How cryptocurrencies can empower the process of innovation in the economy

An economic analysis of cryptocurrencies and their impact on the economy


Academic Paper, 2017

37 Pages, Grade: 9,0/10


Excerpt

Table of contents

Title page

Executive summary

Preface

Table of contents

Glossary

1. Introduction
1.1 Problem statement
1.2 Research objectives
1.3 Research approach

2. Theoretical principles of cryptocurrencies
2.1 Definition and terms
2.2 Types of cryptocurrencies
2.3 Technology and functionality

3. Theoretical principles of money and currency
3.1 Functions of money
3.2 Characteristics of money
3.3 What determines the value and strength of a currency?

4. Evaluation of cryptocurrencies
4.1 Evaluation criteria
4.2 Medium of exchange
4.3 Store of value
4.4 Unit of account
4.5 Evaluation results and improvement possibilities

5. Impact on the economy
5.1 Impact on key financial players
5.2 Impact on developing countries
5.3 Key innovation: blockchain technology

6. Conclusions

7. Limitations and recommendations for further research

References

List of figures

List of Appendices

Executive summary

This report deals with the research issue "How cryptocurrencies[1] can empower the process of innovation in the economy”.

Cryptocurrencies have significantly grown in value over the last couple of years. Nevertheless, there is a real concern about their ability to disrupt existing payment systems by facing complex technological and economic issues. However, cryptocurrencies have been claimed to be an innovation which will change financial interaction between people and businesses. A cryptocurrency is a digital medium of exchange based on the technology of cryptography. The main innovation in cryptocurrencies is that they are based on cryptographic proof instead of trust, enabling two willing parties to transact directly, anonymously, and irreversibly with each other in a decentralized manner without the need for a trusted third party to verify all transactions. It requires an economic analysis about what issues are keeping cryptocurrencies from being accepted in economy and how these issues might be solved to make a cryptocurrency strong enough to have an impact on world’s economy. This leads to the main research question: What issues must be solved to make a cryptocurrency a strong currency that is able to strengthen the process of innovation in the economy?

The evaluation has outlined that, at present, cryptocurrencies do not completely fulfill all three functions associated with money. The current small amount of supply and limited acceptance of users worldwide of cryptocurrencies significantly restricts their use as a medium of exchange. High price volatility of cryptocurrencies limits their ability to serve as a reliable store of value. Cryptocurrencies are not used as an independent unit of account because they represent the value in fiat currency based on their exchange rates instead of measuring the value directly. To overcome the perceived biggest challenges, high price volatility and security risks, a central, governmental independent authority with limited influence, in turn controlled by network participants, may be required. This central authority could control the network by opening the blockchain [2] as needed for more mining, and shutting the blockchain down, depending on supply and demand to keep the market price of the cryptocurrency stable.

Cryptocurrencies with their key advantages such as no third-party interruptions, low transaction fees, user anonymity, and fast cross-border transaction processing have the potential to act as a tool to build new systems of financial services in countries with a high percentage of unbanked population and unstable political situation. This would lead to economic growth in those countries as people can participate in global business markets. If people face political, social and/or financial instability in a country, they might increasingly turn to cryptocurrencies. The technology behind cryptocurrencies, blockchain, opens various technological innovations including trading on distributed exchanges in financial markets, making payments faster and more secure, and verifying sensitive information. But cryptocurrencies and their technologies still need to be adopted and improved to use it on a widespread scale.

Although this report provides widespread analysis of cryptocurrencies, there is still extensive scope for further research. Because the environment of cryptocurrencies is rapidly evolving, further research might consider aspects such as the ongoing development of cryptocurrencies as a form of payment, their potentials and risks to the financial world, setting up baseline studies on usage, and future predictions on blockchain technology.

Preface

Dear reader(s),

the basis of this report is an independent literature research on an economic issue within a period of about three months. Based on this research, the report includes a detailed theoretical analysis of the impact of cryptocurrencies on the economy.

The title given to this report has the following reason. Cryptocurrencies such as Bitcoin and Ethereum have raised massive public attention in the last years. But cryptocurrencies are still not able to replace traditional currencies as stable and sustainable currencies because of various reasons. This report is going to answer the following research question: What issues must be solved to make a cryptocurrency strong enough to strengthen the process of innovation in the economy? Under economic aspects, cryptocurrencies are evaluated based on several criteria and their impact on the economy from different points of view is analyzed. The title “How cryptocurrencies can empower the process of innovation in the economy - An economic analysis of cryptocurrencies and their impact on the economy” precisely reflects this issue.

This report is addressed to all parties who have vested interest in cryptocurrencies. Through the introduction of fundamental principles and the support of simple explained theories, anyone will be able to appreciate the breadth and depth of the analysis presented in this work

Venlo, the Netherlands, November 28, 2017 N. Marx

Glossary

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1. Introduction

This chapter introduces the topic of the report. The first sub chapter reveals the problem statement the author faced during researching. The second part describes the research objectives and, finally, the research approach is presented.

1.1 Problem statement

Increasing digitization has generated more and more innovations in recent years and integrated digital trends into different areas. In 2008, a further innovation emerged in the field of payment methods. Every day people around the world transact with one another. Almost all daily transactions involve a third party like a bank or a financial institution. Ultimately, it is these institutions that carry out the transaction on people’s behalf. This is until the invention of cryptocurrencies in 2008 (Nakamoto, 2008). Cryptocurrencies, such as Bitcoin, as the first digital currency, have significantly grown in value over the last couple of years (Dyhrberg, 2015, p.85). They are transferred directly from person to person via the internet without going through a bank or any third party. Due to a high increase in interest for cryptocurrencies, there is a real concern about the ability of them to disrupt existing payment systems and perhaps even replace monetary systems by facing complex technological and economic issues such as safety, transaction costs, user anonymity and third-party interruptions (Böhme et al., 2015). Another threat for cryptocurrencies being accepted as a global currency are their potentially high price volatility (Ciaian et al., 2016, p.894). Because the market prices of Bitcoin and other cryptocurrencies have yet been mainly driven by speculative investments, cryptocurrencies are not able to compete with traditional currencies (Ciaian et al., 2016, p.897). However, cryptocurrencies such as Bitcoin have been claimed to be an innovation which will change financial interaction and behavior on the internet (Glegg, 2014). It requires a theoretical analysis about what issues are keeping a cryptocurrency from being accepted in the society and economy and how these issues might be solved to make a cryptocurrency strong enough to be a worldwide-used currency. An interesting aspect is what impact such a strong cryptocurrency would have on world’s economy and financial industries.

1.2 Research objectives

The objective of this report is to provide an economical analysis of cryptocurrencies as reliable and long-lasting currencies which can strengthen and modernize the economy. This leads to the main research question: What issues must be solved to make a cryptocurrency a strong currency that is able to strengthen the process of innovation in the economy? In order to answer the central question of investigation, sub-questions are clarified as follows:

- What is a cryptocurrency and how do they work?
- What determines the value and strength of a currency?
- What are the advantages and disadvantages of digital currencies compared to conservative currencies?
- How can cryptocurrencies avoid and overcome their disadvantages?
- How do cryptocurrencies influence world’s economic and the financial industry?
- Do cryptocurrencies may have the potential to compete with traditional currencies such as Dollar and Euro in the future?

The student’s assignment is to answer the above-mentioned questions about cryptocurrencies through in-depth analysis. The analysis critically evaluates the ability of cryptocurrencies to serve as real currencies based on diverse criteria. By comparing cryptocurrencies with incumbent currencies, advantages and disadvantages of both currency types are stated. In the process of the analysis, the student also answers the key research questions what characteristics a cryptocurrency requires to be considered as a stable, sustainable and safe-haven currency and what impact this optimal type of cryptocurrency can have on the economy. The aim is to predict the possible impact of a strong cryptocurrency on the economy in the future through a reflection of cryptocurrencies advantages and disadvantages compared to traditional currencies as well as its development over the last years.

1.3 Research approach

The research was conducted in four main phases. To answer the above-mentioned questions, it is necessary to be able to understand the difference between cryptocurrencies and incumbent currencies. Therefore, the first two steps of the analysis are to clarify the principles of cryptocurrencies in general, their characteristics and functionality and to provide economic theories about what determines a reliable and stable currency. Because cryptocurrencies are mainly based on complex technological theories, its features are briefly and comprehensibly explained for non-technical readers. The third step includes evaluating cryptocurrencies through selected criteria and analyzing the results of the evaluation. Advantages and disadvantages of cryptocurrencies compared to fiat currencies are identified in detail. The results aim to clarify what improvements on cryptocurrencies need to be done to establish an ideal cryptocurrency which might replace incumbent currencies. With the results of the analysis, key questions about the current and future impact of cryptocurrencies on the economy and financial world can be answered precisely in the fourth phase. It must be noted regarding the methodological approach that the available information was mainly obtained through a comprehensive literature research based on various current sources, such as textbooks, articles, and scientific publications, in order to gain a broad overview of the subject and to dive deeper into the problem.

The report structures as follows. Initially, theoretical basics about cryptocurrencies, their characteristics, variations and functionalities are described. Subsequently, economic theories about money and currencies are provided. Afterwards, cryptocurrencies in general are evaluated and analyzed based on various criteria. Further, this report provides a view on current and possible future risk on monetary and financial stability that might be posed by cryptocurrencies and how these risks might be eliminated through an optimization of cryptocurrencies. After putting all results of the analysis part into a conclusion, the report is appraised critically and lets the reader know what the topic still left open and which new approaches might arise from the analysis.

The following figure illustrates the research framework:

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2. Theoretical principles of cryptocurrencies

The following chapter clarifies the theoretical principles of cryptocurrencies including their definition and terms, types as well as technology and functionality.

2.1 Definition and terms

A cryptocurrency is a digital medium of exchange, based on the technology of cryptography, to make secure transactions, as well as to regulate the creation of additional units of currency (Chohan, 2017). Generally, cryptography securely protects information in data systems from third parties by constructing mathematical tracking protocols and preventing manipulation as well as equivocalness (Narayanan et al., 2016). The main innovation in cryptocurrencies is, that they are based on cryptographic proof instead of trust, enabling two willing parties to transact directly and irreversibly with each other in a decentralized manner without the need for a trusted third party to verify all transactions (Nakamoto, 2008). They run on a distributed public ledger, called blockchain, which is a chronological record of all transactions recorded by a network of computers (Böhme et al., 2015). With this pseudonymity, only the unit transaction movements can be held on, but not the person behind it can be assigned. This technology, first established through Bitcoin, has created a growing industry of cryptocurrencies that use different blockchain methods (Blundell-Wignall, 2014). Units of cryptocurrency are created through a complex process called mining which is explained in more detail in Chapter 2.3 (Wright, 2015). Cryptocurrencies incorporate rules that regulate their total amount of supply. Some make use of the mining system which allow the number of coins to grow permanently like Bitcoin and other are created entirely at their inception like Ripple (Ali et al., 2014, p.278). Cryptocurrencies vary in relation to different parameter values such as different block time, supply limit and different consensus scheme (e.g., proof-of-stake instead of proof-of-work) (Hileman et al., 2017).

2.2 Types of cryptocurrencies

Currently, there are more than 1,100 different cryptocurrencies, according to CoinMarketCap.com (2017). The total market capitalization of all cryptocurrencies is worth more than $[3] 160 billion, based on data from CoinMarketCap.com on October 15, 2017. Bitcoin, as the first decentralized digital currency, invented by Satoshi Nakamoto in 2008, is the largest blockchain network at the time of writing. The market capitalization of Bitcoin amounts more than $91 billion or nearly 54% of the market capitalization of all cryptocurrencies (CoinMarketCap.com, 2017). It follows a brief overview of the five most prominent and valuable cryptocurrencies and their characteristics. Bitcoin, as the first virtual currency, invented in 2008, is operated by a decentralized authority, a peer-to-peer network which records transactions by hashing them into an ongoing public ledger “that cannot be changed without redoing the proof-of-work” (Nakamoto, 2008, p.1). Because all transactions executed are computationally impractical to reverse, users are protected from fraud or other attacks. Bitcoin users maintain a digital wallet and trade the currency among each other. Payments can be made at anytime and anywhere worldwide within minutes (Ali et al., 2014). There are 21 million bitcoins programmed into the system that are going to be released. It is a set number but within that every single Bitcoin can be divided up into 100 million different pieces (Nakamoto, 2008). The second largest cryptocurrency by market capitalization, Ethereum, first propose in 2013 and launched in 2015, is a peer-to-peer platform of virtual machines which facilitates smart contracts and applications via its own currency coins, called Ether, and additionally enable developers to create and run decentralized applications (DApps), peer-to-peer software programs. (Bajpai, 2016). Ethereum uses its own decentralized public blockchain which is built “with a turing-complete scripting language that can simultaneously run such smart contracts across all nodes and achieve verifiable consensus without the need for a trusted third party” (Hayes, 2017). Ripple is both, a real-time global payment network, called RippleNet, that offers instant, certain and low-cost international payments, and a currency exchange invented by the company Ripple Labs (Ripple.com, 2017). According to Ripple Labs, Ripple “connects banks, payment providers, digital asset exchanges and corporates via RippleNet to provide one frictionless experience to send money globally” (Ripple.com, 2017). Ripple is the only cryptocurrency among the selected five explained in this chapter, that does not have a blockchain (Hileman et al., 2017). Therefore, the transaction ledger does not need mining, a feature that deviates from other cryptocurrencies. It is all pre-mined by the company Ripple itself. But the company does not control the network or collect fees. In contrast to other cryptocurrencies, payments with Ripple can be made in four seconds (Ripple.com, 2017). Litecoin, as almost technically identical to Bitcoin, is a decentralized peer-to-peer cryptocurrency, created in 2011, which uses an open source cryptographic protocol to verify and construct transactions (Litecoin.org, 2017). Although Litecoin works upon the same fundamental principles of Bitcoin, it has some technical improvements over Bitcoin. The key differences are that Litecoin uses a different proof-of-work algorithm and transactions can be made in 2.5 minutes instead of 10 minutes using Bitcoin (Litecoin.org, 2017). Dash, formerly known as Darkcoin and launched in 2014, is a more secretive peer-to-peer cryptocurrency than Bitcoin, as it utilizes a two-tier network. As other cryptocurrencies, new blocks are created by miners in the first tier. But the second tier consists of three services, called Masternodes: instant transactions (InstantSend), private transactions (PrivateSend) and governance functions that confirms payments instantly and make transactions almost incomprehensible (Dash.org, 2017). Rewards are equally shared between miners and Masternodes (Hileman et al., 2017).

2.3 Technology and functionality

Although all cryptocurrencies vary through different features and technologies, the core functionality is still similar. Cryptocurrencies rely on two fundamental technologies from cryptography (Böhme et al., 2015). Their creation is not controlled by a governmental institution or central banks and cryptocurrencies allow payments to be made instantly between two parties without the need of a trusted authority like a bank (Ali et al., 2014). To eliminate the possibility that any digital record of currency may be copied or spent more than once, a distributed ledger, called blockchain, containing the record of all transactions is publicly available to all users (Ali et al., 2014). Each data block in the ledger contains countless transactions with the addresses of the senders and receivers, as well as the amount of the units of cryptocurrency that have been executed (Böhme et al., 2015). To simplify this technically complex process, the following examples explains how the cryptocurrency system enables to conduct transactions in a decentralized way. User A wants to make a payment and issues payment instructions to user B. Through cryptographic techniques the network, consisting of all users, verifies that user A can spend the amount of currency he wants to send to user B. The validation of the transaction between A and B is made by special users, known as miners, who use a special software and massive computing power to compete with other miners in solving complex mathematical transaction-related algorithms. The purpose of mining is to achieve consensus in a decentralized system and to distribute new coins (Kroll et al., 2014). By successfully solving those mathematical algorithms, the miners add new blocks, in this case the record of A’s transaction to the network’s public blockchain ledger, visible to anyone (He et al., 2016). In return, they are issued a certain number of the currency’s coin per block (Ali et al., 2014). Since miners are required to approve transactions, more miners mean a more secure network (Kroll et al., 2014).

3. Theoretical principles of money and currency

The third chapter provides theoretical information about the main functions and characteristics of money and what determines the value and strength of a currency in order to set up the foundation of the evaluation of cryptocurrencies in the following chapter.

3.1 Functions of money

“From a legal perspective, money is anything that is used widely to exchange value in transactions” (ECB, 2015, p.24). In economics, money is functionally defined (Crowther, 1940). According to Crowther, money, whatever its form, has three different functions. It is a medium of exchange, a unit of account, and a store of value (Crowther, 1940 / Mankiw, 2009, p.80f.).

- Money is a medium of exchange when it is used to intermediate the exchange of goods, services, or other transactions. Through this function, two parties are able to exchange two dissimilar objects and determine their value with each other (Lipsey et al, 2011, p.448).
- To act as a unit of account, money must be a standard numerical unit of measurement to express the market value or price for goods, services, assets, or other transactions (Brunner et al., 1971, p.787). That means money also may be used as an accounting system without having a physical existence of its own (Lipsey et al, 2011, p.449).
- A store of value is the third function of money that can be saved, retrieved, and predictably useful when retrieved. This means that money must necessarily maintain its value over time. “Money is a way to transfer purchasing power from the present to the future” (Mankiw, 2009, p.80). However, if prices are rising or falling, the amount someone can buy with any given quantity of money is changing. This effect is called inflation. Therefore, money must have a relatively stable value (Lipsey et al, 2011, p.449). When the price level is stable, the purchasing power of a given amount of money is also stable.

To sum up, money can be defined as anything that is generally acceptable as it must fulfill all three functions. Using these functions, it avoids the need for a double coincidence of wants and thus facilitates a wider range of transactions (Lipsey et al, 2011, p.448).

3.2 Characteristics of money

According to Desjardins (2015) money in general, must meet the following seven characteristics to fulfill its three functions:

1. fungible: One unit of money must be interchangeable with another one.
2. durable: Money must be a store of value over long periods of time and able to withstand being used repeatedly.
3. divisible: Money must be divisible into smaller denominations.
4. acceptable: Money must be generally acceptable as a medium of exchange by a population.
5. portable: Individuals can carry money with them and transfer it easily to others.
6. uniform: All versions of the same denomination must have the same purchasing power.
7. scarce: The supply of money in circulation is limited and ensures values remain relatively constant and less volatile.

To differentiate money from currency, a currency is the constitution and order of the entire financial and monetary system of a state, which affects the regulation of the circulation of banknotes and coins within the monetary area (Schricker, 1992, p.134). A currency allows the transfer of goods and services without supplying any consideration in the form of other goods and services.

3.3 What determines the value and strength of a currency?

According to the Theory of the Value of Money, explained by the Austrian-American economist Ludwig von Mises (1912, p.97 ff.), money, or currencies must have an objective exchange-value, also called purchasing power. “The objective exchange-value of goods is their capacity […] to procure a specific quantity of other goods as an equivalent in exchange” (Mises, 1912, p.100). That means, the value of a currency itself is determined by demand for it and is measured through exchange rates (Levinson, 2005, p.14). An exchange rate is the rate at which one currency will be exchanged for another (Mises, 1912, p.101). In other words, “the exchange rate […] becomes the fundamental price in any economy” (Levinson, 2005, p.14). So, in order to define what determines the value of a currency, a closer look at exchange rates must be taken. To express the value of a currency, most often two different currencies are compared. The relative value of a currency is determined by the foreign-exchange markets. A foreign exchange-market is a global decentralized market for trading currencies. The exchange rates are strongly influenced by the volume of supply and demand in the market (Levinson, 2005, p.24ff.). According to Levinson (2005, p.24), the real interest rates and inflation play an important role at the determination of exchange rates. A real interest rate shows the rate of interest an investor or market participant expects to receive for allocating money after deducting inflation (Levinson, 2005, p.24). Real interest rates and inflation are therefore correlated. If a country’s inflation is high, prices generally increase, and its currency’s purchasing power decreases relative to other currencies. Hence, high inflation causes real interest rates to decrease. Low interest rates tend to decrease exchange rates and consequently a currency’s value. Inversely, low inflation causes higher interest rates. Because high interest rates tend to attract investors, the demand for the currency increases and as a result the value of the currency rises. In conclusion, the value of a currency is determined by the economic situation of a country and is influenced by various economic factors such as inflation and interest rates. After clarifying what determines the value and strength of a currency, the focus is set on cryptocurrencies and their price determination. What defines the value of a cryptocurrency? Since cryptocurrencies are not issued or controlled by governments and central banks (see Chapter 2.1), their value is not determined by the economic growth. According to Mankiw (2014, p.103), the value of any goods is determined by its utility and scarcity – same for cryptocurrencies. So, to have value, a cryptocurrency must be scarce and useful. The supply of most cryptocurrencies is limited in the quantity in circulation. The supply of bitcoins, for example, is limited by a total amount of approx. 21 million due to technical limitation in the data structure of the blockchain (ECB, 2012, p.24f.). The utility of a cryptocurrency is analyzed in the fourth chapter.

In contrast to the value, the price of a cryptocurrency, like any goods, is determined by supply and demand in the market (Lipsey et al, 2011, p.47ff. / ECB, 2012, p.21). It is the ongoing interaction between buyers and sellers trading with each other that determines the price of a cryptocurrency, also called the equilibrium price: “the price at which quantity demanded equals quantity supply” (Lipsey et al, 2011, p.49). Logically, the price of a cryptocurrency rises when demand exceeds supply, and falls if supply exceeds demand. As explained in Section 2.1, the supply of cryptocurrencies is mainly controlled by minors. By verifying transactions, minors get rewarded with new units. In contrast, demand is controlled by the cryptocurrency’s network participants. If the network participants believe the price of the cryptocurrency will increase in the future, they are willing to buy now and eventually, the demand will more likely increase.

4. Evaluation of cryptocurrencies

In order to evaluate the ability of a cryptocurrency to work as real currency, specific evaluation criteria are defined in this chapter. Furthermore, this chapter provides some analysis of the extent to which cryptocurrencies serve the main functions of money pointed out in the third chapter.Through comparison with established currencies, advantages and disadvantages of cryptocurrencies are drawn up.

4.1 Evaluation criteria

In order to evaluate and analyze cryptocurrencies in general, it is necessary to clarify the various criteria by which currencies are evaluated. Cryptocurrencies must fulfill the three main functions of money, as clarified in the third chapter to be used in the economy. Therefore, in the following sub-chapters, cryptocurrencies are evaluated based on the three main functions of money: (1) medium of exchange, (2) store of value, and (3) unit of account (Mankiw, 2009, p.80f.). To increase the accuracy of the analysis, the seven characteristics of money, explained by Desjardins (2015, see Section 3.2), are considered and assigned to the three money functions. To be considered as a medium of exchange, cryptocurrencies must be fungible, generally acceptable, as well as portable and easily transferable. As a store of value, cryptocurrencies must be durable and scarce, or rather limited in supply to remain relatively constant in value. If cryptocurrencies are divisible and uniform, the function as a unit of account is fulfilled.

4.2 Medium of exchange

To function as a medium of exchange, a cryptocurrency must be generally accepted within a society and therefore known as value (Desjardins, 2015 / Lipsey et al., 2011, p.448f.). Cryptocurrencies have risen over 1,000% between January 2017 and November 2017 in acceptance and use, reaching a total market capitalization of circa $199 billion (CoinMarketCap.com, 2017). Because it is difficult to estimate the number of people that use cryptocurrencies due to their decentralization and anonymity, the worldwide acceptance of cryptocurrencies cannot be determined precisely. At present, there are a few hundred thousand merchants worldwide that are willing to accept cryptocurrency, especially in Japan (Yagami, 2017). According to Yagami (2017), SwissBorg Japan country manager, since April 2017 “virtual currencies” are allowed as a legal form of payment in Japan, which led to a significant growth of cryptocurrency trading in Japan. On some days, the trading volume of Bitcoin, as the most used cryptocurrency in Japan, can reach 60% of the global Bitcoin trading volume (Yagami, 2017). Because this number is relatively inconclusive, a more indicative measure of a cryptocurrency’s acceptance as a medium of exchange is the market capitalization. At the time of writing, the six largest cryptocurrencies (Bitcoin, Ethereum, Bitcoin Cash, Ripple, Litecoin, Dash) by market capitalization, are worth nearly $170 billion, making up 85% of the total market capitalization of all cryptocurrencies (CoinMarketCap.com, 2017, see Appendix 1). According to Desjardins (2017), the total value of all world’s coins and banknotes is roughly $7.6 trillion. That means, the value of the six most valuable cryptocurrencies compared to fiat currencies is extremely low (2.2% of all fiat currencies). Overall, cryptocurrencies have a very low level of acceptance among the public (ECB, 2015, p.23). As investigated by Hilman and Rauchs (2017) in the Global Cryptocurrency Benchmarking Study, “the current number of unique active users of cryptocurrency wallets is estimated to be between 2.9 million and 5.8 million.” Compared to the US dollar, where hundreds of million people agree that the US dollar represent value and the tokens are firmly integrated in the world’s economy, cryptocurrencies still need to be generally accepted among most people (Scott, 2016, p.3).

Cryptocurrencies combine both payment systems and currencies (Ali et al., 2014, p.1). People can trade cryptocurrencies with each other in exchange for other currencies, various asset classes, goods, and services. One of the main differences to fiat currencies, though, is the decentralization of cryptocurrencies (Smith et al., 2014). Virtual currencies were expressly designed to avoid any centralized control and to minimize the degree of trust that participants need to place in any third party. Their supply and payment systems are neither controlled by governments or central banks nor by any other third party (ECB, 2012, p.24). In traditional currency systems, central banks directly control the supply of money by issuing new money (Lipsey et al., 2011, p.453). As a result, risks concerning political instability and economic uncertainty in a country will not have an impact on a cryptocurrency and ultimately, the potential for corruption that come with centralizing information decreases. Additionally, cryptocurrencies solve another main problem of the traditional financial system: inflation. Through its decentralized system and its limited supply of new units, the issuance of money cannot be altered by any government or central bank to generate new money (ECB, 2012, p.25). But because, for example, units of Bitcoin are minted at decreasing fixed rates determined every four years, a long-term appreciation of the cryptocurrency, meaning deflationary effects may be expected, because investors can hold units of cryptocurrency for a long time to drive up prices, according to the European Central Banks (2012, p.25).

Because the transfer of cryptocurrency money is executed without the need of a trusted third party such a bank, transactions fees are lower than usual transactions by credit cards and money transfers with an intermediary involved (Nakamoto, 2008). By monitoring and updating its blockchain ledger in a collective consensus based system, transactions in a cryptocurrency’s payment system does not need any trusted third party. It completely automates the process by minors who verify transactions.

According to the 2017 Credit Card Fee Survey, conducted by CreditCards.com (2017), credit cards have an average of six fees, charging typically at least 3% of the amount transferred or $5 to $10. Compared to the transaction fees of Bitcoin on Coinbase.com, an online platform for cryptocurrency transactions, as an example, which are around 1% of the amount transferred, are much lower (Blundell-Wignall, 2014, p.15). In that case, Coinbase.com and similar platforms are also intermediaries, but the fees of transferring units of cryptocurrencies are lower, though, and can be lowered more without such transactions platforms. Additionally, transactions with cryptocurrencies can be carried out within seconds, no matter how large the geographical distance between two involved parties is. In contrast, money transfers through banks usually take at least one day for domestic money transfers and more than two days for international money transfers.

As identified by Finan, Sunderland and Ana (2013, p.372f.), traditional banking systems are exposed to three main risks:

(1) Credit risk: The risk of default that a debtor will be unable to pay back its debts to the bank. The bank may become insolvent, if the amount of money, owed to debtors, is too large.
(2) Liquidity risk: The risk that a bank may be unable to settle required payments and meet short-term financial demands.
(3) Operational risk: The risk a bank faces if their business operations fail through IT problems so that payments cannot be processed.

Looking at cryptocurrencies, neither credit risk nor liquidity risk are possible due to the decentralizing of the cryptocurrency’s payment system and the independence from banks, as explained in the second chapter. The transparency of a cryptocurrency ensures that nobody can cheat the network without letting other network participants know about that.

Cryptocurrencies avoid credit risk through their blockchain technologies. As explained in Section 2.3, transactions between two parties are settled immediately, meaning the amount of cryptocurrency is transferred directly. No one can give a credit through cryptocurrencies to someone, by accepting to agree to future payments. Since the transactions are controlled and verified by other network participants, it is not possible to transact with each other, when one party is not able to pay the amount. That ensures that liquidity risk is not possible as well. As banks are not a part of the network, the network controls its demand itself. A closer look must be taken into operational risks, as all cryptocurrencies are based on digital technology which may be vulnerable to software problems and hacks. To proof the security of a cryptocurrency, it is necessary to distinguish between (1) vulnerabilities of the cryptocurrency itself and (2) system vulnerabilities of companies, such as exchange platforms and payment processors that service network participants (Walch, 2015, p.860). It is important to note, that a cyber-attack or hack on an intermediary, who services network participants, is not caused by the cryptocurrency network itself. An example of such an attack was faced by the former largest Bitcoin exchange company Mt. Gox in February 2014, where 850,000 bitcoins valued at $460 million were stolen by hackers, causing the Bitcoin exchange rate to plummet (McMillan, 2014). Attacks on a cryptocurrency network are a systematic operational risk in its technical infrastructure – or to put it in another way, its blockchain (Walch, 2015, p.860). The blockchain technology makes it difficult to be attacked through its decentralized and encrypted structure (Walch, 2015, p.860f.). Walch (2015, p.861) stated that the biggest threat would come “from parties who control 51% of the computing power that the […] system uses to validate transactions and create the blockchain”. But this scenario is highly unlikely because the expenses, caused by providing the needed computing power, would be extremely high, and the attacker would destroy the system in which they had invested so much money. The European Central Banks stated that the security concerns are mainly caused because there is no central authority that can solve the issues such as the loss of theft of cryptocurrency units (ECB, 2015, p.22).

4.3 Store of value

A store of value is the function of an asset or a currency to maintain value over time and to be relatively stable (Lipsey et al., 2011, p.449). Cryptocurrencies can be recognized as assets and currencies. On the one hand they can be traded on the stock market as assets, on the other hand they can be used as currency in their own payment systems. As they are not backed by any government authority, there is a concern of credibility as a store of value (ECB, 2015).

Cryptocurrencies are highly volatile over the long-term as well over the short-term. Bitcoin as the first decentralized digital currency, for example, has faced intense price volatility in 2017, according to a Financial Times article written by Samson (2017). The figure on the following page shows the price development of Bitcoin since January 01, 2017 to November 02, 2017, at the time of writing. Starting at a price about $1,000 in January 2017, Bitcoin has surged past $7,000 to hit a record high at the start of November 2017 (Samson, 2017)[4]. That means the price of Bitcoin has risen by 600% since January 2017 – far greater levels than established currencies (Samson, 2017). Other cryptocurrency’s prices, using the same technology as Bitcoin, have also significantly risen in 2017 (CoinMarketCap.com, 2017). This is also exemplified by other cryptocurrencies such as Dash and Ethereum. Dash’s price has increased by over 2,325% to around $270 since January 2017, Ethereum has even risen by circa 3,625% to almost $300 over the last eleven months (CoinMarketCap.com, 2017, see Appendix 2).

Figure 1: Market price of Bitcoin has experienced a significant growth of 600% despite high volatility in 2017

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Source: Samson / Financial Times, 2017

Over the short-term, Bitcoin's daily price developments, representative for other cryptocurrencies, also show a high level of volatility, as can be seen in Figure 2. On November 11, 2017, the price of Bitcoin plummeted on various exchange platforms from over $7,300 in the morning to nearly $6,400 in the evening - a drop of $900 within a few hours (FAZ, 2017). At night Bitcoin’s price jumped back to $6,900. Two days before, its price had risen from around $7,400 to over $7,800 dollars within an hour, but then fell back shortly thereafter (Holtermann, 2017).

Figure 2: Market price of Bitcoin drops $900 in less than 24 hours

illustration not visible in this excerpt

Source: FAZ, 2017

To demonstrate another example of the high short-term volatility of cryptocurrencies, the price development of Ethereum is considered in the following chart below. On October 24, 2017, the price of Ethereum managed to rise from $284 at 1:00am to $305 at 2:00am – an increase of 7.39% within one hour (framed in red). One day later, the price fell back to $290.

Figure 3: Market price of Ethereum rises 7.39% within one hour

illustration not visible in this excerpt

Source: CoinMarketCap.com, 2017 (modified by Marx, N.)

One reason why cryptocurrencies have shown high volatility recently is the received store of value versus the fiat currency (Barker, 2017). According to Barker (2017), a cryptocurrency’s volatility is mainly driven by confirming perceptions of the value of the cryptocurrency “as a store of value and method of value transfer”. Their price is therefore unstable which is a major concern for cryptocurrency to act as a store of value. A rise of the price of a cryptocurrency leads to a decrease in the purchasing power of the currency, the amount of goods that can be purchased with a unit of currency, because more units of cryptocurrency are required to buy a typical basket of goods (based on Lipsey et al., 2011, p.449). Another reason is the scarcity of cryptocurrencies. As explained in Chapter 2, the total supply of cryptocurrency’s units is predetermined at most cryptocurrencies. If all individuals would save their units of cryptocurrency as an asset, in hope that the value along with its price increases, there would be no interaction between purchase and consume as well as no circulation of money (based on Lipsey et al., 2011, p.449). If this happens, consequently, the function as a medium of exchange would become no longer necessary, because no money circulation means no exchange. The worth of a cryptocurrency as a store of value over the long-term depends on the demand, which will in turn depend on user’s expectations about the success of the cryptocurrency in the future (Ali et al., 2014, p.279).

4.4 Unit of account

To act as a unit of account, a cryptocurrency must be used to measure and compare prices of goods, services, and other transactions (see Section 3.1). Because all cryptocurrencies are traded on various trading platforms, such as Plus500, Coinbase, Cryptotrader, and Bitfinex, to name but a few, their exchange prices are expressed in other currencies like US-dollar. Therefore, units of cryptocurrency can be bought and sold through traditional currencies. Rather than being used to measure the value of goods and services directly, they instead represent the value in fiat currency based on their exchange rate (He et al., 2016). Through exchange rates, a fixed price of a cryptocurrency is determined, and in turn, car prices, for instance, can be compared using a cryptocurrency. Assuming someone wants to buy a Porsche 911 Carrera at a starting price of $91,100 and the Porsche dealer is willing to accept Bitcoin as a payment method. On November 11, 2017, at a current Bitcoin price of $6,328.49 (CoinMarketCap.com, 2017), the buyer must pay 14.39521908 bitcoins to get the car. This example shows that cryptocurrencies can be divided into smaller units. Bitcoin, for example, can be divided into a hundred millionth of a single Bitcoin (0.00000001 Bitcoin), named after Bitcoin’s creator Satoshi, so that its unit equals the original value of a good (Nakamoto, 2008). Additionally, a unit of a cryptocurrency is uniform, meaning one unit has the same purchasing power as another unit. But it is questionable whether merchants will quote prices in cryptocurrency exchange rates. For example, it may be irritating for consumers to see prices such as 0.00479382 bitcoins or 0.234938 ethers. Moreover, the high price volatility of cryptocurrencies requires merchants to update prices quoted in cryptocurrency frequently. Merchants who accept payment in cryptocurrency will quote prices in fiat currency, with the cryptocurrency price based on the exchange rate at a point in time. The high price volatility may reduce a cryptocurrency’s power to fulfill the function as a unit of account accurately.

4.5 Evaluation results and improvement possibilities

The following vulnerabilities result from the evaluation of cryptocurrencies based on the three money functions. In theory, cryptocurrencies could serve as money for anybody with access to the internet. However, as shown in the previous sections, they fulfil the three main functions of money only to a limited extent. According to the European Central Banks (2015), cryptocurrencies, as called “virtual currencies”, do not have the “nature of a liquid asset and have not reached the level of acceptance commonly associated with money”. As shown in the previous evaluation, this statement is accurate. Furthermore, the fact that, at present, cryptocurrencies are used by relatively few people, it is questionable whether cryptocurrency can work as a medium of exchange. For most users, cryptocurrencies primarily represent stores of value. By holding units of cryptocurrency over a long period in belief that the value will rise in the future, exchange is impossible. High rewards are possible for speculators, and this has positioned most cryptocurrencies more as an investment or asset class than as a currency used for settling payments. That eventually leads to the main problem of cryptocurrencies: their high price volatility. Because the money supply of most cryptocurrencies is limited and finite, the money supply is not able to vary in response to demand for it, causing high volatility in prices. The potentially high price volatility makes it difficult for consumers and business to use a cryptocurrency as a payment method, and hence, the ability to act as a stable and reliable store of value is not ensured. The problem of volatility can be solved with a central authority, as fiat currencies operate. Cryptocurrencies with a central authority could open the blockchain as needed for more mining, and shut the blockchain down if necessary. They could also lengthen the blockchain if they needed to. But this would be against the decentralized nature of cryptocurrencies. Another way to decrease price fluctuations may be changing the reward system. Currently, users are only rewarded for mining new units of cryptocurrency and keeping the network secure. Additionally, users might be rewarded for using the cryptocurrency. Any time a transaction is executed, the user may get a low percentage of the transaction amount as a reward for using the cryptocurrency. Exchange would increase, holding units like assets and price volatility would decrease, and eventually, the value would stabilize because the more people use the currency, the less impact anyone would have in influencing prices (Scott, 2016).

Another problem, resulted from the evaluation, are the security risks of a cryptocurrency network. Because of the user anonymity, transactions cannot be tracked. Unless users publicize their wallet addresses, transactions are irreversible, meaning no one can reverse a payment that has already been made. By requesting documentation that verifies the identity of each user, the network may make sure that each transaction is not anonymous. This may minimize fraud and operational risks. But consequently, the documentation must be controlled by a central person, which is not the intent of a decentralized cryptocurrency. If the documentation of user information is controlled by the network itself, decentralization is possible.

Another aspect is the sustainability of low transactions fees (Ali et al., 2014, p.281). Currently, transactions fees are mainly charged through the activities of minors who verify transactions and get rewarded with new units of cryptocurrency (Ali et al., 2014, p.281). While the supply of cryptocurrencies is typically fixed to a finite number of units, minors will not get rewarded for their effort in the future when all units are minted. Transactions fees might increase as a result.

Nevertheless, cryptocurrencies have various advantages over traditional currencies, because they solve the problems related to centralization of money by central banks. As explained in Section 4.2, inflation does not exist in a cryptocurrency network, as well as credit and liquidity risks are not present. Other key advantages are no third-party interruptions, low transaction fees, user anonymity, and fast cross-border transaction processing. To sum up, as shown in the previous evaluation, cryptocurrencies do not serve the three money functions to full extent and it is unlikely that a cryptocurrency would be used as the predominant form of money in any economy. Currently, cryptocurrencies face various challenges, that still need to be solved to make full use of their potential and advantages. To solve the perceived biggest challenges, high price volatility and security risks, network’s activities and its security controlled by a central, governmental independent authority with limited influence, in turn controlled by network participants, may be the key solution.

[...]


[1] The term “cryptocurrency” is used throughout this report to describe both the currency and the payment system.

[2] All terms written in italics are listed and explained in the glossary.

[3] The term “$” is used to represent the US dollar throughout this report.

[4] Update: On November 28, 2017, at the end of writing, the market price of Bitcoin has surpassed $10,000 for the first time – an increase in value by 1,000% since the start of 2017 - driving up Bitcoin’s market capitalization to roughly $167 billion (CoinMarketCap.com, 2017).

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Details

Title
How cryptocurrencies can empower the process of innovation in the economy
Subtitle
An economic analysis of cryptocurrencies and their impact on the economy
College
Fontys University of Applied Sciences Venlo
Grade
9,0/10
Author
Year
2017
Pages
37
Catalog Number
V413185
ISBN (eBook)
9783668640283
ISBN (Book)
9783668640290
File size
838 KB
Language
English
Tags
Cryptocurrency, Blockchain, Innovation
Quote paper
Noel Marx (Author), 2017, How cryptocurrencies can empower the process of innovation in the economy, Munich, GRIN Verlag, https://www.grin.com/document/413185

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