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Eli Dourado and Jerry Brito
From The New Palgrave Dictionary of Economics, Online Edition, 2014
Edited by Steven N. Durlauf and Lawrence E. Blume

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.

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

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 ones 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 Bobs. 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

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 PayPals 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
Bitcoins 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

In essence, this is the same problem faced by Bitcoins miners, the specialised
nodes that verify new transactions and add them to the distributed ledger. Bitcoins
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

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 clientand so-called
alt-clientsalso has implications for Bitcoins 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. Its 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 networks 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
Bitcoins 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 others blocks, and
the block chain forkedinto 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

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 malleabilityattacks. 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
Bitcoins 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

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, Bitcoins 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 addresss 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?
Price (USD) Log Scale
Figure 1 The price of Bitcoin. (Source: Bitcoin Price Index data from CoinDesk
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
cryptocurrencys 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

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 dont 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.

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.

See Also
commodity money;
fiat money;

Black, F. 1970. Banking and interest rates in a world without money: the effects of
uncontrolled banking. Journal of Bank Research, 1 (Autumn): 920.
Fama, E. F. 1980. Banking in the theory of finance. Journal of Monetary Economics,
6: 3957.
Hall, R. E. 1982. Monetary trends in the United States and the United Kingdom: a
review from the perspective of new developments in monetary economics. Journal of
Economic Literature, 20: 15526.
Kareken, J. and Wallace, N. 1981. On the indeterminacy of equilibrium exchange
rates. Quarterly Journal of Economics, 96(2): 20722. doi: 10.2307/1882388
Meiklejohn, S., Pomarole, M., Jordan, G., Levchenko, K., McCoy, D., Voelker, G. M.
and Savage, S. 2013. A fistful of Bitcoins: characterizing payments among men
with no names. Proceedings of the 2013 Conference on Internet Measurement.;
Nakamoto, S. 2008. Bitcoin: A Peer-to-Peer Electronic Cash System.
Wallace, N. 1983. A legal restrictions theory of the demand for moneyand the role
of monetary policy. Federal Reserve Bank of Minneapolis Quarterly Review, 7: 17.


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