Binance Bets the Farm
By Daniel Aronoff , MIT Department of Economics [1]
Abstract
Binance recently announced its intention to register a clone cryptocurrency exchange with US regulators to compete for US institutional investor business.[2] The plan has limited upside potential. Binance will face stiff competition from US exchanges like ICE that have deep ties to the institutional investor community. The downside for Binance is unlimited. The holding company’s operation of an unregulated exchange may off-put US investors, while Binance’s operation of a regulated exchange may frighten Chinese traders and others who require anonymity.
The Sudden Emergence of Binance
Binance is the world’s largest cryptocurrency exchange by legitimate daily trade volume. Binance started operations in mid-2017. In September 2017 China barred local crypto exchanges. Binance moved offshore ahead of other China exchanges, captured much of their China trading, and rapidly grew into the largest exchange in the world by trade volume. I believe Binance gained, and retains, a majority of the Chinese market in crypto trading and investment.[3] Despite — or as I shall argue, in part because of — its lack of regulatory compliance, Binance has earned the trust of the Chinese cryptocurrency community.
There are two important lessons to be drawn from Binance’s rise.
One lesson is that crypto investors can shift their trading between exchanges very quickly. They can also arbitrage between exchanges, which is evidenced by the extremely tight pairwise pricing across legitimate crypto exchanges reported in the March 2019 Bitwise SEC presentation.[4] The ease of movement between exchanges means that no single exchange possesses a network externality that would lock in traders. Rather, the network externality pertains to the group of legitimate exchanges and Binance’s rapid ascent demonstrates the ease of filling a niche that is not being served by incumbents. If Binance alienates its customers — say, by creating a worry that it might provide trading information to a regulator- it could lose the patronage of traders as quickly as it gained their business.
The second lesson is that Chinese investors are jittery; they will move out of exchanges which they perceive to be risky.
Binance has deftly threaded a needle by preserving anonymity whilst maintaining trust. Those are the two pillars of its success. It is a delicate matter, because operating without meaningful regulatory oversight creates space for exchange abuse.[5]
Cryptocurrencies as Bubble Assets
Today, the low transaction processing speed of cryptocurrenices precludes their widespread use as a transaction currency. While that may change tomorrow, today the value of crypto is speculative — which is socially and economically beneficial in certain circumstances.
Cryptocurrencies have the potential of becoming coordination bubble assets, by which I mean an asset that (i) does not generate any fiat revenue and (ii) attains its value by a coordinated consensus of opinion by its investors. Binance’s high level of exposure to a culturally affiliated group, Chinese people, may facilitate the spread of such a phenomenon, since both Chinese investors and the Chinese government can benefit from a bubble asset. This effect could potentially confer some increment of network externality onto Binance and/or value to its token BNB.[6]
The Chinese Crypto Market
Prior to the Chinese government ban on cryptocurrency exchanges in 2017, Chinese exchanges dominated Bitcoin trading.[7]
The figure shows Bitcoin to fiat, but it is reasonable to infer (a) that the relationship holds for all other cryptocurrencies and (b) that the majority of participants were Chinese citizens. Binance has gained a significant share of the Chinese investor market.
There are several reasons behind Chinese investor interest in crypto.
First, China has ill-defined property rights compared to OECD countries and, as documented by numerous scholars, provincial and local governments routinely engage in predatory behavior. Through its anonymity, crypto provides Chinese citizens with an investment that cannot be detected- and therefore confiscated — by the authorities.[8]
Second, the Chinese government has suppressed the development of a diversified capital market in order to retain influence over the allocation of investment in the Chinese economy. Limited opportunity for diversification of domestic investment engenders demand for offshore investment. The Chinese government maintains tight controls on capital outflows to suppress the enormous pent up demand among Chinese citizens to shift assets offshore. Crypto provides an avenue to evade capital controls. It is no accident that historically Bitcoin has traded at a premium in countries, like China, that have tight capital controls.[9]
Third, the Chinese economy is dynamically inefficient, which means its rate of investment is so high — China has the highest saving rate ever recorded for any country — that its investment actually lowers the volume of consumption expenditure for the current and all future generations from what it would have been at a lower level of investment.[10] The resultant lowering of investment returns explains another motive to move capital offshore, and hence the demand for cryptocurrencies.
The Chinese government can benefit from a bubble asset in two respects:
- The bubble reduces dynamic inefficiency by increasing interest rates and consumption.[11] The CCP leadership may be constrained by powerful constituencies from directly shifting resources from investment to consumption. A crypto bubble can accomplish the goal without any government directive.
- Crypto may, by providing a narrow channel for capital outflow, relieve some political pressure on the government while alleviating the need to suspend its anti-corruption campaign against customs and financial officials.
Binance’s exchange addresses these issues by providing Chinese citizens convenient access to cryptocurrency, which can be held privately and owned anonymously. However, in order to do so effectively, Binance needs to credibly convey that it will remain a trading venue that allows the parties trading on its platform to retain anonymity and it must be responsive to the implied preferences of the Chinese government.
Regulated vs Unregulated Exchanges
There are myriad benefits from gaining regulatory approval in the US and other OECD countries. The compliance requirements protect traders and investors from fraud and malfeasance. There is, inter-alia oversight and recourse if an exchange mis-appropriates trader funds, manipulates trade accounts or front-runs trades. Institutional investors, which control huge pools of capital, will not place significant funds in an unregulated exchange. In order to carry out its oversight responsibilities, OECD securities regulation requires that the exchanges obtain — and turn over to the regulator- information on the identity and trades of each participant on the exchange platform. [12]
The disclosure requirement, however, creates risk for people who desire anonymity. The fact that Chinese crypto investors appear to prefer unregulated exchanges suggests a key motive for anonymity is to avoid detection from a predatory state. There is, potentially, a huge market in China and other countries for this type of trading platform.
Of course, there are tax cheats, drug dealers, black-market arms dealers and other bad actors who also require anonymity. My purpose in this essay is not to pass moral judgment on the desirability of unregulated exchanges. That seems to be a complex issue. But rather to examine the risks and prospective rewards from Binance’s proposed move to create a US regulated subsidiary.
Betting the Farm
Suppose Binance achieves US regulatory approval for its new exchange. This may cause many Chinese customers to abandon Binance due to a perceived risk of disclosure, even if Binance creates a segregated regulatory entity. This can occur because traders may not trust-or understand — the separation. They will question whether the holding company might disclose the identities and trades on the supposedly non-regulated exchange. Who can predict? More importantly, why should people take the chance when it is so easy to migrate to other exchanges? Granted, it would require that a new ‘trusted’ unregulated exchange enter the market. Binance managed to do it, and so could a new entrant.
In the regulated market, Binance would face competition from immensely powerful US exchanges who already have deep ties with institutional investors, like ICE’s Bakkt, and institutional investors may be deterred from trading on Binance due to the negative reputation of the unregulated part of Binance. Moreover, there is at present no significant institutional investment in crypto. This market doesn’t even exist today.
Therefore, in seeking US regulatory approval, Binance is playing to gain a small slice of a currently nonexistent market. If the gambit backfires, it could lose everything.
[1]Daniel is a doctoral candidate in economics at MIT
[2] See e.g. https://techcrunch.com/2019/06/14/binance-begins-to-restrict-us-customers/}
[3] Chinese exchanges dominates crypto prior to China’s ban on exchanges. Changpeng Zhao has stated that Chinese traders are the core customer base of Binance. Some analysts estimate 85% of trading volume on the Binance exchange is from non-OECD parties
[4] https://www.sec.gov/comments/sr-nysearca-2019-01/srnysearca201901-5164833-183434.pdf
[5] Malta does not count as ‘meaningful’ regulatory oversight
[6] I am referring here to a ‘Schelling point’ in a coordination game. Schelling’s example is “Tomorrow you have to meet a stranger in NYC. Where and when do you meet them?”. The answer, replicated in many experiments, is “noon at the information booth at Grand Central Station”. It is important to keep in mind for this analysis that this coordination reflects common cultural knowledge about New York among subjects of the experiments. Where would people show up in Beijing if asked the same question? Probably only Chinese people -and maybe only those from Beijing and Hebei Province-would coordinate on the same venue. Thomas C. (1960). The Strategy of Conflict (First ed.). Cambridge: Harvard University Press.
[7] Makarov, Igor and Antoinette Schor (2018) Trading and Arbitrage in Cryptocurrency Markets MIT WP p.36.
[8] See, for example, Pei, Minxon (2016) China’s Crony Capitalism Harvard University Press
[9] Makarov and Schor
[10] The classic reference is Abel, A, Mankiw, N.G., Summers, L.H. & Zekhauser, R.J. (1989) Assessing Dynamic Efficiency: Theory and Evidence The Review of Economic Studies 56(1), 1–19. According to a recent study “China today is unquestionably in a serious state of dynamic inefficiency.” Luo, Kevin, Tomolo Kinugasa and Kai Kajtiani (2018) Dynamic efficiency in the world economy Discussion paper Kobe University p.1.
[11] See Diamond, Peter A (1965) National debt in a neoclassical growth model American Economic Review 55(5), 1126–1150.
[12] The regulatory requirement to disclose information on traders also serves other public policy goals, such as enforcement of anti-money laundering statutes and prevention of tax fraud.
