What Popularisers of Cryptocurrencies Don’t Want You to Know


12/06/20

Charles Shaw – cshaw11@mail.bbk.ac.uk


Only a few years after their inception, Bitcoin and its digital decentralized currency cousins have evolved from being a mere technological curio to garnering intense interest on the part of businesses, consumers, policymakers, and central banks. Of course, it is not the first time that we have seen an emerging, retail-focused, highly speculative market that lacks a legal and regulatory framework comparable to other asset classes. But what appears to be different this time, however, is that these assets promise to replace trust in long-standing institutions, namely central and commercial banks, with trust in a novel, fully decentralised system founded on distributed ledger technology. Amidst the hype, it is worth critically examining whether such claims to fundamentally change the financial sector hold any water and which specific economic problems, if any, the current cryptocurrencies can solve.

The NSA white paper

As many people are by now are aware, the genesis of Bitcoin technology can be traced to when Satoshi Nakamoto (quite possibly a nom de plume) published a white paper on metzdowd.com, a cryptography mailing list. But fewer people will be aware that twelve years earlier, a group of National Security Agency researchers working at the NSA’s Office of Information Security Research and Technology published a paper entitled ‘How to Make a Mint: The Cryptography of Anonymous Electronic Cash’. The paper was published as a pre-print on a MIT mailing list [1] and, subsequently, in The American Law Review (Law et al, 1997). It is this 1996 paper that first described the basic protocols surrounding electronic cash, provided a cryptographic description of electronic cash in terms of basic authentication mechanisms and, crucially, outlined specific implementations for transferability and divisibility for off-line use [2].

Fast forward to present day and cryptocurrencies are traded in volumes that vastly exceed conventional stocks. The number of hedge funds that trade cryptocurrencies increased from 55 hedge funds in August 2017 to over 200, including some big hitters such as Renaissance Technologies’ Medallion fund. Admittedly, there is limited utility in comparing cryptocurrency metrics with established securities since tokens do not produce financial statements and few if any fundamentals are directly observable. But we can compare scale. At the time of writing this article, around $32 billion of Bitcoin is traded per day. By way of comparison, Apple trades roughly $4 billion a day in volume. CoinMarketCap.com reports 5,394 Cryptocurrencies being traded with 24h volume of $120 billion.

Although the cryptocurrency market is still relatively new, there have been a number of interesting developments. JP Morgan has substantive investment in blockchain technology, which underpins cryptocurrency transactions. Major futures exchange operators support trading in Bitcoin derivatives. Various banks trade in Bitcoin futures. Such involvement on behalf of institutional market participants makes it important to try and understand the financial implications of the wider adoption of this newly emergent asset class.

But to do so, we first must appreciate that the decentralised creation of trust has severe economic limitations. For trust to be maintained, the system requires the following functional requirements. First, the supply of the cryptocurrency needs to be predetermined by its protocol. Second, all users are required to verify the history of transactions. And third, honest network participants need to control most of the computing power. This decentralised consensus through which transactions are recorded is inherently fragile, meaning that trust can evaporate at any time. As a result, the finality of individual Bitcoin payments is called into question, although there have been attempts by coins such as Stellar, Ripple, and others to address this issue with the implementation of so-called Byzantine Fault Tolerance (BFT) which guarantees finality.

Now, let us step back and think about the fundamental roles of money in an economy. The essence of money is trust in the stability of its value. The institutional arrangements through which money is supplied matter a great deal, a fact which is illustrated by the numerous episodes of failed currencies, monetary instability, and unsuccessful attempts to create new private money. For all the hype surrounding them, the reality is that cryptocurrencies cannot scale with transaction demand, are prone to great jumps in price volatility, and their technology comes with poor efficiency. Resources are, by definition, wasted to mine tokens whilst the magnitude of the energy use involved is vast.

The issue of price volatility is of particular concern, and for the interested reader there exists emergent academic literature on this topic. In the applied econometrics literature, in particular, empirical studies of Bitcoin price dynamics find strong evidence of time-varying jump behaviour, see, for example, Chappell (2018) and the literature cited therein. Similar observations abound for intraday data. Studies looking at Bitcoin exchange data using high-frequency (transaction-level) time-series note the extreme volatility and apparent discontinuities in the price process, see for example Scaillet et al (2017). Based on this strand of research, it is possible to make two empirically motivated observations. First, it appears that jumps are an essential component of the price dynamics of the BTC/USD exchange rate. Second, it appears that jumps cluster in time: one can find runs of jump days that are incompatible with the assumption of, for example, independent Poisson arrival times. Factors such as order flow imbalance, illiquidity, and the dominant effect of aggressive traders are significant factors driving the occurrence of jumps, see, for example, Gronwald (2014).

Cryptocurrencies, by their design, do not rely on the stabilizing policy of a central bank. As a result, the reactions to new information – whether this information is spurious or fundamental – are prone to demonstrate high volatility relative to established assets. This volatility is modulated by the relative illiquidity of the market. Besides, the absence of official market makers would make cryptocurrencies fragile to large market movements. Again, from this point of view, cryptocurrencies represent a poor substitute for the institutional backing of money. This ought to be a concern for anyone with exposure to this emergent market. Even if we ignore the issue of perpetual deflation, the idea that Bitcoins and its cousins are preferable is premised on the view that currency stability is more important than flexibility. But this begs a question. Why should a consumer prefer an inherently volatile currency that will prevent the government from taking purposive action to prevent or lessen recessions? The answer is far from clear.

It is also not clear what economic problem Bitcoin solves by offering a decentralised money supply that operates outside the jurisdiction of traditional monetary authorities. If we recall some basic economics, then we will know that money is a coordination device facilitating transaction in the economy. To act as a coordination device, it needs to efficiently scale with the economy and be provided elastically to address fluctuating demand. These considerations require specific institutional arrangements as a result of which we have today’s accountable and independent central banks. This inevitably means agreed goals: clear financial stability and monetary policy objectives; administrative, instrument, and operational independence; and democratic accountability to ensure legitimacy and political support.

“Cryptocurrency is Not Money”

This is partially true. However, this is a somewhat difficult area. As a well-informed reader will know, money has three functions: medium of account, medium of exchange, and store of value. But these three are not all necessary. Medium of account is the most important one. The interested reader is invited to read Radford’s The Economic Organization of a P.O.W. Camp for an interesting perspective on what is and what is not money. As Fernandez-Villaverde and Sanchez (2016) point out, there is not a clear line separating money from money-substitutes and this can cause all kinds of problems for regulators.

However, Cryptocurrencies are different from other forms of central bank money such as cash or reserves, and the regulation of this nascent market not only raises new challenges but potentially calls for new tools and approaches. The increase in adoption of cryptocurrencies also highlights several policy questions, such as how to further protect consumers and investors, to better ensure the integrity of payment systems, and to provide more robust safeguards to overall financial stability. As the cryptocurrency market attracts increasing attention from retail and institutional investors alike, policymakers are rightly worried about consumer and investor abuses, as well as illicit use. And beware cryptocultists. 

Notes

[1] ‘How To Make A Mint: The Cryptography of Anonymous Electronic Cash’ (1996). http://groups.csail.mit.edu/mac/classes/6.805/articles/money/nsamint/nsamint.htm

[2] It is worth pointing out that the technology has evolved in the 12 years between the publication of the two papers. For instance, although the paper was based on the SHA-1 cryptographic hash function, NSA later invented the hash function that Bitcoin is predicated on, SHA-256.

References

Chappell, D. (2018) ‘Regime heteroskedasticity in Bitcoin: A comparison of Markov switching models’ MPRA paper 90682. Available at https://mpra.ub.uni-muenchen.de/90682/1/MPRA_paper_90682.pdf

Fernandez-Villaverde, J., and Daniel Sanches, D., (2016). ‘Can Currency Competition Work?’ NBER Working Papers 22157, National Bureau of Economic Research

Gronwald, M., (2014) ‘The Economics of Bitcoins – Market Characteristics and Price Jumps’ CESifo Working Paper Series No. 5121.

Law, L., Sabett, S. and Solinas, J. (1997). ‘How to Make a Mint: The Cryptography of Anonymous Electronic Cash.’ American University Law Review 46, no.4 (April 1997): 1131-1162. Available at http://digitalcommons.wcl.american.edu/aulr/vol46/iss4/6/

Radford, R.A., (1945) ‘The Economic Organization of a P.O.W. Camp’ in Economica, 12(48), p. 189–201, Reprinted in Geoffrey Ingham (ed.): Concepts of Money: Interdisciplinary Perspectives from Economics, Sociology and Political Science, series “Critical Studies in Economic Institutions” 8, Edward Elgar Publishing

Scaillet, O., Treccani, A and Trevisan, C., (2017) High-Frequency Jump Analysis of the Bitcoin Market. Swiss Finance Institute Research Paper No. 17-19. Available at https://ssrn.com/abstract=2982298