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What is needed is an electronic payment system

based on cryptographic proof instead of trust

Satoshi Nakamoto (2008)

The Art of Bitcoin by Pierre Bourque

Technology and Economics

200 Bitcoins by Kuno Goda

Bitcoin story: ‘in code we trust’
• ‘Bitcoin story’ is inspirational because it proposes monetary creation
process based on algorithm and free of politics and human error.
• No hyperinflation (Zimbabwe, Venezuela) due to irresponsible CB monetary
• No ad-hoc confiscatory monetary reforms (demotization in India).
• No need for TBTF banks that have been bailed-out by taxpayers money.
• Bitcoin is a monopoly without a monopolist.
• However, Bitcoin is an open-source software that could be updated
periodically. How often? What kind of updates? Who decides?
Governance of bitcoin and other cryptocurrencies is not free of
politics and human error.

Source: Angela Walch

What is the future of bitcoin?
To answer this question, we rephrase it into more precise questions:

1. What is bitcoin’s blockchain technology and does it render it a suitable form of

2. What does history teach us about the adoption of new forms of money by the
3. Does bitcoin fulfill three functions of money?
4. Which flows in the bitcoin technology prevent it from becoming money and can it be
5. Could bitcoin become digital gold (safe haven and hedge)?
6. Could other cryptocurrencies (Bitcoin Cash, Ether, Litecoin, Dash, Zcash, etc) or virtual
currencies (Ripple) correct technological flows of bitcoin and become global
7. What is the role of the governance and regulation?
Technology (How?) and Economics (Why?)
1. Introduction: short history of money
2. Blockchain: technology behind bitcoin
3. Short history of bitcoin
4. Bitcoin: money, commodity or asset?
A. Does bitcoin fulfill three main functions of money?
B. Bitcoin supply and monetary policy
C. Could bitcoin become a hedge, like gold?
5. Market liquidity & volatility or ‘How to choose a cryptocurrency exchange?’
6. Cryptocurrency risks and regulation
A. Technological risks: DCS Trilemma or the scaling debate
B. Operational risks and governance
C. Regulation
1. Introduction: short history
of money
Stages of money development
• Commodity money: Has non‐monetary use and is naturally scarce,
e.g. gold, silver
• Representative money: represents a claim on such a commodity.
• Fiat money (since 1971): No non‐monetary use and scarce only by
design, e.g. Federal Reserve’s discretion
• Digital money: Bitcoin and other cryptocurrencies: scarce by
algorithm (reminiscent of Milton Friedman’s computer controlled
monetary rule).
Money is
• Unit of account, medium of exchange,
store of value (three functions of money)
• An exchange of debt contracts (IOU).
• Credit existed before money. Credo is ‘I
believe’ in Latin.
• A collective fiction
• Example: Yap, a culture that lived in
Micronesia in the early 1900s used limestone
disks as money (“Rai” stones).
• A great human invention (myth) that
allows establishing trust between
• In the moneyless society of the Inca Empire,
labour was the unit of value. The society
depended on central planning and forced
All these pieces of paper are issued with as much solemnity and authority as if they
were of pure gold or silver... and indeed everybody takes them readily, for
wheresoever a person may go throughout the Great Kaan's dominions he shall find
these pieces of paper current, and shall be able to transact all sales and purchases of
goods by means of them just as well as if they were coins of pure gold.
— Marco Polo, The Travels of Marco Polo (13th century).
Short history of representative money
• Tang dynasty China used "feiquan" - flying money - a two-part
document allowing merchants to deposit profits (in copper cash
coins) in a regional office, and reclaim their cash back in the capital.
System was operated by the government.
• The Knights Templar introduced a letter of credit in Europe in 1150. A
pilgrim could leave his cash at Temple Church in London, and
withdraw it in Jerusalem.
• Medici Bank (1397 – 1494) used bills of exchange to finance trade.
• Lyon fairs and bills of exchange (IOU) (16 century), denominated in
the ecu de marc, a private currency used by this international
network of bankers.
Goldsmith bankers and evolution of payment
technology in England
The bank note (paper money) evolved out of receipts for deposits at
• Goldsmith banks (16th century) kept ledgers of their customers’ deposits
which enabled payments to be made by making changes in the ledgers
rather than physically exchanging the assets.
• Since it only worked for customers who shared the same bank, a central
‘clearing’ bank at which all the member banks could hold accounts
• Modern banking began when these receipts were issued not just to those
who had deposited money but also to those who borrowed money.
• Instead of bearing the name of a particular depositor or borrower, soon the
receipts were issued to the “bearer.”
• The Promissory Notes Act of 1704 ratified the practice.
Money creation in the modern economy
Bank A
Assets Liabilites
Loans 100 Deposits 100

Bank A
Assets Liabilites
Loans 200 Deposits 200
History of digital money
• Cypto‐currencies have been around since the 1980s
• The early ones (Digicash and Ecash) failed because they did not
provide a solution to the “double spend” problem, i.e. with the same
digital key you could spend twice or more.
• Bitcoin solves the double spend problem
Digital currency/Virtual currency/Cryptocurrency
• Digital currency is an asset represented in digital form and having some
monetary characteristics. Digital currency can be denominated to a
sovereign currency and issued by the issuer responsible to redeem digital
money for cash. In that case, digital currency represents electronic money
(e-money). More generally, central bank digital currency is a digital
currency with a centralised ledger. (BIS, 2015. Digital currencies).
• Virtual currency is a digital currency with decentralized or automatic
issuance (not issued by a central bank, credit institution or e-money
institution), which, in some circumstances, can be used as an alternative to
money. (ECB, 2015. Virtual currency schemes – a further analysis)
• Most virtual currencies are ‘cryptocurrencies’: they seek consensus
through means of techniques of cryptography.
• There are also a small number of virtual currencies (Ripple), that seek
consensus through non-cryptographic means.
Digital currency

Central Bank Digital Virtual Currency: issued by entities

Currency other than CB, credit institutions,
e-money institutions.

Cryptocurrency: consensus is based Virtual Currencies with

on cryptograhpy other types of concensus.
E.g. Bitcoin, Bitcoin cash, Ether, E.g. Ripple
Litecoin, etc.
Cryptocurrencies market capitalization

Motivation for the adoption of
• Ideology
• The first block in Bitcoin’s block chain (the ‘genesis block’) includes the text:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks in
reference to a newspaper article (Duncan and Elliott, 2009).
• The need for a decentralized system without a central authority
• When CB monetary policy leads to inflation (Venezuela, Zimbabwe)
• Ad-hoc confiscatory monetary reforms
• To avoid capital controls
• Criminal activity
Motivation for the adoption of
• Pursuit of lower transaction fees in payments and money
• Transfering funds between banking accounts is not immediate today even
within your own bank! 3-5 days in Europe and at least one week outside of
Europe. Outside Europe, transfers are costly.
• Currently, merchant transactions fees are around 2% + terminal fees +
incidental fees.
• Money transfer network (Western Union and Moneygram) is $500 billion per
2. Blockchain: technology
behind bitcoin
Why bitcoin is innovative?
A key problem for any electronic
payment system is how to ensure
that money cannot be ‘double
• The approach used in the
modern banking system is for
banks to maintain master ledgers
and to hold accounts recorded in
the ledger of the central bank.
• A modern computerised version is
just a replication of the earlier
paper-based records
Why bitcoin is innovative?
• Bitcoin relies on a fully decentralized payment system, in which copies
of the ledger are shared between all participants.
• Technology behind bitcoin: blockchain technology or distributed
ledger technology.
• Since anybody can check any proposed transaction against the ledger, this
approach removes the need for a central authority and thus for participants
to have confidence in the integrity of any single entity.
Bitcoin blockchain is
A distributed, secure, transparent, public ledger that
establishes ownership and allows for the efficient
exchange of ownership
• Transparent and public: every transaction is available to
anyone for download on the Internet
• Distributed: quickly and easily accessed and shared by
many. Does not depend on trust in a central counterparty.
• Secure: Blockchain is immutable: you can only add to it –
you cannot alter history. Backed by strong cryptography
secured by the world’s most powerful network of
computers. Miners provide security and are rewarded
with new cryptocurrency
Hashing 101
A simple hash
• Suppose I send an email to Marie. However, she needs to verify that what I
sent her is exactly what she received.
• Email contains a single word “hello”.
• Encode the word (a=1, b=2, …, z=26), so 8 5 12 12 15.
• Multiply the numbers to get 86,400.
• I post the hash on my website. After Marie gets my email, she does the
same hash and checks my website.
• If the message was corrupted the hash will not match, for example,
“hallo”= 8x1x12x12x15=17,280 which does not match the original.
• This hash is too simple (e.g. hello=ohell) and causes a “collision”
Hashing 101
SHA-256 (Secure Hashing Algorithm)
• Hashing is a one-way function.
• Hashing is not “encryption” because you can’t decrypt.
• For example, passwords are routinely stored on websites in hashed
• The output of a SHA-256 is 256 bits no matter how big the input
• Let’s do some examples:
Hashing 101
SHA-256 (Secure Hashing Algorithm)
• King James Bible (4.2mb)

• King James Bible (4.2mb) –with 5 characters deleted


Note: You can hash the hashes

• SHA-256 of King James Bible SHA-256
Hashing 101
How many combinations in a SHA-256 hash?
• Need 2255 = 1.15*1077guesses
• Which is roughly the number of atoms in the known universe!
Hashing 101
SHA-256 hashes widely used for email and file transfer
• Returning to the email example, I want to send a file to Marie
• I SHA-256 the file
• I send Marie the original file
• Marie does her own SHA-256 hash of the file
• Marie checks to see if her hash of the file matches the hash that I
have on my website
• If there is any difference, the file has been corrupted
• This all happens automatically and is called “checksum”
Hashing 101
How does the bitcoin blockchain work?
Each miner holds a copy of the current ledger i.e., all previous blocks
and all transaction requests are broadcast to all miners.
Ledger broken up into 10 minute “blocks” (1M of data in every block)
• Every block contains a hashed reference to the block before it so you
can trace every transaction all the way back to 2009
How does the bitcoin blockchain work?
• Example. In block 1000, Cam buys a car (for 17 BTC) from John
How does the bitcoin blockchain work?
• Suppose Cam edit the block on his computer –to give himself 17 BTC!
How does the bitcoin blockchain work?
• Even making that small change results in a very different block hash.
It no longer matches what is stored in block 1001.
How does the bitcoin blockchain work?
• Blockchain clients automatically compute the hash themselves -if no
match, they reject the block
• Check other peers in the network for correct block
How to achieve consensus?
• The defining feature of a distributed payment system is the manner by
which consensus is reached about any proposed changes to the ledger.
• In principle, a system like Bitcoin could validate transactions using a simple
consensus by majority vote. But then an attacker could game the system
by creating numerous fake identities (Sybil attack)
• Consensus by ‘Proof of work’: To ensure that Bitcoin maintains a unique
record of transactions, a tournament is used to randomly select a miner to
add a block of transactions to the ledger. Solving the puzzle provides “proof
of work”; in lieu of “one person, one vote,” Bitcoin thus implements the
principle of “one computational cycle, one vote.”
To achieve consensus, bitcoin blockchain
relies on the ‘proof of work’
• Miners group the current transactions together and take a hash of the
transactions plus a “magic number” –called a “nonce”.
‘Proof of work’
• Miners try different nonces to get a special hash that has a certain
number of leading zeros
• Think of shuffling 5 decks of cards. You goal is to turn over 5 aces of spades in
the first five cards! That will be a lot of shuffling.
• Someone finds the winning hash approximately every 10 minutes
• System is immune to increases in computing speed –the difficulty
automatically adjusts if the hash is found in less than 10 minutes
• June 2017: 5.5 million therahashs calculated every second (1 terahash=1
trillion hashes )
• Finding the winning hash is difficult, but it is easy to verify that the
hash is correct!
‘Proof of work’

The whole block then gets sent

out to every other miner in the
network, each of whom can
verify it. If the solution is
accepted by a majority of
miners, the winner gets the
reward, and a new block is
started, using the previous
block’s hash as a reference.
Miners ignore mined blocks
that are not legal.
How does the bitcoin blockchain work?
• Incentive to assemble and create legal blocks!
• The tournament-winning miner is paid when he mines a new block,
but only after newer blocks augment the chain on top of his block.
Other miners will build on top of his block only if they consider it
legal. Consensus forms on a ledger that includes the new block.
• Miners are rewarded with cryptocurrency for finding the winning
hash and verifying transactions.
• At first, miners received 50 bitcoins. This reward is periodically (every 210 000
blocks or 4 years) cut in half (‘block reward halving). November 28, 2012: first
halving from 50 to 25. July 9, 2016: from 25 to 12.5. After 21 million bitcoins
minted, the reward falls to 0 (2140).
• Hence, the protocol design for Bitcoin sets a controlled pace for the supply of
the currency and an ultimate limit to the number of bitcoins issued (which
gives it a sense of rarity like gold).
• Buyer and seller can also offer to pay a “transaction fee”, whose role
increases as the amount of new bitcoins goes down.
Vulnerability of bitcoin
due to the concentraion of mining
• 51% attack: If a mining pool gains
51% of computing capacity, it can
attack the network: rewrite all the
blocks and create a new block
• January 9, 2014 had 45%
of all mining. It appealed to people
to exit the pool!
• Not clear what the incentive is to
“take over”
• If it ever happened, the value of
the Bitcoin would disappear Source:
Bitcoin's environmental footprint
• Decentralization is expensive!
• There are several kinds of potential waste in miners' efforts that
would not be necessary in a centralized system.
• Miners spend substantial resources (electricity) in the tournament to declare
a block legal and thereby receive the reward.
• All miners spend resources ascertaining that the transactions conform to the
Bitcoin's environmental
footprint ?
3. Short history
of Bitcoin
Genesis (block)
Nakamoto, S., 2008. Bitcoin: A Peer-to-Peer Electronic Cash System,
White paper published on 31 October 2008,

January 2009, the bitcoin network came into existence with the release
of the first open source bitcoin sofware and the mining (issuance) of
the first bitcoins (genesis block).
First bitcoin transaction: Nakamoto has sent 10 bitcoins to Hal Finney,
programmer and first supporter, adopter and contributor to bitcoin.
Genesis (cont.)
• October 2009: Bitcoin Forum
• October 2009: First dollar-based
exchange rate (based on the cost of
electricity for mining) is quated on a
new xeb site New Liberty Standard:
BTC1309.03 for $1
• Bitcoin Faucet, created by Andresen, gave away bitcoin to expand
usage, grow the community and build up the currency.
• 22 may 2010 – first bitcoin purchase transaction. Laszlo Hanyecz paid
10 000 bitcoins ($30-40) for 2 pizzas.
Price of bitcoin in US$
Close Price China, Japan, Goldman Sachs,
Bitcoin Cash, IMF

PBC, arrests,
bankruptcy of
4000 Mt.Gox

3000 Treasury
recognizes the
benefits of virtual

Price of bitcoin in US$
Bull market at the end of 2013
November 18, 2013: Financial Crimes Enforcement Network, US
Department of the Treasury: “The decision to bring virtual currency
within the scope of our regulatory framework should be viewed by
those who respect and obey the basic rule of law as a positive
development for this sector. It recognizes the innovation virtual
currencies provide, and the benefits they might offer society. Several
new payment methods in the financial sector have proven their
capacity to empower customers, encourage the development of
innovative financial products, and expand access to financial services.
We want these advances to continue.”
January 2014, ACPR: « Seuls les établissements de crédit, de paiement
ou de monnaie électronique, pourront désormais recevoir des fonds
d’un acheteur de bitcoins pour les transférer à un vendeur. »
Bear market in 2014
January: arrest of Charlie Shrem, head of bitcoin brokerage BitInstant and
vice-chairman of the Bitcoin Foundation on charges of money loundering at
the Silk Road.
February: banruptcy of Mt.Gox, bitcoin exchange, with the announcement
that it had lost 850000 coins worth $500 million (127 000 investors)
Fraud and price manipulation at Mr. Gox:
April: The People’s Bank of China has explicitely barred banks from dealing
with bitcoin business.
July: EBA recommends that national supervisory authorities discourage
credit institutions, payment institutions and e-money institutions from
buying, holding or selling VC
Bull market in 2017
2017: Traditional financial institutions join
bitcoin ecosystem
• Two regulated exchanges have started offering bitcoin futures:
• Chicago Board Options Exchange (CBOE) started trading bitcoin futures on 10
of December 2017. It relies on the bitcoin price on Gemini, one of the largest
bitcoin exchanges
• Chicago Mercantile Exchange (CME), started trading its futures on 18
December, 2017. Relies on the CME CF Bitcoin Reference Rate (BRR) and CME
CF Bitcoin Real Time Index (BRTI), a standardized reference rate and spot price
index. Several bitcoin exchanges and trading platforms will provide pricing
data, including Bitstamp, GDAX, itBit and Kraken.
4A Does bitcoin fulfill three main
functions of money?
A successful currency typically functions as a medium of exchange, a
unit of account, and a store of value.
Bitcoin as a unit of account?
• For a currency to
function as a unit of
account, consumers
must treat it as a
numeraire when
comparing the prices of
alternative retail goods.
• But bitcoin is too
volatile and prices
would change too fast.
Major Bitcoin Units

Abbreviation Common Name Formal Name Units in BTC

BTC bitcoin bitcoin 1 BTC
mBTC millibitcoin 0.001 BTC
µBTC bit microbitcoin 0.000001 BTC
satoshi satoshi 0.00000001 BTC
Bitcoin as a medium of exchange?
• Early: Silk Road and Other Illicit Activities
• Life on bitcoin: A documentary about a
couple living on bitcoin for 3 months
• is the first major retailer to
accept the digital currency Silk Road Prison Art by
• News about merchants that accept bitcoin: FBI's wallet address that held the seized
s-bitcoin/ coins + the Brooklyn prison where Ulbrict
was being held.
The volume of bitcoin sent ↑ but the max size of block is 1M …
…increasing transaction fees for sending bitcoin
What constitutes a good store of value?
• Given a limited number of bitcoin (21 mln), many argue that bitcoin could
be a good store of value.
• Does bitcoin make the cut? Let's go back to 1867 to see what William
Stanley Jevons would say

Source: JP Koning l

Bitcoin is (still?) too volatile
to be store of value
Bitcoin as a store of value?
• Bitcoin is not correlated with other
• Security for “digital wallets” has
become a major difficulty for the
bitcoin industry.
• Digital wallet service keeps the required files on a shared server with access via
the web or via phone-based apps. Some services (including,
StrongCoin, and CoinPunk) let the user maintain control over private keys,
meaning that the service is incapable of spending the user’s bitcoin. A user
might lose the key or allow it to be compromised (by hackers) is at high risk.
Other services (such as Coinbase and Xapo) require users to let the service
store their private keys.
4B. Bitcoin and monetary policy

• Bitcoin's algorithm states that at some point the total

supply of Bitcoin will be capped at around 21 million.
• Hence, the supply of Bitcoin is fixed exogenously.
Consequences of the fixed Bitcoin supply
• Fixed supply = No monetary policy
• If money is neutral (true in the long run), lack of monetary policy is not a problem
• Neoclassical Quantitative Theory of Money: amount of money influences price level
• Bitcoin is deflationary: If economy grows and the amount of money is fixed, prices need to go
down. Consensus among economists is 2% of inflation due to nominal rigidities, liquidity trap
• Similar to the classical gold standard, criticized for the depth of the Great Depression
• If money is not neutral (true in the short run), bitcoin has a major flaw as money
• Keynesian view: Money supply has an impact on interest rates. Monetary policy could
compensate changes in money demand.
• A money supply rule that does not respond to shifts in money demand generates large
fluctuations in prices.
• Decline in prices generates debt deflatin and horading, which deepen recessions. See, the
story of the baby-sitting co-op as a methaphora for the monetary policy:
• Bitcoin ‘area’ is not likely to be an ‘optimal’ currency area.
• If national currencies remain unit of account and bitcoin is used for payments, monetary
policy concerns is not relevant.
Increase of money supply by the CB avoids an increase of
interest rate due to pessimistic expectations of agents

Interest (Ms)1 (Ms)2


(r*)1 = (r*)2



Money as credit
• Since banks in the modern economy create money by extending
credit, money is nothing more than the highest form of credit.
• The payment system is essentially a credit system, in which offsetting
promises to pay clear with only very minimal use of money.
• One can imagine automating a lot of that activity–and blockchain
technology may well be useful for that task–but it is more difficult to
imagine eliminating the credit element. Credit is not a bug, but a
• Bitcoin does not allow credit/money creation.
Could cryptocurrencies allow have inflation
and monetary policy?
• Algorithm could allow inflationary cryptocurrency:
• E.g. Monero: beginning in May 2022, 0.3 monero will be released every
minute (0.8% inlation, but decreasing afterwards as the monetary base
increases). Monero is also famous (like Zcash and Dash) to create real privacy
for users.
• Ethereum has not decided yet on the supply function.
• There is virtually no debate about how to design a cryptocurrency
that would allow monetary policy.
• Central bank digital currency
• Digital money replacing cash would make it easier for central banks to lower
interest rates far below zero per cent, as Buiter, Haldane, Kimball and others
have explained. Investors would have no cash to run to.
4C Is bitcoin a safe haven, like
Bitcoin as digital gold?

Gold has been traditionally considered a hedge and a safe haven.

• A diversifier is an asset that has a weak positive correlation with
another asset on average.
• A weak (strong) hedge is an asset that is uncorrelated (negatively
correlated) with another asset on average.
• A weak (strong) safe haven is an asset that is uncorrelated (negatively
correlated) with another asset on average during times of stress.
Empirical findings (2011 -2015)
• Bitcoin can serve as an effective
diversifier for most of the cases.
• Daily data shows that bitcoin is a
strong hedge against
movements in Japanese and
Asia Pacific stocks as well as the
commodity index.
• Weakly data shows that bitcoin
is a strong hedge and safe
haven against movements in
Chinese stocks.
• A negative correlation means that
Bitcoin, gold or silver may be
served as a hedge or a safe haven.
• During the post-2016 U.S.
election period, Bitcoin price and
S&P 500 index are negatively
correlated in the short and the long
term, but uncorrelated in the
• Gold ans silver have lost their safe
haven properties in the short run.
Venezuela's Currency Crisis Is A Case Study For
• As the bolivar continues to fall,
many Venezuelans are turning to
Bitcoin as an alternative.
• Humanitarians can donate Bitcoin
to those in need, who can then
use Bitcoin to buy Amazon gift
cards, then purchase goods
through the online retailer.
5. Market liquidity and volatility
or how to choose a
cryptocurrency exchange?
Bitcoin infrastructure: exchanges
Bitcoin is a decentralized digital currency but around it a centralized
infrastructure is developing:
• Currency exchanges allow users to trade bitcoins for traditional
currencies or other virtual currencies.
• Ranking exchanges:
• What do exchanges allow to do:
• Opening long and short positions in cryptocurrencies
• Stop loss order
• Trade using leverage (up to 5:1 on Kraken)
Bitcoin infrustructure: wallets
• Digital Bitcoin wallets are data files that include Bitcoin accounts,
recorded transactions, and private keys necessary to spend or transfer
the stored value.
Cryptocurrency exchanges
Data from cryptocurrency exchanges allows to compute liquidity and
volatility of different markets.
• Trading volumes
• Liquidity (Bid-ask spread)
• Orders sum in BTC required to move price by 1%
• Volatility
The user can also compare exchanges to choose the most liquid one.
Bitcoin trading (in USD): sum of BTC traded in selected period

For update:

Bitcoin trading (in EURO)
Bitcoin trading (in JPY)
Bitcoin trading in (CNY)
Bid-ask spread in USD
Spread - bid/ask spread as percentage, calculated as
Bid-ask spread in EURO
Orders sum in BTC required to move price by 1%
Orders sum in BTC required to move price by 1%
Bitcoin volatility (in USD): Volatility - price volatility calculated as standard
deviation from all market trades.
Bitcoin volatility (in EURO)
Case study: Bitstamp
Case study: Bitstamp
• Bitstamp is often presented as the European Union’s “first and only”
licensed digital currency exchange.
• Bitcoin exchange Bitstamp was originally founded in Slovenia in 2011, but
later moved its registration to the UK in April 2013, then to Luxembourg in
• When incorporated in the UK, the UK's Financial Conduct Authority
informed Bitstamp that bitcoin was not classed as a currency, so the
exchange was not subject to regulation.
• After a two-year application process, in April 2016, the Luxembourgish
government granted a EU license to Bitstamp to be fully regulated as a
payment institution. Not licensed as an exchange!
Case study of Bitstamp
• Bitstamp is one of the oldest exchanges (as old as infamous MtGox).
• It has survived scandals, hacking, etc. (unlike MtGox)
• Currently, the fourth largest exchange in the world.
• The third largest exchange in USD (15% markest share in the last 6 months),
but much higher bid-ask spread than its competitors (because located outside
the US?). Third in terms of liquidity, measured as ‘Orders sum in BTC required
to move price by 1%’
• Since moving to Luxembourg, an increasing volume share in EURO (10% of the
market share), but lagging behind Kraken (60%). Second, in term of volumes
and liquidity. Much higher bid-ask spread than Kraken.
• Volatility is similar to other large exchanges.
6. Cryptocurrency
risks and

1. Technological risks: DCS Trilemma or the scaling debate

2. Operational risks
Blockchain Trilemma:
D(ecentralization) C(onsistent consensus) S(cale)
• Decentralized: where no single entity controls the network and
where anyone can join the network as a validating node. Server-free
• Consistent consensus, where the network aims to keep data in sync.
Being consistent is a prerequisite to preventing double-spends, and
therefore storing tokens of value.
• Scale: sufficient performance characteristics to serve planet-scale
(100K tx/s).

DCS Trilemma
DCS Trilemma
• Bitcoin and Ethereum are DC. They PoW based consensus algorithm, where
every full node stores all the data. No one entity controls the network.
Anyone can join the network and run a full node. Both Bitcoin and
Ethereum are consistent, in that all nodes see the same data at the same
• Neither Bitcoin nor Ethereum are planetary scale.
• The Bitcoin network has a theoretical maximum of 7 tx/s. Post-Segwit: 1.4x higher.
• The Lightning network does not fully solve this because it gives up other major
advantages of blockchains for speed, namely transparency, auditability, storage, and
a different trust model.
• Latency is 60 minutes: 10 minutes for one block confirmation; one typically waits for
3–6 blocks for sufficient probability the block remains stable.
• Capacity is limited: Bitcoin users worry about “bloat” despite holding just 70GB of
Why scaling of decentralized technologies is
• Technologically, bitcoin transactions are more expansive than transactions
performed by centralized institution.
• Why? Because decentralization LEADS to high transaction fees
• There are 5000 miners/nodes, and the marginal cost to process a
transaction for a miner (i.e. verify it, add it a block, and store it) is $0.0001.
The total cost on the whole network is roughly 5000 * $0.0001, or $0.50.
• The average transaction fees needs to be $0.50 in order for this network to
be sustainable.
• If the fees were less, less efficient miners will not be able to make more
than their cost and will be forced to shut down their miners and quit. This
leads to less security and more centralization.
Proposed solutions to lower transaction fees
on Bitcoin
1. SegWit or Segregated Witness (Since August, 2017 for bitcoin):
splitting the transaction into two segments, removing the
unlocking signature ("witness" data) from the original portion
(the sender and receiver data) and appending it as a separate
structure at the end, which would be counted as a quarter of its
real size.
2. Increasing the 1M limit on the block size. See excellent article by
Laura Shin (Forbes) about SegWit2x fork (that did not happen)

3. The Lightning Network: a separate protocol ‘off chain’ that sits

atop the bitcoin blockchain, “Layer Two” solution:
Other cryptocurrencies offer solutions to lower
transaction fees
Bitcoin’s protocol is based on open-source software. Hence, others can
use it to create alternative coins (altcoins) that aim at improving it:
• Cutting the block time (useful for merchants)
• Litecoin : created in 2011, block time is 2.5 minutes and a different hash function.
• Increasing the 1M limit on the block size
• Bitcoin Cash is born after a fork in 2017 and it allows an 8M limit on the block size.
• Dash and Zcash: 2M. Unlike Bitcoin, these coins are also really anonymous. Bitcoin uses a
public key that allows to trace all transactions.
• The potential problem with increasing the blocksize
• Larger blocksize means larger computational power and hence more concentration of
mining, which is risky and goes against the decentralized ideology of bitcoin
“A higher limit can be phased in once we have actual use closer to the limit and make sure it's working
Eventually when we have client-only implementations, the block chain size won't matter much. Until
then, while all users still have to download the entire block chain to start, it's nice if we can keep it
down to a reasonable size.
With very high transaction volume, network nodes would consolidate and there would be more pooled
mining and GPU farms, and users would run client-only. With dev work on optimising and parallelising,
it can keep scaling up.”

Other cryptocurrencies offer solutions to lower
transaction fees (2)
• ‘Proof-of-stake’ consensus (Ethereum is working on it)
• Centralized solutions:
• Ripple (created 2004, before bitcoin!): there are no miners. Instead a consensus algorithm
relies on trusted subnetworks to keep a broader decentralized network of validators in sync.
Most of coins are controlled by Ripple Labs.
• Central bank digital currency
• Private or permissioned blockchains (Note that Bitcoin relies on the
public permissionless blockchain)
Bitcoin’s operational risks

• Basel 3: Operational risk is defined as the risk of loss resulting from

inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic
and reputational risk.
• In case of bitcoin, other cryptocurrencies and public blockchaines,
operational risks exist due to the decentralized nature of the blockchain
and open-source software. This leads to undefined governance.
• Governance is "the processes of interaction and decision-making among
the actors involved in a collective problem that lead to the creation,
reinforcement, or reproduction of social norms and institutions."
Bitcoin ecosystem/stakeholders
1. Developers (“core developers”):
• The actual creator of the open-source Bitcoin software, known by the
pseudonym “Satoshi Nakamoto” remains a mystery.
• A mix of volunteer and paid programmers determine changes through
informal consensus.
2. Miners. Dominated by businesses devoted to mining and mining
consortiums (known as “pools”) (concentrated!)
3. Investors and users (1000 whales own 40% of bitcoin)

4. Start-up ecosystem (wallets, exchanges, payments, etc)

5. Governments
Risk 1: Bitcoin is a software

1. Software always has bugs

2. Software is vulnerable to attack
• Important to distinguish between hacking (a) Bitcoin software (has never happened) and (b)
surrounding ecosystem (wallets, exchanges) that has been vulnerable
• 51% attack could destroy the credibility of bitcoin. It requires “enormous investment,” but
could conceivably be launched by a well-funded (state?) attacker. It is not in the interest of
the attacker to undermine bitcoin (due to losses). 51% concentration of mining has already
happened without an attack.
• distributed denial of service (DDOS)

Source: Angela Walch

Risk 1: Bitcoin is a software
3. software is ever-changing through new releases to fix bugs or to
introduce new features (e.g. block size debate)
• A soft fork is a software upgrade that introduces a new rule to the network that is
backward compatible (Decrease of block size from 1MB to 500K blocks).
• A hard fork isn't compatible with the older software (Increase block size from 1M to
2MB). Hard fork results in a doubling number of coins (If you had 100 coins on the
old fork, you will have 100 coins on the new fork). Naturally, the value will not
double and depend on the popularity of the chain.
Why This Is a Problem for Bitcoin?
Software bugs, attacks, new releases are also part of the traditional
financial market infrustructure. However,
• 51% attack is a new type of technological risk
• In a centralized financial market infrastructure (or even in “permissioned
blockchains”) new releases of software are likely be implemented more easily,
since adopting the new version can be mandated on participants
• The problem with hard fork comes when a portion of the community decides
to stick by the old rules no matter what (Ethereum classic).
• No danger of ‘hard forks’ in centralized forms of the financial market
Risk 2. Bitcoin’s Decentralized Structure
Decentralization is bitcoin’s strength but it also brings risks
1. there is no entity or person that assumes responsibility for the
performance of Bitcoin
2. no one is in charge;
3. it is impossible to tell who the voice of the group is
4. there is no defined group that comprises Bitcoin or its management –
just an amorphous, ever-shifting cluster of people who come and go
Why This Is a Problem for Bitcoin?
A decentralized structure creates the risks that
• no one will even attempt to ensure that Bitcoin works;
• even if someone does step up to help, he or she has no official
authority or ability to implement suggested fixes;
• the crisis management process may be slowed
• no one is accountable
Risk 3. Bitcoin as Open-Source Software
• Open-source software is software that makes its “source code” freely
available to the world.
• Software that is open-source is made available to users through a
license agreement that gives the user permission to alter the source
code. E.g. Mozilla.
• Open-source software is contrasted against “proprietary software”
(Microsoft or Adobe), which is issued under a license agreement that
forbids the licensee from making any changes to the software.S
Risk 3. Bitcoin as Open-Source Software
1. The risk that no one will properly maintain the code because no one
has the actual responsibility to do so;
2. The risk that conflicts of interest may shape the management of the
Bitcoin code and therefore financial market infrastructure itself
(between users, developers, miners, exchanges);
3. The risk that consensus on changes may be unachievable, leading to
splits (or “forks”) in the network.
Remuneration of bitcoin developers…
• At first, bitcoin developers were volunteers and, thus, not
• As of this writing, several of Bitcoin’s core developers are based in the
MIT’s Digital Currency Initiative.
• It is unclear who is paying the remaining core developers (if anyone),
but in the past, some of the core developers were paid by the
nonprofit Bitcoin Foundation, while others were full-time employees
of Bitcoin focused businesses (e.g. BitPay).
… could lead to conflicts of interest
• If a developer is paid by a particular business to do work on a
communal, public project like Bitcoin, the developer has a strong
incentive (i.e., a paycheck) to prioritize his employer’s interests over
the interests of the Bitcoin community as a whole.
• Why is it a problem? Because financial market infrastructures such as
money and payment systems act as public goods.
ICO as a creative way to fund the software
developers public blockchains
• Ethereum: the software developers have been compensated by a “pre-
sale” of ether, the currency of the Ethereum blockchain, and finances
appear to be managed by the Ethereum Foundation, a Swiss non-profit set
up specifically to offer financial and advisory support to the development
• Zcash blockchain: the developers fund themselves through the issuance of
“tokens” that will trade on the blockchain (in effect, acting as an issuer of
money that will be used in this particular blockchain community).
• A flurry of so-called “app coins” have sprung up in 2016-2017, funded, like
Zcash and Ethereum, through the sale of tokens by developers.
• Called an “Initial Coin Offering” or ICO, this funding model has drawn
scrutiny from securities attorneys, who warn that the issuance of these
tokens without registration may violate the securities laws.
Risk 4. Bitcoin’s Expertise Problem
• Few people understand how bitcoin software works (requires
knowledge in software coding, networks, cybersecurity, economics,
payment systems, money, financial and economic history, finance)
• Software coders, who make the decisions about what the Bitcoin
software will look like and what functions the system will have, are
not necessarily financial systems experts. The known backgrounds of
the core team of developers are in computer science and software
development, not in economics, finance, financial systems, or
monetary policy.
Examples of hard forks:
March 2013 “hard fork”
• The march 2013 unintended hard fork was a result of slow updating
to the newly released version of the protocol. The new chain was
growing faster than the old one.
• However, the core developers convinced major pools, without any
coordination with users, to back the shorter chain because it
functioned under both old and new versions.
• In doing so, they violated the basic blockchain rule of the authenticity
of the longest chain.
• Mining rewards worth 26,000 $ in the new chain were lost, and
10,000 $ double spent as a result of the fork.
Example 2: Bitcoin Cash hard fork
• ‘Blocksize debate’: How much computer memory a “block” should
• Original blockchain is limited to 1M.
• Bitcoin Cash supports 8M
• The size of a block determines how much memory a computer has to
devote to storing copies of the blockchain, which costs money and
determines determines who is able to afford to participate in the
• The more money it costs to participate (due to larger blocksize), the
fewer “nodes” or “miners” there will be in the network or the more
concentrated mining pools become.
Example 3: SegWit2x fork
Laura Shin (Forbes) about
SegWit2x fork that was not
activated due to the lack of
Will This Battle For The Soul Of
Bitcoin Destroy It?
Example 4: July 2016 Ethereum Hard Fork
• In May 2016, the DAO, a venture capital fund built on Ethereum,
raised around $168 million (representing 15% of all outstanding
ether), with the intention of investing in projects using smart
contracts. In June, $50 million USD were stolen from the accounts in
the DAO due to the vulnerability of the DAO code (not Ethereum!).
• Members of The DAO and the Ethereum community debated what
actions, if any, should occur to resolve the situation. A vote in July
2016 decided to implement a hard fork in the Ethereum code and to
restore ether to the owners.
• Ethereum Classic came into existence when 10% of the Ethereum
community rejected the hard fork on the grounds of "immutability“.
Blockchain governance is a major issue!
• Vitalik Buterin: “People who think that the purpose of
blockchains is to completely expunge soft mushy human
intuitions and feelings in favor of completely algorithmic
governance (emphasis on “completely”) are absolutely crazy.”

Source: Notes on Blockchain Governance
What kind of governance for
1. Currently, the governance of Bitcoin and most other blockchains is informal (off-chain). De
facto, first-generation blockchains empower centralized core development teams or
miners to formulate design choices. Developers coordinate through the Bitcoin
Improvement Proposals (BIPs) process and a mailing list. Miners vote on forks (see
SegWit2x fork).
2. “On-chain governance” (via coin-holder voting ) refers to the idea that the blockchain
nodes automatically upgrade when an on-chain governance process decides on an
upgrade and that it’s time to install it. (E.g. Dash
• Low participation rate
• Non-representativeness: Coin holder interests (store of value) and user interest (medium of exchange)
are not naturally aligned.
• Cyptocurrency holdings is highly concentrated in the hands of a very small number of people (whales).
• In case of fiat currency, monetary policy decisions are not voted in national elections. Decision-making
is done by independent experts in CB.
Vitalik Buterin on governance
“The approach for blockchain governance that I advocate is “multifactorial
consensus”, where different coordination flags and different mechanisms
and groups are polled, and the ultimate decision depends on the collective
result of all of these mechanisms together. These coordination flags may
• The roadmap (ie. the set of ideas broadcasted earlier on in the project’s
history about the direction the project would be going)
• Consensus among the dominant core development teams
• Coin holder votes
• User votes, through some kind of sybil-resistant polling system
• Established norms (eg. non-interference with applications, the 21 million
coin limit)”
References on governance
• Fred Ehrsam, 2017. Blockchain Governance: Programming Our Future, 27

• Vlad Zamfir, 2017. Against on-chain governance. Refuting (and rebuking)

Fred Ehrsam’s governance blog, December 1.

• Vitalik Buterin, 2017. Notes on Blockchain Governance, December 17,


• Corporate Governance for Complex Cryptocurrencies? A Framework for

Stability and Decision Making in Blockchain-Based Organizations Author:
Philipp Hacker
Regulation of
3 justifications for regulating bitcoin
Similar other industires, regulation is justified in case of market failures:
1. Assymetric information (e.g. Consumer protection)
• A number of cryptocurrency exchanges and wallets have suffered hacks during which
bitcoin and other cryptocurrencies were stolen (Mt. Gox, Bitstamp, etc.).
2. Negative externalities: illicit transactions and transfers, tax evasion,
financial instability (failure of an exchange), undermining monetary
3. Lack of competition: concentration of miners and coin holders.

What should be regulated? Exchanges, Miners, Users ?

Trade-off between innovation and financial stability

Source: William J. Luther

Regulation of cryptocurrency exchanges
• BitFinex, the largest US exchange, is unregulated
• Kraken, the largest EU exchange, has partnered with regulated Fidor bank
• Japan and Luxembourg (BitStamp) regulate exchanges as payment institutions
• China has banned exchanges, but P2P platforms have developped.
• NY Department of Financial Services issues BitLicense (Circle, Ripple, Coinbase)
• What is the appropriate regulation?
• Register with the proper authorities and Provide periodic finational statements
• Collect identifying information on users (KYC)
• Report transactions suspected to be involved in money laundering (AML)
• Cybersecurity and disaster recovery
• Enforce taxes
• Forbid insider trading
• Disclosure
Central bank digital currency?
• ‘Bitcoin story’ is inspirational because it proposes monetary creation process
based on algorithm and free of politics and human error.
• Currently, bitcoin does not fulfill 3 functions of money:
• Bitcoin’s transaction fees are too high for the bitcoin to serve as medium of exchange. It also
consumers a lot of energy. This prevents it from scaling.
• Bitcoin is too volatile to serve as unit of account or store of value.
• Econometric studies show that bitcoin has behaved in the past as digital gold
(hedge and safe haven).
• Bitcoin Paradox:
• Numerous developers are working on the problem of high transaction fees (either by
changing bitcoin open-source software or by creating alternative coins).
• Future software updates could improve the functioning of the bitcoin market, but it also
means that bitcoin is not free of politics and human error. Governance problems and conflicts
of interest (between developers, miners, start-ups) could ruin it (e.g. forks).
• Getting started with Bitcoin, blockchains, and cryptoassets
• Bitcoin Resources:
• Michael Nielsen, How the Bitcoin protocol actually works:
• Cryptocurrencies with Tim Ferriss, Nick Szabo and Naval Ravikant. Podcast and a a
transcript from Episode 244 of the Tim Ferriss Show: The Quiet Master of Cryptocurrency
with supporting documents and diagrams
• Neil Gandal and Hanna Halaburda, Competition in the Cryptocurrency Market , Bank of
Canada working Paper
• Vigna, Paul and Michael J. Casey, 2015. The Age of Cryptocurrency: How Bitcoin and
Digital Money Are Challenging the Global Economic Order
• For more information about regulation of cryptocurrencies in the US:
A Fistful of Bitcoins: Characterizing Payments Among Men with No
The Great Bitcoin Scaling Debate — A Timeline