  3. that the funds, when dispersed to Slock.it and other “products,” could take years, if ever to return a dividend

Why would this pool of capital provide any better expected return-on-investment than others?

Or as Nick Zeeb explained to me:

My sense about The DAO is that it’s a fascinating experiment that I do not want to be part of. I also do not think that a committee of over 1,000 strangers will make wise investment decisions. Most good investment decisions are taken by courageous individuals in my opinion. Anything that can get past a big committee will probably not be the next Google. Imagine this pitch: “Hi I’m Larry and this is Sergey and we want to build the world’s 35th search engine.”

While it probably wasn’t the 35th search engine, tor those unfamiliar with the history of Google, Larry Page and Sergey Brin are the co-founders who created a search engine in what was then though a very crowded market.

So why the excitement?

I think part of it is quite simply: if you own a bunch of ether, there really isn’t much you can do with it right now.  This is a problem that plagues the entire cryptocurrency ecosystem.

Despite all the back-patting at conferences, the market is already filled with lots of different tokens. There is a glut of tokens which do not currently provide many useful things that you couldn’t already do with existing cash systems.5

Part of it also is that most probably think they will some become rich quick through dividends, but that probably won’t happen anytime soon, if at all.

With The DAO, only the development teams of projects that are voted and approved by The DAO (e.g., the thousands of users with DAO Tokens), will see any short term gains through a steady paycheck.  And it is only after they build, ship and sell a product that the original investors may begin seeing some kind of return.

Or in other words: over the past several weeks, the pooling of capital has taken place for The DAO.  In the future there will be various votes as to where that capital goes.  Shortly thereafter, some capital is deployed and later KPI’s will be assessed in order to determine whether or not funding should continue.  All the while some type of profit is sought and dividend returned.

Why, I asked another friend, would this pool of capital offer any better risk adjusted return-on-investment than other asset classes?

In his view:

The return might be high but so is the risk. Always adjust for risk. I think The DAO is better compared to a distributed venture capital firm. Whether that’s better or worse I don’t know — I mean you have the crowd deciding on investments. Or more realistically: nerds who know how to obtain ether (ETH) get to decide on investments.

Does that make them better VCs? Probably not. However, The DAO can decide to hire people with actual credentials to manage and select the investments, admitting its own weakness which would then turn into a strength. I think this can go either way but given the regulator is not prepared for any of this it will probably not work out in the short term.

Does the ‘design-by-giant-nerd-committee’ process work?

Over the past year we have already seen the thousands, probably tens-of-thousands of man-hours dropped into the gravity well that is known as the “block size debate.”  In which hundreds of passionate developers have seemingly argued non-stop on Slack, Twitter, reddit, IRC, conferences and so forth without really coming to an amicable decision any one group really likes.

So if block size-design-by-committee hasn’t worked out terribly well, will the thousands of investors in The DAO take to social media to influence and lobby one another in the future?  And if so, how productive is that versus alternative investment vehicles?

Redistributing the monetary base

Assuming Ethereum has an economy (which it probably doesn’t by most conventional measures), will The DAO create a deflationary effect on the Ethereum economy?

For instance, at its current rate, The DAO could absorb about 20% of the ether (ETH) monetary base.

Does that mean it permanently removes some of the monetary base?  Probably not.

For example, we know that there will be some disbursements to projects such as Slock.it, so there will be some liquidity from this on-chain entity.  And that future DAOs will spend their ether on expenses and development like a normal organization.

But we also know that there is a disconnect between what The DAO is, an investment fund, with what many people see it as: a large vault filled with gold laying in Challenger Deep that will somehow appreciate in value and they will be able to somehow extract that value.

Sure, we will all be able to observe that the funds exist at the bottom of the trench, but someone somewhere has to actually create value with the DAO Tokens and/or ether.

For the same reason that most incubators, accelerators and VC funds fail, that entrepreneur-reliant math doesn’t change for The DAO.  Not only does The DAO need to have a large volume of deal flow, but The DAO needs to attract legitimate projects that — as my friend point out above — have a better risk adjusted return-on-investment than other asset classes.

Will the return-on-investment of the DAO as an asset class be positive in the “early days”?  What happens when the operators and recipients of DAO funds eventually confront the problem of securities regulation?

So far, most of the proposals that appear to be geared up for funding are reminiscent to hype cycles we have all seen over the past couple of years.

Let’s build a product…

  • 2014: But with Bitcoin
  • 2015: But with Blockchain
  • 2016: But with DAO

Maybe the funds will not all be vaporized, but if a non-trivial amount of ETH ends up being held in this DAO or others, it could be the case that with sluggish deal flow, a large portion of the funds could remain inert.  And since this ether would not touching any financial flows; it would be equivalent to storing a large fraction of M0 in your basement safe, siloed off from liquid capital markets.

Ten observations

  1. Since the crowdsale / crowdfund began on April 30, the market price of ETH has increased ~30%; is that a coincidence or is there new demand being generated due to The DAO crowdsale?
  2. A small bug has been discovered in terms of the ETH to DAO Token conversion time table
  3. The DAO surpassed the Ethereum Foundation to become the largest single holder of ether (note: the linked article is already outdated)
  4. In terms of concentration of wealth: according to Etherscan, the top 50 DAO Token holders collectively “own” 38.49% of The DAO
  5. The top 500 DAO Token holders collectively “own” 71.39% of The DAO
  6. As of this writing there are over 15,000 entities (not necessarily individuals) that “own” some amount of a DAO Token
  7. Why is “own” in quotation marks? Because it is still unclear if controlling access to these private keys is the same thing as owning them.  See also: Watermarked Tokens as well as The Law of Bitcoin
  8. Gatecoin, which facilitated the crowdsale of both The DAO and DigixDAO was recently hacked and an estimated $2 million in bitcoins and ether were stolen
  9. Yesterday Gavin Wood, a co-founder of Ethereum, announced that he is stepping down as a “curator” for The DAO.  Curators, according to him, are effectively just individuals who identify whether someone is who they say they are — and have no other duties, responsibilities or authority.
  10. Three days ago, the Slock.it dev team — some of whom also worked on creating The DAO — did a live Q/A session that was videotaped and attempted to answer some difficult questions, like how many DAO Tokens they individually own.


About 17 months ago I put together a list of token crowdsales.  It would be interesting to revisit these at some point later this year to see what the return has been for those holders and how many failed.

For instance, there hasn’t really been any qualitative analysis of crowdsales or ICOs in beyond looking at price appreciation.6 What other utility was ultimately created with the issuance of say, factoids (Factom tokens) or REP (Augur tokens)?

Similarly, no one has really probed Bitcoin mining (and all POW mining) through the lens of a crowdsale on network security. Is every 10 minutes an ICO? After all, the scratch-off contest ties up capital seeking rents on seigniorage and in the long run, assuming a competitive market, that seigniorage is bid away to what Robert Sams has pointed out to where the marginal cost equals the marginal value of a token. So you end up with this relatively large capital base — divorced from the real world — that actually doesn’t produce goods or services beyond the need to be circularly protected via capital-intensive infrastructure.

Other questions to explore in the future include:

  • what are the benefits, if any, of using a centralized autonomous organization (CAO) versus decentralized autonomous organization (DAO) for regulated institutions?
  • how can a party or parties sue a decentralized autonomous organization? 7
  • what are the legal implications of conducting a 51% attack on a network with legally recognized DAOs residing on a public blockchain?8
  • will the continued concentration of ether and/or DAO Tokens create a 51% voting problem identified in the “Curator” section?

Still don’t fully understand what The DAO is?  Earlier this week CoinDesk published a pretty good overview of it.

[Special thanks to Raffael Danielli, Robert Sams and Nick Zeeb for their thoughts]


  1. Note: for the purposes of The DAO, “curators” are effectively identity oracles. []
  2. It appears that currently, once a quorum is achieved, a relatively small proportion of token holders can vote “yes” to a proposal to trigger a large payout. []
  3. The current line-up of goods and services are not based around solving for problems in which censorship is a threat, such as those facing an aid worker in a politically unstable region. []
  4. That is not to say that they all fail. In fact according to one statistic from Kickstarter, there was a 9% failure rate on its platform. Thus, it depends on the platform and what the reward is. []
  5. CoinGecko is tracking several hundred tokens. []
  6. ICO stands for “initial coin offering” — it is slight twist to the term IPO as it relates to securities. []
  7. An added wrinkle to identifying liable parties is: what happens when systems like Zcash launch? []
  8. This presupposes that a DAO will gain legal recognition and/or a public blockchain gains legal standing as an actual legal record. []
Send to Kindle

AFA Presentation: Cryptocurrencies, Blockchains and the Future of Financial Services

The slideshow below was first presented at an AFA panel on January 4, 2016 in San Francisco.


Send to Kindle

Some housekeeping of events and interviews

It has been a little while since I posted the events, panels and presentations I have been involved with.  Below is some of the public activity over the past 5-6 months.

Interviews with direct quotes:

Indirect quotes:

Academic citations:

Presentations, panels and events:

Send to Kindle

Buckets of Permissioned, Permissionless, and Permissioned Permissionlessness Ledgers

A few hours ago I gave the following presentation to Infosys / Finacle in Mysore, India with the Blockchain University team.  All views and opinions are my own and do not represent those of either organization.

Send to Kindle

Learning from the past to build an improved future of fintech

[Note: below is a slightly edited speech I gave yesterday at a banking event in Palo Alto.  This includes all of the intended legalese, some of which I removed in the original version due to flow and time.  Special thanks to Ryan Straus for his feedback.  The views below are mine alone and do not represent those of any organization or individual named.]

Before we look to the future of fintech, and specifically cryptocurrencies and distributed ledgers, let’s look at the most recent past.  It bears mentioning that as BNY Mellon is the largest custodial bank in the world, we will see the importance of reliable stewardship in a moment below.

In January 2009 an unknown developer, or collective of developers, posted the source code of Bitcoin online and began generating blocks – batches of transactions – that store and update the collective history of Bitcoin: a loose network of computer systems distributed around the globe.

To self-fund its network security, networks like Bitcoin create virtual “bearer assets.” These assets are automatically redeemable with the use of a credential.  In this case, a cryptographic private key.  From the networks point of view, possession of this private key is the sole requirement of ownership.  While the network rules equivocate possession and control, real currency – not virtual currency – is the only true bearer instrument.  In other words, legal tender is the only unconditional exception to nemo dat quod non habet – also known as the derivative principal – which dictates that one cannot transfer better title than one has.

Several outspoken venture investors and entrepreneurs in this space have romanticized the nostalgia of such a relationship, of bearer assets and times of yore when a “rugged individual” can once again be their own custodian and bank.1 The sentimentality of a previous era when economies were denominated by precious metals held – initially not by trusted third parties – but by individuals, inspired them to invest what has now reached more than $800 million in collective venture funding for what is aptly called Bitcoinland.

Yet, the facts on the ground clearly suggests that this vision of “everyone being their own bank” has not turned into a renaissance of success stories for the average private key holder.  The opposite seems to have occurred as the dual-edged sword of bearer instruments have been borne out.  At this point, it is important to clearly define our terms.  The concepts of “custody” and “deposit” are often conflated.  While the concepts are superficially similar, they are very different from a legal perspective.  Custody involves the transfer of possession/control.  A deposit, on the other hand, occurs when both control and title is transferred.

Between 2009 and early 2014, based on public reports, more than 1 million bitcoins were lost, stolen, seized and accidentally destroyed.2 Since that time, several of the best funded “exchanges” have been hacked or accidentally sent bitcoins to the wrong customer.  While Mt. Gox, which may have lost 850,000 bitcoins itself, has attracted the most attention and media coverage – rightfully so – there is a never ending flow of unintended consequences from this bearer duality.3

For instance, in early January 2015, Bitstamp – one of the largest and oldest exchanges – lost 19,000 bitcoins due to social engineering and phishing via Gmail and Skype on its employees including a system administrator.4 Four months later, in May, Bitfinex, a large Asian-based exchange was hacked and lost around 1,500 bitcoins.5 In another notable incident, last September, Huobi, a large Bitcoin exchange in Beijing accidentally sent 920 bitcoins and 8,100 litecoins to the wrong customers.6  And ironically, because transactions are generally irreversible and the sole method of control is through a private key they no longer controlled them: they had to ask for the bitcoins back and hope they were returned.

A study of 40 Bitcoin exchanges published in mid-2013 found that at that time 18 out of 40 – 45% — had closed doors and absconded with some portion of customer funds.7 Relooking at that list today we see that about another five have closed in a similar manner.  All told, at least 15% if not higher, of Bitcoin’s monetary base is no longer with the legitimate owner.  Can you imagine if a similar percentage of real world wealth or deposits was dislocated in the same manner in a span of 6 years?8

In many cases, the title to this property is encumbered, leading to speculation that since many of these bitcoins are intermixed and pooled with others, a large percentage of the collective monetary base does not have clean title, the implications of which can be far reaching for an asset that is not exempted from nemo dat, it is not fungible like legal tender.9

As a consequence, because people in general don’t trust themselves with securing their own funds, users have given – deposited – their private keys with a new batch of intermediaries that euphemistically market themselves as “hosted wallets” or “vaults.” What does that look like in the overall scheme?  These hosted wallets, such as Coinbase and Xapo, have collectively raised more than $200 million in venture funding, more than a quarter of the aggregate funding that the whole Bitcoin space has received. Simultaneously, the new – often unlicensed – parties collectively hold several million bitcoins as deposits; probably 25-30% of the existing monetary base.10 Amazingly, nobody is actually certain whether a “hosted wallet” is a custodian of a customers bitcoin or acquired title to the bitcoin and is thus a depository.

Yet, in recreating the same financial intermediaries that they hoped to replace – in turning a bearer asset into a registered asset – some Bitcoin enthusiasts have done so in fashion that – as described earlier – has left the system ripe for abuse.  Whereas in the real world of finance, various duties are segregated via financial controls and independent oversight.11 In the Bitcoin space, there have been few financial controls.  For example, what we call a Bitcoin exchange is really a broker-dealer, clearinghouse, custodian, depository and an exchange rolled into one house which has led to theft, tape painting, wash trading, and front-running.12 All the same issues that led to regulatory oversight in the financial markets in the first place.

And while a number of the better funded and well-heeled hosted wallets and exchanges have attempted to integrate “best practices” and even third-party insurance into their operation, to date, there is only one Bitcoin “vault” – called Elliptic — that has been accredited with meeting the ISAE 3402 custodial standard from KPMG. Perhaps this will change in the future.

But if the point of the Bitcoin experiment, concept, lifestyle or movement was to do away or get away from trusted third parties, as described above, the very opposite has occurred.

What can be learned from this?  What were the reasons for institutions and intermediation in the first place?  What can be taken away from the recent multi-million dollar educational lesson?

We have collectively learned that a distributed ledger, what in Bitcoin is called a blockchain, is capable of clearing and settling on-chain assets in a cryptographically verifiable manner, in near-real time all with 100% uptime because its servers – what are called validators – are located around the world.  As we speak just under sixty four hundred of these servers exist, storing and replicating the data so that availability to any one of them is, in theory, irrelevant.13

Resiliency, accountability and transparency, what’s not to like?  Why wouldn’t financial institutions want to jump on Bitcoin then, why focus on other distributed ledger systems?

One of the design assumptions in Bitcoin is that its validators are unknown and untrusted – that there is no gating or vetting process to become a validator on its open network.  Because it is purposefully expensive and slow to produce a block that the rest of the network will regard as valid, in theory, the rest of the network will reject your work and you will have lost your money.  Thus, validators, better technically referred to as a block maker, attempt to solve a benign math problem that takes on average about 10 minutes to complete with the hope of striking it rich and paying their bills. There are exceptions to this behavior but that is a topic for another time.14

The term trust or variation thereof appears 13 times in the final whitepaper.  Bitcoin was designed to be a solution for cypherpunks aiming to minimize trust-based relationships and mitigate the ability for any one party to censor or block transactions. Because validators are unknown and untrusted, to protect against history-reversing attacks, Bitcoin was purposefully designed to be inefficient.15 That is to say attackers must expend real world resources, energy, to disrupt or rewrite history.  The theory is that this type of economic attack would stave off all but the most affluent nation-state actors; in practice this has not been the case, but that again is a topic for another speech.

Thus Bitcoin is perhaps the world’s first, commodity-based censorship resistance-as-a-service.  To prevent attackers on this communal network from reversing or changing transactions on a whim, an artificially expensive anti-Sybil mechanism was built in dubbed “proof of work” – the 10 minute math problem.  Based on current token value, the cost to run this network is roughly $300 million a year and it scales in direct proportion to the bitcoin market price.16

Thus there are trade-offs that most financial institutions specifically would not be interested in.

Why you may ask?

Because banks already know their customers, staff and partners. Their counterparties and payment processors are all publicly known entities with contractual obligations and legal accountability.  Perhaps more importantly, the relationship created between an intermediary and a customer is clear with traditional financial instruments.  For example, when you deposit money in your bank account, you know (or should know) that you are trading your money for an IOU from the bank.17 On the other hand, when you place money in a safe deposit box you know (or should know) that you retain title to the subject property.  This has important considerations for both the customer and intermediary.  When you trade your money for an IOU, you are primarily concerned with the financial condition of the intermediary.  However, when you retain title to an object held by somebody else, you care far more about physical and logical security.

As my friend Robert Sams has pointed out on numerous occasions, permissionless consensus as it is called in Bitcoin, cannot guarantee irreversibility, cannot even quantify the probability of a history-reversing attack as it rests on economics, not technology.18 Bitcoin is a curious design indeed where in practice many participants on the network are now known, gated and authenticated except the transaction validators.  Why use expensive proof-of-work at all at this point if that is the case?  What is the utility of turning a permissionless system into a permissioned system, with the costs of both worlds and the benefits of neither?

But lemonade can still be squeezed from it.

Over the past year more than a dozen startups have been created with the sole intent to take parts of a blockchain and integrate their utility within financial institutions.19 They are doing so with different design assumptions: known validators with contractual terms of service. Thus, just as PGP, SSL, Linux and other open source technology, libraries and ideas were brought into the enterprise, so too are distributed ledgers.

Last year according to Accenture, nearly $10 billion was invested in fintech related startups, less than half of one percent of which went to distributed ledger-related companies as they are now just sprouting.20

What is one practical use?  According to a 2012 report by Deutsche Bank, banks’ IT costs equal 7.3% of their revenues, compared to an average of 3.7% across all other industries surveyed.21)  Several of the largest banks spend $5 billion or more in IT-related operating costs each year.  While it may sound mundane and unsexy, one of the primary use cases of a distributed ledger for financial institutions could be in reducing the cost centers throughout the back office.

For example, the settlement and clearing of FX and OTC derivatives is an oft cited and increasingly studied use case as a distributed ledger has the potential to reduce counterparty and systemic risks due to auditability and settlement built within the data layer itself.22

How much would be saved if margining and reporting costs were reduced as each transaction was cryptographically verifiable and virtually impossible to reverse? At the present time, one publicly available study from Santander estimates that “distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.”23

With that said, in its current form Bitcoin itself is probably not a threat to retail banking, especially in terms of customer acquisition and credit facilities.  For instance, if we look at on-chain entities there are roughly 370,000 actors.  If the goal of Bitcoin was to enable end-users to be their own bank without any trusted parties, based on the aggregate VC funding thus far, around $2,200 has been spent to acquire each on-chain user all while slowly converting a permissionless system into a permissioned system, but with the costs of both.24

That’s about twice as much as the average bank spends on customer acquisition in the US.  While there are likely more than 370,000 users at deposit-taking institutions like Coinbase and Xapo, they neither disclose the monthly active users nor are those actual Bitcoin users because they do not fully control the private key.

If we were to create a valuation model for the bitcoin network (not the price of bitcoins themselves), the network would be priced extremely rich due to the wealth transfer that occurs every 10 minutes in the form of asset creation.  The network in this case are miners, the block makers, who are first awarded these bearer instruments.

How can financial institutions remove the duplicative cost centers of this technology, remove this $300 million mining cost, integrate permissioned distributed ledgers into their enterprise, reduce back office costs and better serve their customers?

That is a question that several hundred business-oriented innovators and financial professionals are trying to answer and we will likely know in less time it took Bitcoin to get this far.

Thanks for your time.


  1. Why Bitcoin Matters by Marc Andreessen []
  2. Tabulating publicly reported bitcoins that were lost, stolen, seized, scammed and accidentally destroyed between August 2010 and March 2014 amounts to 966,531 bitcoins. See p. 196 in The Anatomy of a Money-like Informational Commodity []
  3. Mt. Gox files for bankruptcy, hit with lawsuit from Reuters []
  4. Bitstamp Incident Report []
  5. Bitfinex Warns Customers to Halt Deposits After Suspected Hack from CoinDesk []
  6. Why One Should Think Twice Before Trading On The Bitcoin Exchanges from Forbes []
  7. See Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk by Tyler Moore and Nicolas Christin []
  8. This has occurred during times of war.  See The Monuments Men []
  9. Bitcoin’s lien problem from Financial Times and Uniform Commercial Code and Bitcoin with Miles Cowan []
  10. Based on anecdotal conversations both Coinbase and Xapo allegedly, at one point stored over 1 million bitcoins combined. See also: Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  11. See Distributed Oversight: Custodians and Intermediaries []
  12. See Segregation of Duties in the CEWG BitLicense comment []
  13. See Bitnodes []
  14. See Majority is not Enough: Bitcoin Mining is Vulnerable from Ittay Eyal and Emin Gün Sirer []
  15. See Removing the Waste from Cryptocurrencies: Challenges and More Challenges by Bram Cohen and Cost? Trust? Something else? What’s the killer-app for Block Chain Technology? by Richard Brown []
  16. See Appendix B []
  17. See A Simple Explanation of Balance Sheets (Don’t run away… it’s interesting, really!) by Richard Brown []
  18. Needing a token to operate a distributed ledger is a red herring []
  19. See The Distributed Ledger Landscape and Consensus-as-a-service []
  20. Fintech Investment in U.S. Nearly Tripled in 2014 from Accenture []
  21. IT in banks: What does it cost? from Santander []
  22. See No, Bitcoin is not the future of securities settlement by Robert Sams []
  23. The Fintech 2.0 Paper: rebooting financial services from Santander []
  24. One notable exception are branchless banks such as Fidor which is expanding globally and on average spends about $20 per customer.  See also How much do you spend on Customer Acquisition? Are you sure? []
Send to Kindle

A blockchain with emphasis on the “a”

Over the past month a number of VCs including Chris Dixon and Fred Wilson use the term “the blockchain” in reference to Bitcoin, as if it is the one and only blockchain.1

There are empirically, many blockchains around.  Some of them do not involve proof-of-work, some of them are not even cryptocurrencies.  Yet despite this, Dixon blocked Greg Slepak on Twitter (creator of okTurtles and DNSChain) for pointing that out just a couple weeks ago.

But before getting into the weeds, it is worth reflecting on the history of both virtual currencies and cryptocurrencies prior to Bitcoin.

The past

Below are several notable projects that pre-date the most well-known magic internet commodity.

  • DigiCash (1990)
  • e-gold (1996)
  • WebMoney (1998)
  • PayPal (1998) “Bitcoin is the opposite of PayPal, in the sense that it actually succeeded in creating a currency.”  — Peter Thiel
  • Beenz (1998)
  • Flooz (1999)
  • Liberty Reserve (2006)
  • Frequent flyer points / loyalty programs
  • WoW gold, Linden Dollars, Nintendo Points, Microsoft Points

According to an excellent article written a couple years ago by Gwern Branwen:

Bitcoin involves no major intellectual breakthroughs, so Satoshi need have no credentials in cryptography or be anything but a self-taught programmer! Satoshi published his whitepaper May 2009, but if you look at the cryptography that makes up Bitcoin, they can basically be divided into:

  • Public key cryptography
  • Cryptographic signatures
  • Cryptographic hash functions
  • Hash chain used for proof-of-work
    • Hash tree
    • Bit gold
  • cryptographic time-stamps
  • resilient peer-to-peer networks

And what were the technological developments, tools and libraries that spearheaded those pieces?  According to Branwen:

  • 2001: SHA-256 finalized
  • 1999-present: Byzantine fault tolerance (PBFT etc.)
  • 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, i2p etc.)
  • 1998: Wei Dai, B-money
  • 1997: HashCash; 1998: Nick Szabo, Bit Gold; ~2000: MojoNation/BitTorrent; ~2001-2003, Karma, etc
  • 1992-1993: Proof-of-work for spam
  • 1991: cryptographic timestamps
  • 1980: public key cryptography
  • 1979: Hash tree

Other prior art can be found in The Ecology of Computation from Huberman.2 One open question for permissionless systems is whether or not a blockchain is a blockchain if it is neither proof-of-work-based or proof-of-stake-based (“Cow system” in Bram Cohen’s terminology).  But that’s a topic for another post.

The present

About two weeks ago, /r/bitcoin learned that Bitcoin was not the creator of all this fundamental technology.  That indeed, there were over 30 years of academic corpus that cumulatively created the system we now call “a blockchain,” in this case, Nakamoto consensus.  And this has spawned a sundry of other experiments and projects that have since been kickstarted.

For example:

  • CoinMarketCap currently tracks 592 cryptocurrencies / 59 assets
  • CoinGecko tracks 225 cryptocurrencies/assets
  • Ray Dillinger’s “Necronomicon” includes over 100 dead altcoins
  • Map of Coins is currently tracking 686 derivatives of various cryptocurrencies; this includes all hashing functions (e.g., scrypt, X11, X13) and includes existing and defunct chains
  • These are just publicly known blockchains and there are likely dozens if not hundreds of private trials, proof of concepts in academia, institutions and from hobbyists (e.g., Citibank announced in July 2015 that it was testing out three blockchains with a “Citicoin” to better understand use-cases)

So it appears that there are more than one in the wild.

Yet, a couple weeks ago Fred Wilson wrote that:

If you think of the blockchain as an open source, peer to peer, massively distributed database, then it makes sense for the transaction processing infrastructure for it to evolve from individuals to large global corporations. Some of these miners will be dedicated for profit miners and some of them will be corporations who are mining to insure the integrity of the network and the systems they rely on that are running on it. Banks and brokerage firms are the obvious first movers in the second category.

He later clarified in the comments and means the Bitcoin blockchain, not others.

One quibble is that transaction processing is not clearly defined relative to hashing.  Today, bitcoin transactions are actually processed by very small, non-powerful computers (even a Raspberry Pi).

What about the pictures with entire rooms filled with computers?  Why does it cost so much to run a hashing farm then?

Because of the actual workhorse of the network: ASICs designed to generate proofs-of-work.  These hashing systems do not do any transaction processing, in fact, they cannot even run a Bitcoin client on them.3

Tangentially William Mougayar, investor and author, stated the following in the AVC thread:

Only trick is that mining is not cheap initially, and the majority is done in China. It presents an interesting energy challenge: you need lots of electricity to run the computers, but also to keep them cool. So, if you’re using solar you still need to cool them. And if you put them in cool climates like near the north pole, there is no solar. Someone needs to solve that equation.

Mining cannot be made “cheaper” otherwise the network becomes cheaper to attack.

In fact, as Bram Cohen mentioned last week, “energy efficient” proofs-of-works is a contradiction in terms.

Thus, there is no “equation to solve.”  In the long run, miners will bid up the marginal costs to which they equal the marginal value (MC=MV) of a bitcoin in the long run.  We see this empirically, there is no free lunch.  If hashing chips somehow became 50% more efficient, hashing farms just add 50% more of them — this ratcheting effect is called the Red Queen effect and this historically happens in a private seigniorage system just as it does in proof-of-work cryptocurrencies.4

organ proportionalismAs shown in the chart above, hashrate follows price; the amount of resources expended (for proof-of-work) is directly proportional to market value of a POW token.

Furthermore, in terms of Wilson’s prediction that banks will begin mining: what benefit do banks have for participating in the mining process?  If they own bitcoins, perhaps it “gives them a seat at the table.”  But if they do not own any, it provides no utility for them.

Why?  What problem does mining solve for organizations such as banks?  Or to put another way: what utility does proof-of-work provide a bank that knows its customers, staff and transaction processors?5

Permissioned Permissionlessness, BINO-style

One goal and innovation for Bitcoin was anonymous/pseudonymous consensus which comes with a large requirement through trade-offs: mining costs and block reorganization risk.

To quote Section 1 of the Nakamoto whitepaper regarding the transaction costs of the current method of moving value and conducting commerce:

These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party


  • Bitcoin was designed with anonymous consensus to resist censorship by governments and other trusted third parties.
  • If you are running a ledger between known parties who abide by government regulations, there is no reason to pay that censorship-resistance cost.  Full stop.

Today several startups and VC funds have (un)intentionally turned an expensive permissionless system into a hydra, a gated permissioned network without the full benefits of either.  Consequently, through this mutation, some of these entities have also turned a bearer asset into a registered asset with the full costs of both.

For instance, it is currently not possible to build a censorship-resistant cash system on top of a permissioned ledger (due to the KYC requirements) yet this is basically what has attempted with many venture funded wallets such as Coinbase.

The end result: Bitcoin in name only (BINO).  In which a permissionless network is (attempted to be) turned into a permissioned network.  It bears mentioning that companies such as Peernova and Blockstack are not trying to compete with Bitcoin — they are not trying to build censorship-resistant cash.

While financial institutions can indeed download a client and send tokens around, Bitcoin was purposefully designed not to interface with financial intermediaries as it was modeled on the assumption that no one can be trusted and that parties within the network are unknown.  Therefore if parties transacting on the network are both known and trusted, then there probably is no reason to use Bitcoin-based proof-of-work.  Instead, there are other ways to secure transactions on a shared, replicated ledger.

Ask the experts

I reached out to several experts unaffiliated with Bitcoin itself to find out what the characteristics of a blockchain were in their view.

Ian Grigg has spent twenty years working in the cryptocurrency field and is the author of the Financial Cryptography blog as well as the Ricardian Contract and most recently the “Nakamoto signature.”  Below are his thoughts:

As far as *history* is concerned, it looks like just about every individual component of Bitcoin was theorised before 2009.  The last thing that I’d thought was new was the notion of a shared open repository of transactions, but it seems Eric Hughes actually proposed it in the 1990s.  And of course Todd Boyle was banging the triple entry drum in the late 1990s.

Bitcoin has no monopoly on any term except bitcoin and BTC as far as I can see. The big question is really between permissioned and permissionless ledger designs.

If you go for a permissioned ledger, then you can do some more analysis and also reduce the need for the consensus signing to be complicated. At the base level, just one signatory might be enough, or some M of N scheme. But we don’t need the full nuclear PoW-enfused Nakamoto Signature.

But also, the same analysis says we don’t need a block. What’s a block? It’s a batch of transactions that the ‘center’ works on to make them so. But if we’ve got permissioned access, and we’ve reduced the signing to some well-defined set, why not go for RTGS and then we haven’t got a block.

The block in the blockchain exists because of the demands of the networking problem – with a network of N people all arguing over multiple documents, we know it can’t be done in less than a second for a small group and less than 10 seconds for a large group. So to get the scaling up, we *have to make a block* or batch of *many* transactions so we can fit the consensus algorithm over enough tx to make it worthwhile.

Therefore the block, the Nakamoto Signature, PoW and the incentive structure all go together. That’s the blockchain.

Zaki Manian, co-founder of SKUChain and all around Bay-area crypto guru:

Cryptography is interesting right now because the primitives have matured and pre-cryptographic systems are becoming less and less robust.

Commitment schemes are widely used in cryptography. Nakamoto signatures (if Adam Back wants to concede the naming rights) are the thermodynamic commitment to a set of values. A conventional signature in attributable commitment.

A cryptocurrency is an application of a ledger. A distributed ledger needs to syndicate the order of stored transaction. There is a lot of value to syndicating and independently validating the commitments to interested parties. Generalized Byzantine Agreement, n-of-m signatures and transaction syndication decrease the discretion in the operating of systems. Ultimately, discretion is a source of fragility. I think Ian’s reference to RTGS is somewhat disingenuous. Systems with a closed set of interacting parties aren’t particularly helpful. Open participation systems are fundamentally different.

There don’t seem to be any settle lines between the properties of permissioned and permission-less systems. We have both and time will tell.

Pavel Kravchenko, formerly chief cryptographer at Stellar, now chief cryptographer at Tembusu Systems:

I’ve seen the discussion, it seems rather political and emotional. Since the term blockchain is not clearly defined people tend to argue. To make everything clear I would start from security model – who is the adversary, what security assumptions we are making, what is the cost of a particular attack etc. For now (still very early days of crypto-finane) using blockchain as a common word for such variety of conditions is acceptable for me.

Vlad Zamfir, who has helped spearhead the cryptoeconomics field alongside others at Ethereum (such as Vitalik).  In his view:

“Blockchains” are a class of consensus protocols (hence why I like to pedantically refer to them as blockchain-based consensus protocols).  They are not necessarily ledgers, although blocks always do contain ordered logs.

These logs need not be transactions – although we can call them transactions if we want, and so you can call it a ledger if you want – it’s just misleading.

Blockchains are characterized by the fact that they have a fork-choice rule – that they choose between competing histories of events.

Traditional consensus protocols don’t do this, so they don’t need to chain their blocks – for them numbering is sufficient.

Economic consensus protocols contain a ledger in their consensus state, in which digital assets are defined – assets who are used to make byzantine faults expensive.

It is much less misleading to refer to this class of protocols as ledgers, than to blockchains generally speaking – although it is still misleading.

You can make an economic consensus protocol that lets people play chess. It would have a ledger, but it wouldn’t be fair to call it a distributed ledger – it’s a distributed chess server.

Economic consensus allows for public consensus, which acts as a (crappy) public computer.

Public consensus protocols have no “permissioned” management of the computers that make up this crappy public computer.

Non-public consensus protocols have “permissioned” management of these computers.

I think the main thing that is consistently lacking from these discussions is the fact that you can have permissioned control of the state of a public consensus protocol without “permissioning” the validator set.

Robert Sams, co-founder of Clearmatics who has done a lot of the intellectual heavy lifting on the “permissioned ledger” world (I believe he first coined the term in public), thinks that:

If I were to guess, I’d say that the block chain design will eventually yield to a different structure (eg tree chains). It’s the chaining that’s key, not the particular object of consensus (although how the former works is parasitic on the latter).

I think Szabo’s use of “block chain” rather than “blockchain” is more than a question of style. Out of habit I still merge adjective and noun like most people, but it’s misleading and discourages people from thinking about it analytically.

I tell you though, the one expression that really gets on my nerves is “the blockchain” used in contexts like “the blockchain can solve problem X”. Compound the confusion with the definite article. As if there’s only one (like “the internet”). And even when the context assumes a specific protocol, “the” subconsciously draws attention away from the attacker’s fork, disagreements over protocol changes and hard forks.

Anyway this debate with people talking up their Bitcoin book and treating innovation outside its “ecosystem” as apostasy is tiresome and idle.

Christopher Allen, who has had a storied career in this space including co-authoring the TLS standard:

I certainly was an early banner waiver — I did some consulting work with Xanadu, and later for very early Digicash. At various points in the growth of SSL both First Virtual and PGP tried to acquire my company. When I saw Nick’s “First Monday” article the day it came out, as it immediately clicked a number of different puzzle pieces that I’d not quite put together into one place. I immediately started using the term smart contracts and was telling my investors, and later Certicom, that this is what we really should be doing (maybe because I was getting tired of battles in SSL/TLS standards when that wasn’t what Consensus Development had been really founded to solve).

However, in the end, I don’t think any thing I did actually went anywhere, either technically or as a business, other than maybe getting some other technologists interested. So in the end I’m more of a witness to the birth of these technologies than a creator.

History in this area is distorted by software patents — there are a number of innovative approaches that would be scrapped because of awareness of litigious patent holders. I distinctly remember when I first heard about some innovative hash chain ideas that a number of us wanted to use hash trees with it, but we couldn’t figure out how to avoid the 1979 Merkle Hash Tree patent whose base patent wouldn’t expire until ’96, as well as some other subsidiary hash tree and time stamp patents that wouldn’t expire until early 2000s.

As I recall, at the time were we all trying to inspired solve the micropayment problem. Digicash had used cryptography for larger-sized cash transactions, whereas First Virtual, Cybercash and others were focused on securing the ledger side and needed larger transaction fees and thus larger amounts of money to function. To scale down we were all looking at hash chain ideas from Lamport’s S/KEY from the late 80’s and distributed transactional ledgers from X/Open’s DTP from the early 90s as inspirations. DEC introduced Millicent during this period, and I distinctly remember people saying “this will not work, it requires consumers to hold keys in a electronic wallet”. On the cryptographic hash side of this problem Adam Back did Hashcash, Rivest and his crew introduced PayWord and Micromint. On the transaction side CMU introduced NetBill.

Nick Szabo wrote using hashes for post-unforgeable transaction logs in his original smart contract paper in ’97, in which he referred to Surety’s work (and they held the Merkle hash tree and other time signature patents), but in that original paper he did not look at Proof of Work at all. It was another year before he, Wei Dai, and Hal Finney started talking about using proof-of-work as a possible foundational element for smart contracts. I remember some discussions over beer in Palo Alto circa ’99 with Nick after I became CTO of Certicom about creating dedicated proof-of-work secure hardware that would create tokens that could be used as an underlying basis for his smart contract ideas. This was interesting to Certicom as we had very good connections into cryptographic hardware industry, and I recommended that we should hire him. Nick eventually joined Certicom, but by that point they had cancelled my advanced cryptography group to raise profits in order to go public in the US (causing me to resign), and then later ceased all work in that area when the markets fell in 2001.

I truly believe that would could have had cryptographic smart contracts by ’04 if Certicom had not focused on short-profits (see Solution #3 at bottom of this post for my thoughts back in 2004 after a 3-year non-compete and NDA)…

What is required, I believe, is a major paradigm shift. We need to leave the whole business of fear behind and instead embrace a new model: using cryptography to enable business rather than to prevent harm. We need to add value by making it possible to do profitable business in ways that are impossible today. There are, fortunately, many cryptographic opportunities, if we only consider them.

Cryptography can be used to make business processes faster and more efficient. With tools derived from cryptography, executives can delegate more efficiently and introduce better checks and balances. They can implement improved decision systems. Entrepreneurs can create improved auction systems. Nick Szabo is one of the few developers who has really investigated this area, through his work on Smart Contracts. He has suggested ways to create digital bearer certificates, and has contemplated some interesting secure auctioning techniques and even digital liens. Expanding upon his possibilities we can view the ultimate Smart Contract as a sort of Smart Property. Why not form a corporation on the fly with digital stock certificates, allow it to engage in its creative work, then pay out its investors and workers and dissolve? With new security paradigms, this is all possible.

When I first heard about Bitcoin, I saw it as having clearly two different parts. First was a mix of old ideas about unforgeable transaction logs using hash trees combined into blocks connected by hash chains. This clearly is the “blockchain”. But in order for this blockchain to function, it needed timestamping, for which fortunately all the patents had expired. The second essential part of Bitcoin was through a proof-of-work system to timestamp the blocks, which clearly was based on Back’s HashCash rather than the way transactions were timestamped in Szabo’s BitGold implementation. I have to admit, when I first saw it I didn’t really see much in Bitcoin that was innovative — but did appreciate how it combined a number of older ideas into one place. I did not predict its success, but thought it was an interesting experiment and that might lead to a more elegant solution. (BTW, IMHO Bitcoin became successful more because of how it leveraged cypherpunk memes and their incentives to participate in order to bootstrap the ecosystem rather than because of any particularly elegant or orginal cryptographic ideas).

In my head, Bitcoin consists of blocks of cryptographic transactional ledgers chained together, plus one particular approach to time-stamping this block chain that uses proof-of-work method of consensus. I’ve always thought of blockchain and mining as separate innovations.

To support this separation for your article, I have one more quote to offer you from Nick Szabo:

Instead of my automated market to account for the fact that the difficulty of puzzles can often radically change based on hardware improvements and cryptographic breakthroughs (i.e. discovering algorithms that can solve proofs-of-work faster), and the unpredictability of demand, Nakamoto designed a Byzantine-agreed algorithm adjusting the difficulty of puzzles. I can’t decide whether this aspect of Bitcoin is more feature or more bug, but it does make it simpler.

As to your question of when the community first started using the word consensus, I am not sure. The cryptographic company I founded in 1988 that eventually created the reference implementation of SSL 3.0 and offered the first TLS 1.0 toolkits was named “Consensus Development” so my memory is distorted. To me, the essential problem has always been how to solve consensus. I may have first read it about it in “The Ecology of Computation” published in 1988 which predicted many distributed computational approaches that are only becoming possible today, which mentions among other things such concepts as Distributed Scheduling Protocols, Byzantine Fault-Tolerance, Computational Auctions, etc. But I also heard it from various science fiction books of the period, so that is why I named my company after it.

The future

What about tokens?

Virtual tokens may only be required for permissionless ledgers – where validators are unknown and untrusted – in order to prevent spam and incentivize the creation of proofs-of-work.  In contrast, if parties are known and trusted – such as a permissioned ledger – there are other historically different mechanisms (e.g., contracts, legal accountability) to secure a network without the use of a virtual token. 6

Is everything still too early or lack an actual sustainable use-case?

Maybe not.  It may be the case, as Richard Brown recently pointed out, that for financial institutions looking to use shared, replicated ledgers, utility could be derived from mundane areas, such as balance sheets.  And you don’t necessarily need a Tom Sawyer botnet to protect that.

What attracts or repels use-cases then?

  • Folk law: “Anything that needs censorship-resistance will gravitate towards censorship-resistant systems.”
  • Sams’ law: “Anything that doesn’t need censorship-resistance will gravitate towards non censorship-resistant systems.”

Many financial institutions (which is just one group looking at shared, replicated ledgers) are currently focused on: fulfilling compliance requirements, reducing cost centers, downscaling branching and implementing digital channels.  None of this requires censorship-resistance.  Obviously there are many other types of organizations looking at this technology from other angles and perhaps they do indeed find censorship-resistance of use.

In conclusion, as copiously noted above, blockchains are a wider technology than just the type employed by Bitcoin and includes permissioned ledgers.  It bears mentioning that “permissioned” validators are not really a new idea either: four years ago Ben Laurie independently called them “mintettes” and Sarah Meiklejohn discussed them in her new paper as well.


  1. See The financial cloud from Adam Ludwin []
  2. Thanks to Christopher Allen for pointing this out. []
  3. See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  4. See Bitcoins: Made in China []
  5. Why would banks want to use a communal ledger, validated by pseudonomyous pools whom are not privy to a terms of service or contractual obligation with? See Needing a token to operate a distributed ledger is a red herring and No, Bitcoin is not the future of securities settlement []
  6. See also Needing a token to operate a distributed ledger is a red herring and Consensus-as-a-service []
Send to Kindle

Panel with financial service professionals involved with baking shared, replicated ledgers into organizations

The last part of the PwC discussion 10 days ago involved a panel with myself moderating, Peter Shiau (COO of Blockstack) and Raja Ramachandran (co-founder of eFXPath and an advisor at R3CEV).  Robert Schwentker (from Blockchain University) also helped provide a number of questions for us.

We cover a number of topics including use-cases of distributed ledgers for financial institutions.

Send to Kindle

Q&A regarding the Distributed Ledger Landscape

About 10 days ago I had the pleasure of speaking at Blockchain University (hosted over at PwC) regarding distributed ledgers (permissioned and permissionless).  One of the slides was intentionally taken out of context by a user on reddit and unsurprisingly the subsequent /r/bitcoin thread covering it involved a range of ad hominem attacks that really missed what was being discussed at the actual talk: what are the characteristics of a blockchain.

I will likely write a post on this topic at length in the next couple of days.  In the meantime, below is the video which incidentally pre-emptively answered a few of the questions from that thread.

Also, for those curious to know who were asking the good questions in the audience, this included: Jeremy Drane (PwC), Christopher Allen (co-creator of the TLS standard) and Nick Tomaino (Coinbase) among others.

Send to Kindle

Needing a token to operate a distributed ledger is a red herring

Over the last few weeks a number of posts and interviews on social media have promoted the position that “you cannot separate bitcoin from the blockchain” and that only Bitcoin (and no other distributed or decentralized ledger) is the future of finance.

In prose form this includes Adam Ludwin, CEO of Chain (here), Martin Tiller (here) and many more on reddit.

Others include Jerry Brito, executive director at Coin Center, who recently tweeted:

jerry brito tweet

Source: Twitter

At the most recent Inside Bitcoins NYC event, Barry Silbert, co-founder of DCG, spoke about several myths surrounding Bitcoin (video):

[The second myth] is that the technology is great, but the currency is not necessary. […] The reason why Bitcoin blockchain is transformative is because it’s a secure ledger and you have the ability to process large amounts of transactions.

The only reason why it is secure and it has that transaction capacity is because you have thousands of miners around the world that have been provided a financial incentive to invest resources, capital to build the facilities that is what makes the ledger secure and gives the protocol the capacity to do transactions.

So if you eliminate the financial incentive which is the currency there is no incentive for miners to mine and thereby you don’t have a secure network and you don’t have the ability to process large amounts of transactions.

Why the “only-Bitcoin” narrative is (probably) incorrect for Financial Institutions

In the other corner, Robert Sams described in detail why Bitcoin will not be the future of securities settlement, Piotr Piasecki explored a couple different attack vectors on proof-of-work blockchains (as it relates to smart contracts) and even Ryan Selkis pointed out a number of problems with the Bitcoin-for-everything approach.

So why is the Bitcoin maximalism narrative at the very top probably incorrect for financial institutions?

Because these well-meaning enthusiasts may not be fully looking at what the exact business requirements are for these institutions.

  • What do financial institutions want?  Cryptographically verifiable settlement and clearing systems that are globally distributed for resiliency and compliant with various reporting requirements.
  • What don’t they need?  Censorship resistance-as-a-service and artificially expensive anti-Sybil mechanisms.

The two lists are not mutually exclusive.  I published a report (pdf) two months ago that covered this in more detail.

Bitcoin tries to be both a settlement network and a provider of a pseudonymous/anonymous censorship resistant virtual cash.  This comes with a very large trade-off in the form of cost: as the network funds mining operations to the tune of $300 million this year (at current market prices) for the service of staving off Sybil attacks.1 This cost scales in direct proportion with the token value (see Appendix B).

The financial institutions that I have spoken with (and perhaps my sample size is too small) are interested in operating a distributed ledger with known, legally accountable parties.  They do not need censorship resistant virtual cash or proof-of-work based systems.  They do not have a network-based Sybil problem.2

If you do not need censorship resistant as a feature, then you do not need proof-of-work

Recall that one of the design assumptions in the Bitcoin whitepaper is that the validators are unknown and untrusted.

In section 1, Nakamoto wrote:

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.   Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.  In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions.  The system   is   secure   as   long   as   honest   nodes   collectively   control   more   CPU   power   than   any cooperating group of attacker nodes.

And later in section 4:

To implement a distributed timestamp server on a peer-to-peer basis, we will need to use a proof- of-work system similar to Adam Back’s Hashcash [6], rather than newspaper or Usenet posts.

Financial institutions operate under completely different conditions.  They not only know the identities of their customers, staff and partners but their processing providers are also known, legally accountable entities.  There is no Sybil problem to solve for them on the network.  There is no need for proof-of-work or $300 million in annual mining costs.

If you don’t need proof-of-work, you don’t need necessarily a token to incentivize validation or secure the network

Instead, validation can be done by entities with contractual obligations that are legally enforced: known validators with real-world identities and reputations.

Permissioned distributed ledgers using this type of known validator, such as Hyperledger and Clearmatics (disclosure: I am an advisor to both), are not trying to be “cryptocurrencies” or even entrants in the virtual cash marketplace.

Nor are they trying to provide pseudonymous-based censorship resistant services.  Instead they are attempting to provide a solution for the financial institution requirements above.

But if Bitcoin has the largest user base of pseudonymous virtual cash, wouldn’t concepts like sidechains allow systems like Hyperledger to be run on a sidechain and therefore we should all focus on Bitcoin?

Again, permissioned ledger systems like Hyperledger are not a cyrptocurrency, so sidechains (as they are currently proposed) would probably not provide any benefit to them.  Bitcoin may – temporarily or permanently – have the largest mind share for cryptocurrency as whole and for censorship resistant services but this does not seem to really be a top priority for most financial institutions.

Thus, it would be comparable to saying why don’t we connect all Excel workbooks directly onto the Bitcoin blockchain?


Source: Gizmag

Or akin to the Wright brothers trying to sell a biplane to modern day international air carriers.  Just because you created the first proof-of-concept and own a lot of equity in the companies in the supply chain for Wright brothers wooden airplanes (because you know aeronautical vehicles is a growth industry), does not mean the first model will not be iterated on and evolved from.  Even modern day dirigibles provide different utility than large wide-body air cargo planes.

There is a case to be made that you only need a token as an incentive within proof-of-work-based (and proof-of-stake) cryptocurrency networks.  Yet as described elsewhere, there are other ways to build distributed networks and economic consensus mechanisms that do not need follow the Nakamoto design (see Vlad Zamfir’s forthcoming Reformalizing Consensus paper).

Thus, the authors cited at the beginning of this post are likely asking the wrong question.  What these writers seem to be collectively saying is: “Hey banks, you want a better settlement method?  Then you need Bitcoin.”  Instead they should be asking banks, “What problems do you have?  Would a censorship-resistant service like Bitcoin’s blockchain sustainably solve that problem?”

Financial institutions each face different problems and challenges but it is unlikely that  proof-of-work necessarily solves them.3  Nor is it the case that banks need yet another currency to manage and hedge.  Though to be even handed, perhaps other financial institutions like hedge funds will find it useful for speculation.

Blocks and miners

Not to pick on Barry Silbert (this is just an example), but his statement above is wrong: “you have the ability to process large amounts of transactions.”

Bitcoin, with the current 1MB block size, is in theory able to process about 7 transactions per second.  If some of the expansion proposals under discussion are enacted, then block sizes may increase to 20 MB in the coming year.  This, again in theory, would mean that the Bitcoin blockchain would be able to process about 140 transactions per second.

One bullish narrative has been that Bitcoin will one day be able to handle transaction processing rates on part with networks like Visa (which on average handles 2,000 – 3,000  transactions per second each day).4   For comparison, in 2013 PayPal had 128 million active accounts in 193 markets and 25 currencies around the world and processed more than 7.6 million payments every day.

Baring something like a full roll-out of the Lightning Network, is unlikely to occur without the use of trusted parties.

Thus it is unclear what metric Silbert is using when he references the “large amounts” being processed, because in practice the Bitcoin network only handles about 1.5 transactions per second on any given day, and most traffic is comprised of spam and long-chains transactions and not the actual commerce that Visa handles.

trade block 1trade block 2

Source: TradeBlock

Above are two charts from TradeBlock which recently published some analysis on block sizes and capacity.  Based on their analysis and following the current trend in block size usage, the 1 MB capacity will be reached in about 18 months, so only in December 2016 will 2.8 transactions per second be achieved.  Dave Hudson ran simulations last year and came to a similar conclusion.

Further, Visa’s network — although centralized — is actually very secure (with moats and all).  No one hacks Visa, they hack the edges, institutions like Target and Home Depot.  This is similar to Bitcoin, where it is cheaper to hack Bitstamp, Bitfinex, Mt. Gox and countless others (which have all been hacked over the past 18 months), than it is to do a Maginot Line attack via hash rate.

In fact, if we measure adoption and usage by actual end users (i.e., where most transactions actually take place), the adoption is not with Bitcoin’s blockchain, but instead with trusted third parties like Coinbase, Circle, Xapo and dozens of other hosted wallets and exchanges.  As I mentioned in my review of The Age of Cryptocurrency, one of the funnier comments I saw on reddit last month was someone saying, “You should try using Bitcoin instead of Coinbase.”

blockchain longtail

Source: the long tail usage of blockchains by Vitalik Buterin

Are permissioned distributed ledgers the solution for financial institutions?

Maybe, maybe not.  It depends on if they securely scale in a production environment..  It also depends on the specific business requirements.  It could turn out that distributed databases like Chubby or HyperDex are a better fit for some problems.

It is also hard to say that a large enterprise can axiomatically replace its existing systems with a new distributed ledger network and save X amount of money.  There are a variety of costs that have to be factored in: compliance costs, reconciliation costs, legal costs, IT costs, costs from capital tied up in slow settlement times, etc. 5  Add them all together and there is, in theory, room for large saving, but this is still unknown.  It cannot be derived a priori.

Another common claim is, “Bitcoin is a larger, better supported blockchain and therefore will win out since it has market makers and market support.”

But Bitcoin, as a censorship-resistance payment rail and virtual cash, is a solution for cypherpunks, not for financial institutions who again, have known counterparties.  A proof-of-work blockchain only matters for untrusted networks and pseudonymous validators.

It may seem repeitive, but if you are designing a semi-trusted/trusted networks, then the token itself is more akin to a receipt than an informational commodity.  Bitcoin, in its current form, likely needs a token because it needs to pay its pseudonymous validators for the censorship-resistance service.  If you operate a bank, with a state charter and KYC/AML requirements, this is probably not a must-have feature.

Either way, it is too easy to become caught up in this red herring and miss the utility of a distributed settlement system for the roller coaster ride surrounding the token.

But isn’t using known validation just centralization by any other name?

No, it could be institutionalized (which is different than centralization) in that the nodes are globally separated and controlled by different keypairs and organizations.6  In effect, distributed ledgers are a new, additional tool for financial controls — and an attempt to abuse the network would require additional compromises and collusion that the edges of a proof-of-work networks are also prone to.

Yet in the event an attack occurs on a permissioned ledger, the validators are contractually and legally accountable to a terms of service — pseudonymous validators are not and thus end users for something like Bitcoin have no recourse, legal or otherwise, and are left with options like begging mining pools on reddit.7


Bitcoin may be a solution to some market needs, but it is likely not the silver bullet that many of its promoters claim it is.  This is especially true for financial institutions, particularly once the costs of mining and censorship-resistance, is added into the mix.

There is room for both types of networks in this world, just like there is room for dirigibles and jumbo jet freighters.  Yet it is impossible to predict who will ultimately adopt one or the other or even both.8

But as shown in the picture below, the Bitcoin mining game (within a game) includes mining pools that are not always incentivized to include transactions.9  Which raises the question: how can you require them to since there is no terms of service?

blockchain block 1 tx

Source: Block 358739

Every day there is always one or two blocks (sometimes more) that include a lonesome transaction, the coinbase transaction. In fact, in the process of writing this post, F2Pool included no additional transactions in block 359422, this despite the fact that there are  unconfirmed transactions waiting for insertion onto the communal chain.

Mining pools have differing incentives as to whether or not to include actual transactions, to them the bulk — roughly 99.5% of their revenue still comes from block rewards so sometimes they find it is not worth processing low fee transactions and instead propagate smaller blocks so as to lower orphan races and instead work on the next hash; see for instance Chun Wang’s comment related to F2Pool and large block sizes posted last week.

I reached out to Robert Sams, CEO of Clearmatics, who has written on this topic in the past.  According to him:

To me the crux of the issue is that permissionless consensus cannot guarantee irreversibility, cannot even quantify the probability of a history-reversing attack (rests on economics, not tech).

It’s a curious design indeed where everyone on the Bitcoin network is now known and authenticated… except the transaction validators!

I also reached out to Dan O’Prey, CEO of Hyperledger.  According to him:

It all comes down to starting assumptions. If you want the network to be censor-resistant from even governmental attacks, you need validators to be as decentralised as possible, so you need to allow anyone to join and compensate them so they do, so you need to use proof of work to prevent Sybil attacks and have a token.

If you’re dealing with legal entities that governments could shut down then you don’t get past step one. If you’re dealing with a private network between multiple participants then you don’t need to incentivise validators – it’s just a cost of doing business, just as web servers are.

Fun fact: according to Blockr.io, there have been 85275 blocks with one transaction and 12438 blocks with 2 transactions (the bulk of which occurred in the first year and a half).10

Is that the type of game theoretic situation upon which to build a mission-critical, time sensitive settlement system for off-chain assets with real-world identities on top of?11 Maybe, maybe not.  Both types of networks have their trade-offs but focusing on a token is probably missing the bigger picture of meeting business requirements which vary from organization to organization.

[Acknowledgements: thanks to Pinar Emirdag, Todd McDonald, Dan O’Prey, Robert Sams and John Whelan for their feedback.]


  1. This annualized number comes from the following calculation: money supply creation (1,312,500 bitcoins) multiplied by current market price (~$230). []
  2. Large institutions and enterprises may have issues with authentication and identification of customers/users but that is a separate operational security issue. []
  3. It is important to note that if the costs of mining somehow decreased then so too would the costs to successfully attack a proof-of-work network.  See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  4. Note: In the UK, Visa Europe currently settles over RTGS though Mastercard does not.  See: The UK Payments landscape []
  5. Thanks to Dan O’Prey for his thoughts on the matter. []
  6. It bears mentioning that having 15 banks in 15 different countries operating validators is more decentralized than a few mining pools in a couple of countries, although it is not a fully direct comparison. []
  7. In theory on-chain “identity” starts pseudonymously and later users can either fully identity themselves (via traditional KYC, or signing of coinbase transactions) or attempt to remain anonymous by not reusing addresses and through other operational security methods.  Miners themselves can be both known and unknown in theory and practice.  Other terminology refers to them as a dynamic- membership multi-party signature (DMMS). []
  8. Peter Todd has argued that financial institutions can take a hash from a permissioned ledger and insert it into a proof-of-work chain as a type of “audit in depth” strategy. []
  9. According to John Whelan who reviewed this post, “The science of incentives is far more complex than just ‘show me the money’.  Indeed, workplace incentive specialists have coined the term ‘total rewards of work’ that recognizes that there are many levers other than compensation that may be pulled to motivate employees to perform at their maximum potential (e.g., workplace rewards).  With distributed ledger systems there is a lot of room to gain a clearer understanding of the kinds of incentives that will motivate transaction validators or nodes that offer other services such as KYC/AML, etc.  It is definitely not a one-size-fits-all.” []
  10. For comparison, Litecoin has 245447 blocks with 1 transaction and 105765 blocks with two. []
  11. At an event in NYC last month Peter Todd opined that perhaps some firms will take this risk and will encode a series of if/then stipulations in the event that a history-reversing attack occurs. []
Send to Kindle

The final version of the BitLicense was released

A reporter from CoinDesk reached out yesterday to ask if there were any questions I had in relation to the final version of the BitLicense being released.

They subsequently posted a follow-up story with one of the comments I sent.  Below are the remaining questions and comments that came to mind after quickly reading through the final BitLicense.

The current wording in the final version still seems to leaves a few unanswered questions:

1) When a miner (hasher) sends work to a pool, the pool typically keeps the reward money on the pool before sending it to the miner or until the miner manually removes it.  Would mining pools be considered a custodian or depository institution since they control this asset?  What if a pool begins offering other services to the miner and these assets remain on the pool? (e.g., some pools have vertically integrated with exchanges)  Update:  The mining pool BTC Guild has announced it is closing down and citing concerns over the BitLicense with respect to these issues.

2) Are there any distinguishing factors or characteristics for entities that issue or reissue virtual currencies?  For instance, both non-profit groups (like Counterparty, Augur) and for-profit organizations (like Factom, Gems) issued virtual currencies and it appears that federated nodes that operate a sidechain, in theory, will effectively (re)issue assets as well.  Are they all custodians?  In light of the FinCEN enforcement action with Ripple, do these projects need to be filing suspicious activity reports (SAR) as well?

3) How hosted wallets comply with 200.9(c) and whether startups like Coinbase violate that given this UCC filing (pdf)? (E.g., assuming the bitcoins held by Coinbase for customers are covered by the filing, it seems as if it could violate 200.9)

Send to Kindle

Housing all financial controls under one roof, managed by one person

A new story up on FusionFormer Mt. Gox CEO: Current Bitcoin exchanges are a ‘disaster waiting to happen’ — looks at a recent post from Mark Karpeles regarding the segregation of financial controls within the Bitcoin exchange framework.  I provided a couple of quotes for some perspective.

In addition to the snippets in the article, it bears mentioning that I would disagree with his view that it is possible to make a fully decentralized exchange today due to the fact that cash is centrally created and thereupon controlled by a variety of agencies.  He is right about the intersection of AML and how some companies are unable (or more likely, unwilling) to legally comply with it due to how they operate (such as LocalBitcoins and Purse.io).

As an aside, virtually most (if not all) VC-funded, US-based hosted wallet and exchange is likely in non-compliance of a variety of custodian/depository regulations though it is unclear if/when any jurisdiction will prosecute them:

One last comment about that story, there may be ways to create financial controls to reduce the ability for maleficence to occur but as Karpeles ironically pointed out (he did not acknowledge it but probably is aware of it), by converting bitcoins into an altcoin, you effectively are delinking provenance and creating a money laundering mechanism.  Based on a number of conversations with altcoin traders I suspect that a non-negligible portion of the litecoin trading volume on a daily basis (on BTC-e and ShapeShift.io) are related to money laundering type of activities.  Though this would be hard to verify and prove without building a good network heuristic and/or access to the server logs at these companies.

See also: CEWG BitLicense comment

Send to Kindle

In what ways does Bitcoin resemble a command economy?

I have a new article up over at Let’s Talk Bitcoin which attempts to answer that question.

The feedback I have received so far (including the comments at LTB) makes it pretty clear that many adopters simply do not understand how, in general, economics or finance works or how developing countries struggle with credit expansion.  And that is fine, but can be disastrous when making what amounts to investment decisions.  Again, a vocal minority (majority?) of these adopters think they will be lounging on yachts and private islands because the price of bitcoin reaches $1 million.

And that likely will never play out for a variety of reasons that I have described in numerous articles.

Below is a list of pieces and papers that I have published covering these issues over the past three months in chronological order:

Send to Kindle

Outside funding of cryptocurrency and Bitcoin startups

According to CB Insights, VCs spent $74 million across 40 BTC-related deals in 2013,  the two largest rounds were Coinbase ($25m) and Circle ($9m).

Despite the increased media attention, even if these numbers are repeated again this year this may not help boost the poor performance for VC funds as a whole.1 Even with the optimistic outlook many of the VC firms apparently now have, their actual results at ~6% per annum over the past decade have underperformed the Russel 2000.2

Why?  Some VCs not as nimble at feeling out business models with actual revenue generating capabilities as many angel investors are.

Changes over four decades

Consistent with secular theme of ubiquitous adoption of open source software as well as cloud computing that has lowered the cost of developing software and more importantly the costs associated with launching new companies, so too has this trend lowered the threshold for tech investments.  Where previously the funding of start-ups was limited to deep-pocketed professional investors, namely VCs, the deflationary landscape has increasingly enabled greater numbers of individual investors, angels to compete in funding environment.

The new class of angel investors is more astute than the passive and non-tech-savvy high net worth investor of yesteryear.  Increasingly, angel investors today have deep domain experience.  Many have worked in the sector that they are funding, are entrepreneurs and experienced operators themselves and visionary at feeling out new business and innovative trends.  The historical barrier to entry for angel investing is one of risk given the magnitude of investment commitment.  With lower costs of starting businesses, this hurdle is largely gone.  Smart angels with deep operational domain expertise is disruptive to the traditional VC universe.  They may be better attuned and friendlier with terms that are less predatory than the historical VC norm.

This is not to say that VCs will not flourish once again, however as it stands most angels began as entrepreneurs and learned how to generate sales and revenue first hand.  Furthermore, as noted above, over the past decade technological costs that have driven down expenses.  For example, relatively cheap cloud services like github and Compute Engine provide services (CaaS, SaaS and IaaS) that allow many tech start-ups to be leaner than before in terms of what funding they require to cover operating costs.  On top of this are better organized angels who now have an entire ecosystem of choices to fund through such as AngelList, 500 Startups and Y Combinator.  In fact, over the past six months, BitAngels.co have invested $7 million in 12 crypto projects globally.

Another way that cryptocurrency-related startups are being funded through are crowdfunded IPOs.  This includes Mastercoin, which raised $5 million in part by 4,700 bitcoins from “investors.”3  NextCoin (Nxt) and the upcoming Ethereum IPO have also included raising funds through bitcoin transfers.  While I am not necessarily endorsing any of these particular fundraising models, this illustrates how small (and perhaps large) development teams can financially cover costs without seed funding by VCs.

See also: MoneyTree Report from PricewaterhouseCoopers and the every-growing list of funded Bitcoin companies listed on CrunchBase

[Special thanks to DA for his comments and feedback.]

  1. Kauffman Foundation Bashes VCs For Poor Performance, Urges LPs To Take Charge from The Wall Street Journal and Most venture capital funds lose money from CNN|Fortune []
  2. Venture capital kingpin Kleiner Perkins acknowledges weak results from Reuters []
  3. Backed by $5 Million in Funding (4,700 BTC), Mastercoin Is Building a Flexible, New Layer of Money on Bitcoin from MarketWired []
Send to Kindle

No, there is no (coming) collapse of China’s interbank system

Last week I spoke with Mark DeWeaver (video) and we touched on a number of issues related to China’s financial system but did not cover the liquidity issues that have arisen the past 6-9 months.

As a consequence, I highly recommend reading through this overview from Rhodium Group that does away with hyperbole or exaggeration to explain what is really happening: China’s Interbank Squeeze: Understanding the 2013 Drama and Anticipating 2014


Send to Kindle

Interview with Mark DeWeaver, co-founder of Quantrarian Capital Management

Earlier today I had the opportunity to interview a friend, Mark DeWeaver.  Mark is the author of Animal Spirits with Chinese Characteristics and wrote a very kind foreword for my own book.  He worked in China for 9 years and later co-founded Quantrarian Capital Management which is fully invested in the Iraqi Stock Market.

We discussed a number of topics including the “rebalancing” of China’s economic model, the Soviet tech industry during Gorbachev1 , technological innovations with regards to the Great Firewall (GFW) and spent the last 15 minutes discussing cryptocurrencies, smart property, trustless asset management and specifically an article written by Mr. Sheng from the PBOC.2

Other stories mentioned:

  1. See “The Soviet Machine-Building Complex: Perestroyka’s Sputtering Engine” from the Office of Soviet Analysis published by the Directorate of Intelligence []
  2. Mr. Sheng’s article on Bitcoin and cryptocurrencies is “虚拟货币本质上不是货币” []
Send to Kindle

Cryptocurrency Cat-and-Mouse games in China

btcc voucherSeveral updates to this ongoing cryptocurrency story in China and elsewhere (each subheading below is a slightly different topic).

Yesterday Bill Bishop linked to a story posted at Sina, “虚拟货币本质上不是货币” written by Sheng Songcheng.  Mr. Sheng is the head official of investigation and statistics at the PBOC (the central bank).

Bishop’s quick comment of the article was that, “No reason the belie[f] there will be any positive news from PRC regulators about bitcoin, or that somehow the recent crackdown was good, as some of the bitcoin bulls have been trying to spin.”

Too long; didn’t read

In addition to Bishop’s nutshell, another tl;dr comment that I would add is this, because Mr. Sheng works for the PBOC, his essay pretty much encapsulates what that important organ of the government thinks. Based on his essay, they do not recognize Bitcoin’s legality (although there is no clear indicator that they see a difference between protocol and token) and according to his own words, without government oversight or backing by any country, the token itself has no value.  Mr. Sheng uses the example of the recent 60% price drop of the bitcoin token on BTCChina last month as proof that without government approval, it has little value (a correlation-causation fallacy).  Furthermore, he thinks that if there is a developing country (such as China) that does begin using it, the deflationary aspect (the fixed ‘money’ / token supply) would actually present an obstacle and hinder the country’s economy to grow.  In fact, he says that Bitcoin and other cryptocurrencies will never become a country’s major currency and as a consequence, will not be a “real” currency.  And that it could only become so in the “utopian view of technocrats and libertarians” (技术至上主义和绝对自由主义者的乌托邦).  Yes, he uses the Chinese word for idyllic libertarian  (绝对自由主义者).

From a technical viewpoint, he states all cryptocurrencies do not have a unique origin, nor are its token generation, exchange and storage methods particularly special.  Any currency that has Bitcoin’s features could replace it such as Litecoin, which the public has become familiar with.  And continuing, he states that Bitcoin does not have any physical attributes found in gold and silver nor exclusivity enforced by the law so it will be really easy to replace.  Therefore it cannot replace the role of general currency which is the medium of trading. Thus his overall attitude (and that of the PBOC) is that the central government does not recognize any specific values of the token; that it is illegal to use (though he does not specifically say who or what timeframe) and it doesn’t justify its own existence.

Again, while we can argue over the epistemological, economic and technical problems with this essay (e.g., why do economies grow, deflation versus inflation [pdf], the economics of Bitcoin [pdf], what utility cryptocurrencies have, how the protocol works, etc.) all of which have been discussed elsewhere, as Bishop noted above, this essay is hardly a positive sign for the crytpocurrency segment in China.  Thus, while speculative, after reading the article the impression readers are left with is that the PBOC will crack down on cryptocurrencies on the mainland for the foreseeable future.


There have been discussions over the past weeks as to how mainland exchanges could bypass the current hurdles.  One idea was to create yet another type of virtual token that could then be exchanged on exchanges.

Over the past couple of hours on reddit, users have posted a new method that BTCChina is using to get around the current depository predicament the mainland industry is currently in (e.g., all payment processors are barred from providing fiat liquidity to crypto exchanges).  However, the small stop-gap solution is for BTCChina customers internally (this is not the same thing as the online vouchers like BTCe has).  BTCC code is to allow one customer with CNY on the site to sell the CNY to another customer.  The medium is the BTCC code which is in two parts: one is for the customer the other is for the site.

Imaginary Capital Markets has a few more details and screenshots, but let me just emphasize once more that this is not a complete workaround (yet) but just a way for BTCC users to exchange CNY with one another.  My speculation: if the CEO role as sole depositor is still active, perhaps this could be a way for him/her to distribute funds to friends & family who can then exchange the fund to the wider customer base.  If this is the case, perhaps other exchanges will follow suit (assuming that the CEO can still deposit funds into the exchange through their personal account, see the explanation here for more).

[Update: Taobao has a new rule (Chinese) that will ban the buying and selling of crypto coins.  Thus it will purportedly impact vouchers such as those being offered by BTCChina]

Also regarding the CEO bank accounts I discussed the past two weeks, Eric Meng, an American attorney friend of mine currently in China explained to me that the use of personal bank accounts to do business is a huge red flag in general.   It does not mean that anything is being done illegally, but it’s something that investigators watch out for.1

Bots again

Regarding the purported fudged numbers on Chinese exchanges (discussed here), another friend (in Europe) recently wrote to me explaining that someone could easily write a bot and test the liquidity to see whether it is real or not.  It could be that some exchanges on the global stage act as a market maker (similar to the NYSE which employs “specialists” [pdf explanation] who always make sure that there is a reasonable bid and ask available and who take short term positions in order to provide liquidity).

This same friend who has both mined and then built proprietary HFT arb software on BTCe is reasonably sure that BTCe runs their own arbitrage bots with zero fees but sometimes turns them off (or they have certain limits, he is not sure).  Again, arbitrage is not bad per se and basically makes sure that you can execute your orders at a ‘fair price’ all time.  Of course it would be better if the exchanges are more forthcoming about what they do behind the scenes but as long as there are no regulations they can do whatever they want and earn some extra money.  Yet again, no one is forced to use a particular exchange so people can easily vote with their feet or open their own (transparent) exchange.

Notes in the margin

One last comment I received is from Mark DeWeaver (author of Animal Spirits with Chinese Characteristics and GWON’s Foreword) is that,

It occurred to me that the argument about bitcoin having a big “carbon footprint” is really poorly thought out.  Is the footprint really bigger than that of paper currency, which has to be transported from countless businesses to bank’s safe deposit boxes at the end of each day.  And think of all the gas people must burn on trips to ATM’s!

This is in response to my explanation of Charles Stross’ contention that cryptocurrencies are more of a burden on the environment than fiat currencies are (they are not).  Mark’s comments are empirically valid because these up-armored vehicles (typically Ford 550 chassis or similar classes from competitors) are frequently used to move fiat currencies to and from distribution centers to branch banks and ATMs.  For example, The Armored Group currently lists many used armor transportation cars for sale.  And a quick search on Fuelly gives you an idea of how much fuel the average F550 consumes in the city (~9 mpg).  This also ignores the supply chain needed to build the vehicles in the first place which is an entire logistical segment that cryptocurrencies do not need.  Nor does it include the carbon consumption of the driver and guards ferried around in the vehicles (e.g., eating, sleeping, shelter, etc.).  One can only imagine the sheer number of vehicles in developing countries where digital fiat are not nearly as common and thus paper/metal is transported more frequently.

Again, this is not to say that cryptocurrencies are mana from heaven, that they won’t be replaced or will somehow axiomatically usher in a world of milk and honey.  But these specific claims by detractors need to be backed up with real numbers as they are positive claims (e.g., burden of proof).  If you do think that the Bitcoin transaction network (the most computationally powerful, public distributed system currently)2 consumes more carbon than all ~200 fiat currencies right now, you need to prove that.  And from my quick research I detailed in my article, that does not seem to be the case (today).

Also, for other occasional commentary on crypto in China I recommend visiting my friend’s site, Aha Moments (specifically this recent post).  Drop him a note and tell him to update more.

  1. Eric also suggested I link to the following guide that potential investors conducting due diligence pay attention to in the aftermath of Madoff: Six Red Flags and Tips for Investment Risks from CAMICO. []
  2. See Global Bitcoin Computing Power Now 256 Times Faster Than Top 500 Supercomputers, Combined! from Forbes []
Send to Kindle

What happened with the “cash crunch” in China two weeks ago?

While there have been many explanations for why the People’s Bank of China (temporarily) allowed (easy) credit to dry up, I think Mark DeWeaver has a very plausible and well-reasoned explanation.  Mark wrote the foreword to my book and is the author of Animals Spirits with Chinese Characteristics.

Below is his op-ed published two days ago in The Wall Street Journal.  Be sure to check out his predictions for why this solution probably will not stick:

Beijing’s War on Shadow Banking

China’s central bank cracks down on credit that is not under the government’s control.

On June 20, China’s central bank precipitated a major credit crisis by withholding funds from the nation’s cash-starved banking system. The People’s Bank of China’s refusal to act as liquidity provider of last resort froze lending in the interbank market. Overnight rates, which had been as low as 2.1% in early May, exploded, closing at a record 13.4%.

As rumors swirled about the solvency of China’s state-owned banks, some commentators began talking about a Chinese “Lehman moment.” But the crisis passed and the overnight interbank lending rate quickly came back to earth. By July 4, it had fallen to 3.4%.

Trouble in the interbank market had been brewing since early June, when Beijing began a crackdown on illicit inflows of foreign exchange, previously a major source of growth in the local money supply. The demand for yuan also began rising, as Chinese banks prepared for their June 30 book closings and their customers for their first-half tax payments.

The result was a growing imbalance between the supply of and demand for credit. As rumored large-scale interventions by the People’s Bank of China repeatedly failed to materialize, commercial banks realized they would have to fend for themselves. Lenders hoarded cash to guard against potential counterparty defaults, and the normal flow of funds among financial institutions quickly dried up.

The central bank’s immediate objective seems to have been to rein in China’s “shadow banking” system, which has grown rapidly in recent years and now accounts for a significant share of total Chinese credit. Shadow banking in China involves lightly regulated products that allow savers to earn more than the official deposit rate while providing financing for “subprime” borrowers.

Generally the funding is relatively short-term, which makes the business highly sensitive to liquidity conditions. Shadow lenders require inflows of new money to pay off maturing obligations. These typically come either directly from the banks—for example, via their “wealth management products”—or from entities with access to bank financing such as state-owned enterprises.

There may be a larger political game going on. The People’s Bank of China is not an independent central bank, so the order to turn off the credit spigot must have come directly from the Politburo. The central bank’s surprise attack on bank credit must therefore be understood in the context of the leadership’s current focus on improving economic efficiency. This objective will be impossible to achieve unless the central government can overcome resistance from the powerful local interests that benefit from the status quo. The Politburo’s goal may have been to starve opponents of reform into submission.

Local governments appear to be the central bank’s real targets, because they rely heavily on shadow financing to subvert Beijing’s reform initiatives. Shadow funds flow directly into local government projects that the central government views as wasteful, and the funds benefit localities indirectly by pushing up land prices. As long as this money keeps flowing, over-investment in infrastructure, heavy industry and real estate will continue unchecked and Beijing’s vision of a new economy driven mainly by consumer demand and productivity growth will be impossible to realize.

The credit crunch occurred a few days after the launch of the Communist Party’s new “mass line” campaign, which seeks to make the party more sensitive to the needs of the people by circumventing official government and party hierarchies. This idea goes back to Mao Zedong, for whom the goal was to realize “democratic centralism” and bypass bureaucratic factions that threatened his agenda. Going directly to the “masses” was a way to attack the opposition from the outside—to “bombard the headquarters” in a famous slogan of the Cultural Revolution era.

In Mao’s time, bombarding the headquarters meant unleashing a reign of terror. Today the leadership has turned to less violent means. The central bank’s strike against shadow banking will undermine today’s vested interests in a way that Mao could scarcely have imagined—simply by cutting off their financing.

There are two problems with this approach. First, the central bank’s policy will result in considerable collateral damage. Small- and medium-size private firms will be particularly hard hit. They tend to be ineligible for bank loans and often depend on shadow financing to make ends meet.

Second, attacking anti-reform factions will not be enough to generate real reform. Without radical changes in the economic role of local governments, they will quickly return to business as usual once the fallout has cleared.

The People’s Bank of China may have won a battle, but the Politburo is far from winning the war.

Send to Kindle

A friend discusses alternative wealth management products (WMPs)

In Chapter 5 and 17 I briefly mention that due to the current legal and financial system on the mainland there are very few financial alternatives and investment vehicles to park funds.  As a consequence, wealth management products (WMPs) such as trust companies are a new type of wealth management service that collectively amounts to more than $1 trillion and is considered to be an integral part of a “shadow” banking system (e.g. off-balance sheet transactions).  According to Xiao Gang, chairman of Bank of China, there are 20,000 WMPs in circulation currently.

It should be pointed out that the term “shadow” has been hyped up and distorted by many analysts to mean the equivalent of “shady” and “fraudulent.”  In economic terms, while there may be illicit or fraudulent activity taking place (e.g., money laundering), all the “shadow” activity technically forms part of the larger informal economy.  That is to say, given continued financial reforms, some of these 20,000 WMPs could eventually integrate and become part of the formal economy.  While there may be any number of pyramid and Ponzi schemes in this segment, this is not to say that the entire $1 trillion under management will all collapse into nothingness (it could, but you cannot say it a priori).

How does it work?

I asked a Chinese friend, Kevin C, to briefly explain how he manages his assets in this alternative system.  Here is his response:

I began my first “shadow” investment in the early part of December 2012.  The “shadow” bank system offers different deposit terms ranging from 1 month to 6 months and sometimes up to12 months (which is the longest).  Most companies originally offered interest rates from 17% per year last year, however this has been reduced to 13-14% per year now.  There are more than ten public companies operating this kind of private investment path and promote it via their websites.  In order to open an account, you need to register a user ID and mobile number.  In addition, you need a Chinese National ID Number, plus your personal bank account number which will be used to transfer money back to your account.  In practice, I have placed 80% of my capital in the 1 month term,15% in a 3 month term and 5% for longer terms.

I try to choose the company carefully before make my own investment and of course there is no single website can guarantee 100% safety.  However, if it doesn’t look like a short term business for those companies which I believe, as long as they offer a one month product, I think it will be relatively safe to me.  As far as trying to fund it through debt like credit cards, I looked into taking out a simple loan and found out that the monthly interest rate that I would owe actually outpaces what I would receive in return from one of these private investment plans.  So I am actually using my own money to try this out.  So far so good.  And even though I still worry about the risk, as I said before, the one month term is the most attractive to me for this reason.

Again, I am not endorsing this service.  In fact, it is really hard to see how this particular service can provide these high rate of returns in the long term and may in fact be powered solely through speculation and exuberance.  Perhaps these 10+ firms Kevin mentions do not even reinvest the capital into actual productive projects but merely recycle the money to other customers cashing out each month.  Perhaps other customers do fund a lot of their investments through debt (e.g., borrowing to reinvest it into one of these 10 firms) and have a great deal to lose in the event one of the companies goes bankrupt.  However, this was just an example to give you an idea of what the process is like.

For more see: Examining China’s ‘Shadow Stimulus’ from The Wall Street Journal, In China, Hidden Risk of ‘Shadow Finance’ from The Wall Street Journal, Regulating shadow banking from China Daily, Uncertain foundations from Financial Times, China to tighten shadow banking rules  from Financial Times, China’s brokerages turn shadow banks from Financial Times and Don’t Worry About Wealth-Management Products, Regulator Says from The Wall Street Journal

Send to Kindle

Chapter 5 – Financial services

[Note: below is Chapter 5 from Great Wall of Numbers]

Since Deng Xiaoping’s “Southern tour” in 1992, China has consistently been one of the top recipients of foreign direct investment (FDI), totaling $85 billion in 2010 and $574 billion overall.  In contrast, up until recently the US still led in both annually received FDI ($194 billion in 2010) and $2.58 trillion overall.  Even though its full year FDI received fell from the year before – a decline that continued through February 2013 – in the first half of 2012 China actually overtook the US for received FDI ($59.1 billion versus $57.4 billion).1

And while US firms and institutions currently invest more FDI within China than Chinese firms invest in the US (in 2011, Chinese companies invested $6.3 billion in the US representing 0.15% of total foreign investment in the US) this will probably change – despite a closed capital account (discussed in Chapter 10).234 For example, among other deals, a Chinese firm was recently granted approval in December 2012 to purchase bankrupt Massachusetts-based battery maker A123 Systems for $256.6 million.5 As a consequence Chinese outbound investment in 2012 such as mergers and acquisitions reached $8 billion for the first time in the US, globally increased to $93.09 billion (compared to $13.58 billion in 2007) and its outbound direct investment (ODI) is expected to reach $150 billion by 2015 due to deals such as A123 Systems.678 One example of continued investment is from ENN Group, one of the largest private companies in China.  Through a joint venture with CH4, a Utah-based energy company, ENN plans to open a network of 50 natural gas stations across the US this year.  Each station costs about $1 million to build and the joint venture has a goal of building 500 stations altogether.9 For comparison, the EU collectively receives twice as much FDI from China than the US currently does (due in part to political trepidation).10

Where are the potential investments that Chinese firms have looked at in the US?  For example, during the build-out of the enormous Haynesville natural gas fields in the Texarkana region, one of the investors courted by local energy companies was CNOOC (the 3rd largest oil company in China), which at the time reportedly wanted to invest $750 billion into the North American energy business.11 It is unclear as to how much they did end up investing (or if they returned a profit) but several Chinese energy companies have now moved up to Canada and invested $3 billion in a new pipeline project in the tar sands as well as put together a “$15.1 billion deal to acquire Nexen.”1213 In February 2013 the deal closed marking the completion of the largest overseas acquisition by a Chinese company.  And depending on regulatory conditions North American energy firms may or may not continue to do business with Chinese firms, yet there is one area that foreign experts can provide inside of China right now.

So what opportunities are there for foreign financial professionals?

While it has become almost cliché to say, finance is one of the industries that is undergoing “reform and opening up.”  This involves building institutions, physical infrastructure and a legal structure – all of which is thoroughly discussed in both Mark DeWeaver’s new book as well as a Brookings Institute report in June 2012.14 Yet reforms in general are always just around the corner.15

For example, because of pent up savings due to relatively few investment vehicle choices on the mainland, once larger liberalizations begin, there will be opportunities that can come from not just asset management and private equity (PE) markets but through the large expertise requirements in the relevant fields that currently do not exist (e.g., debt structuring).  As part of the once-in-a-decade leadership transition that began in November 2012, one expectation was and is that there will be a “big bang” of reforms in the coming months.1617 One immediate, visible reform was the creation of super-ministries referred throughout this book (e.g., Ministry of Health dissolving to become National Health and Family Planning Commission).18 Another case in point, on November 19, 2012 the State Administration of Foreign Exchange (SAFE) announced that it “ended 35 foreign-exchange approval rules and simplified others.”19 By reducing paperwork and shortening approval processes, such liberalizations are done with the intention of attracting FDI.  On December 12, 2012 the Shanghai stock index surged to its highest daily gains since October 2009 due to policy changes in the Qualified Foreign Institutional Investor program (QFII合格境外機構投资者).20 As a consequence sovereign wealth funds such as Qatar Holdings and central banks are now allowed to raise more than the $1 billion previously permitted for investing in the securities market.21

Another instance is on December 17, 2012, where a number of new liberalizations were implemented such as reducing regulatory approval and remittance of profits for foreign-owned companies.  Continuing this trend, on February 28, 2013, the government expanded its short-selling program which will now enable select brokerages to borrow shares from preapproved publicly traded companies.22 And on March 15, the China Securities Regulator Commission announced that effective immediately, brokerages could convert loans and other assets into securities, paving the way for securitized business.23 On a provincial level, financier Harry Ding (see below) explained to me, that pilot regions throughout China are also enacting reforms to make it easier for entrepreneurs to begin operating.  Shenzhen and Zhuhai in Guangdong announced that effective March 1st they have streamlined 18 different business licenses, created a new version of business licenses which no longer requires lengthy documentation procedures and removed some of the registered capital restrictions.24

Another specific area you and your firm may be able to literally capitalize on shortly is building a local bond market in structured debt.  Over the past several years there have been attempts to roll out local government bond markets on the mainland.  In November 2011, Shanghai issued China’s first local bond issuance yet eight months later, all of the programs were scrapped.25  Yet a year later, in November 2012, the China Securities Regulatory Commission (CSRC) approved a plan from ICBC (the largest commercial bank in China and in the world) to start a pilot program of selling bonds known as asset-backed securities (ASB) beginning in 6 months.26 The local market of this local debt, based on several estimates of over 10,000 local-government financing vehicles (entities that were set up to bypass these kinds of bans) is between $1.7 trillion and perhaps up to $5.4 trillion, which I discuss later in Chapter 17.27

Foreign firms specializing in managing distressed loans have already capitalized on opportunities on the mainland (with mixed results), including Shoreline Capital Management who raised $300 million for a new fund last year specifically to invest in distressed Chinese debt.28 DAC Capital is also in the process of raising $300 million for a new Chinese-focused fund.  The gamble is while investors in such debt may receive returns if and when a borrower repays portions of the loan, local government policies and a nebulous court system can make returns lower than they would have otherwise would have been (e.g., transaction costs and opportunity costs).

In October 2012 I spoke with Shawn Mesaros, CEO of Pamria an asset management firm located in the financial district in downtown Shanghai.29 Despite these setbacks above, in his view SOE banks will “eventually become facilitators, that they will offload debt which can then be restructured.  As a consequence there will then be a bigger market for sovereign debt.”  In addition, even though public capital (through SOEs) is currently cheaper than private capital Mesaros thinks that private equity (PE) is still a relatively good business, “it is not as easy as you think because domestic companies typically would rather not share equity in exchange for your capital.”  For perspective, according to the consultancy Bain, “the total value of mainland private equity investments jumped from US$3.7 billion in 2005 to US$15.2 billion in 2011.”30 And nearly $230 billion worth of deals were collectively completed between 2001 and 2012.31

Yet to give you an idea of the soft PE market today in China, according to a recent report from the Wall Street Journal, both foreign and domestic PE firms have been struggling over the past two years.32 The value of PE deals in 2012 declined 27% to $21.9 billion in part because of the domestic stock market performance.33 Between 2010 and 2012 the Shanghai Stock market declined roughly 37%.  Fortunes however, may continue to fluctuate in the future as the main benchmark index regained about 9% in the first six weeks of 2013 then lost 7% over the following month through mid-March.34 However because many investors cash-out of their positions through the securities exchange, fewer firms have wanted to go public.

Subsequently, private-equity firms which provide this junction have been affected as well.  In fact, in 2012 there was a 70% drop in initial public offerings (IPOs) – in the first half of 2012 alone there was a 37% drop in IPOs, from 218 during the same time last year to 138.35 PE deals as a whole “fell an unprecedented” 43% last year.36 Furthermore, of the 10,000 PE deals conducted between 2001 and 2012, 7,500 remain “unexited” as the firms cannot go public on Chinese exchanges.  And whereas PE firms in China raised 75 yuan-denominated funds in 2011 and raised another 52 yuan-denominated funds last year, only 2 new funds have been raised in 2013 (both focused on real-estate investment).37 This is in part because there has been an across the board red light from Chinese regulators since last summer (as of January 31, 2013, a record 873 companies have filed for IPOs in China yet have to wait) and Chinese firms trying to list on American credit markets are essentially persona non grata due to regulatory oversight from the SEC and disagreements with Chinese auditing regulators.383940

However despite these drops, there is still an active set of foreign and domestic PE activity, including Jiuding (the top domestic PE firm) who has averaged an internal rate of return of 30% since 2010 (an IRR is one gauge of how profitable investments are).41 Furthermore, this “softness” in the PE market may have a silver lining as well.  For example, according to Peter Plakidis of Deutsche Bank, “[a] softer equities capital market has meant that private equity is not competing as much with public money, and depressed public valuations have improved the returns for private-equity firms.  Hence, private-equity firms now have more companies on their radars as attractive investment opportunities.”42

In addition to PE, according to Mesaros, one large SOE bank on the mainland is already filling an office floor just for fixed-equity investments.  And if they are doing it, then perhaps other SOEs are close behind.  What this means to Mesaros is that eventually the big spreads “that can roll over price takers will become smaller.”  This also means that there is potential for foreign experts in this field to also train and get involved at a variety of levels within the periphery of this investment field.

Human capital

And in both the long and short-term, irrespective of growth trends on the macro side (which I discuss in later chapters), expertise in these two areas is in short supply.  At the same time, as noted above one challenge in this type of training is retention.  I was told by an another American source that a very large US bank (top 3) has trained numerous local financial experts in some of these sub fields (like forfaiting and futures) yet was unable to retain them due to an insatiable demand for such experts at mainland institutions.  Or in short, since talented human capital in certain areas is scarce, training may be a risky endeavor.43

Natalia Shuman, the new COO of Kelly Services’ in China recently explained the labor supply issues of financial experts in this region,

[…] the lack of supply and high demand is reflected in compensation.  If you look at Shanghai’s market today it’s not only financial analysts.  There are multiple positions and multiple functions where salaries are very competitive compared with global.  People are getting the same salary, maybe even higher, particularly in Shanghai and Beijing, compared to New York or London nowadays.44

And recruiting local talent for financial positions is also a seller’s market in Shuman’s view “Chinese with Western experience who are coming back here; they could easily get more money here than they would get in New York or London.”45 Further human resource constraints including retention issues are discussed later in Chapter 15.

For perspective in December 2012 I spoke with a Chinese financial manager at Fosun International (复星国际有限公司) in its Hong Kong corporate subsidiary.  Fosun is the largest privately held company in China, generating 25.73 billion RMB ($4.12 billion) in the first half of 2012.46 According to him, “I have colleagues who have a lot of career experience in the financial industry on the mainland but they currently do not have a competitive edge over their international counterparts when applying for finance positions in Hong Kong or elsewhere.  Yet simultaneously, if they want to further their career they would prefer working outside the mainland because both the experience gained and the compensation in the international marketplace is significantly higher than anywhere on the mainland.  And since the financial infrastructure and investment instruments in Shanghai still have not reached ‘critical mass’ it is basically more of a regional financial center compared with Hong Kong, which itself is filled with experienced staff in dozens of specialties that do not exist yet on the mainland.  Concurrently, because there are more and more banks in China and more and more people that have financial backgrounds and overseas educations they also want to pursue careers in this industry making it very competitive in certain specialties compared with previous years.”47

On the other hand, he still sees opportunities as “the mainland industry needs experts to train local people how to work in all areas in this growing market because there are relatively few providers doing it today.  Not just in debt markets, M&A, private equity or IPOs, but also in all forms of international trade such as letter of credit, trade finance, arbitrage and export finance.  Since there is a lot of overseas businesses that want to do business in China these banks will continually need to hire people capable of not just fulfilling relatively basic financial services today, but also the more advanced investment instruments and complex transactions in the future.  And since nearly all of corporate finance on the mainland still depends on bank loans for credit, banks typically provide most finance and capital for nearly all companies.  Thus foreign service providers can potentially bring their knowledge to our young industry for a mutually beneficial exchange.”

What are these salaries like?  A recent Bloomberg report similarly noted the demand for qualified financial professionals and experts for China, yet also found that managing directors now earn less than they would in the US and roughly “on par with those in Europe and the U.K.”48 For example, managing directors in Beijing and Hong Kong earned between $900,000 and $1.3 million in salary, bonus and stock options last year – while their counterparts in the US earned $1.2 – 2.01 million and their peers in the UK and Europe earned $850,000 – $1.77 million.

Wealth management

In November 2012 I spoke with Richard Johnsson who was the President & CEO of Soderberg & Partners in Beijing.  Soderberg & Partners is an independent financial advisory targeting high-net worth Chinese citizens since 2007.  According to Johnsson, “one of the challenges early-on was to establish a business in a field that didn’t exist in China, and few could see the benefits of independent advice.  The competition was all about returns, as opposed to for example tax planning; and the commissions were very low.  But lately, the industry has expanded very fast.  And one of the opportunities is of course that it is highly likely that the tax system and regulatory setup will look more and more like in the West.  This will mean complicated tax systems and tax deductions will make planning hard for people, thus driving sales.  On the other hand, other parts of government will try to control the industry, driving extensive compliance.49 But the former will likely come before the latter.”  All of the Big Four auditing firms and Big Three management consulting firms have long ago established mainland offices; can your firm provide similar services?

In January 2013 I also spoke with Harry Ding, a native of Guangdong who has worked as a manager in the finance industry on the mainland for the past five years.  According to him, “one of the opportunities for activities like day-trading and forex trading is that you do not need to have a PhD in finance to understand and be successful or even profitable in these segments.  As a consequence, the companies I have worked with over the past several years usually involves training new college graduates with finance backgrounds how to use econometric models and computing technology to conduct their trades.  While there are licensing and training fees as well as a learning curve, in the long-run their relatively lower labor costs usually acts as a profitable form of arbitrage.  That is to say, that because they can effectively trade on exchanges like the Toronto Stock Exchange, they are usually several times cheaper to hire and manage than local talent in Canada.”  Forex means ‘foreign exchange’ and typically involves the buying, selling and trading of foreign currencies (e.g., JPY, USD, GBP).

Ding also sees a few challenges in that, “because of the numerous restrictions on the financial industry and because of its overall developmental status, there are not as many investment tools and instruments available and those that exist can be difficult to trade profitably at large volumes.  As a result, many individuals and institutions have turned to overseas investment.  And by virtue of the fact that much of a firm’s activities are conducted overseas, it normally requires investors to transfer money out of China which oftentimes makes domestic clients feel uncertain as their assets are not physically close by, creating a psychological insecure feeling (e.g., uncertainty) especially in recent years as Western countries have had numerous financial scandals that have shaken investor trust and confidence.  In addition, China has a capital transfer restriction that strictly prevents citizens from transferring assets to a broker or investment firm outside the mainland over an annual limit of $50,000 USD.  Thus any amount beyond that requires other legal ways to process and transact it.”  These capital restrictions are discussed in Chapter 11.  Furthermore, can you or your company utilize local talent like Ding’s firms have?

Ding’s point regarding a dearth of investment instruments was recently echoed by Nick Yim head of Goldman Sachs China Market.  According to Boston Consulting Group, the total value of private investible assets in China reached $12 trillion in 2012 (a 14% increase year over year).50 Where are these assets?  According to Yim, most of his high-network clients only have “have 20% to 30% of the funds parked offshore, the rest remains onshore.”51 And because of the global financial crisis and relatively slower domestic growth, these clients “have become more conservative and now behave more like U.S. clients.”  This means they are looking for safe, conservative lower yield products.  While there are a limited number of investment products and a scarcity for seasoned bankers, which he considers to be the two biggest challenges, Yim sees a lot of growth potential due to improving legal and regulatory frameworks.  And ultimately, because China also has a single culture, currency, language and regulator, he thinks that there are a lot of opportunities for Western private banks to provide diversification, risk management and retirement planning services in what may become the world’s largest economy in the next decade.

Takeaway: With more than 57 million inbound tourists that spent $48 billion last year, the domestic Chinese tourism industries is one of the largest in the world.  Training staff and putting together a brand positioning campaign are just two areas of many that foreign expertise can bring to the growing industry (which may grow from 2 million hotels today, to 5 million in the next four years).  In addition, financial service companies may be able to find opportunities to not only to train local financial firms on bond technicalities but also provide ancillary services to fixed-equity investment programs.  And in addition to conducting your due diligence it is also recommended that you read through Chapter 10 regarding legal and regulatory risks and uncertainties.


  1. See China’s Foreign Direct Investment Declines for Eighth Month from Bloomberg, China 2012 FDI suffers first annual fall in three years from Reuters and China Overtook US as main Destination for FDI in First-half 2012 –UNCTAD from The Wall Street Journal []
  2. Investment from China in US reaches record high from China Daily []
  3. According to the World Bank total overseas investment by Chinese firms reached $21.4 billion in Q1 2012.  This is substantially higher than $17.8 billion in all of 2009.  See China Buys Overseas Assets from The Wall Street Journal and China’s overseas direct investment strategy from finfacts []
  4. The Shift from East to West: Chinese Investment in North America from Firmex []
  5. See Chinese company buys battery maker that got recovery funds from The Washington Post and Investment from China rises amid concern from The Washington Post []
  6. See Chinese Investment to the U.S. Speeds Up from Caijing from Caijing, Chinese outbound investment accelerates from China Daily, Investment from China rises amid concern from The Washington Post and Make It for China to Buy U.S. Businesses from Bloomberg []
  7. Another area Chinese individuals and firms are now investing in is the US real estate and property market.  According to a recent report, “[b]uyers from China also invested almost $2 billion in commercial property in 2011, or quadruple what they spent several years ago.”  One of the recent deals was led by China’s Vanke (the largest real estate developer on the mainland) who agreed to a $620 million project in San Fransico in December 2012.  See Chinese buyers lead foreign investment in US housing market from Fox News, China Vanke Arrives in U.S. from The Wall Street Journal and Lennar Said to Get $1.7 Billion San Francisco Loan from Bloomberg []
  8. See A Gateway to the U.S. by Daniel Rosen and Thilo Hanemann, China’s outward FDI to reach US$150bn by 2015 from Want China Times and FDI with Chinese characteristics from The Economist []
  9. Chinese firm puts millions into U.S. natural gas stations from Reuters []
  10. Chinese Investment: Europe vs. the United States from Rhodium Group []
  11. After the Boom in Natural Gas from The New York Times []
  12. Another segment Chinese firms are expanding into in the US and Europe is construction equipment.  Sany is China’s largest heavy machinery manufacturer (e.g., excavators) and aims to become the largest globally in the world.  As a consequence it is looking abroad for mergers, acquisitions and joint-ventures.  Perhaps your firm could find a new partnership with them.  See Sany Tries to Gain Traction in the U.S. from The Wall Street Journal []
  13. China takes new step in oil sands from The Globe And Mail []
  14. See Animal Spirits with Chinese Characteristics by Mark DeWeaver and Achieving 2020 from the Brookings Institute []
  15. See Foreign capital rules eased from China Daily and China Capital Account Restrictions Loosened for Foreign Investors by Stan Abrams []
  16. China Big Bang Seen Like London in New Regime: Cutting Research from Bloomberg and Reins on Shanghai set to be loosened from South China Morning Post []
  17. In addition to QFII, a recent report suggests that citizens of Taiwan, Hong Kong and Macau could invest directly into mainland stock exchanges.  See Mainland to allow overseas citizens in stock market from Xinhua []
  18. Graphics: Super Ministry from Caixin []
  19. SAFE Issues New Rules to Further Relax the Foreign Exchange Controls over Direct Investment from King & Wood Mallesons []
  20. See China Scraps QFII Limit on Sovereign Funds, Central Banks from Bloomberg, China’s Stocks Drop Below 2,000 from Bloomberg and China stocks fall below 2000 to 4-year low from South China Morning Post []
  21. See Qatar granted $1b QFII quota from Reuters, China’s Qualified Success In Attracting Qualified Foreign Investors from China Bystander, China pledges to expand QFII, RQFII programs from China Daily and 64 More Institutions Enter China via QFII, CSRC Official Says from Caixin []
  22. China to Expand Short-Selling Program as Part of Reform from Bloomberg []
  23. China Allows Brokerages to Conduct Securitization Business from Bloomberg []
  24. 深圳、珠海商事登记改革3月1日起正式实施国家工商总局支持两地启用新版营业执照from Guandong Province Administration for Industry & Commerce []
  25. See Shanghai makes China’s first direct local-bond issue from Reuters and China Scraps Trial of Local Government Bonds, Studies Risks from Bloomberg []
  26. Regulator Allows Bank Subsidiary to Sell Special Bonds from Caixin []
  27. According to Shang Fulin, chairman of the China Banking Regulatory Commission, as of September 2012 the local government debt collectively amounted to $1.48 trillion.  See High local debt levels coming under control from China Daily and China averts local government defaults from Financial Times.  Other higher estimates can be found in China tells banks to roll over local govt loans: report from Reuters and Are Chinese Banks Hiding “The Mother of All Debt Bombs”? from The Diplomat []
  28. Back in Fashion: China’s Bad Debt from The Wall Street Journal []
  29. Pamria Asset Management []
  30. No exit from China Economic Review []
  31. Private Equity in China: Which Way Out? from The New York Times []
  32. Chinese Headwinds Beset Private-Equity Highfliers from The Wall Street Journal []
  33. China Private Equity Chilled by ’Old Days’ Asking Prices from Bloomberg []
  34. See China’s Stocks Slump to Two-Month Low on Property Curbs from Bloomberg, Finding Investment Opportunities in a Tough Market from The Wall Street Journal and China IPO Hiatus May Prompt Smaller Firms to Seek HK Listing from The Wall Street Journal []
  35. This decline in IPOs is not a new phenomenon; even Hong Kong has had difficulties this past year.  See Bankers See Fees Fade as China Era of Jumbo IPOs Draws to Close from Bloomberg and Hong Kong Has Tough IPO Road Ahead from The Wall Street Journal []
  36. China Private Equity Chilled by ’Old Days’ Asking Prices from Bloomberg []
  37. Doubts Over Returns Hit Fundraising in China from The Wall Street Journal []
  38. See China IPO Hiatus May Prompt Smaller Firms to Seek HK Listing from The Wall Street Journal, Private Equity in China: Which Way Out? from The New York Times, Auditing Spat Dividing U.S. and China Turns Ugly from Caixin and MNCs in China and PCAOB deregistration from China Accounting Blog []
  39. Foreign auditing firms such as the Big Four are stuck between the proverbial rock and hard place.  On the one hand the SEC requires that these firms hand over audit documents to be verified and audited by the government, yet due to Chinese laws, the same auditing firms sometimes cannot hand over some of the documents as the audit documents are considered “state secrets.”  See Deloitte sued over audits of ChinaCast Education from Reuters and MNCs in China and PCAOB deregistration from China Accounting Blog []
  40. The IPO process has been frozen for six months in China because the security regulators are currently reorganizing both the process and the personnel involved in the approval process.  See Finding IPO Alley from Caixin []
  41. The private equity (PE) market has also been directly affected by other policies recently discussed in With Great Power Comes Great Responsibility from Peterson Institute for International Economics.  On the other side of the Pacific, PE and Chinese firms were recently discussed in Chinese Firms Take Lonely Buyout from The Wall Street Journal []
  42. In China IPOs, the Upside of Scarcity for Private Equity from The Wall Street Journal []
  43. Another short term area for opportunities may be as an auditor due to the large dispute between the US and China over potential delistings of Chinese firms from US credit markets.  See What U.S.-China Auditing Dispute Means for Chinese Business Culture from The Wall Street Journal, U.S. audit watchdog chief hopeful on China dispute from Reuters, Auditing Spat Dividing U.S. and China Turns Ugly from Caixin and MNCs in China and PCAOB deregistration from China Accounting Blog []
  44. Developing a Competitive Edge from Insight []
  45. Ibid []
  46. Fosun International Announces 2012 Interim Results Revenue and Net Portfolio Value Continue to Grow from PRNewswire []
  47. For a detailed explanation of criteria and challenges regarding Shanghai’s push to become an international financial center see Achieving 2020 from the Brookings Institute. []
  48. China Bankers Earn Less Than New York Peers as Pay Dives from Bloomberg []
  49. See Starting a business in China from the World Bank and New Path for Trade: Selling in China from The New York Times []
  50. Private Banks Enter ‘Golden Period’ in China from The Wall Street Journal []
  51. Ibid []
Send to Kindle