Current Issues in Applied Economics
Economics of Cyrptocurrencies
Ibrahim Inal
February 2018
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Introduction
At the end of this lecture:
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you should have a basic understanding of cryptocurrencies
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you should be able to understand the economics of
cryptocurrencies
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Some Questions
We will ask three related questions.
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What are cyrptocurrencies?
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Why on earth do we need cyrptocurrencies?
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Should we care about them?
To answer these questions we will briefly look into the technical
details (Do not worry this will not be a CS lecture)
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Centralized-Decentralized
Any system can be classified as centralized or decentralized.
For example, the US government (Federal vs. State) Networks
(Google vs. BitTorrent).
The former requires all data to pass through a singular point(server
or hub) whilst the latter do not. Instead, many points connect,
known as a P2P network
Centralized systems make
1. data collection extremely easy
2. information tracking easy
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Simple Description of Cryptocurrencies
We will mostly consider Bitcoin (Other CCs are similar though).
Definition
Bitcoin(or CCs in general), nothing but a big spreadsheet (like
LOTUS123 or Excel) - before it was called a ledger.
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The Bitcoin software
Wallet which
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stores bitcoins
creates node for the user in P2P network
provides access to ‘blockchain’
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Figure 1: Bitcoin Wallet GUI
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Money transactions
Although details are pretty complex in a nutshell to send money
one will use
I public key (think as account number) and it is shared
I private key (think as ticket that allows you to spend your
bitcoins) and it is private
Suppose that Alice has three bitcoins that she wants to give to
Bob. She publishes a message in the Bitcoin network indicating
that she is transferring three of her existing bitcoins, along with a
reference to the transaction where she had received those bitcoins.
Part of this message is encrypted by Alice’s private key to prove
that the instruction came from her, in a method akin to a signature
on a paper check. Later, if Bob wants to send bitcoins to Charlie,
he publishes a message, again encrypted with his private key,
indicating that he got his bitcoins from Alice and what he wants to
send to whom. The Bitcoin network identifies Alice, Bob, and
Charlie only by their public keys, which serve as account numbers.
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Blockchains and Mining
Each transaction is periodically grouped with others as a block and
added to the database by following particular rules and structure.
This is called block chains.
Keeping the transaction record operational and updated is a public
good. To encourage users to assist, the Bitcoin system periodically
awards newly minted bitcoins to the user who solves a
mathematical puzzle that is based on the pre-existing contents of
the block.
Upon solving the puzzle, the user publishes a “block” which
contains a proof-of-work that a solution was carried out along with
all observed transactions that have taken place since the last puzzle
solution was announced and a reference to the previous complete
block. After other users verify the solution, they start working on a
new block containing new outstanding transactions. This process
is called “mining” and recursively ensures that the total historical
ordering on all blocks (“chain”) is agreed by the entire network.
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Bitcoin’s Approach to Transaction Flow and Validation
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Why all the fuss then?
Bitcoin and (almost all) other CCs do not have a governance
structure
It challenges middle-man business model
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MM Model
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CCs as money
To call CCs money
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store of a value
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medium of exchange
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unit of account
There is little evidence of CCs being used as medium of exchange
or unit of account.
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Figure 2: Price volatility of Bitcoin
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What is Bitcoin?
Theoretically it has not functioned as money yet. It is a bit like
gold
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Like gold, supply is fixed
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Bitcoin mining sounds gold mining
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Like gold it is a hedge against inflation
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Both gold and Bitcoin are unregulated by banks
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Price of Bitcoin: Supply
How does the price of Bitcoin form?
Let us use a simple framework (See here for a complex model)
Suppose B represents the total stock of bitcoins in circulation and
P B denotes the exchange rate of Bitcoin (i.e., dollar per unit of
Bitcoin). So the total Bitcoin money supply is given by
MS = PBB
(1)
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Price of Bitcoin: Demand
By following quantity theory of money
M D V = PG
(2)
where M D is the demand for circulating Bitcoins in dollar
denomination, P is the price level of goods and services, G is the
size of the Bitcoin economy and V is the velocity of Bitcoin.
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Equilibrium
So the equilibrium price will be determined by
PB =
PG
VB
(3)
Yet, a more realistic equilibrium price should be
PB =
PG
S
VB
where S is the size of the speculation.
There is an evidence that S is quite important.
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QTM Revisited
The quantity theory of money
M V̄ = P Ȳ
implies that money increase would result inflation
For Bitcoin, however, QTM
M̄ V̄ = PY
implies price volatility. More particularly, deflation
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Using both fiat money and CCs
In the previous discussion we implicitly assume Bitcoin is the only
money. Suppose we have the usual money supply
M = LT (Y ) + LS (i)
and Bitcoin which can be used for transactions and speculative
purposes.
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Using both fiat money and CCs con’t
If people use Bitcoin for transaction purposes then the money
demand for transactions in national currency LT (Y ) decreases, say
by the share of x. So we have,
(1 − x)LT (Y ) = LT (Y ) − Lcc
T (Y , a)
with Lcc
T (Y , a) = x · LT (Y )
where a is the level of acceptance.
Question
How do Y and a affect the function Lcc
T?
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If people use Bitcoin for speculative purposes then the money
demand for speculation in national currency LS (i) decreases, say
by the share of z. So we have,
(1 − z)LS (i) = LS (i) − Lcc
S (i)
with Lcc
S (i) = z · LS (i)
Question
How does i affect the function Lcc
S ?
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Crowding Out
One thing we can conclude, without further math, is that Bitcoin
may ”crowd out” the national currency both as payment vehicle
and speculation asset.
This result is in line with the proposal of Hayek (1977) and
Gresham’s law.
It is this possibility- and many others- give rise to worries of
policymakers, especially CBs.
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Bitcoin: Advantages
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Fast-easy transactions
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Low transaction fee
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Anonymity etc.
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Bitcoin: Advantages
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Bitcoin: Advantages
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Bitcoin: Advantages
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Bitcoin: Disadvantages
Everything you can think as a ”good feature” of Bitcoin could be
interpreted ”bad feature” as well.
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Risks in CCs
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Market risk
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Shallow market problem
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Transaction risks
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Operational risks(protocol design etc.)
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Regulating CCs
Regulation for three criminal concerns:
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Bitcoin-specific crimes: Bitcoin thefts, attacks on mining
pools, DoS attacks
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Money laundering
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Bitcoin-facilitated crimes
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Bitcoin Checklist
Bitcoin promised
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Fast transaction
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No banks
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Low transaction fees
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Security
but...
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6 confirmation needed from miners, each block takes on
average 10 minutes to mine
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without a bank account it is very difficult to use bitcoin, even
for trading
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it reached levels higher than $50
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security issues (Mt Gox, personal, design problems)
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Looking Ahead
What is the future of Bitcoin and other virtual currencies?
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To replace credit cards for everyday consumer payments?
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To displace Western Union and other firms for international
cash payments?
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To supplant banks for short-term deposits?
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References
J. Sloman et al.
Economics : Chs.18-19.
Pearson, 2015.
Böhme et al.
Bitcoin:Economics, Technology, and Governance.
Journal of Economics Perspectives, 29(2):213–238, 2015.
Ali et al.
The Economics of Digital Currencies
Bank of England Quarterly Bulletin, 54(3):276–286,2014.
G.P. Dwyer.
The Economics of Bitcoin and Similar Private Digital
Currencies
Journal of Financial Stability, 17: 81–91, 2015.
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