A fascinating fresh survey of microeconomics literature on crypto currencies: "The Microeconomics of Cryptocurrencies" by Hanna Halaburda, Guillaume Haeringer, Joshua Gans, Neil Gandal (CESifo Working Paper 8841, 2021, NBER version link here: https://www.nber.org/papers/w27477).
The paper is really too extensive to summarize here, so I encourage everyone interested in cryptos to read it. I can, however, offer some non-priority ordered comments on some of the passages I find interesting and novel.
Let's start with 'efficiency' and the 'nothing-at-stake problem'. Authors reference Saleh (2019) which derives "sufficient conditions that guarantee that consensus" to fork is an equilibrium. "Saleh then derives two additional results.
- "First, restricting the ability to large stakeholders facilitates and speeds up consensus in case of a fork. The intuition is that [large] stakeholders have the most to lose from a disagreement, i.e., from the persistence of two or more branches." This seems to me a built-in incentives mechanism for increasing concentration of holdings of cryptos. Just as monopolistic power can lead to cartelization and collusion, so is the need for faster / more efficient consensus on development can lead to market dominance and concentration. The side effect of this would be likely reduced liquidity and also likely manipulation of exchange rates. Neither is good for cryptos susceptible to concentration becoming actual money (unit of account, unit of storage, unit of exchange).
- Second, "Saleh finds that the lower the miners' reward the better. The reason behind this counter-intuitive result is that low rewards enable the accumulation of vested interest in the blockchain (i.e., miners have less incentives to cash out their tokens). Given this, preserving one's vested interest in the blockchain (the tokens) increase the incentives to favor consensus." This is ugly. It further compounds holdings concentration and reduces liquidity. Worse, by inducing longer holding time horizons, it risks potential over-reaction to price movements in the longer run, so that markets price discovery can be severely restricted, and financial bubbles can form and inflate faster and more viciously.
Another issue, relating to efficiency, is transaction costs: the paper reviews Huberman et al. (2019) on this. There are several problems relating to the Bitcoin system capacity to process and record information that relates to the way transaction fees are being priced and charged. These are largely consistent also with Easley et al. (2019). One is that "miners are not only engaged into a hashing race, but they also strategically select transactions to process in order to grab the highest fees." Another is that the system requires congestion to generate fees. The third is that once block rewards are exhausted, the system can lead to concentration of market power as miners will rely solely on transaction fees to exist. This power concentration can lead to higher costs of transactions, and "may result in turn in a weakening of the system's safeguards against double-spending". Lastly, "if all users pay the fee, the deviation to no fee is very costly, because it automatically puts the no fee transaction at the very end of the queue. This cost may be higher than the fee itself." In other words, in the "all users pay" environment, system congestion can lead to highly costly delays in processing of information.
User adoption: "Foley et al. (2019) find that approximately one-quarter of bitcoin users are involved in illegal activity, which they estimate to represent 46% of bitcoin transactions. Based on their estimates, the illegal use of bitcoin generates approximately $76 billion of illegal activity per year. In terms of comparison, they note that the scale of the US and European markets for illegal drugs is only slightly larger! They do find that since 2016 the proportion of bitcoin activity associated with illegal trade has declined, but the absolute amount of activity (in USD) has continued to increase."
"One example of illegal activity that currently flourishes with Bitcoin is "ransomware" attacks in which criminals exploit vulnerabilities in computer networks to "lock" files so that the user cannot access them. As documented in an article in the New York Times by Nathaniel Popper, in 2019, more than 200,000 organizations submitted files that had been hacked in a ransomware attack. This was a 40 percent increase from the year before,"
The literature on the subject is "consistent with what we know about adoption by large merchants. According to the Economist magazine using data from Morgan Stanley, in 2018, only three of the largest 500 online retailers accept Bitcoin for payments", which is down from five such retailers accepting Bitcoin in 2017. "The conventional wisdom for the lack of adoption of Bitcoin as a payment system is that very few "legal" goods are purchased using Bitcoin because its value is not stable and the system is very slow in processing transactions."
User intent: "Most of the empirical research we discussed... suggest that currently, bitcoin demand is driven by speculation alongside likely illegal intent. A broader claim about bitcoin demand is that it is used as a hedge against inflation" (or as a form of 'digital gold'). The paper argues that BTC/USD pricing of July 2019 or something around USD9,630 per BTC would be consistent with all cryptocurrencies taken as whole replacing 100% of the privately held investment gold in the world for the gold price of USD 1,444 per ounce. As we say before running a Category V rapid... "Good luck on the down".
Pump and dump coins: "Hamrick et al. (2018) present compelling evidence of pervasive pump-and-dump schemes resulting from a systematic analysis of multiple datasets ... they identify more than 3,000 pump-and-dump schemes over a just 6 month period in 2018."
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