China’s Crypto Holdouts Test the Limits of Xi’s Decay

by Arthur · October 10, 2022

(Bloomberg) — This summer, word began to spread across Chinese social media about a conference in Dali, a city nestled among 4,000-meter-high peaks in the country’s southwest.

Most read from Bloomberg

Organizers expected fewer than 200 attendees, but ended up selling out the 1,000-person venue only to see more than double that number eventually show up for the August event. The theme of the gathering: crypto, the sector China’s government largely declared illegal a year ago.

Before the crackdown, China emerged as the epicenter of the crypto world, spawning giant exchanges such as Binance Holdings Ltd. and the largest Bitcoin mining companies. Beijing’s move to ban cryptocurrency trading and mining, announced in September 2021, appeared to bring the entire domestic industry to a halt.

That’s not exactly how things turned out. Instead, a mix of companies have emerged that emphasize the Communist Party’s agenda of promoting state-sanctioned blockchains and the digital yuan; some rogue Bitcoin miners; and crypto-entrepreneurs trying to scale their new firms without crossing any perceived red lines.

How China ends up dealing with remnants of the crypto sector will have major ramifications because digital assets ranging from Bitcoin to non-fungible tokens are at the heart of what advocates such as venture capitalist Marc Andreessen refer to as web3, or the next iteration of today’s internet.

Read more: Inside ‘Web3’, Crypto’s Plan to Retool the Internet: QuickTake

China has “three red lines: crypto trading, over-the-counter transactions and mining,” said Jason Kam, founder of Folius Ventures, an investment fund focused on Asian crypto startups. “At its core, the Chinese government is going to curb speculation and capital outflows, but for the rest of the web3, such as developers writing code, the government has a ‘one eye open, one eye closed’ approach.”

Finding the way

China’s decision in the 1990s to build the Great Firewall gave the CCP unprecedented power to restrict the free flow of information online and set the stage for an Internet industry from which Western companies such as Alphabet Inc.’s Google and Twitter Inc. are largely barred . The fear among many of China’s remaining crypto entrepreneurs is that the government will take a similar approach to Web3, stifling innovation and keeping internet users isolated from the rest of the world.

Interviews with more than a dozen industry participants based in China, ranging from founders to programmers and operations specialists, paint a picture of a sector trying to find its way by experimenting with new products and services in the hope that regulators won’t crack down. They all asked not to be identified for fear of inviting government scrutiny.

Researchers at Chainalysis Inc. who track crypto adoption around the world earlier this year noticed a surprising phenomenon: China was actually gaining ground on other nations, to such an extent that it ranked 10th in Chainalysis’ latest Global Crypto Adoption Index, up from 13th in 2021. “Our data suggest that the ban has been either ineffective or loosely enforced,” they wrote.

Read more: The $8.6 billion startup helping governments track crypto

“There are informal crypto markets that operate in something of a legal gray area,” said Kim Grauer, director of research at Chainalysis. “We’ve talked to merchants who are in sub-Saharan Africa and Latin America who are buying goods from China using cryptocurrency in this informal market capacity. We can see that people in China are still visiting large centralized exchanges.”

Home of “HBO”

For part of the industry’s short history, China was a crypto powerhouse. As recently as 2017, it was home to the world’s three largest cryptocurrency exchanges – Huobi, Binance and OKX, collectively known as HBO. At its peak, the country was estimated to account for roughly three-quarters of the world’s Bitcoin mining capacity. Cheap labor and sophisticated supply chains gave mining giants Bitmain Technologies Ltd. and Canaan Inc. an edge over Western rivals.

Such was China’s gravitas that crypto-entrepreneurs ranging from Ethereum co-founder Vitalik Buterin to FTX’s Sam Bankman-Fried flew there to seek funding for their fledgling ventures.

“China has always been one of the hot spot countries to stop at for any project that wanted to grow and strive for adoption,” said Edith Yeung, general partner at Race Capital, an early investor in FTX.

But China also has an uneasy relationship with widespread speculation, with the inevitable busts seen as a potential threat to the CCP’s grip on power. And few asset classes are as susceptible to speculative craze as cryptocurrencies. Officials were also concerned about money laundering and difficult to track currency outflows.

In September 2017, the central bank and other regulators banned exchanges from facilitating trade between fiat money and crypto and banned initial coin offerings, where issuers raise money by selling new tokens. Authorities also began discouraging energy-guzzling Bitcoin mining as President Xi Jinping sought to polish China’s environmental credentials.

The final accounting came in 2021. In May of that year, a regulatory body led by Vice Premier Liu He called for a full-scale crackdown on crypto mining and trading. Then, on September 24, the authorities banned all cryptocurrency transactions and promised to completely eradicate mining.

“Crypto transactions and crypto services of any kind are banned in China. No room for discussion. No gray area,” Henri Arslanian, then head of crypto and partner at PwC, declared on Twitter.

By then, Binance had already moved its business elsewhere. Two months later, Huobi would announce plans to move to Singapore and promise to sever ties with all users based in China (co-founder Leon Li recently sold his controlling stake). A large number of smaller crypto outfits also cracked down.

But even amid the carnage, there was still widespread enthusiasm for digital assets.

Dali Crypto Conference

When entrepreneurs, students and current and former workers at China’s major tech companies traveled to Dali in August for the crypto conference, Covid restrictions made a central location impractical. So the participants joined impromptu panels in bars and restaurants scattered around the city over three days.

Local officials were excited to host a conference on topics like the metaverse, said one of the organizers, who asked to be identified only by the first name Kai because of the sensitivity of the matter. Still, organizers were careful to toe the line, avoiding seeking sponsorship from crypto miners and centralized exchanges, Kai said.

At that conference, just as at a much smaller gathering in Beijing in September, discussions tended to revolve around web3, envisioned as a more decentralized version of today’s internet built around blockchains—the digital ledgers that underpin lot of crypto. And more specifically: Which areas within web3 are safe to pursue, given China’s restrictions?

Web3, as described by protagonists, involves things the CCP approves of (blockchains) and frowns upon (cryptocurrencies like Bitcoin and Ether). It also contains NFTs, the certificates of digital ownership that China’s government has embraced, at least in part.

How China Embraces NFTs, With Strings Attached: QuickTake

The ambiguity towards NFTs – for example, it’s fine to create and sell them, but trading them on secondary markets and using cryptocurrencies for settlement is prohibited – is partly what prompted Frank Chen, 26, to leave his job as chief product officer at Tencent Holdings Ltd. and found a project called Strxngers.

In August, Strxngers released their first batch of NFTs that resemble pixelated 80s-style video game avatars. They sold out in seconds, according to Chen.

“I chose NFT as an area to experiment in China because I don’t think the country is completely against it,” Chen said. “Before any regulation on digital collectibles comes out, there is a gray area that allows people to experiment.”

However, there are signs that even NFTs are making the authorities uneasy. In April, China’s banking, securities and internet finance associations warned of financial risks associated with such assets and barred industry members from offering trading venues or financing for them.

Even in areas the government has unequivocally declared illegal, enforcement has proven challenging at times. The latest data from the Cambridge Center for Alternative Finance shows that miners in China still accounted for 21% of global mining capacity in January, months after the ban. Cambridge said in May that the resurgence indicates “significant underground mining activity” in China.

The Chinese government has yet to adopt a comprehensive official position on web3. But at a conference in Shanghai in early September, Zhang Ping, a member of the Chinese Academy of Engineering, said that web3 poses a threat to China’s strategic interests, as previously predicted.

Instead, Zhang proposed a “permission-based” version of web3 tailored to the country’s own needs, with stablecoins pegged to the yuan and issued by commercial banks.

If anyone can be said to be the face of the CCP’s preferred version of web3, it might be He Yifan, CEO of Beijing-based Red Date Technology. The company operates a hub of sorts for developers to build applications for everything from NFT transactions to drug delivery tracking – all running on permission-based blockchains under government oversight.

Unlike a traditional blockchain such as Ethereum, transaction costs are denominated in fiat currency and set at 0.05 yuan per transaction. Daily transactions on Red Date’s Blockchain-based service network have increased to over 1 million, according to He, comparable to volumes on Ethereum.

“Crypto is about commerce and applications, and we are about the technical infrastructure,” he said. “Two completely different worlds.”

With the government appearing to favor the latter of those worlds, the mood at the Dali conference was one of mixed feelings: optimism about the business opportunities web3 brings to Chinese developers, and pessimism about China’s place in it, said Kai, the organizer.

“China is missing out on how the future of the internet will be structured,” said Race Capital’s Yeung.