Cryptocurrency

February 13, 2018

Cryptocurrency

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Cryptocurrency

Eli Dourado and Jerry Brito

From The New Palgrave Dictionary of Economics, Online Edition, 2014

Edited by Steven N. Durlauf and Lawrence E. Blume

Abstract

For most of history, humans have used commodity currency. Fiat currency is a more

recent development, first used around 1000 years ago, and today it is the dominant

form of money. But this may not be the end of monetary history. Cryptocurrency is

neither commodity money nor fiat money – it is a new, experimental kind of money.

The cryptocurrency experiment may or may not ultimately succeed, but it offers a

new mix of technical and monetary characteristics that raise different economic

questions than other kinds of currency.

This article explains what cryptocurrency is and begins to answer the new

questions that it raises. To understand why cryptocurrency has the characteristics it

has, it is important to understand the problem that is being solved. For this reason,

we start with the problems that have plagued digital cash in the past and the

technical advance that makes cryptocurrency possible. Once this foundation is laid,

we discuss the unique economic questions that the solution raises.

Keywords

anonymity; Bitcoin; Byzantine Generals Problem; censorship resistance;

cryptocurrency; cryptography; double spending problem; exchange rate indeterminacy;

mining pools; money; new monetary economics; open source;

peer-to-peer networking; proof of work; pseudonymity; trust; volatility

JEL classifications

E40; L31; F31; O30

Article

Technical overview

Cryptocurrency is the name given to a system that uses cryptography to allow the

secure transfer and exchange of digital tokens in a distributed and decentralised

manner. These tokens can be traded at market rates for fiat currencies. The first

cryptocurrency was Bitcoin, which began trading in January 2009. Since then,

many other cryptocurrencies have been created employing the same innovations

that Bitcoin introduced, but changing some of the specific parameters of their

governing algorithms. The two major innovations that Bitcoin introduced, and

which made cryptocurrencies possible, were solutions to two long-standing

problems in computer science: the double-spending problem and the Byzantine

Generals Problem.

Double spending

Until the invention of Bitcoin, it was impossible for two parties to transact

electronically without employing a trusted third party intermediary. The reason was a

conundrum known to computer scientists as the ‘double spending problem’, which

has plagued attempts to create electronic cash since the dawn of the Internet.

To understand the problem, first consider how physical cash transactions work.

The bearer of a physical currency note can hand it over to another person, who can

then verify that he is the sole possessor of that note by simply looking at his hands.

For example, if Alice hands Bob a $100 bill, Bob now has it and Alice does not.

Bob can easily verify his possession of the $100 bill and, implicitly, that Alice no

longer has it. Physical cash transfers are also final, in the sense that to reverse a

transaction the new bearer must give back the currency note. In our example, Bob

would have to hand the $100 bill back to Alice. Given all of these properties, cash

makes it possible for different parties, including strangers, to transact without trusting

each other.

Now, consider how electronic cash might work. Obviously, paper notes would

be out of the picture. There would have to be some kind of digital representation of

currency. Essentially, instead of a $100 bill, we might imagine a $100 computer file.

When Alice wants to send $100 to Bob, she attaches a $100 file to a message and

sends it to him. The problem, as anyone who has sent an email attachment knows, is

that sending a file does not delete it from one’s computer. Alice will retain a perfect

digital copy of the $100 she sends Bob, and this would allow her to spend the same

$100 a second time, or indeed a third and fourth. Alice could promise to Bob that

she will delete the file once he has a copy, but Bob has no way to verify this without

trusting Alice.

Until recently, the only way to overcome the double spending problem was to

employ a trusted third party intermediary. In our example, both Alice and Bob would

have an account with a third party that they each trust, such as PayPal. Trusted

intermediaries like PayPal keep a ledger of all account balances and transactions.

When Alice wants to send $100 to Bob, she tells PayPal, which in turn deducts the

amount from her account and adds it to Bob’s. The transaction reconciles to zero.

Alice cannot spend the same $100, and Bob relies on PayPal, which he trusts, to

verify this. At the end of the day, all transfers among all accounts reconcile to zero.

Note, however, that unlike cash, transactions that involve a third party intermediary

are not final, as we have defined it, because transactions can be reversed by the third

party.

In 2008, Satoshi Nakamoto (a pseudonym) announced a way to solve the double

spending problem without employing third parties (Nakamoto, 2008). His invention,

Bitcoin, is essentially electronic cash. It allows for the first time the final transfer, not

the mere copying, of digital assets in a way that can be verified by users without

trusting other parties. This is accomplished through the clever use of public key

cryptography, peer-to-peer networking and a proof-of-work system.

Like PayPal, the Bitcoin system employs a ledger, which is called the block

chain. All transactions in the Bitcoin economy are recorded and reconciled in the

block chain. However, unlike PayPal’s ledger, the block chain is not maintained by a

central authority. Instead, the block chain is a public document that is distributed in a

peer-to-peer fashion across thousands of nodes in the Bitcoin network. New

transactions are checked against the block chain to ensure that the same bitcoins

have not been previously spent, but the work of verifying new transactions is not

done by any one trusted third party. Instead, the work is distributed among thousands

of users who contribute their computing capacity to reconcile and maintain the block

chain ledger. In essence, the whole peer-to-peer network takes the place of the one

trusted third party.

Byzantine Generals Problem

Bitcoin’s solution to the double spending problem – distributing the ledger among

the thousands of nodes in a peer-to-peer network – presents another problem. If

every node on the network has a complete copy of the ledger that they share with the

peers to which they connect, how does a new node connecting to the network know

that she is not being given a falsified copy of the ledger? How does an existing node

know that she is not getting falsified updates to the ledger? The difficult task of

reaching consensus among distributed parties who do not trust each other is another

longstanding problem in the computer science literature known as the Byzantine

Generals Problem, which Bitcoin also elegantly solved.

The Byzantine Generals Problem posits that a number of generals each have

their armies camped outside a city that they have surrounded. The generals know

that their numbers are large enough that if half their combined force attacks at the

same time they will take the city, but if they do not attack at the same time they will

be spread too thinly and will be defeated. They can only communicate via

messenger, and they have no way of verifying the authenticity of the messages being

relayed. They also suspect that some of the generals in their ranks are traitors who

will send fake messages along to their peers. How can this large group come to a

consensus on the time of attack without employing trust and without a central

authority, especially when there will likely be attempts to confuse them with fake

messages?

In essence, this is the same problem faced by Bitcoin’s ‘miners’, the specialised

nodes that verify new transactions and add them to the distributed ledger. Bitcoin’s

solution is to require additions to the ledger to be accompanied by the solution to a

mathematical problem that is very difficult to solve but simple to verify. (This is

much like calculating prime factors; costly to do, but easy to check.) New

transactions are broadcast in a peer-to-peer fashion across the network by parties to

those transactions. Miners look at those transactions and confirm by checking their

copy of the ledger (the block chain) that they are not double-spends. If they are

legitimate transactions, miners add them to a queue of new transactions that they

would like to add as a new page in the ledger (a new block in the block chain).

While they are doing this, they are simultaneously trying to solve a mathematical

problem in which all previous blocks in the block chain are an input. The miner that

successfully solves the problem broadcasts his solution to the problem along with the

new block to be added to the block chain. The other miners can easily verify

whether the solution to the problem is correct, and if it is they add that new block to

their copy of the block chain. The process begins anew with the new block chain as

an input of the problem to be solved for the next block.

The mathematical problem in question takes an average of 10 minutes to solve.

This is key because the important thing is not the solution itself, but that the solution

proves that the miner has expended 10 minutes of work. On average, a new block is

added to the block chain every 10 minutes because the problem that miners must

solve takes on average 10 minutes to solve. However, if more miners join the

network, or if computing power improves, the average time between blocks will

decrease. To maintain the rate at which blocks are added to six per hour, the

difficulty of the problem is adjusted every 2016 blocks (every two weeks). Again,

the key here is to ensure that each block takes about 10 minutes to discover.

How does this solve the Byzantine Generals Problem? Suppose that a miner is

confronted with two competing block chains (just as a general might receive

messages with different attack times). To choose which chain to accept and work to

extend, a miner can look to see which is longer; that is, which chain has had the

most processing power devoted to it. By always choosing the longest chain, an

honest miner can ensure that he is in the company of at least 51% of the other

honest miners. The gap between the longest chain and competing chains will

grow as time passes, since the longer chain will have more processing power

behind it.

New blocks contain not just the new transactions that have been broadcast on

the network, but also a transaction that assigns the winning miner 25 newly created

bitcoins, which incentivises them to dedicate their computing capacity to the

network. The size of the reward to miners that accompanies new blocks also halves

every 210,000 blocks (every four years). The reward began at 50 bitcoins with each

block when the network was launched in 2009. Today the reward is 25 bitcoins and

will halve again to 12.5 in 2016. This means that the total number of bitcoins that

will ever exist will not exceed 21 million. As mining rewards diminish, what

incentive will miners have to lend their computing power to verify transactions? The

answer is that parties to a transaction can include a transaction fee to be paid to the

miner who successfully adds their transaction to a block in the block chain.

The economics of cryptocurrency Governance

Cryptocurrencies do not have central banks to regulate the money supply or oversee

financial institutions, but no one should neglect the importance of cryptocurrency

governance institutions. We focus our discussion on two separate but interrelated

ways that cryptocurrencies can be said to be governed.

Algorithmic governance

Rules for what are considered valid cryptocurrency transactions are embedded in the

peer-to-peer software that cryptocurrency miners and users run. One valid kind of

transaction is the creation of new coins out of thin air. Not everyone can execute this

kind of transaction – miners compete for the right to execute one of these

transactions per block (on Bitcoin, every ten minutes or so). When a miner discovers

a valid hash for a block, they can claim the new coins.

A transaction in which a miner claims new coins, like any other transaction, has

to conform to the expectations of the network. The network will reject a block that

contains a transaction in which a miner awards themselves too many new coins. The

growth of coins is limited by a pre-determined amount per block.

On Bitcoin, the pre-determined amount is not scheduled to be constant over

time, but rather is set to halve every 210,000 blocks, or about every four years, as

described above. The total supply of bitcoins will asymptotically approach, but never

exceed, 21 million. It will reach 20 million in 2025 and stop growing altogether in

2140.

Open source governance

The astute reader will note that the Bitcoin software that enforces particular rules

about valid transactions and the rate of money creation does not appear out of thin

air. Rather, the rules embedded in the software emerge from an interplay between

leaders of the open source project that manages what is known as the ‘reference

client’, other developers, miners, the user community and malicious actors. The

dynamic between these players is as crucial to understanding Bitcoin as that of

central banks, traditional monetary institutions and monetary politics is to

understanding fiat currency.

Bitcoin, like all other even moderately successful cryptocurrencies to date,

is a non-proprietary open source project. Users tend to look with suspicion on

cryptocurrency projects that are closed source, that feature significant pre-mining in

order to reward insiders, or that have other proprietary features. Other expectations

of the user community also impose a check on developers. For example, the hard cap

of 21 million bitcoins, while in principle subject to change through a software

update, appears to be non-negotiable for Bitcoin, although other cryptocurrencies

have different money supply rules.

The division of Bitcoin software into a ‘reference client’ and so-called

‘alt-clients’ also has implications for Bitcoin’s evolution. The community looks to

the Bitcoin Core team for leadership as to the direction of the network. An

alternative approach would be for the community to agree on the specification for

the network, and then let independent teams write clients that implement the

specification. The fact that Bitcoin has such a dominant reference client means that

evolution can occur more quickly, although it may also have hidden costs. For

example, the community has to put a lot of trust in the Bitcoin Core developers not

to make bad changes to the network. A less concentrated approach to cryptocurrency

development would slow down development, which would prevent any changes to

the network without full deliberation of the community. It’s possible that over time

Bitcoin could move more to this model, but for now, the advantages of rapid

evolution might outweigh the costs.

Miners also play an important role in governance. Because miners

cryptographically guard against double spending, their consensus on what counts as

a valid transaction is necessary for a cryptocurrency to function. A majority of

miners must adopt any change to Bitcoin, and therefore the miners are able to

impose a check on developers. Miners also exert influence through mining pools.

Miners join pools in order to earn a more consistent payout. A single miner working

alone might go for some time without discovering a block. But if miners pool their

work and split their rewards, they can earn daily payouts.

Mining pools raise complications. For example, the biggest Bitcoin mining

pool often has a third or more of the computing power of the Bitcoin network. If a

pool ever obtained more than half of the network’s computing power, it could

double-spend. Double spending would destroy confidence in the Bitcoin network and

would likely cause the price of bitcoins to plummet. Consequently, we observe some

self-regulation by the mining pools, which are heavily invested in the success of Bitcoin.

Whenever the top pool starts to approach 40% or so of computing power of

the network, some participants exit the pool and join another one. So far this norm

has persisted, but many in the community are concerned about mining pool

concentration. Recently, the GHash.IO mining pool briefly exceeded 50 percent of

Bitcoin’s mining power. There is no evidence that the pool used its position to

double spend, but many observers were alarmed that it was able to happen.

Concentrated mining pools have benefits as well as risks. In a crisis, it is useful

to be able to assemble the key players. Such a crisis occurred on the night of

11 March 2013, when it became clear that a change in version 0.8 of the reference

client introduced an unintentional incompatibility with version 0.7. As a result of the

incompatibility, the two implementations of Bitcoin rejected each other’s blocks, and

the block chain ‘forked’ into two versions that did not agree on who owned which

bitcoins. Within minutes of the realisation that there was a fork, the core developers

gathered in a chat room and decided that the network should revert to the 0.7 rules.

Over the next few hours, they were able to confer with the major mining pool

operators and persuade them to switch back to 0.7, sometimes at a non-trivial cost to

the miners who had mined coins on the 0.8 chain. The fact that mining pools are

relatively concentrated meant that it was relatively easy to coordinate in the crisis.

Within about seven hours, the 0.7 chain pulled permanently ahead and the crisis was

resolved.

Another problem occurred in February 2014 when Mt. Gox, the oldest and

largest Bitcoin exchange, claimed that its bitcoin holdings had been depleted through

‘transaction malleability’ attacks. Although it remains unclear whether Mt. Gox

losses were really due to attacks, it became clear over the next several days that

misunderstandings about transaction malleability were creating vulnerabilities. Some

Bitcoin sites temporarily suspended withdrawals while the issues were addressed by

the core development team, which updated the Bitcoin software and helped educate

the community about transaction malleability, which, when properly understood, is a

feature of Bitcoin, not a bug.

There is considerable scope for further study of cryptocurrency governance.

Medium of exchange versus unit of account

Bitcoin’s lack of a central bank and fixed-trajectory money supply have earned it

some criticism from economists concerned about macroeconomic stabilisation.

Countercyclical inflationary stimulus is impossible.

However, this criticism may be misplaced. On most Keynesian and monetarist

theories of monetary non-neutrality, the macroeconomic properties of money inhere

in its unit-of-account function. Bitcoin is typically used as a medium of exchange

without serving as a unit of account; that is, transactions will be denominated in

dollars or another currency, but payment will be made using bitcoins. Unless prices,

wages and contracts come to be denominated in Bitcoin, we would expect use of

Bitcoin to have little cyclical impact.

Cryptocurrencies have a number of properties that make them especially useful

as media of exchange, if not as units of account. Unlike paper money, they can be

transacted online as well as in person, if an Internet connection is present. Unlike

credit cards, the network fee for a simple cryptocurrency transaction is low and

voluntary; it is used to incentivise rapid processing of transactions by the miners.

Credit card networks typically charge a swipe fee of 25b plus about 3% of the value

of the transaction. On the Bitcoin network, transaction fees are at most a few

pennies. Some retailers use merchant services to accept Bitcoin-denominated

payments and have the equivalent amount of dollars deposited directly in their bank

accounts. The service providers commonly charge a 1% fee for this convenience,

though this may decrease as hedging costs go down (discussed below). Even with

this conversion fee, merchants save 2% or more on transactions via the Bitcoin

network. Another feature that could attract merchants is that customers who disavow

a purchase cannot reverse most Bitcoin transactions, as they can credit card

transactions.

In its separation of the medium of exchange and the unit of account,

cryptocurrency brings to life some creative research from the 1970s and 1980s by

economists such as Fischer Black (1970), Eugene Fama (1980), Robert Hall (1982)

and Neil Wallace (1983). These authors regard the received monetary economics as

highly contingent on legal and institutional arrangements; under laissez faire, they

argue, we would observe explicit or implicit prices on media of exchange and a

breakdown in the distinction between money and other financial assets. While

cryptocurrency remains a niche payment mechanism and existing monetary

institutions remain dominant, experimentation at the edges of our current monetary

system with Bitcoin and other new cryptocurrencies could be fertile ground for new

research in this tradition.

Pseudonymity and censorship resistance

Early news reports on Bitcoin focused on its use on the online black marketplace

Silk Road. These reports propagated the misconception that Bitcoin transactions are

anonymous. In fact, Bitcoin’s ledger (called the block chain) is a completely public

document. There is therefore a publicly accessible record of every Bitcoin transaction

ever made. Bitcoin transactions occur between Bitcoin addresses, which are strings

of random numbers and letters (a cryptographic hash of the address’s public key).

While there is no meaningful name attached to a transaction on the block chain,

Bitcoin addresses function as pseudonyms for users. If a Bitcoin address can be

identified as belonging to a particular individual, then all of the transactions on the

block chain using that address can be attributed to that individual.

Users can take several steps to obfuscate identities and preserve some measure

of financial privacy. They can generate and use a virtually unlimited number of

addresses (there are 2160 valid Bitcoin addresses). It is considered best practice for

merchants to generate a new receiving address for every transaction in order to

protect their customers from scrutiny and to prevent espionage from competitors. It

is also becoming increasingly common for transaction processors to collate several

transactions into a single one so that no one knows which address is paying which.

If Alice wishes to pay Bob and Charlie wishes to pay David, a single transaction in

which Alice and Charlie put in money and Bob and David take it out can make it

unclear who is paying whom.

Despite the availability of these steps, the Bitcoin network remains vulnerable

to sophisticated analysis. Meiklejohn et al. (2013) were able to trace bitcoins from

well-known thefts through the network to centralised services such as exchanges,

which in principle could be subpoenaed to reveal the identities of the criminals. They

used only publicly available data; a well-equipped law enforcement agency could

de-anonymise the network even further.

Although transactions are not fully anonymous, Bitcoin represents a significant

shift in the enforcement burden for illegal transactions. Because non-cryptocurrency

electronic payments pass through financial intermediaries, governments can enforce

restrictions on transactions by regulating those intermediaries. A drug dealer cannot

generally accept Visa payments because Visa will not approve a merchant whose

business is dealing drugs. Illegal Bitcoin transactions may be subject to ex post

punishment, but they are not subject to prior restraint through the regulation of

financial intermediaries. This could have a significant effect on the number and kind

of laws that governments are able to economically enforce.

Future developments in cryptocurrency technology could bring strong

anonymity to Bitcoin or another currency. Zerocash is one proposed anonymisation

system that could either be added to a future iteration of Bitcoin or released as its

own currency. The strong anonymity provided by Zerocash or a similar system could

have significant implications for governments who rely on controlling the financial

system to enforce laws.

Pricing and volatility

Bitcoin traded over $1 for the first time in February 2011, for $30 in June 2011,

below $7 in July 2011, below $2.50 in October 2011, climbed back up to $10 by

August 2012, to over $230 in April 2013, fell to below $70 within a week and rose

to over $1100 in November 2013 before falling by several hundred dollars again

(see Figure 1). This volatile trend raises questions about the price of

cryptocurrencies: What is the fundamental value of a Bitcoin? Why is Bitcoin so

volatile? What could increase or decrease the volatility of Bitcoin in the future?

7/1/2010

7/1/2011

7/1/2012

7/1/2013

7/1/2014

100

Price (USD) Log Scale

1000

Figure 1 The price of Bitcoin. (Source: Bitcoin Price Index data from CoinDesk

http://www.coindesk.com/price/.)

Since Bitcoin is not asset-backed, its value as a currency can only lie in its

usefulness as a medium of exchange. As we have discussed, in some contexts,

Bitcoin is superior to cash (e.g. it can be used online) and credit card payments

(it is cheaper). In addition to its technical characteristics, its usefulness depends on

the network effects that it can generate. The extent of future network effects remains

uncertain, which is perhaps the biggest reason for the volatility of Bitcoin prices so

far. Some of this uncertainty will necessarily resolve itself over time, as Bitcoin is

revealed either to be valueless or to have enduring value. Bitcoin is always likely to

be more volatile than fiat currencies, however, because it lacks a central bank and its

supply is not responsive to changes in demand.

Cryptocurrencies also raise in a new way questions of exchange rate

indeterminacy. As Kareken and Wallace (1981) observed, fiat currencies are all alike:

slips of paper not redeemable for anything. Under a regime of floating exchange

rates and no capital controls, and assuming some version of interest rate parity holds,

there are an infinity of exchange rates between any two fiat currencies that constitute

an equilibrium in their model.

The question of exchange rate indeterminacy is both more and less striking

between cryptocurrencies than between fiat currencies. It is less striking because

there are considerably more differences between cryptocurrencies than there are

between paper money. Paper money is all basically the same. Cryptocurrencies

sometimes have different characteristics from each other. For example, the

algorithm used as the basis for mining makes a difference – it determines how

professionalised the mining pools become. Litecoin uses an algorithm that tends to

make mining less concentrated. Another difference is the capability of the

cryptocurrency’s language for programming transactions. Ethereum is a new

currency that boasts a much more robust language than Bitcoin. Zerocash is

another currency that offers much stronger anonymity than Bitcoin. To the extent

that cryptocurrencies differ from each other more than fiat currencies do, those

differences might be able to pin down exchange rates in a model like Kareken and

Wallace’s.

On the other hand, exchange rate indeterminacy could be more severe among

cryptocurrencies than between fiat currencies because it is easy to simply create an

exact copy of an open source cryptocurrency. There are even websites on which you

can create and download the software for your own cryptocurrency with a few clicks

of a mouse. These currencies are exactly alike except for their names and other

identifying information. Furthermore, unlike fiat currencies, they don’t benefit from

government acceptance or optimal currency area considerations that can tie a

currency to a given territory.

Even identical currencies, however, can differ in terms of the quality of

governance. Bitcoin currently has high quality governance institutions. The core

developers are competent and conservative, and the mining and user communities are

serious about making the currency work. An exact Bitcoin clone is likely to have a

difficult time competing with Bitcoin unless it can promise similarly high-quality

governance. When a crisis hits, users of identical currencies are going to want to

hold the one that is mostly likely to weather the storm. Consequently, between

currencies with identical technical characteristics, we think governance creates

something close to a winner-take-all market. Network externalities are very strong in

payment systems, and the governance question with respect to cryptocurrencies in

particular compounds them.

Cryptocurrency volatility could also be reduced by the introduction of

exchange-traded futures and options markets. At present, the CFTC has still not

opined on the legality of cryptocurrency derivatives. However, a number of

Bitcoin-based businesses have been calling for the normalisation of hedging

instruments for Bitcoin, which could also have the advantage of lowering merchant

processing fees. Greater access to cryptocurrency derivatives is necessary for the

health of the ecosystem. Some developers have begun work on decentralised

derivatives exchanges, which could be important if financial regulators refuse to

approve ordinary derivatives.

Conclusion

Cryptocurrency is an impressive technical achievement, but it remains a monetary

experiment. Even if cryptocurrencies survive, they may not fully displace fiat

currencies. As we have tried to show in this article, they provide an interesting new

perspective from which to view economic questions surrounding currency

governance, the characteristics of money, the political economy of financial

intermediaries, and the nature of currency competition.

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