Pay to Play

Chinese Miner: I would like to build a new mine in China.

Beijing: Well Sheeeeeeit. Partner, you’re gonna have to pay to play.

The recent actions by Chinese authorities to stymie the growth of Bitcoin reminded me of John D. Rockefeller’s quest to tame the infantile oil market. Rockefeller was able to exert god-like control over the oil industry because he eradicated wildcatters.

Wildcatters were small outfits that drilled oil wells wherever they could. They were not organised, and this chaotic drilling reduced the lifespan of oil patches and caused intense volatility in the price of oil. The ways in which Rockefeller culled the wildcatters earned him the title of a Robber Baron.

The Chinese government and Rockefeller have many things in common. The Chinese government wants to control every aspect of the economy. When a new sector emerges, they allow fierce competition. Once a few winners have emerged they decimate the small fish, and present the survives with an offer they can’t refuse. Pay to play, or die.

The payment can be in many forms. But essentially Beijing can tap dat ass whenever it likes, and you better smile during the session. The Bitcoin mining industry is no different.

Local governments all vie to post earth shattering growth numbers every quarter. They will do anything in their power to achieve growth. Success guarantees a seat at the table in Beijing, and riches for your family.

For this reason, as well as overinvestment in aluminum production capacity, many poor parts of north western China have an abundance of electrical generation capacity. The boom in Bitcoin mining meant that anyone with capital and some connections at the local government level could profitably mine Bitcoin. Read the BitMEX Research report titled Mining Incentives – Part 2 – Why Is China Dominant in Bitcoin Mining, for a more indepth discussion of this topic.

The Chinese mining industry is dominated by a few large pool operators and miners. However, there are scores of smaller mining outfits. Beijing has little visibility into many of the smaller outfits. That could not continue forever.

A recently leaked document outlines how Beijing may block the propagation of Bitcoin blocks via the Great Firewall (GFW). Many correctly pointed out that miners could easily evade these measures through the use of VPNs. I brought this up with a laowai mining friend of mine during the recent Bitkan conference. He said that the use of a VPN or other means to evade the GFW would slow down the broadcast of your successfully mined block to the point where someone else would beat you to the punch.

In his opinion, these actions will kill all small mining outfits. The big boys can afford direct lines that bypass the GFW. Beijing sells these lines to compliant comrades, and can monitor all traffic. The fees paid are akin to a bribe to the government to continue operation. Absent this, you will be too slow to compete internationally. Now Beijing has complete control over the success or failure of your business, and you will pay whatever they ask.

He further added:

For instance, Inner Mongolia has relatively low population and economic growth. No one wants to move there. A few years ago the local Inner Mongolian government offered Chinese companies large pieces of land if they moved operations from other provinces. Each company who moved there actually got two titles, one for building manufacturing facilities and the other for strip mining coal.

The companies could cheaply and easily mine the coal for sale or build their own smaller coal power plants to run their operations. This led to a staggering amount of coal power plants in Inner Mongolia, most of them fairly small, around 50 to 250 MW.

After these companies moved there they were hit by the global slowdown in the commodity industry. Almost everyone of these factories started mining Bitcoin on the side. They write off miners as an equipment expense, and use the higher electricity usage costs to lower corporate profit and tax. In return they get a consistent side revenue that is not taxed.

While Bitmain is certainly the biggest miner in China, it by no means dominates. The vast majority of factories in Inner Mongolia and neighboring provinces are all doing this and collectively represent a significant amount of hash power.

I think this is the most likely the reason for the mainland crackdown on mining as all these factories are avoiding tax and laundering profits. By shutting things down at a network level that will force a greater centralization, the large players will then get licensed, and the government can regulate and tax them. In my opinion I don’t believe mining will be dead in China, I think it will become a permissioned industry.

The 21 million Bitcoin question is whether Beijing would use its new power to attempt to kill Bitcoin. Given that many local governments and senior members of the party profit from the continuation of mining racket, I believe the status quo suits Beijing.

Beijing’s treatment of the internet is an apt comparison for how I believe they will treat Bitcoin. Beijing tolerates the existence of VPNs, and sells private lines to bypass the GFW to certain organisations. Operation of a VPN seems cheap and easy to many readers; however, the vast majority of the Chinese masses are too poor to purchase a VPN, and more importantly have no desire. They are perfectly content with the China intranet, and have no desire to escape.

Beijing has no problem with the wealthy elite enjoying a few freedoms, as long as the mindset of the masses is not poisoned. A prime example is the job of a friend of mine in Shanghai. He re-taught elite Chinese students slated to study abroad the correct version of certain historical events. China has no problem with the masses being ignorant, but they don’t want their best and brightest to appear stupid vs. their international peers.

The recent closure of exchanges, banning of ICO fund raising, and the probable disruption of the Bitcoin network by poisoning block propagation, ensures that the masses may not enjoy the fruits of cryptocurrency, but the wealthy few can.

Time will tell whether Bitcoin and other cryptocurrencies present a real value proposition to the Chinese masses. If cryptocurrencies are like water, they will reach the lowest point given enough time. If they are not, then a small percentage of Chinese investors will continue to trade, invest, and use the technology.