An amazing chart from Morgan Stanley, cited by the Financial Times, sheds new light on the Bitcoin and cryptocurrency phenomenon. As is usually the case, good data and good stories are mutually reinforcing. The chart alone doesn’t tell us why things are happening, or even entirely what things are happening. Instead, it helps understand what events in the real world were significant. And offers evidence to support hypotheses, whether about the past or the future. Almost no piece of data from the chart is new, but seeing it laid out in one place is revealing.
Four Eras of Bitcoin
There have been four distinct eras in the relatively brief history of cryptocurrency. The early hobbyist days went from Bitcoin’s 2009 launch to the rise of two dominant platforms: the Mt. Gox exchange and the Silk Road dark marketplace. There was turmoil when both collapsed between late 2013 and early 2014. The price of Bitcoin plummeted from over $1000 to under $300, where it largely stayed for two years.
In 2014–2016, activity diversified away from Bitcoin, in two directions. First, Ethereum and other platforms generalized Bitcoin’s digital currency into a mechanism for decentralized applications and services. Second, enterprises and governments got excited about distributed ledger systems that added a permission layer to Bitcoin’s open network. These were the days of “blockchain, not Bitcoin.”
In 2017, the pendulum swung again, as the price of bitcoin and other cryptocurrencies suddenly took off. Initial coin offerings (ICOs) and cryptoasset trading were all the rage. The price of bitcoin briefly approached $20,000 in December 2017, bringing the total value of cryptocurrencies in circulation to roughly $750 billion. Millions of retail investors around the world piled in, hoping for massive gains. The Coinbase exchange’s mobile client was briefly the top download in the Apple App Store.
And then in early 2018, the market corrected. Bitcoin fell swiftly to roughly $8,000. Regulators such as the SEC started going after fraudulent and non-compliant ICOs, while China and South Korea banned them entirely. What’s surprising isn’t that the bitcoin bubble popped. Unlike 2013, it didn’t. It deflated in a relatively orderly way. The folk explanation is that cryptocurrency holders, convinced of the fundamental superiority of this form of money, will hold on (or HODL in the lingo) when normal investors would run for the exits, triggering a panic.
Now let’s look at the chart.
Remember, this isn’t a diagram of bitcoin prices; it shows what bitcoin sellers are exchanging it for. Yet all the market shifts are there. In early 2014, the market fell off a cliff with the death of Silk Road and, especially, Mt. Gox, which at its peak represented something like 80% of the bitcoin exchange market. That we know. What the Morgan Stanley chart highlights is where all the activity went: to China. (CNY is the Chinese currency, the yuan.) From mid 2013 to mid-2014, China went rapidly from a negligible share of bitcoin trading to virtually the entire market. There are a few possible explanations for this. Perhaps bitcoin/yuan volume spiked as a percentage when bitcoin/dollar volume cratered, even though it didn’t change much in absolute terms. Perhaps it related to Chinese dominance of bitcoin mining, which arose around this time. Miners earn newly-minted bitcoin, which they then often sell. Or perhaps something sparked an upsurge in bitcoin trading activity in China. It will take more data to answer this question.
The period from 2014–2016, when bitcoin prices were in the doldrums and the newer blockchain and distributed ledger technology (DLT) platforms were getting off the ground, was therefore also something else: the era of Chinese bitcoin hegemony. What’s odd is that the Chinese government during this period wasn’t exactly welcoming the spread of the cryptocurrency. It was clamping down, banning banks from engaging in bitcoin transactions. Reports from the time noted this paradox, but couldn’t explain it. There are two likely explanations. Ether the Chinese authorities didn’t appreciate, or didn’t care, that it was ground zero for bitcoin during a critical period of its development, because the activity was small and disconnected from the official financial system. Or they wanted it that way, so long as too much currency wasn’t leaking out of the country or being used for scams.
Then in spring 2016, there’s another massive shift reflected in the chart. Overnight, the bitcoin market leapt across the Sea of Japan. The Japanese yen went from marginal to the largest trading partner for bitcoin, a status it still appears to enjoy today. In this case, the precipitating event is not hard to identify. In March 2016, the Japanese cabinet approved bills declaring bitcoin and other cryptocurrencies to be legal forms of money, and authorizing exchanges subject to regulation. The prospect of a nearby global financial center expressly allowing cryptocurrency transactions, compared to their quasi-illegal status in China, was obviously compelling. In mid-2017 China banned exchanges from bitcoin/yuan trading, but as the chart indicates, the market had already shifted completely.
Strangely it seems, the biggest bull market in bitcoin history looks relatively stable on the Morgan Stanley chart, with yen remaining the dominant trading partner. And there’s no sudden phase transition like 2014 or 2016 when the bitcoin market reversed in 2018 either. Instead, there are two less dramatic yet very noticeable trends. One is the rise of “other” currencies, which become as large or larger a share of the market than yen at times. The chart doesn’t say, but these are almost certainly other cryptocurrencies, rather than fiat currencies issued by governments. The graph to the right shows that category representing 40% of all cryptocurrency trades today. In 2017, that represented the rise of ICOs, which mostly took in bitcoin or ether in return for their newly created tokens. The percentage of ICO transactions dropped in early 2018 according to the chart, but then stabilized, which is consistent with databases of ICO activity. The big driver of the Bitcoin bull market, it seems, wasn’t bitcoin at all. It was people buying bitcoin and ether as gateways to other tokens.
That brings us to the final stage of the market, so far. One question is why the price of bitcoin fell. A second is why it didn’t fall further. To answer the first, we need to look at another chart recently published by the Financial Times, this one based on analysis from blockchain analytics firm Chainalysis.
What happened around December 2017 is that long-time bitcoin holders (here labeled as investment coins) collectively cashed out some $30 billion to speculators. That much selling, in what remains by financial standards a thin market, is bound to push down the price.
So why wasn’t there more of a crash? Partly it’s the HODL factor. Those long-term investors sold a lot, but they kept a lot too, as shown in the bottom-most graph in the Chainalysis chart. Partly it’s residual optimism about cryptocurrencies, institutional money flowing into cryptoasset trading, and bitcoin taking share away from gold as a basic “store of value” immune from politics. But partly, it’s the last bit of the earlier Morgan Stanley chart.
The new entrant on the bitcoin trading scene at the very end of 2017 is a cryptocurrency called tether. Tether is a “stablecoin” which is, in theory, pegged to the value of the U.S. dollar. It is affiliated in poorly-disclosed ways with Bitfinex, a major cryptocurrency exchange. Over $2.5 billion of tether has been issued, supposedly backed 1-to-1 by U.S. dollar reserves, though no one really believes that. Still, all that tether became a huge destination for bitcoin. Tether essentially creates new buying pressure for bitcoin. The money stays in cryptocurrencies, because tether is not actually redeemable by right for dollars. So the price impact of the bitcoin selling is moderated.
There are valuable uses for a cryptocurrency stablecoin. Circle, a major cryptocurrency firm that has been scrupulous about regulatory compliance, announced its intent recently to create something that sounds suspiciously like tether, only without all the suspicious elements. For now, though, tether is the one determining the fate of the bitcoin market. Critics have identifiednumerous highly questionable aspects of tether, which its promoters have never fully answered. The announcement in late May that the U.S. Department of Justice (DOJ) and Commodity Futures Trading Commission (CFTC) of a criminal probe of cryptocurrency market manipulation could be the harbinger for action against tether. Whether or not that happens, the shift from a crypto-to-fiat market into a crypto-to-crypt-market is likely to define this next stage of development.
Where do we go from here? Too early to tell, and this analysis isn’t designed as investment advice. One lesson from the Morgan Stanley chart is that bitcoin itself hasn’t changed all that much technically in nearly ten years, but the bitcoin market has gone through tumultuous shifts. There’s no reason to believe it will look similar in 2020 to what it does today. The industry around cryptocurrencies is maturing, and it’s converging at points with the mature ecosystem of financial services companies. But there’s no way to read the Morgan Stanley chart that suggests a master trend rather than sharp reversals. It’s hard to imagine the volatility that has been one of its dominant characteristics going away any time soon. And as I hope to elaborate in a follow-up post, the chart confirms that the biggest factor in the bitcoin market is the very one it was designed to avoid: government policy decisions.