A recent report out of China may have solved the mystery of how Chinese bitcoin exchanges were able to remain profitable whilst operating on a zero fee platform.
Xinhua reported that the Huobi and OKCoin exchanges were investing customers’ funds into what are known as Wealth Management Products (WMPs): financial “shadow” products that exist outside of regular investment vehicles offered by financial institutions.
Exchanges Operating on Fractional Reserve Basis
While commonplace in China, the fact that a bitcoin exchange was investing customer funds in such investment vehicles, without user consent, means they were essentially operating — and profiting from — a fractional reserve system.
This would provide one reason why the Chinese government cracked down on local cryptocurrency exchanges, halting their operations and withdrawals, for such a long period in early 2017.
Rumors had been swirling for a number of years, with BitMex CEO Arthur Hayes writing back in 2015:
“I believe that Chinese exchanges act as shadow banks. They borrow at 0% from clients who wish to trade bitcoin, and lend out customer funds by purchasing China debt instruments.”
(h/t Tuur Demeester)
From the perspective of the exchange operators, perhaps the lure of easy money was just too strong. By attracting users with fee-free trading, the exchange could then use “idle” funds to purchase short-term, high-yielding WMPs. The result is free money for the exchange.
That’s as long as customers do not want their “idle” funds back — where a possible bank run scenario could develop — then the exchange profits.
According to the China Banking Wealth Management Registration System, the average WMP tracked “matures in 127 days”, enabling the exchange to “roll over” products on short timeframes, reducing the risk of an exchange run.
Bitcoiners May Not Be Aware of What’s Happening
One of the aspects of Bitcoin that sets it apart from other assets is its supposed non-correlation with traditional market practices. However, it seems Huobi and OKCoin, who led the way in BTC volume for a number of years, were taking such risks with customer funds that a Mt. Gox style exchange collapse could easily have occurred.
OKCoin’s terms and conditions do not make any mention of the use of customer funds, however they do state users must agree to arbitrate any dispute instead of suing in court. Further, arbitration must be exclusively undertaken in a Belize court.
— Tuur Demeester (@TuurDemeester) August 22, 2017
While these terms are broadly clear, there is no mention of using customer funds for investment purposes.
In general there is no recourse for investors if a WMP was to incur losses, as they exist in a shadow market where reserve requirement ratios (RRRs) are not enforced.
Don’t Worry, the Government Will Protect Us… Right?
Despite these risks, many Chinese reportedly believe there is little chance of the WMP industry — currently worth around $4.2 trillion — taking a hit. The belief is that there’s an implicit guarantee the Chinese government will not let the market collapse.
Similar thinking exists in Western countries, where in the post dot-com era (when former U.S. Fed chair Alan Greenspan lowered rates to spur the market) the sentiment is known as “The Federal Reserve Put” — or currently, “The Yellen Put”.
For Chinese investors, the sentiment is that the government is bluffing when it talks about tightening regulation in the asset management sector.
“Cracking down on implicit guarantees is just like curbing home prices… it’s something that the government needs to say, but it’s not something they will eventually do,” said Yang Mo, a 29-year-old public relations professional in Beijing.
The use of customers’ funds without their knowledge should be deeply worrying for the Bitcoin industry. A sudden WMP collapse could have a ripple effect for BTC holders, and essentially create a run on the exchange.
So while the actions of the CCP earlier in the year created plenty of innuendo and rumour, it may turn out to have been a blessing in disguise. If the failure of a large WMP were to have a domino effect on the market, at least now it seems Bitcoiners will once again be able to fall back on the “bitcoin user not affected” meme.
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