The Economics of Cryptocurrencies

J. Mark Munoz, Michael Frenkel, J. Mark Munoz, Michael Frenkel

• Publisher: Routledge
• Year: 2020
• Print ISBN:
  9780367191030
• eBook ISBN:
  9780429575686
• Topic: Economics
• Subtopic: Finance
• Index: Economics

Cryptocurrencies have had a profound effect on financial markets worldwide. This edited book aims to explore the economic implications of the use of cryptocurrencies. Drawing from chapter contributors from around the world, the book will be a valuable resource on the economics of cryptocurrencies. The intended audience is composed of academics, corporate leaders, entrepreneurs, government leaders, consultants and policy makers worldwide.

Over the past few years, the topic of cryptocurrencies has gained global attention and has been the subject of discussion in various news media, in policy-making bodies and government entities, and in financial institutions, classrooms and boardrooms. Despite widespread interest, much remains unknown on what the economic implications of cryptocurrencies are. This book enhances the reader's understanding of cryptocurrencies, its impact on industry and its implications on the political and economic environment. Drawing from chapter contributions from leading academics and thought leaders from around the world, this book is the definitive guide on the economics of cryptocurrencies.

There is scarcity of well conceived, academically grounded literature on the impact of cryptocurrencies on industry, politics and economics. This pioneering book provides up-to-date and in-depth analysis on the subject. The book will be appealing to academic communities, business professionals and entrepreneurs in their quest for better understanding the challenges and opportunities brought about by cryptocurrencies. Consultants, government officials and policy makers will find the information helpful in defining strategic pathways into the future.

Part I

Understanding cryptocurrencies

1 Cryptocurrencies in an economic context

An introduction

J. Mark Munoz and Michael Frenkel

Introduction

Cryptocurrencies are online protocols that serve as virtual currencies. The most famous cryptocurrency is bitcoin, which is based on a white paper published under the pseudonym “Satoshi Nakamoto” and which was launched in 2009. It aimed at creating digital money that would entail advantages that cash and other forms of currency do not offer. The notion of digital currency is not a new phenomenon. It was used in the 1990s through the use of value nodes through peer-to-peer payments (Clemons et al., 1996).

Cryptocurrencies have transformed the financial and economic terrain by reconfiguring the way money is transferred. Since the first cryptocurrency, bitcoin, was launched, it has become a global endeavor involving millions of individuals and organizations (Nakamoto, 2008; Hileman & Rauchs, 2017). Until mid-2016, the market of cryptocurrencies was not very dynamic, and total market capitalization was about USD 10 billion. A relatively short-lived hype in cryptocurrencies in 2017 led to a market capitalization that looked like a bubble with a peak at around USD 780 billion in January 2018. Although total market capitalization was down to USD 239 billion in mid-January 2020, the number of cryptocurrencies had increased significantly to more than 5,000 in 2020. However, most of the cryptocurrencies have a relatively low market capitalization. Bitcoin has by far the highest market capitalization (USD 158 billion), accounting for about two-thirds of the entire market (CoinMarketCap, 2020).

As Figure 1.1 shows, the market capitalization of bitcoin in early 2020 was only about half of what it was at the peak of the market in January 2018. However, average daily trading volume in early 2020 was about twice as high as in 2018.

Figure 1.1 Bitcoin market capitalization and trading volume, 2016–2020

The next most important cryptocurrencies are Etherium and Ripple with about ten and six percent of bitcoin’s market share, respectively (Figure 1.2). The share of the next most important cryptocurrencies goes down very fast. The number 100 in the ranking of the cryptocurrencies of more than 5,000 different coins, accounting for 0.01 percent, and number 1,000, accounting for just 0.0003 percent. After the peak of the cryptocurrency market, market capitalization of Etherium and Ripple, just like the vast majority of cryptocurrencies, declined much more than the market leader, bitcoin. However, their daily market volume has increased much more significantly than that of bitcoin.

Figure 1.2 Etherium (ETH) and Ripple (XRP) market capitalization and trading volume, 2016–2020

The technological architecture of cryptocurrencies

The use of cryptocurrencies has been revolutionary. Cryptocurrencies like bitcoin represent a new form of digital currency that uses computer cryptology. It makes use of the blockchain technology applying distributed ledger technology. Ledgers comprise a number of standardized “blocks” that include information on the change of ownership and thus on transactions (Lansky, 2018).

Its basic structure is a decentralized authentication system and is thus independent of a central institution like a central bank. It appears useful to compare this structure with other payment structures. For example, paying cash requires the physical presence of the two parties involved. The ownership requires protection so that it is not stolen. Sending money within an electronic payment system uses a central institution checking the legitimacy of owners and payments and keeping records on accounts. Such a system uses a central authority to avoid the so-called double spending problem, which arises if transfer files can be copied several times. The central authority provides verification and confirmation. Such a payment system requires that participants trust the central authority to record the transactions and to manage the central ledger correctly. Nevertheless, this system can be subject to hacker attacks and technical failures. It also carries the risk of interference and confiscation of governments. By contrast, bitcoin does not use a central authority. Instead, there is a network, in which everyone can manage his or her own ledger.

Cryptocurrencies are available for trade. The most common form for an investor to enter the bitcoin system is to open an account with one of many existing bitcoin exchanges, to which fiat money can be sent and then exchanged in bitcoins. The system is anchored on a ledge system that collates balances using public keys. The method for making a transaction entails a person, say, the buyer of some products, who possesses a private key and broadcasts a message in a peer-to-peer network. This message informs the network that the bitcoin address of the seller of the products is the new owner of the bitcoins. The network validates the transaction in a public ledger and commits a block in the ledger. Evidence of work is often utilized to prevent tampering of the block. Each block points to another block, creating a so-called blockchain. Cryptocurrency miners seek to create a new block through solving a complex mathematical problem. The incentive for miners to find a solution is to collect a reward. This reward is predefined and in the bitcoin system consists of receiving newly created bitcoins through the new transaction. When a miner finds a new block, the block is broadcasted in the peer-to-peer network for other miners to validate and start the mining process for the next block. The ownership is recorded in multiple copies in the network. The mechanism of verifying and storing information about transactions to all nodes, i.e., the consensus mechanism, is the central innovation of the blockchain system.

The consensus mechanism representing an agreement on the transaction is called “proof of work.” The number of participants in this peer-to-peer network is large, and every participant can remain anonymous (Berentsen & Schär, 2018). Even if the number of nodes increases or declines, the network is not endangered.

Contemporary economic features of cryptocurrencies

The cryptocurrency model has shifted financial transactions away from the use of central authorities (i.e., government institutions and banks) to the described system using cryptographic protocols. Cryptocurrencies set the stage for participation of millions of international and anonymous participants, thereby resulting in a profound economic impact.

At least ten attributes characterize cryptocurrencies in today’s global economic environment:

• Infancy: The cryptocurrency market is still in its early stages. The rate of its growth, usage and popularity will determine its future course.
• Evolvement: The nature of cryptocurrencies has been evolving largely due to changes in market perception and participation.
• Volatility: In recent years, the value of cryptocurrencies fluctuated heavily based on swings in market psychology and changes in supply and demand.
• Inclusion: Buyers and sellers of cryptocurrencies span the globe. Participants in its global trading have included private individuals, investment houses and corporations across many countries.
• Anonymity: Trading in cryptocurrency has been set up to keep trade transactions anonymous and confidential. The model prevents any entity from monitoring or blocking movements of funds.
• Legitimacy: The blockchain model supporting cryptocurrency creation has been created to optimize security and legitimacy of transactions.
• Energy: Mining of cryptocurrencies such as bitcoin requires the use of a lot of energy. Energy costs factors heavily into the viability of cryptocurrency mining.
• Location: Since energy costs vary across locations, cost of bitcoin mining varies from one location to another. Locations with lower energy costs tend to be more attractive to cryptocurrency miners.
• Technology: The creation and mining of cryptocurrency requires a significant level of technological competencies. Individuals and organizations that have a strong technological foundation can gain a unique competitive advantage.
• No oversight: Given the emphasis on privacy and security in cryptocurrency transactions, there is a lack of oversight and control of trading processes. Illegitimate as well as legitimate participation in the cryptocurrency ecosystem elevates transaction risk despite the sustainability of the model as a whole.

In the economic realm, these attributes suggest that countries differ in their ability to develop cryptocurrencies within the country or even to actively participate in cryptocurrency trading. Given the reliance on certain skills, technological infrastructure and government policies, there exist a variation worldwide in cryptocurrency usage across countries. The depth of the economic impact of cryptocurrencies therefore differs from one country to another.

Are cryptocurrencies money?

If cryptocurrencies function as money, they can have a significant impact on investment, consumption, money supply, prices and the development of wealth (Selgin, 2014). However, are cryptocurrencies money? Economists typically refer to the standard three functions of money: (1) money as a medium of exchange, (2) money as a unit of account and (3) money as a store of value. In order for cryptocurrencies to become a medium of exchange, one must be able use them to buy goods or assets. Common acceptance, low costs of transactions, divisibility, stability and protection from counterfeiting are among the prerequisites for a good medium of exchange, which increase the efficiency of the economy. While fiat money fulfills these conditions in most countries, bitcoin and other cryptocurrencies fulfill them to a much lesser extent. There are indications that bitcoin has mainly served as a medium of exchange for illicit purposes (Foley et al., 2018). As for other payments, the fact that cryptocurrencies have no intrinsic value and have shown high price volatility vis-à-vis other currencies has especially limited the willingness of economic agents to accept them as media of exchange. While some merchants and institutions have begun to accept bitcoins as a means of payment, such cases have so far been more of an exception. Other problems in this context are that transactions are costly because digital wallets are expensive to maintain and obtaining bitcoins is not as easy as obtaining fiat money (Yermack, 2015).

Money as a unit of account reflects that it is widely used as a numéraire to quote prices and thereby indicate the value of goods and assets. This function is important in the decision making about buying and selling and is therefore crucial for enabling and smoothing trade and investment. The main prerequisite for this function of money is stability because only then can economic agents design sensible financial plans and assess the value of goods and assets o...

Table of contents

• Cover
• Half Title
• Series
• Title
• Copyright
• Contents
• List of illustrations
• List of contributors
• Part I Understanding cryptocurrencies
• Part II Cryptocurrencies in industry
• Part III Political and economic implications of cryptocurrencies
• Index