China's Bitcoin Ban Offers a Glance Into a Strategy to Protect Capital Reserves
“Other things being equal, we should prefer a demonstration which derives from fewer postulates or hypotheses.”
This quote from Aristotle is also known by another name. Occam’s Razor. Attributed to William of Occam, a 14th-century philosopher, Occam’s Razor is a problem-solving solution that suggests as long as the explanations fit the evidence, the solution with the fewest guesses is most likely to be true.
If, when you’re using Occam’s Razor the guess seems to raise more questions than answers, you’re moving away from simplicity and towards a more complicated solution. If the questions you ask raise more questions than answers, you’ll soon be lost in a fog of confusion.
Planet killer, Ponzi scheme, or a genuine store of value?
As someone who's interested in cryptocurrencies, you might not be interested in Bitcoin. You might think it’s got no future. You might think Bitcoin is unsustainable because of the cost of discovering a block, and you might think it’s unusable because of how difficult Bitcoin is to scale due to its transaction speed and cost. You might think it’s a giant scam and can’t believe we’ve all fallen for it. And with any of those views, you might be right.
But whatever you think of Bitcoin, it’s essential you take notice of what it’s doing because it represents 53% of the entire cryptocurrency market. Currently, Bitcoin is over 325% more valuable than Ethereum, the next largest coin, and accounts for over a third of all daily cryptocurrency volume.
The cryptocurrency market is highly correlated. When Bitcoin goes up, most coins go up, and when Bitcoin goes down, most coins go down. What you’re looking for is a decoupling, but until that happens, Bitcoin can be used as a quick way to figure out the general direction of the cryptocurrency you are interested in.
It’s natural for us to bombard ourselves with complex solutions to find answers to important questions. How many times have you thought to yourself that a solution can’t be right because it’s too simple? That’s Occam’s Razor inverted.
Maybe it’s a by-product of our education system, but we generally find it difficult to trust simple solutions to our problems.
But what if simple solutions could be used to answer difficult questions. How useful would this be?
How many piano tuners are there in the Chicago metro area?
Imagine you’re asked this question. Impossible right? Actually no. Not if you keep it simple.
In Thinking in Threes, we discussed the technique of asking simple questions about a market and trusting the answers. Let’s tackle the piano tuner problem the same way. Let’s ask some questions.
How many pianos are there in the Chicago metro area?
How often do they need tuning?
How long does it take to tune a piano?
How many hours does a piano tuner work in a year?
To answer question number one let’s guesstimate.
1. How many people live in the Chicago metro area?
Answer = 9,000,000.
2. How many households are there?
You guesstimate an average of two people per house. Remember, a lot of people live alone, so two per household is a reasonable guess.
Answer = 4,500,000.
You need to figure out how often a piano is tuned so let’s guesstimate it’s once per year.
3. How many households have a piano that is regularly tuned once per year?
You guesstimate 1 in 20, or 5%.
You’ve just asked three simple questions to come with a guesstimate of the number of pianos in Chicago.
And the answer is…
9,000,000 people divided by two per household equals 4,500,000 households. And 1 in 20 is 5%, therefore 4,500,000 x 5% equals 225,000 pianos that are regularly tuned.
Now you’re going to ask how long it takes to tune a piano?
You guesstimate two hours is a reasonable amount of time.
Finally, you’re going to ask how many hours a year a piano tuner works.
You figure a piano tuner works 50 weeks a year. They work five days a week and 8 hours a day.
And you guesstimate from this a piano tuner works a total of 50 weeks x 5 days a week x 8 hours a day to arrive at 2,000 billable hours a year.
Now you have the billable hours you can figure out the number of piano tunings per year by each piano tuner.
You guessed it takes about 2 hours to tune a piano, so 2,000 billable hours divided by 2 hours per piano gives 1,000 piano tunings a year.
If there are a total of 225,000 pianos that are regularly tuned and each piano tuner completes 1,000 tunings per year then 225,000 divided by 1,000 gives a total of 225 piano tuners in Chicago.
Wolfram Alpha gives the actual number as 290. But this is all musical instrument repairs. Assuming a high percentage of instruments will be pianos because pianos are the second most popular instrument behind electric guitars 225 is even more accurate.
All from asking a few simple questions.
Physicist Enrico Fermi used the technique of finding answers to complex problems using simple questions. Fermi worked on the Manhattan project (developing the first atomic bomb) during WWII, and after the war developed the world’s first nuclear reactor. Fermi was the master of guesstimating. He used the technique to estimate the strength of the atomic bomb by dropping pieces of paper from his hand during the blast.
Another way to show the power of guesstimating is to use a thought experiment.
You’re a golfer, and you’ve got to make a twenty yard put in two shots to win the tournament. The hole seems a long way off, and the run of the green is complex. Instead of trying to make the put, imagine the target is not the hole itself but a dustbin lid surrounding the hole. It’s a lot easier to get the ball within the circumference of a dustbin lid than it is to place the ball in a hole 4.25 inches wide.
This is the power of guesstimating.
Guesstimating is not about being perfect. It’s about getting you closer to the place where you can be effective.
Art Not Science
It’s May 2016, and you’re offered the following three bets.
On June 23rd the British people will vote to leave the EU.
Within 24 hours of the vote, the British Prime minister will resign.
Donald Trump will win the US election in November.
Two days before Brexit, you watch a live debate with five thousand people in the crowd. You notice the leave side is getting much better responses from the audience and putting forward a strong case. The stay team is not connecting. They’re somehow distant and not putting over the case in a way where the audience responds.
In other words, in front of a sample size of 5,000 people, the leave side is dominating the audience.
Two days later, a couple of hours after the polls close, you could still get 16 to 1 odds on the leave side winning. The market was pricing in only a 5.88% chance of the leave side winning the referendum, and this means they were pricing in a 94.12% chance of the stay side winning.
The polls were split, and after accounting for standard error, they were giving the odds as 1:1 or 50%.
After witnessing the sample size debate a couple of days earlier, 16 to 1 odds of the leave side winning is the value bet of the century. It should be priced at 50%. You can buy it for 5.88%. For those of you who aren’t familiar with betting or odds, this is a very rare mispricing.
David Cameron, the British Prime Minister, resigned the day after losing the Brexit vote.
On October 18th, 2016, Paddy Power, the 3rd largest bookmaker in the UK, paid out the bet on Clinton winning the election — nearly three weeks before the election.
On the day you could still get odds of 5 to 1 on a Trump victory. That’s pricing in the chance of a Trump win at 20% and a Clinton win at 80%.
By asking how polling companies use data from past elections, you would have seen a substantial mispricing opportunity. Polling companies weight data from the last three elections and use this as the basis for coming up with a number.
This method underestimated the number of voters who would come out for Trump and overestimated the number of voters who’d back Clinton.
Your return, if you’d have been able to get someone to underwrite combining the Brexit vote being leave and a Trump victory, was 85 to 1. A $500 risk wins $42,500.
Mis-pricing like this is rare. The point is, by using Fermi’s estimate technique, you’re placing yourself in a position where the explanations fit the evidence, and you’ve used just a few simple questions to get yourself within a dustbin lid of the prize.
No system, no matter how good, wins all the time. The 5% club, the consistently profitable, understand this. They focus on risk and money management, and not on future profits.
What if you could use Fermi’s guesstimating techniques and Occam’s Razor to figure out the likelihood of long-term conditions favourable to the mass adoption of blockchain technology? What if you could use this type of analysis to figure out the likelihood of the next catalyst for Bitcoin?
We asked if trust between nations was more likely to decline given the evidence of trade wars and a move towards the alt-right in western politics.
And if so, how does blockchain technology help to maintain the interconnected web of global supply chains? It’s because, in an environment of less trust, a technology that helps smooth or nullify the effects of less trust is more likely to succeed.
Bitcoin. Is it more likely to succeed or fail?
If you search, you’ll find a sea of arguments both for and against Bitcoin. How do you decide?
The future value of Bitcoin ranges from five hundred thousand dollars a coin all the way to zero, but who says you have to decide on Bitcoin reaching the stars or collapsing into oblivion?
You can learn a lot from the game of Poker. Specifically, Texas hold-em. The vast majority of players, around 90%, sit down at a table and do one of two things. They either bet on getting a big hand to showdown, or they play tight and aggressive.
Elite players can easily beat both strategies.
Deciding now if Bitcoin is on its way to $500,000 is like being a fish poker player betting on a hand that in reality has a tiny likelihood of being made, but it's how the majority think.
Take a tip from top poker players and play the game in front of you. Poker’s top players do this by understanding the possible range of hands you’re most likely holding. It's called reading the texture of the board. And by texture, I mean possible outcomes.
If you ask simple questions based on the evidence of what is actually happening, you’ll be able to adjust your expectations on the likelihood of Bitcoin regaining its title as the hottest game in town or imploding and continuing its descent. By asking the right questions and adjusting your expectations, you’ll be able to spot the windows in time where Bitcoin tips its hand.
What do you see? Bitcoin, in early September 2018, is in a sideways range after a down move. Since the 6th February 2018, Bitcoin has made four lows. The February low, a low in April, June, and the latest low in August. Each high in-between those lows are lower than a previous high. It's the definition of a downtrend.
Let’s take each low in turn.
The move off the February low was led by Ripple, Cardano, Litecoin, and Stellar. Bitcoin’s influence on the rally ended on the 17th February. The rally lasted twenty-seven days. Bitcoin demand continued for the first eleven. By the time of the high on the 5th March, the buying demand had gone.
Bitcoin then dropped back to the testing zone set by the 6th February low. You would expect this to happen because the previous rally was not lead by Bitcoin.
The rally off the 1st April low lasted thirty-four days. Bitcoin’s influence on the rally continued for the first nineteen days. The move off of the April low was lead by EOS, Stellar, and LiteCoin.
Again, because the rally wasn’t lead by Bitcoin, and because, like the first attempted rally, Bitcoin only participated in the demand for the first nineteen days, you expect Bitcoin to re-test the testing zone set up by the 6th February low.
The rally off the June low lasted thirty days. Bitcoin Cash, Stellar, LiteCoin, and EOS lead the move. Bitcoin’s influence continued for the first ten days.
If a rally in cryptocurrencies is not lead by Bitcoin, you have to treat the up move with caution. Why? Because Bitcoin represents over 50% of the entire market, and because Bitcoin volume far exceeds the volume of any other coin or token. This situation will last until there is a permanent decoupling between Bitcoin and the rest of the market. The cryptocurrency market is highly correlated, and until this breaks, Bitcoin, because it’s the dominant coin with most of the volume, should be leading the change in trend.
Hindsight is a wonderful skill. Now let’s get real.
What is happening at the hard right edge of the action?
On the fourth rally attempt, after testing the Bitcoin test zone three times, Bitcoin is leading the rally. Not only that, instead of just one or two of the top twenty coins (by market capitalisation) matching the relative strength of Bitcoin, this time several of the top twenty coins are matching Bitcoin’s strength.
What can you expect? Are you going to make a bet that Bitcoin will make new all-time highs? This is low probability thinking. It’s like the rookie poker player who is trying to make their pre-flop hand into a blockbuster at showdown. Bitcoin is still in a downtrend. It’s moving sideways within a range of prices from a testing zone low between $5,800 and $6,800.
A more realistic expectation is for Bitcoin to test the 24th July high of $8,500. It does not mean Bitcoin is going to $8,500. It means given the evidence of what is happening right now this is the best you can expect.
If you expect Bitcoin, because of the evidence, to test the $8,500 high, do you enter randomly? The 5% club don’t enter positions randomly. They ask questions about a market and focus on risk.
Bitcoin is currently trading at $7,223. In the 4th Dimension and Thinking in Threes we asked the question — Is anyone trapped?
The 5% club do not chase trades. If you enter now at $7,223, your first question should be — What’s my risk?
Traders who are long are right, and they’re in no hurry to get out.
What is the fear gauge telling you?
The fear-gauge is confirming there’s complacency on this timeframe and to expect a reversal down.
What about anyone who bet the market would go down?
The last day Bitcoin reversed was the 30th August, so that’s a day where some traders got caught. The low of this day is $433 away from your potential entry price.
Moving down a time frame from daily to 240 minutes helps find areas where traders were trapped.
The fear-gauge on the 240-minute chart confirms the 30th August low as the last point you should have considered entering this move.
Entering at $7,223 is not a high probability position because the level of complacency is too high.
The 5% club are patient and wait for positions where the risk to reward ratio of the trade is in their favour. Typically 3 to 1 at a minimum. If you have a 3 to 1 risk reward ratio, you only have to be correct 25% of the time to break even. (See Escape Velocity)
If you take a $433 risk, the 5% club would be looking for a 3 x $433 or $1,299 reward. The entry price plus the reward will bring the price to the previous high at around $8,500.
The trade will have to be perfection in terms of price movement, and the likelihood of that given the current market complacency is low. The $433 stop is also at an obvious position.
Why obvious? Bitcoin’s average true range is currently $234 per day, and the 95% often place their stops at 2x ATR.
In the 4th Dimension article, we talked about implied volatility and how it can be used to give an estimate of expected price movement.
The expected price movement is plus or minus $655 from $7,000. The obvious stop level of around $6,800 is easily within this range.
The 5% club prefer positions where their stops are outside of the range of normal movement. By doing this, they get binary feedback from the market they are positioning in. The 5% club generally prefer entering positions when the price is near the bottom of the expected range of movement. This way they can keep their stops closer, and this means the expected reward is a higher ratio of risk.
If they enter when the price is at the edge of the expected range, they could use a tight $200 stop. If the bottom edge of the expected range was $6,800, they could set their stop at $6,600. If they thought Bitcoin had a shot at testing the previous high at $8,500 that’s $1,700 instead of $1,267 away. And because they have reduced the risk, this means the risk-reward ratio of the trade is 8.5 times risk instead of 3 times risk.
The formula for Expectancy is
(%Win x Average Win) - (%Loss x Average Loss)
(11% x $850) - (89% x $100)
And this means they only have to be correct 11% of the time to be in profit.
The 5% club structure and enter their positions this way. To the 5% club, it’s all about context.
The 5% club ask questions regarding the market they are looking to enter. Questions like…
What is the level of fear?
What is the dollar amount of risk?
What is the risk/reward ratio?
What is the expected move?
How can the risk/reward ratio be improved?
What is the expectancy?
The 5% club build entries only after these factors have been figured out. They also look at the bigger picture. They look at the context of their entry location in relation to the market trend.
If Bitcoin is going to break out to new highs and start a new uptrend, it’s going to need a catalyst.
Some analysts are optimistic that China will lift its ban. If it does, then this could provide the trigger for Bitcoin to move into a new uptrend.
What are the chances of this happening and how do you find out? The 95% start googling and searching online for an opinion. The 5% club don’t. Instead, using the same technique that figured out the number of piano tuners in Chicago, they begin by asking questions.
China has aggressively dissuaded its citizens from buying Bitcoin, yet China dominates Bitcoin mining. Over 70% of all Bitcoin mining is Chinese owned.
In Heatseeker, we talked about how Warren Buffett, the world’s most successful long-term investor, makes decisions. Buffett asks simple questions, but before he invests the first question Buffett asks is, “What is the probability of this investment being exposed to catastrophic risk?”
China allows Bitcoin mining, yet it makes it difficult for its citizens to buy and sell Bitcoin. China has banned cryptocurrency initial coin offering (ICOs) and exchanges. Today, Chinese citizens are forced to use sites like LocalBitcoins to buy and sell. It’s slow and not convenient compared to an exchange.
The 5% club ask questions and assign probabilities.
Why has China banned ICOs and easy access to Cryptocurrencies?
Why does China allow Bitcoin mining? What would happen to the price of Bitcoin if China banned Bitcoin mining, given that over 70% of Bitcoin miners are Chinese?
What is the likelihood of China lifting its Bitcoin exchange ban?
Why has China banned Bitcoin trading and ICOs? China is a major exporter and maintains an edge by having an undervalued currency. The Chinese use a hybrid fixed peg to the US dollar to value the yuan. The yuan is free to move plus or minus 2% from the fixed peg. The current rate is 6.83 yuan to the US dollar.
China, like all developed countries, has a foreign currency reserve account. As US dollars flow into China via Chinese exports, China stockpiles the dollars, and doing this makes the value of the US dollars go up, and the value of the yuan against the US dollar go down. Remember, it’s in China’s interest to have the yuan undervalued because it makes Chinese exports more competitive.
If the stockpile of Chinese held US dollars goes down, this pushes up the value of the yuan against the dollar, making Chinese exports less competitive.
In 2016, the IMF (International Monetary Fund) added the yuan to its international basket of currencies called the SDR, or the Special drawing right. The advantage China gains from this is it gets to vote in IMF decision making. The United States currently dominates the decision making because the US is the only country within the IMF with the right to veto.
The yuan being part of the IMF currency basket allows China to form alliances with other countries and collectively aggregate enough of the voting power to challenge the United States dominance within the IMF. Because of the inclusion of the yuan into the IMF currency basket, China is likely to be more transparent and less likely to shock the financial markets with a yuan revaluation.
China wants the yuan to become a global currency. The United States has a substantial competitive advantage over the rest of the world because the US dollar is the accepted global reserve currency.
If the yuan becomes a truly global currency, then China will be able to price its exports in yuan, and not in US dollars. The world’s central banks will have to hold yuan in their foreign exchange reserves, and this will create yuan demand. Demand for the yuan will drive interest rates down in China because bonds denominated in yuan would be in high demand. Demand for bonds keeps interest rates low, and this will give Chinese exporters lower borrowing costs. Eventually, China will launch commodity exchanges, pricing global commodities in yuan and not US dollars.
China will challenge the United States global supremacy using these strategies. China is playing a long game.
China needs to control the flow of yuan across its borders. And Bitcoin at 2017 prices is a threat.
The problem China has is its stockpile of foreign exchange reserves is going down.
Currently, there are around 3.1 trillion US dollars in reserve. But this value has dropped by 25% since 2014. 3.1 trillion sounds like a lot, but unfortunately, a large percentage of this figure is not liquid. Of the 3.1 trillion, around 1 trillion is invested in non-liquid assets.
China has another problem too. Because of the rapid growth, China’s banks are believed to have a lot of “off the book” loans, and as much as a quarter of all loans could be bad. To protect the banks, China needs to ring-fence another 1 trillion US dollars.
It brings the liquid amount of US dollar reserves to around 1 trillion. If this sounds like a lot, it’s not. Currently, China has between 50 and 100 billion of capital reserve outflows per month.
If this is accurate, China has between 12 months and 24 months worth of reserves.
This is probably the real reason Bitcoin exchanges have been banned. The official line is they don’t want Chinese citizens exposed to fraud, but the more likely reason is they need to protect their capital reserves.
If this is true, then it’s highly unlikely China can be a catalyst for higher prices in Bitcoin.
It means the exact opposite. Bitcoin miners are at least 70% Chinese owned, and around 90% of the computing power used to uncover a new bitcoin block is controlled by a Chinese mining company.
If you wanted to kill Bitcoin how would you do it? (Apart from unplugging the internet.)
Ask yourself what would happen to Bitcoin prices if the Chinese government outlawed all Chinese Bitcoin mining?
By asking simple questions, you’ve discovered China has a liquidity squeeze on its foreign reserve account. You’ve discovered 50 to 100 billion of capital is flowing out of the country, and 50 to 100 billion is 5% to 10% of its available currency reserves.
It's an environment that can only be negative for Bitcoin because of the amount of global Bitcoin hash power that’s controlled by Chinese miners.
Using Enrico Fermi’s guesstimating techniques, you can build probabilities around specific outcomes. And using Occam’s razor, you can observe if the conditions you notice, conditions that are actually happening, match your expected result. If they do, you’ve uncovered an edge.