Bitcoin as a Competitor for Fiat Money


Bachelor Thesis, 2018
45 Pages, Grade: 1,7

Excerpt

Table of Content

1. Introduction

2. Introducing the Competitors
2.1 Fiat Money
2.2 Bitcoin

3. Comparing Bitcoin and the Fiat Money System
3.1 Synthetic commodity money
3.2 Centralization
3.3 Privacy
3.4 Contemporary Differences
3.4.1 Acceptance of Bitcoin
3.4.2 Comparing Volatility

4. Fiat Money and Bitcoin in Competition
4.1 Preferences
4.1.1 Preferences for Private Agents
4.1.2 Preferences for Governments
4.2 Network Effects and Switching Costs
4.3 Government Intervention

5. Conclusion

References

List of Figures and Tables

Figure 1: Bitcoin Transactions

Figure 2: Block Header

Figure 3: Classification Scheme proposed by Selgin

Figure 4: Size of mining pools by hash rate distribution over the last four days (29.01.2018)

Figure 5: Growth Rate Previous Period Consumer Price Index USA

Figure 6: Daily price of Bitcoin in $US from January 2009 to January

Figure 7: Daily price of Bitcoin in $US from 1th of January 2011 to 30th of March

Figure 8: Daily price of Bitcoin in $US from 1th of January 2009 to 06th of January

Figure 9: Daily price of Bitcoin in $US from 26th of November 2017 to 24th of January

Figure 10: Network Effects, Switching Costs, and the Fraction of Population Continuing to Use Incumbent Money

Table 1: Market shares of exchanges in the last 30 days on 23.12.2017

1. Introduction

Bitcoin received little attention when it was introduced. Back then the little community around it, probably hardly imagined the enormous attention Bitcoin was about to experience, especially after the price of one Bitcoin rapidly increased to almost 20.000 $US within the last months of 2017. Today Bitcoin seems to be a topic everywhere, it constantly finds its way in the media and opinions about it expressed in the media differ. The American venture capitalist James Altucher made it to the headlines by his prediction of the Bitcoin price being able to reach 1.000.000 $US by 20201. The optimism is shared by John McAfee, founder of the computer anti-virus company McAfee Associates, correcting his original prediction of Bitcoin reaching 500.000 $US by 2020 to also 1.000.000 $US by 2020 via Twitter2. As mentioned opinions differ, and so well-known investor Warren Buffett is quoted by CNBC stating regarding Bitcoin and similar cryptocurrencies ‘I can say almost with certainty that they will come to a bad ending’3. The idea behind Bitcoin is not limited to the interest of private individuals, but even arouses the interest of governments. The Russian and Venezuelan government intend to adopt the mechanism to release state backed cryptocurrencies, while also the Bank of England and the People’s Bank of China, are showing interest in the technology4.

Besides this also the academic world shows a growing interest in Bitcoin and various publications about it made it to top scientific journals. This thesis will be concerned with Bitcoin and the leader of the market, which it is trying to enter, fiat money. While Bitcoin is based on a relative new concept and there are numerous consequences that follow from it, that are surely worth to be examined in an academic manner, the ultimate question regarding Bitcoin is: will it prevail in competition and be able to establish itself as a new money or will it ultimately fail to challenge the domination of fiat money? This thesis aims to answer the question what the determinants for this competition are and look like. What this thesis does not intend to do - and I want to emphasize this -, is to predict the final outcome of this competition process. This would be impossible, due to the limitations this analysis will face. First, the competition in the field of money is by no means limited to Bitcoin and fiat money. An analysis of all potential competitors could fill several hundreds of pages and still would not be complete, as there are at least over 1.500 different cryptocurrencies5 that may have very different specific attributes compared to Bitcoin and an analysis including all of them still would not account for competitors that are not cryptocurrencies. Second, the question for the result of a competition process, is ultimately a question of the preferences of the individuals involved. Giving a final answer to what the result of the competition will be, would mean to claim to possess exact knowledge about the preferences of the individuals involved. It would mean not only to know how they wish each determinant to be designed, but also the relative importance each of these determinants has to them. These two points I made in combination, lead me to believe that this final answer cannot be given by the means of the knowledge a single individual can possess.

The value this thesis is intended to provide is instead to use Bitcoin and fiat money as two examples to show the reader what determinants are important in the process of money competition. I chose the two competitors for specific reasons. Bitcoin I chose because of the recent attention it receives and the fact that it is a relatively young concept, showing that technological progress has not come to an end in the field of money. Fiat money on the other hand seems to me to be a reasonable choice, because of its dominant role as money in the present. The structure of the thesis can be applied to other examples and may help to serve as a foundation for future analysis of money in competition.

We will start in section 2 by introducing both competitors, Bitcoin and fiat money by looking at their main characteristics and how each of them works in order to develop an understanding of the subjects of the thesis. Section 3 will then examine the differences between Bitcoin and fiat money, that will deepen the understanding of the two subjects, especially how they differ from each other. Based on this we will investigate into the process of competition in section 4. First, we work out reasons for preferences towards Bitcoin from the point of view of private agents and governments. The next step will be to examine the role of network effects in combination with switching costs regarding the decision to adopt Bitcoin or not to adopt it. Afterwards, we will analyze potential government interference in the market. Finally, there will be a quick summary of what we learned and which conclusion we can draw from it.

2. Introducing the Competitors

This section is concerned with the introduction of the two competitors we will examine. As they compete as monies, it seems appropriate to begin with some words about money in general, before the thesis will proceed to take a more detailed look at the competitors we are specifically concerned with afterwards. In section 2.1 we will therefore analyze fiat money and do the same for Bitcoin in section 2.2 as the last subsection of this part of the thesis.

An economic textbook defines Money as an asset that agents within an economy frequently use to purchase goods and services from other agents (Mankiw and Taylor 2012, p.760). This definition stresses in particular the function of money as a medium of exchange. It resolves the problem that in the absence of money, for a transaction to take place, both parties involved in the transaction must possess a good the other party is willing to exchange for the offered good, a problem known as double coincidence of wants. A second function is the unit of account, which means it is used as a scale to declare prices in the economy. Mankiw and Taylor give an example of a t-shirt costing 20 € and a hamburger costing 2 €, emphasizing that although it would be technically correct to say the t-shirt costs 10 hamburgers, prices are never declared like this, but in terms of units of the money used by the economic agents. Another frequently named function of money is the store of value. Money therefore makes it possible to produce a good and give it away now, but to obtain another good in exchange for the product good at some point in the future, exchanging it for money in the meanwhile and thereby storing the produced value for the future.

This approach to money can be found in similar form in many economic textbooks. Another way to think about money, that might be less common in textbooks, is to view money as a form of memory. There is the argument that money contributes to society by providing a way to keep track of the past interactions of agents, meaning money acts as a verification that the agent has provided value to another agent before (see for instance Kocherlakota 1996 or Kocherlakota 1998). This approach is not in conflict with the textbook approach and not to be misunderstood as rivaling concept, but simply another perspective. Thinking about money like this, makes it especially clear that it is not the good chosen as money itself that gives value to money, for it is the knowledge gained by the individual that enables them to engage in trades beyond those with a double coincidence of wants. The information stays the same whether it is transported in the form of gold, paper, virtual data or any other way.

2.1 Fiat Money

The textbook definition of fiat money characterizes it as money without any intrinsically value and being used because of a government decree (Mankiw and Taylor 2012, p.762). The lack of intrinsic value means that the demand for it and thereby resulting value of it is not constituted by the commodity that is used as money, meaning that an individual would not be willing to exchange a good for the same amount of paper that is not declared (fiat) money by the government as it is willing to for paper declared as money by the government. This sets it apart from commodity money like gold, where the value derives from the commodity itself and the concrete form is of minor concern.

Now although fiat money does not have any intrinsically value it nevertheless takes an important role in various economies, that can be observed by its ubiquity in any economic activity throughout the world, for it provides the functions discussed above. However, the missing intrinsic value implies that the resource used - for instance paper - is not very scarce. It is thus theoretically possible to extend the supply of fiat money until its value converges to the value of the resource itself or in other terms to experience a hyperinflation. Fiat money hence comes with a need to restrict supply artificially, which for example gold as a commodity money, solves by its very nature as gold is subject to a physical limitation in its amount, that determines the value. One possibility to archive this would be to issue an amount of money at one point of time and keeping the amount of money at exactly this limit. However, most economists view it as a desirable feature of the money in use to enable a public institution to intervene into the economy by the means of monetary policy, increasing or decreasing the total supply of money, even though the question to which extent and in which situation interventions should take place is answered differently by the different schools of economics. Due to these circumstances, it not surprising, that fiat money is commonly provided by a public institution, mostly a central bank, as a not profit- maximizing monopolist, creating a very centralized structure within the currency area.

In the following we will refer to the issuer simply as government, for the central bank is clearly a public institution and the thesis is not concerned with the reasons why the central bank in many cases is set up as an independent institution from the national administration or the consequences that follow by it.

Fiat money also often is declared legal tender, which defines it as money from a legal perspective. Depending on how this legal aspect is designed, it may play a more or less important role in economic analysis. That is legal tender laws may only determine which money is provided by the government and to be used when a private agent interacts with the government. Further, direct effects of legal tender laws on economic interactions between private individuals are only given to the extend they discourage the use of alternative monies by punishments. The issue of government interference will be discussed in more depth in subsection 4.3.

The main things to keep in mind about fiat money is that it is a kind of money, that has no intrinsic value, but obtains its value by being declared as money by government and is typically issued by the government in a monopolistic manner to archive an otherwise not given level of scarcity.

2.2 Bitcoin

Bitcoin was introduced in 2009 by Satoshi Nakamoto, which is a pseudonym for an unknown individual or group, as “a peer-to-peer electronic cash system” that is based on the blockchain technology. This subsection aims to provide the reader with a basic understanding of Bitcoin. It will explain how Bitcoin works in a technical way. Consequences from this design, especially in comparison to fiat money, will be outlined in section 3 of the thesis.

Bitcoin is a “electronic cash-system” (Nakamoto 2008) that only exists in a virtual form and makes use of asymmetric cryptography, which is why Bitcoin and similar systems, called Altcoins (Alternative Coins), are referred to as cryptocurrencies. This cryptographic method provides each participant in the network with two keys, the public and the private key. These keys are linked, but it is not possible to generate the one out of the other. The public key is announced to other participants of the network and can be used by them to encrypt a message for the owner of the key, who is the only one to be able to decrypt it by using his private key, which he keeps secret to the network. This process also works the other way around, meaning a user can encrypt a message with the private key and other participants can confirm the authenticity by successfully decrypting it with the corresponding public key, in other words the sender signs the message with his private key (Diffie and Hellman 1976).

In the case of Bitcoin, one must obtain an account, called a wallet, to take part in transactions within the network. These wallets communicate directly with one another forming a peer-to-peer network, which is key to the concept of Bitcoin (Grinberg 2012, p.163). Each wallet consists of the previously explained set of two keys that enable the owner to send and receive Bitcoins. Ownership over a Bitcoin is not established by the possession of a file, but by input in a publicly shared file, known as the blockchain. Bitcoins are chains of signatures conducted and verified by the public and private keys that form wallets. This means Bitcoins themselves take the form of records of transactions. In concrete, a transaction contains the public key of the recipient and is signed by the private key of the payee, wherefore it not only includes the information where the Bitcoins shall go to, but also where he received them from as can be seen in figure 1 (Nakamoto 2008, p.2).

illustration not visible in this excerpt

Figure 1: Bitcoin Transactions Source: Nakamoto 2008, p.2

This setup is part of Bitcoins solution to a problem, that every virtual payment systems must solve somehow. Other than for physical objects, sending something from one computer to another, the recipient taking possession of the item does not automatically go hand in hand with the giving party of the transaction losing possession of it. This poses a problem to virtual payment systems, as scarcity is a necessity for money to have value, that is known as the double-spending problem. To prevent the user from spending units he already spent before, conventional virtual payment systems implement financial institutions as authority to verify that the money has not been spent so far and ensure it will not be spent again in the future. In this case every transaction involves not only a payer and a payee, but also a trusted third party. This setup leads to a system that is all dependent to this authority (Böhme et al. 2015, p.215). In the design of Bitcoin, Nakamoto solved the double-spending problem in an alternative way, which removes the trusted third party from the process. If a user decides to conduct a transaction, it is announced to the Bitcoin network, which is publicly accessible, and as we already noted this means besides the information where the funds will go to also the information from where they were obtained before is made public. The Bitcoin system is therefore enabled to verify that the Bitcoin was not spend by the payer before and will only accept the earliest transaction (Nakamoto 2008, p.2).

Technically this is done by grouping recent transactions together to a block by the system and connecting these blocks to form a blockchain. For this the transactions are converted into a sequence of signs of a fixed length by a hash function (“hashed”). Hash functions convert any input into a unique sequence of letters and numbers of a fixed length and it is important to note that changing the input by any means, no matter how slightly, will result in a completely different output. In addition, these are one- way functions, meaning it is mathematically not possible to recover the input from the output6.

illustration not visible in this excerpt

Figure 2: Block Header

Source: Nakamoto 2008, p.4

The resulting sequences are hashed together again until only a single hash, called root hash, is generated out of all the transactions grouped together in the block, a principle known as Merkle Tree as shown in figure 2 (Nakamoto 2008, p.4). This root hash, the previous block hash and a nonce form together the block header that is hashed to the block hash.

The previous block hash is included into the header of the next block to link the blocks in a chain, which is why the concept is known as blockchain-technology. The nonce in the block header is part of the so-called proof-of-work system. The point is that the nonce must be chosen so that together with the other parts of the block header the hash resulting from the items put into the function starts with a given number of zeros. The average work required to find the fitting nonce rises exponentially with the number of zeros required, but can always be verified easily by executing one single hash. Thereby it is possible to adjust the difficulty in a way that blocks are found on average every 10 minutes (Yermack 2017, p.11). This whole process is known as “mining” and people taking part in this process are referred to as “miners”.

This “mining” process serves to verify the transactions and thereby protect users against fraud. Deleting or manipulating any transaction afterwards, requires also to search for a new, fitting nonce for the block containing it and every block following it afterwards, as the block hash always includes the previous block hash. This protection does not work by making these changes impossible, but time consuming in dependence of the CPU available. As it is the longest chain that is valid, an attacker would have to control over 50% of the CPU in order to be surely able to catch up with the unmanipulated blockchain (Nakamoto 2008, p.3). It should be emphasized, that the only manipulation possible is to take back Bitcoins, he spent before, because adding a transaction transferring Bitcoins owned by another individual, would require him to possess access to the private key of the individual. Thus, the attacker would always start some blocks behind the unmanipulated blockchain, as he needs his victim to believe the transaction took place for some time. Nakamoto (2008, pp.6-8) shows that the probability to catch up for an attacker controlling 10% of the CPU power drops below 0.1% once he is 5 blocks behind and even if he controls 25% of the CPU power, the probability drops below 0.1% once he is 15 blocks behind. To put this into perspective, between the beginning of November and the end of December the total hash rate per second in the Bitcoin network was swinging between roughly 14 to 22 trillion7, which requires enormous CPU power to archive.

Based on the many resources put into this mining process, the question for the incentive to participate in the process may arise. The answer is that a successful miner, the one that found the solution to the mathematic puzzle described above first, receives a certain amount of Bitcoin, once other miners verify his solution and the process moves on to the next block. One part of these Bitcoins are new Bitcoins created, answering the previously unanswered question where all these Bitcoins enter the system, or in other terms where all these records of transactions begin. Another possible part are voluntarily paid transaction fees by those conducting transactions (Nakamoto 2008, p.4). The number of new Bitcoins entering the system this way was first set to 50 Bitcoins per block, but is reduced by 50% every four years and will drop to zero when Block 6.930.000 is mined, approximately in the year 2140. By this design, given that as mentioned earlier blocks are found on average every 10 minutes by a miner, the total amount of Bitcoin converges to 21 million, which it will never reach (Grinberg 2012, p.163)8.

3. Comparing Bitcoin and the Fiat Money System

The thesis will continue with a comparison between Bitcoin and fiat money in this section. This comparison is important for the examination of the competition process in the next section, since the choice agents make between the competitors is obviously dependent on their characteristics relative to each other. Based on what is discussed in this section, we will establish reasons for preferences in favor or against Bitcoin in subsection 4.1 afterwards. In this section we will highlight fundamental differences resulting from the very nature of Bitcoin and fiat money which the reader was introduced to in subsections 2.1 and 2.2 at first. Namely we will discuss what kind of money Bitcoin is, centralization and decentralization in both systems as well as the question of privacy. Afterwards, we will look at contemporary differences, that might change at some point in time.

3.1 Synthetic commodity money

To examine the differences between Bitcoin and fiat money, first of we look at how to classify Bitcoin. Fiat money already is a category of money itself, which is why we do not have to be concerned to classify it at this point logically. A well-known classification scheme is the simple distinction between commodity money and fiat money. Commodity money we did not encounter in this thesis in-depth. Money is referred to as commodity money, when it consists of a good useful for non-monetary purposes and is naturally scarce. Having a non-monetary use means there is an intrinsic value to the good used as money. Competitive supply alone leaves it with a positive value in equilibrium equal to the marginal costs of production, meaning that no artificial scarcity needs to be implemented.

Fiat money, as we saw before, does not consist of a good useful in trade besides exchanging it for other goods. It usually comes in the form of paper notes or bank credit that is convertible into paper notes, with a value in equilibrium, that exceeds the marginal cost of production. Friedman (1960, p.7) notes that the marginal costs of production are near-zero, as the nominal quantity of fiat money can be increased almost independent from the amount of paper used by issuing larger-denominated notes. Thus, he argues fiat money is unsuitable for competitive supply of homogenous units, as it would leave its value finally also near-zero, since every individual supplier is incentivized to extend his supply until a literal paper standard would be reached. Fiat money therefore can be characterized by a need for artificial scarcity. Selgin (2014, p.2) points out that in order for the value of fiat money to exceed the marginal cost of production in equilibrium, there has to be a monopolistic supply to provide scarcity. The monopolist however, must not be guided by profit-maximization, as the provided amount would still exceed the level necessary to preserve purchasing power (Easterly et al. 1995).

Selgin (2014) expands this binary classification model to a model with four possible classifications, by using the way scarcity is achieved and the question if there are non- monetary uses as separate characteristics. Absolute scarcity and potential nonmonetary uses characterize commodity money. A kind of money for which the opposite in both characteristics is the case is classified as fiat money. The first of the new types of money is the “Coase Durable”, which does have nonmonetary uses, but no absolute scarcity. Finally, the last category of money in the model is “Synthetic Commodity”.

This category includes money that is absolute in scarcity, but cannot be used for nonmonetary purposes. The classification can be seen in figure 3.

illustration not visible in this excerpt

Figure 3: Classification Scheme proposed by Selgin

Source: Selgin 2014, p.2

Bitcoin does not have any non-monetary use, for itself cannot be used for anything but to transfer it to another agent, as owning a Bitcoin comes down to having an entry in the blockchain file stating this to be the case. There is also no fixed exchange rate to another good that would back it, leaving it without any intrinsic value. Hence it is clearly not a commodity money, but nevertheless Bitcoin is not just some kind of private fiat money. Other than fiat money, it shares the absolute scarcity as a feature with commodity money. As explained in subsection 2.2, the number of Bitcoins in circulation will stop to grow at a certain point in time and no further Bitcoins will come into existence. Bitcoin is thus a hybrid between classic commodity money and classic fiat money that can be classified as “synthetic commodity money” as done by Selgin (2014).

3.2 Centralization

Decentralization is what sets Bitcoin apart from other virtual currencies and besides being a core feature to its concept, it also is often viewed as a driving motive for its development in response to distrust and perceived abuse of the current fiat system, enabled through the centralized structure (Lo and Wang 2014, p.12, Yermack 2017, p.12). Decentralization averts a concentration of power and eliminates possible complications that arise with a system that has a potential central point of failure. If the European Central Bank would fail to work the consequences for the Euro system would be quite serious if not devastating. Bitcoin as a peer-to-peer network on the contrary simply does not feature this one point, that the whole system is dependent to. However, there are market forces, that drive certain points in the Bitcoin ecosystem towards centralization, that are worth to be examined.

[...]


1 https://www.cnbc.com/2017/12/01/james-altuchers-bitcoin-predictions.html (retrieve 04.02.2018)

2 https://twitter.com/officialmcafee/status/935900326007328768?lang=en (retrieve 04.02.2018)

3 https://www.cnbc.com/video/2018/01/10/warren-buffett-cryptocurrency-will-come-to-a-bad- ending.html (retrieve 04.02.2018)

4 https://www.nytimes.com/2018/01/03/technology/russia-venezuela-virtual-currencies.html (retrieve 04.02.2018)

5 https://coinmarketcap.com/all/views/all/ (retrieve 04.02.2018)

6 This simplified explanation should be sufficient for the thesis. For more in-depth discussion see for example Naor and Yung 1995.

7 https://blockchain.info/de/charts/hash-rate (retrieve 04.02.2018)

8 See also https://en.bitcoin.it/wiki/Controlled_supply (retrieve 04.02.2018)

Excerpt out of 45 pages

Details

Title
Bitcoin as a Competitor for Fiat Money
College
Friedrich-Alexander University Erlangen-Nuremberg
Grade
1,7
Author
Year
2018
Pages
45
Catalog Number
V432089
ISBN (eBook)
9783668742635
ISBN (Book)
9783668742642
File size
1152 KB
Language
English
Tags
Bitcoin, Fiat Money, Geld, Geldsystem, Money, Crypto, Cryptocurrency
Quote paper
Oliver Freimuth (Author), 2018, Bitcoin as a Competitor for Fiat Money, Munich, GRIN Verlag, https://www.grin.com/document/432089

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