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Beyond Bitcoin – The Economics of Digital Currencies

Beyond Bitcoin - The Economics of Digital Currencies

Chapter 1 – Introduction

In the last two decades, the Internet combined with the smartphone revolution has created a permanently connected world transcending national borders, time differences, and geographic distance. In this way, the Internet has become the backbone for most of our activities—not only communication and entertainment, but also economic activities, like commerce or work. By the 2010s, it has become actually difficult—if not impossible—to live without using the Internet one way or another.

The technological progress also affected how we store our money and how we pay for the goods and services we need. Most intriguing is that we are changing our perception of what money is, or can be, and are starting to experiment with types of money that have not been seen before in human history—digital currencies. The digital currencies only live in the virtual world of the Internet, computers, or smartphones.

They have strange-sounding names, they are governed by often unfamiliar rules, and they require us to adopt new habits if we want to use them. Some of the digital currencies come from issuers we are familiar with, for example, social networks such as Facebook or commerce platforms such as Amazon. Others belong to the mysterious group of cryptocurrencies: digital currencies that have no person or institution managing their issuance, have no authority regulating them, and operate throughout a decentralized peer-to-peer network.

While currencies issued by the likes of Amazon and Facebook are arguably more important in the economy, it is cryptocurrencies that drive people’s interest in digital currencies. They certainly deserve the attention because of the technical innovation they represent. For example, Bitcoin involves a sophisticated algorithm that solves a long-standing computer-science puzzle, known as the “Byzantine generals problem.” In spite of the problem’s colorful name, relatively few people have heard about it. And yet most of us have heard about Bitcoin.

This is because of the tantalizing implication of a solution to the obscure problem with colorful name—the possibility of payment systems, or even currencies, which operate in a distributed network, with no issuer or institution that controls or manages it and with enough security to withstand malicious attempts to infiltrate it. As we will discuss, this innovation has the potential to meaningfully change the economy, from the way cross-border remittances are sent, to making micropayments economically sustainable, to offering a way of transacting online that protects privacy better than any other method, to changing the way con- tracts are enforced.

The timing of the innovation could not have been bet- ter. Around the same time, the world experienced the largest global financial crisis in modern history. The crisis led some people to question the management of state-issued currencies and the institutions involved in it, in particular, the financial sector and the government.

Struggling banks and, indeed, actual bank runs highlighted the potential fragility of traditional financial institutions as safe places for people’s deposits, while extraordinary government debt in many countries raised questions about the future value of state-issued currencies. This led some to the conclusion that the time had come for the creation of a money system that is safe, practical for global economic interactions, and importantly, independent of existing large financial institutions and governments. An important aspect of the economic rationale for such a money system has relied on the argument that the current international transfer systems are expensive and inflexible, imposing unreasonable costs on individuals and companies. Beyond these economic rationales, some people, perhaps influenced by a libertarian ideal, also felt the need for a money system that is, simply, out of governments’ sight.

Bitcoin has captured media’s attention also because of its association with the shadow economy. Some people have always sought secrecy and anonymity in an alternative pay- ment system for the purpose of escaping the law. Since their appearance, the Internet and e-commerce have been used for illegal activities—mostly for the trade of arms and drugs. The size of this illegal trade is hard to estimate but its order of magnitude is in billions of US dollars. One of the most well-known elements of that shadow economy was Silk Road, widely covered in the mainstream media, especially after October 2013, when US law enforcement shut it down and arrested its founder, Ross William Ulbricht.

In 2015, Ulbricht was convicted for running the site, and sentenced to life in prison. Silk Road was just one of many—although arguably one of the largest—websites that specialized in matching buyers and sellers of illegal products, operating on the so-called “darknet,” a layer of the Internet where activity cannot be (easily) traced back to the physical locations of its participants. For people involved in such illegal trading activities, a payment system guaranteeing secrecy and anonymity has always been very attractive proposition.

What fed the media frenzy was the mystique surround- ing the first cryptocurrency system, Bitcoin. Bitcoin was introduced in 2008 by a mysterious character named Satoshi Nakamoto, whose real identity is unknown. With a quick and relatively broad adoption, the cryptocurrency was experiencing a phenomenal success, at least until 2013. Since then, it has suffered a series of setbacks from a variety of interrelated factors, including a market crash, fraud, security issues, and regulatory challenges from a number of governments.

More important, Bitcoin’s early success has led to an incredible proliferation of competing cryptocurrencies. Today, the complex ecosystem that emerged faces considerable uncertainty, raising the question, What will the future of finance look like after the “Cambrian Explosion” of cryptocurrencies?

Before even considering this question, one needs to realize that the universe of digital currencies goes far beyond that of cryptocurrencies. Indeed, a whole new family of digital currencies has emerged in parallel to Bitcoin and its competitors.

The rise of these currencies is also closely linked to the emergence of the Internet, and has been motivated by the needs of large Internet businesses: Amazon, Facebook, Tencent, and so on.
Permanent and ubiquitous connectivity provided by the Internet has also given rise to these new businesses that allow a very large number of people to interact in sophisticated ways.

Social networks, e-commerce platforms, online game platforms, or virtual worlds are so-called “transaction platforms” that create value by facilitating exchange between their members, who often represent different groups of consumers: buyers, sellers, advertisers or developers.

The nature of the exchange, whether it is social/commercial, whether it is for entertainment, or whether it concerns a particular professional/business purpose, often defines the business model of the platform, including its value proposition and the way the platform earns its revenue. While these value propositions and revenue models substantially vary across transaction platforms, quite naturally, most of them provide the possibility of economic exchange between their members and between these members and the platform itself.

This raises the question of the necessity of a medium of exchange, essentially an efficient payment system, which may be tailored to the special needs of the platform. Many platform businesses have considered introducing a special currency to provide one. Platform-based currencies are, by definition, centralized currencies where the platforms control (to the extent possible) the “rules” governing the use of their currencies.

Interestingly, the core issues guiding the introduction of these platform-based currencies are very different from those of cryptocurrencies. While in the latter case, the goal is to create a fully functional currency to replace state-issued currencies, platform-based currencies try to purposefully design their payment systems with specific objectives in mind. This usually boils down to restricting some of the functionalities of their currencies.

Yet, despite these restrictions, platform-based currencies captured the public imagination to the same extent that Bitcoin did, no doubt partly because of these platforms’ sheer size and global nature. For example, when Facebook was moving forward with their Facebook Credits in 2011, commentators saw them as a threat to state-issued currencies. “Could a gigantic non-sovereign, like Facebook someday launch a real currency to compete with the dollar, euro, yen and the like?” wrote Matthew Yglesias (2012).

Similarly, renowned payments economist David Evans (2012) wrote: “Social game companies could pay developers around the world in Facebook Credits and small businesspeople could accept Facebook Credits because they could use them to buy other things that they need or reward customers with them.

In some countries (especially those with national debts that are greater than their GDPs) Facebook Credits could become a safer currency than the national currency.” Similar concerns were expressed when Amazon introduced Amazon Coins in 2013. Market- Watch, affiliated with the Wall Street Journal, wrote: “But in the long term what [central banks] should perhaps be most worried about is losing their monopoly on issuing money.

A new breed of virtual currencies are starting to emerge—and some of the giants of the web industry such as Inc. are edging into the market.” As we will argue below, many of these concerns are exaggerated, even if in some instances, platform-based currencies have had an impact much beyond the business of their issuers.

The goal of this book is to explore the young and dynamic universe of digital currencies to understand their origins and their meaning for our economies. We approach these currencies from the viewpoint of economists, analyzing the needs they fulfill for customers and merchants, the incentives they create for their users, and the way they compete with other potential currencies in the market-place.

Whenever possible, we will do that in a way that abstracts away from technical details of how digital currencies work, making this book suitable for people with little experience or education in computer science, cryptography, and so on. Sometimes we won’t be able to avoid talk- ing about technical aspects of a currency—for example, we could scarcely avoid discussing the ingenious algorithm that underlies cryptocurrencies such as Bitcoin—but we will attempt to do so in a way that is as approachable as possible. Rather than create a technical manual, we intend to describe the economic forces governing the evolution of digital currencies.

The objective is to understand why certain models seem to succeed over others: what drives competition between alternative currencies, which currency is likely to prevail if one currency can replace another, and what design features (or restrictions) make sense in given economic or business contexts.

To this end, we will start at the very beginning: we will describe how human societies invented money, how money facilitated transactions, and how weaknesses in the design of money led to innovation and improvements in the way we pay for things. Digital currencies may seem far removed from such history, or even prehistory, of money.

However, this historical overview allows us to identify some of the core economic forces that drive the use of different types of money, highlight the specific needs that money serves, and illustrate the key attributes that money should have. These needs and attributes are remarkably universal, and they are as important now as they were centuries ago. Their analysis will lay the groundwork for our subsequent discussion of digital currencies and give us a framework in which to analyze them.

Such a framework is critically important. Without it, it can be difficult to understand what exactly is going on in the digital currency universe. Much of the narrative sur- rounding digital currencies is a bit sensationalist, undoubtedly influenced by the tumultuous events surrounding the introduction of digital currencies, or the spectacular developments in Bitcoin—not only its rise to immense popularity but also the less optimistic episodes of the Silk Road shutdown or the closing of the Mt. Gox exchange.

Starting with an economic framework will help us see through the confusion to better understand the phenom- enon of digital currencies and its potential to change our economy.

In the next part of the book, we will use this framework to explore the universe of platform-based digital curren- cies that are centrally managed by the businesses that have introduced them. We will analyze the economic forces that made it attractive for Amazon to issue the Amazon Coin or for Facebook to issue Facebook Credits, and why Facebook decided to shut it down soon afterward. Here, we will also discuss what drives the platform’s choice of particular design features for its currency.

It turns out that platform-based digital currencies could hardly function as money in the broad sense of the word— not because they are inherently flawed, but because plat- forms issuing them go to great pains to disable the main functions that are necessary for a widely adopted currency. We will see that this should not be surprising: such restrictions fit well with the platforms’ business models and make their currencies more useful in generating a higher profit for the platform.

A widespread adoption, and perhaps even crowding out state-issued currencies, is something often discussed in the context of decentralized digital currencies, or cryptocurrencies such as Bitcoin. We discuss these innovations in the last part of the book. We look at the still ongoing evolution of their design, the value they provide over and above existing alternatives, and some of the challenges they currently face.

We again come back to our economic framework and show that many of cryptocurrencies’ features are specifically designed to address a particular economic need that has in the past been fulfilled by a corresponding feature of traditional—that is, non-digital—money.

This helps us identify features that might be flashy and broadly discussed but that do not change the economics of a cryptocurrency and that make a new cryptocurrency, for all practical pur- poses, about as useful or as promising as an earlier one. We also look into the ecosystem that cryptocurrencies exist in, focusing on its more economically meaningful parts. For example, we discuss the evolution and the role of online cryptocurrency exchanges and discuss how effectively they function as part of the cryptocurrency infrastructure.

Finally, we discuss the competition between various cryptocurrencies (at the time of writing, there are a few hundred of them that are actively traded) and, perhaps more tantalizingly, the competition between a cryptocurrency and the traditional, state-issued currencies such as the US dollar.

Such discussions often turn into speculation about the future, a temptation we have not managed to resist. At the same time, we clearly recognize that it is too early to paint an exact picture, given the broad scale experimentation still under way.

More important, such forecasts are particularly difficult in the light of the uncertainty about how governments will respond to the emergence of digital currencies. In this respect, our book is not a policy piece about central banking or currency regulation. Rather, it is an analysis of the economic forces that drive the emergence and efficient use of competing money systems applied to the digital world.

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