Cryptocurrencies & Their Effects On Monetary Policy

21 minute read

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Cryptocurrencies & Their Effects On Monetary Policy

By Deniz Özgür

Posted May 14, 2019

Abstract

The programmable economy is a natively “smart” economic system that supports and/or manages the production and consumption of goods and services, enabling diverse scenarios of exchange of value (monetary and non-monetary). Beyond the hype, beyond the expectation lies a digital future ahead of us with great speed of adaptation both by individuals and the institutions. This report briefly explains blockchain and how cryptocurrencies work; examines pros and cons; mentions some of the most powerful implications on financial institutions and potential effects on monetary systems; and lastly announces technology projections and predictions of research companies.

What is Blockchain ?

An insane contradiction and confusion lead people to become quite radical about distributed technologies. Depending on who you ask, blockchains are either the most important technological innovation since the internet or a solution looking for a problem. Here is the definition of blockchain: A blockchain is a decentralized, distributed and public digital ledger that is used to record transactions across many computers so that the record cannot be altered retroactively without the alteration of all subsequent blocks and the consensus of the network. But what does this really mean? Let’s break this definition down. First, a digital ledger is a digitalized collection of transaction records. When something is “decentralized and distributed,” there’s no central service center or supercomputer hosting and storing these records. Rather, the records, or digital ledger, are separated, or distributed, into millions of identical copies and on different machines (known as nodes).Second, “public” means that the digital ledger is open to the public, as opposed to being held by a particular entity. This also means that all the machines or computers in the blockchain network have access to add transactions and update all the copies on other machines. In a 2017 Harvard Business Review article, Marco Iansiti and Karim R. Lakhani define blockchain as “the technology at the heart of bitcoin and other virtual currencies,” and “an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.”

Towards Bitcoin

There is this misconception that blockchain and crypto currencies came out of nowhere. Originally built upon some strong economical, philosophical and technological concepts, even though 2008 is known to be a milestone, digital currencies have 30 years of past starting from Digicash (1989) enabling users to make untraceable, anonymous transactions. It was perhaps too early for its time. Later that attempt, history has witnessed E-Gold (1996), which was a digital currency backed by real gold. The company was plagued by legal troubles, and its founder Douglas Jackson eventually pled guilty to operating an illegal money-transfer service and conspiracy to commit money laundering. That acquisitions never seem to put out the fire because only 2 years later in 1998 B-Money and Bit-Gold was developed by two famous cryptographers Wei Dai (B-money) and Nick Szabo (Bit-gold) each proposed separate but similar decentralized currency systems with a limited supply of digital money issued to people who devoted computing resources.

Economic Crisis & Bitcoin

What didn’t kill us literally made us stronger. A devastating crisis for the world economy resulted in massive unemployment and market collapse. But what were the factors which led us to rethink the economy? Let us look at a few:

  1. Selfish Interest of Banks: The investment bankers, traders and executives took excessive risk without proper market study. They just wanted to drive in profits, without pondering on the ways in which it could be done. The risk to reward ratio did not fit, but they took the chances anyway. The bonus culture prevalent that time led the bankers to sell as many products as they could. They did not focus on building a long-term relationship with their customers. The Incentives and Bonus which came with each sale clouded their judgment. Loans were issued to even poorly rated credit borrowers. These were the people who had a bad reputation in the market regarding repayment of loans and handling their own finances. The bankers were only focused on giving out loans, and thus even the bad elements got involved in the process. Securitization of high-risk assets was done. Also, these securities were kept off the balance sheet. Investors took a heavy risk in these securities. But perhaps they were not really aware of this, thanks to the credit rating agencies. The bankers chose sales targets over sustainability. There was a difference in interest.The role of credit rating agencies is to give information on riskiness, safety and quality of securities issues. Some of the very famous credit rating agencies were handling this job for the big banks these days. Now they had incentives on giving ratings to these securities. In order to develop positive sentiments, they gave a positive score to even very high-risk securities. Perhaps they had realised that none of those securities was of any value, but they had to look at their own profits as well. This led to the banks issuing more securities and investors taking the risk.
  2. Lack of Financial Education: Another very important factor was the lack of education among the masses. When loans were issued, the interest rates used to be low. In time these rates changed and the people who took these loans could not understand this variation. The new interest rates were higher than what they were initially asked to pay. When borrowers realised they could not pay their loans at these rates, they defaulted. Even the bankers did not fully understand the terms and conditions of the deals they made and the risks they took. One classic example would be the Housing Bubble which popped and many banks went into bankruptcy.
  3. Monetary Policies and Lack of Regulation: Monetary policies are what determine the interest rates and the circulation of currency which influence the economy as a whole. Many individuals mortgaged at a certain interest, and when these rates rose, they defaulted. The regulations were not so strong, particularly in the US and the banks were free to do what they wanted. Glass-Steagall Act was introduced in 1933 after the Great Depression. This Act led to the separation of commercial banking and investment banking. Prior to this, both the functions were carried under the same roof. The Act was revoked before the 2000s and the banks returned to their old ways. Commercial banking and investment banking was merged again, leading to banks taking greater risks. It was a careless gesture which led to the doom of economy. In conclusion, this chain of continuous negligence and concession has shaken the trust to central authorities as well as any intermediaries. It made people question the economic mechanism which intuitively was the responsibility of government and central bank. Just like when discussions on separating politics and religion took place a hundred years ago, now it was time to have individual sovereignty on money management. What is even more noteworthy, people started to become more aware about their financial ignorance and even blamed the education system.

“Those crashes, these bailouts, are not accidents. And neither is it an accident that there is no financial education in school. […] It’s premeditated. Just as prior to the Civil War it was illegal to educate a slave, we are not allowed to learn about money in school.”— Robert Kiyosaki”

Without Policy, No Control! How Does It Work?

There are three main concepts Bitcoin and most of the following crypto currencies are built upon: Decentralization: There is no central entity governing the system. Every participant of the network contributes to keeping it alive. This removes security holes, because even if a single, big party gets hacked, the other members of the network aren’t affected and the overall system recovers. Shared memory: A record of all transactions between all parties on the blockchain is stored on every computer in the network. Forever. And everyone can see it. This makes the network secure against fraud and data loss. Cryptography: Through a set of complex algorithms and math problems, all transactions and participants are protected by encryption. There are tradeoffs between these features and different projects interpret them in different ways, but in the end, these three elements are what defines not just Bitcoin, but all blockchains. When it comes to Bitcoin in particular, the combination of these blockchain features serves two core functions: storing value and enabling direct, financial transactions from one user to another. These functions are part of any working currency, Bitcoin just aims to make them better.

  1. Trustless Transactions In a government-issued currency, the trust that enables you and me to exchange $1 bills at constant value is delegated to the government. We hope no matter what happens, the government will make sure we get our $1 worth of goods. Whether that’s an apple today or a car in 50 years, no one knows. When we process money through banks, we trust that the government has trusted in them to extend that guarantee, and so on. “The Bitcoin network enables that same 1-on-1 transaction power at constant unit value, minus the governments and the banks.” Every user has an individual address, like a bank account you use today. It keeps a balance of how much value in Bitcoin you have and enables users to send money from one address to another. What’s different is that users don’t need the bank and can still expect the transaction to be secure. They don’t even need to know each other. Hence the ‘trustless’ part. You don’t need to delegate trust to any third party in order to exchange value for currency and vice versa.
  2. Storing Value The way a government can guarantee a dollar will always be interchangeable for another dollar is by backing the sum of all dollars with a massive amount of assets. While governments do own a lot of those — land, real estate, landmarks, national treasure, and tons of commodities, like gold — their number one asset is that they can print the currency at will. It’s called inflation.

Bitcoin’s “supply formula”

Bitcoin tackles this need by more directly copying the economic model which has evolved around gold. The two are often compared because both have a limited supply. As with gold, it gets harder to create, that is mine, new Bitcoins over time. While nobody knows exactly how much gold is still to be discovered, the maximum supply of Bitcoin is detained in the open source code: 21 million coins, over 17 million of which have already been mined. The last Bitcoin will be created around the year 2140. With a fixed supply of money, but an infinitely growing population of humans, demand is bound to outpace supply sooner or later. In fact, it already has, which is why the price of Bitcoin has exploded so much. If population growth stagnates at some point and everyone uses Bitcoin, the price might stagnate too. But as long as it doesn’t and more people keep joining the currency network, the price goes up. That makes holding Bitcoin a great store of value for those, who have some.

“Bitcoin’s value proposition is not digital currency — 90% of existing money only exists as digital currency; Bitcoin’s value proposition is its methodology in guaranteeing the trustworthiness of digital currency.”

How About Fractional Reserve Flexibility?

Talking about value, one should remember how arrangeable money supply giving a useful flexibility to the central banks. What has been called expansionary monetary policy, quantitative easing or fiscal stimulus to the economy all refers to that clever tool but almost instinctively hides the meaning from society to cover the obvious intervention. Godfrey Bloom, addressing the European Parliament during a joint debate, said it way better than I ever could:

“[…] you do not really understand the concept of banking. All the banks are broke. Bank Santander, Deutsche Bank, Royal Bank of Scotland — they’re all broke! And why are they broke? It isn’t an act of God. It isn’t some sort of tsunami. They’re broke because we have a system called ‘fractional reserve banking’ which means that banks can lend money that they don’t actually have! It’s a criminal scandal and it’s been going on for too long. […]We have counterfeiting — sometimes called quantitative easing — but counterfeiting by any other name. The artificial printing of money which, if any ordinary person did, they’d go to prison for a very long time […] and until we start sending bankers — and I include central bankers and politicians — to prison for this outrage it will continue.” Don’t get me wrong: There is nothing wrong with making economical arrangements. There is nothing wrong with fractional reserve banking if having entire authority also means to have the responsibility to take the controlling action. There isn’t even anything wrong with good old regular banks to store your wealth somewhere more secure than in your sock drawer. However, what has been proposed here is basically a self-controlling, living mechanism which sustains perfect information opportunity among the voluntary participants.

Grandchildren Of Bitcoin: Altcoins

Following the success of bitcoin, there have been more than 1630 (according to Coinmarketcap data) other cryptocurrencies created, they are collectively called “Alt Coins” since they serve as an alternate of bitcoin in the digital currency world. The main motivation of their core developers was to advance Bitcoin’s flaws such as scalability, the amount of energy and time consumption during its transaction verification process which is called Proof Of Work. Not without mentioning, those reasons keep people to develop applications, generate use cases and more importantly, evolve their businesses with distributed technologies. In 2011, an important question was arisen: What if your set of ideas does not overlap with Bitcoin’s? What if you wish to change Bitcoin’s set of ideas, not convinced of the futility of this endeavor? What if you are downright repulsed by some of its ideas? Criticising the obvious weaknesses of the old father, who will take the throne instead? Those who wanted to change Bitcoin’s ideas in a fundamental way, draw their own path which is called forking in software ecosystem. With forking, Bitcoin’s open source code, permissionless network structure, and lack of formal organization of any kind was basically allowing anyone to copy, modify, and run the code without asking for permission. Although most of the projects failed to generate a unique approach to Bitcoin and their set of ideas necessarily overlaps with it; in most cases they were almost the same.

New Term Has Arisen: CryptoEconomics

As more and more networks and alt coins came alive, theories and models are needed to understand the issues facing contemporary communities. Crypto-economics as a discipline is an attempt to create models that allow the analysis of interrelationship in increasingly complex frameworks of human interaction in distributed systems. Most commonly accepted public blockchains are a product of crypto-economics. The term “Crypto-Economics” has been defined in several different ways. Most commonalities in definitions for the term crypto-economics include the use of cryptography and incentive design to created networks, applications, and systems. Further, crypto-economics is interdisciplinary. We already know economics examines how individuals and groups respond to incentives. Connecting it to traditional economics, crypto-economics is mostly associated with mechanism design, a sub-discipline of economic theory and mathematics. Crypto-economics is what makes blockchains interesting, what makes them different from other technologies. As a result of Satoshi’s white paper, we have learned that through the clever combination of cryptography, networking theory, computer science and economic incentives we can build new kinds of technologies. These new crypto-economic systems can accomplish things that these disciplines could not achieve on their own. Blockchains are just one product of this new practical science. Blockchain networks are in need of economics especially with the incentives listed below, which exists in every blockchain but in various shapes:

  1. Tokens: The actors who actively participate and contribute to the blockchain get assigned cryptocurrencies for their efforts.
  2. Privileges: Actors get the decision-making rights which gives them the right to charge rent. Eg. Miners who mine a new block become the temporary dictator of the block and decide which transactions go in. They can charge transaction fees to include transactions within the block itself.
  3. Rewards: Good participants get a monetary reward or decision-making responsibility for doing well.
  4. Punishments: Bad participants have to pay a monetary fine or they have their rights taken away for behaving badly

With those incentives, some obvious subfields of economics are adapted through cryptographers. As we almost always see economics, supply and demand curves are also very popular here as well. Deciding on the total supply of the coins (or tokens), their releasing mechanisms, burning strategies (to withdraw the money from the market) with the ultimate goal of creating a self organizing living organism which serves as and economical environment with participants fully informed and motivated. Soon after, digital currency design required people to study game theory to search for the motivations of the contributors and built the action-result mechanisms. Nodes (devices in the network representing individuals), miners and authorities (if any) are expected to behave on their best interests while never sacrificing the maintenance of the network. Free and competitive market mechanisms is replicated in public blockchain systems while private chains gives priority to institutional organization and authority delegation. If crypto-economics of a network is poorly designed or executed, individuals have every right to shift towards a greedy strategy. In order to widen the perspective of building the perfect maintenance for participant one should consider the subjects of economics that are listed below:

  1. Game theory
  2. Mechanism Design
  3. Consensus Mechanisms
  4. Network Effects - Behavioral Economics
  5. Governance - Political Economics

Investment In Blockchain Technology

A technologic phenomena has never given that much priority to finance and economics. Not because designing consensus systems strictly requires economics, but because allowed millions for open market investments. Thousands of people flocked to the cryptocurrency markets hoping to catch the hype occurred in October 2017. They have learned investment tools before learning the blockchain itself. Fraud-Proof characteristics of transactions, transparent ledgers, borders trade opportunity, lack of regulative dominance, scarce coins, seamless development of technology and high adaptation rates lead to a bubble for 5 months and resulted inevitable loss afterwards. On the bright side, attracted attention never goes away and that hyped is rather perceived as the true potential of an egalitarian cyber movement. Blockchain history, at that times, witnessed the transformation of a traditional funding method called IPO (Initial Public Offering) into ICO (Initial Coin Offering) which offered international funding framework for those who expect high ROI with enchanted growing and marketing potential in an unregulated environment to avoid taxes. While some of the leading blockchain startups today are the products of those ICO’s, 95% of them were scam. Cryptocurrency investment, no matter how volatile it is, has madly expanded throughout the years of spreading from ear to ear. Leading cryptocurrency exchanges already started to dominated the market even though their level of security and objectivity is still questioned. Binance, the biggest exchange founded in 2017, has been hacked in May 2019 and 7.000 BTC is stolen. What is even more interesting, CEO offered to reorganize the chain to rollback before the hack and almost for a week people sharply criticized him daring to manipulate the network. With the increasing costs, CEO took a step back and apologized but that incident remained some solid questions behind: How safe are we? How come the strongest exchange is that helpless against hacks? Eleven years after 2008 and are we still missing something? Those, we won’t be able to answer in near future.

Cryptocurrencies: The Future Ahead

The most debated topics today in blockchain space has much to say about what lies in future. Any comment about the upcoming years should be investigated through three main problems: volatility, scalability and competition against incumbent money’s network effects. Starting with the volatility hurdle, this is one of the most talked about issues with cryptocurrencies. High volatility is bad because it prevents a cryptocurrency from being a good unit of account or store of value. As we know from the economics, this feature is compromised by definition from high volatility. This is bad because if the volatility of a money is very high then the agent who accepts this money as payment runs substantial financial risk from the volatility, this overall makes the money in question far less appealing for real world agents. One potential solution is the hope that as cryptocurrencies become mainstream and secure user adoption, they will become stable in the markets themselves. This we call “maturity dampening effect”. The argument often given for this thesis is as follows:

“Cryptocurrencies are still infant technologies. There is high uncertainty about their future use and adoption, hence, high volatility is entirely natural because small updates in market information will cause large shifts in market expectation. Once the dominant cryptocurrencies emerge and become adopted by all those who will use them, they will reach a saturation point which will make their price become more stable.” Another solution is the creation of stablecoins, cryptocurrencies that have volatility reducing design structure built into them. A stablecoin that relies on using USD or another currency as its unit of account would be a far less revolutionary outcome than that of a real independent cryptocurrency. Another issue is scalability. At the moment all decentralised cryptocurrencies cannot scale effectively because of the current technology limitations. By scale effectively people mean increase the amount of transactions by a large magnitude with negligible effect on speed of transaction and cost of transaction. The difficulty in large part comes from the cryptocurrencies who choose to stand by the commitment to decentralisation of the network with a permissionless blockchain. Many cryptocurrencies such as XRP have managed to scale effectively, however, this comes at the cost of a centralised network. That bears one questions: Since we only manage to scale the network with centralized structures, will the institutions dominate blockchain and use it for their benefits? Community surely resists that idea. Lasly, cryptocurrencies are definitely competing against the network effects of incumbent moneys. Money is only useful if enough other people accept and use it. It is one of the most classical examples of network effects — the greater the number of participants the more valuable the network (normally increasing in a non-linear fashion). Therefore, motivations behind cryptocurrency adaptation should be investigated. One reason why a cryptocurrency might be used instead of something like the dollar, is if there was a large scale financial crisis. For instance, if the dollar itself was called into question because of large government debt, then there may be a wide enough fear of national fiat that cryptocurrencies are turned to as alternatives. However, this would be then leaving the hope of powerful network effects to be established by apocalyptic events. Another reason for higher adoption might be from an ideologically motivated reason whereby people feel cheated by the current system and seek to try out of it by using cryptocurrencies. However, the practical cost of such an ideological position will be significant, buying groceries, getting paid all become much harder. Aside from this, the other option for cryptocurrencies might be to offer money for specific use cases, such as being used for the internet of things, or as an alternative to remittances rather than the all encompassing use cases that current currencies have. Some of these 3 challenges for current and future cryptocurrencies feed into each other. The uncertainty of any one cryptocurrency’s acceptance in the future makes it hard to gain a large network, and this in turn makes it more volatile. The technical issues of scalability may reasonably be overcome. However, without the power of a government to help create a monopoly which is how most of money over time has been created, some of these challenges may prove to be insurmountable.

Conclusion

Bitcoin is is the marriage of economics and computer science; a digital deflationary currency and ledger run on a decentralised network, which was launched to replace the current inflationary fiat system, following the 2008 economic crash. Surely an economic phenomena rather than a technologic one with the consideration of mechanism design and incentive arrangements are at the heart of this innovation. The interpretation of blockchain as an experiment field for economics would even clears the doubts and fears out of the way which encourages economists to lead and take responsibility of bringing their open market theories into life. With abilities like control and flexibility, they are allowed to design replicable systems with millions of participant who have defined roles and incentives and more importantly economists can come up with real industry solutions. We should definitely get involved, definitely be decentralised.

Sources

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