WU Vienna University of Economics and Business Diploma Thesis Thesis title: Economics of Bitcoin: is Bitcoin an alternative to fiat currencies and gold? Author: Peter Šurda Student ID no.: 9650205 Academic program: Betriebswirtschaft J151 Advisor: Univ. Doz. Mag. Dr. Peter R. Haiss With this statement, I declare that this academic thesis: was written entirely by me, without the use of any sources other than those indicated and without the use of any unauthorized resources; has never been submitted in any form for evaluation as an examination paper in Austria or any other country; is identical to the version submitted to my advisor for evaluation. Date Signature Economics of Bitcoin: is Bitcoin an alternative to (cid:28)at currencies and gold? by Peter (cid:146)urda Advisor: Univ. Doz. Mag. Dr. Peter R. Haiss http://ssrn.com/author=115752 Abstract ThispaperpresentsaneconomicanalysisofBitcoinfromalibertarianpointofview. Thetheoretical partanalysestheapplicabilityoftheAustrianSchoolofEconomicsatBitcoin. Ofparticularinterestare the evolution of money, competition among media of exchange, and the concept of money supply. The empirical part analyses the following variables: price, price volatility, liquidity, visibility and velocity. I cometotheconclusionthattheoretically,BitcoincanbeclosertotheAustrianidealofmoneythaneither (cid:28)at money or gold, and it is possible that it will evolve into that position. The results of the empirical analysis are consistent with Bitcoin being a medium of exchange. Keywords: Bitcoin,digitalcash,currencycompetition,Austrianbusinesscycletheory,Mises’regres- sion theorem JEL Codes: E390, E410, E420, E510, G210 Highlights: (cid:136) Bitcoin emerged as a market (catallactic) process and is evolving (cid:136) Bitcoin can evolve into money (cid:136) Bitcoin can prevent business cycles through inelastic supply of money (cid:136) Empirical analysis shows that Bitcoin may be an immature medium of exchange Acknowledgements I would like to thank my thesis advisor, Univ. Doz. Mag. Dr. Peter R. Haiss (http://ssrn. com/author=115752). He provided great guidance, kept me on track with proper scienti(cid:28)c research and provided information sources outside of my own scope of specialisation. IwouldliketothanktheopponentsofsomeofmyviewsonBitcointhatIdebated,particularly: Niels Van der Linden, Smiling Dave, David Kramer, Atheros, DeathAndTaxes, Jorge Tim(cid:243)n. I would like to thank people for the Bitcoin community that I was in contact with or who provided interestinginsights: AmirTaaki,VladimirMarchenko,MeniRosenfeld,molecular,MoonShadow,Marek Palatinus, deepceleron, Stephen Gornick, Pierre Noizat, Juraj BednÆr, Iain David Stewart, Michael Parsons, Mike Hearn, Je(cid:27) Garzik. I would like to thank the economists I talked to: George Selgin, Walter Block, Stephan Kinsella, Philipp Bagus, David Gordon, Peter G. Klein, Robert P. Murphy, Detlev Schlichter, Hans Hermann Hoppe, John Barrdear, Jon Matonis, Koen Swinkles. A special thanks goes to Satoshi Nakamoto for designing Bitcoin. John Tobey for Abe (cid:16)Open Source blockchain explorer knocko(cid:27)(cid:17) which I used for analysing the blockchain data. Mt.Gox for the trade data and historical exchange rates. Felix Tendler for historical Mt.Gox order book data. Lastbutnotleast,Iwouldliketothankmymother,Doc. RNDr. Viera(cid:146)urdovÆ,CSc.,andmywife, Seah Lay Chee. 1 Contents 1 Introduction 4 1.1 Methodological comments . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2 Current status of Bitcoin 7 2.1 Components of Bitcoin (in the narrower sense) . . . . . . . . . . . . . . . 7 2.2 Socioeconomic e(cid:27)ects of Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . 8 2.3 Forms of Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.3.1 Native forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.3.2 Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . 16 2.4 Products and services of the broader Bitcoin ecosystem . . . . . . . . . . . 18 2.5 Advanced features of Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 3 Theoretical analysis of Bitcoin 21 3.1 Functions of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 3.2 Austrian classi(cid:28)cation system for money . . . . . . . . . . . . . . . . . . . 23 3.2.1 Money in the narrower sense . . . . . . . . . . . . . . . . . . . . . 23 3.2.2 Money substitutes . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 3.2.3 Classi(cid:28)cation of Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . 26 3.2.4 Complementary currencies . . . . . . . . . . . . . . . . . . . . . . . 27 3.3 Evolution of money as competition among media of exchange . . . . . . . 28 3.3.1 Liquidity (network e(cid:27)ect, double coincidence of wants) . . . . . . . 30 3.3.2 Store of value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 3.3.3 Transaction costs in the narrower sense . . . . . . . . . . . . . . . 32 3.3.4 Summary of Bitcoin competing with other currencies and payment systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 3.4 If Bitcoin fails, what would replace it? . . . . . . . . . . . . . . . . . . . . 37 3.5 Mises’ regression theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 3.5.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 3.5.2 Self sustainability of media of exchange without non-monetary de- mand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 3.5.3 Summary and reformulation of the regression theorem . . . . . . . 40 3.6 The origin of the price of Bitcoin (application of the regression theorem) . 41 3.6.1 Supply side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3.6.2 Demand side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 2 3.6.3 Emergence of market price . . . . . . . . . . . . . . . . . . . . . . . 42 3.6.4 Emergence of liquidity . . . . . . . . . . . . . . . . . . . . . . . . . 42 3.6.5 Critical mass . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 3.7 Austrian Business Cycle Theory, fractional reserve banking, money supply and Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 3.7.1 Money supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 3.7.2 Emergence of money substitutes . . . . . . . . . . . . . . . . . . . 45 3.7.3 Money supply of Bitcoin . . . . . . . . . . . . . . . . . . . . . . . . 46 3.7.4 Alternative methods for avoidance of credit expansion . . . . . . . 47 3.8 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 4 Empirical analysis of Bitcoin 50 4.1 Price and visibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 4.1.1 Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 4.1.2 Visibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 4.1.3 Correlation between price and visibility . . . . . . . . . . . . . . . 52 4.2 Liquidity and price volatility . . . . . . . . . . . . . . . . . . . . . . . . . 54 4.2.1 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 4.2.2 Evolution of liquidity over time . . . . . . . . . . . . . . . . . . . . 55 4.2.3 Price volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 4.2.4 Correlation between liquidity and price volatility . . . . . . . . . . 64 4.2.5 Correlation between price and liquidity . . . . . . . . . . . . . . . . 69 4.3 Velocity of circulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 4.3.1 Velocity of other currencies . . . . . . . . . . . . . . . . . . . . . . 73 4.3.2 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 4.4 Conclusion of empirical analysis . . . . . . . . . . . . . . . . . . . . . . . . 76 5 Conclusion 77 List of Tables 79 List of Figures 80 Index and Abbreviations 82 Bibliography 84 3 Chapter 1 Introduction WhiletherehavebeenattemptstoanalysetheeconomicpropertiesofBitcoin,particularly from within the online Bitcoin community, such as G(cid:252)ring and Grigg (2011), Pattison (2011),HamacherandKatzenbeisser(2011),Beckeretal.(2012)orBabaio(cid:27)etal.(2012), thesefollowverynarrowpathsandmissthebroadercontext. Myowngoalwastoanalyse Bitcoin from a libertarian view and to answer the research question, whether Bitcoin is an alternative to (cid:28)at currencies and gold. From the point of view of market actors, Bitcoin can be interpreted as a de-centralised clearing mechanism, based on a virtual unit (called (cid:16)bitcoin(cid:17) with a lower case (cid:16)b(cid:17)). The clearing is controlled by asymmetric cryptography, the public key identifying an account, while a corresponding private key allows sending balances from that account. In addition to clearing, Bitcoin also contains an inelastic production function. Clearing mechanism together with a de(cid:28)ned supply allows Bitcoin to be used as a medium of exchange. Several names have been proposed for such media of exchange, for example (cid:16)virtual currency(cid:17) (European Central Bank (2012)), (cid:16)digital cash(cid:17) (Tanaka (1996)), (cid:16)cryptocur- rency(cid:17) (Elias (2011)). For the purposes of this thesis, the exact name is not important, rather the economic features are. I will use (cid:16)(cid:28)at money(cid:17) to refer to a monetary system similar to the one that exists now. I will used the term (cid:16)gold(cid:17) and (cid:16)gold standard(cid:17) to refer to a system based on a physical commodity chosen by a market to be a medium of exchange (it thus refers not only to gold directly but also silver or other physical commodities), for example historical gold standards, or hypothetical systems based on reforms such as the one described by Rothbard (2005) or Selgin (1988). In Chapter 2, I present Bitcoin as it is, describing its workings and the historical and existing products and services associated with Bitcoin. I explain how Bitcoin can and is used. The information presented is of qualitative nature, and allows to build a mental picture of the (cid:16)visible(cid:17) part of the Bitcoin ecosystem. I attempt to provide answers to the questions (cid:16)what was(cid:17) and (cid:16)what is(cid:17). I attempt to put it in a broader context, so that the potential of Bitcoin is clari(cid:28)ed. In Chapter 3 I follow up with interpreting Bitcoin through economic theory (mainly according to the Austrian School of Economics), attempt to classify it and formulate criteria which in(cid:29)uence its evolution. Of particular interest are the evolution of money, competition among media of exchange, and the concept of money supply. This part is not strictly Bitcoin speci(cid:28)c, it also applies to some hypothetical future types of money. I attempt to provide the answer to the questions (cid:16)why(cid:17) and (cid:16)how(cid:17), from a libertarian, rather anti-(cid:28)at-money, anti-fractional- 4 reserve-banking point of view and argue that the theoretical foundation of Bitcoin is closer to the Austrian’s School ideal of money than either the (cid:28)at money or gold. Lastly, in Chapter 4, I analyse several aspects of Bitcoin quantitatively. The variables analysed areprice,pricevolatility,liquidity,visibility(meaninghowintensivethepublicperception of Bitcoin is) and velocity of circulation. The empirical analysis is an attempt to provide support for it. The thesis (cid:28)nishes up with a conclusion in Chapter 5 where I summarise my (cid:28)ndings. 1.1 Methodological comments Before approaching the topic in more depth, I would like to provide some background for the methodology used and my motivation. Large parts of this thesis are based on the teachings of the Austrian economic school. Thereareseveralreasonsforthis. Asforthesubjectiveones, itistheschoolIamfamiliar with the most, and that I (cid:28)nd myself in most agreement with. But there is an objective reason as well. It is the same as presented by North (2011): (cid:16)This theory of endogenous money is unique to Mises and his followers. No other school of economic opinion accepts it. Every other school appeals to the State, as anexogenous coercivepower, toregulate themoney supply andcreate enough new (cid:28)at or credit money to keep the free market operational at nearly full employment with nearly stable prices. Every other theory of money invokes the use of the State’s monopolistic power to supply the optimum quantity of money.(cid:17) [emphasis added] Similarly, Salerno (2010) writes: (cid:16)Needless to say, the three modern macroeconomic schools under examination all staunchly support the idea that supply of money needs to be centralized under a political monopoly.(cid:17) In other words, with respect to the introduction of a money through market forces and people being able to voluntarily choose which money to use, economic schools other than the Austrian do not have much to say. Nevertheless, occasionally they break this trend and analyse some aspect of money under the assumption that these two conditions are present. But even then, they still tend to continue with the ideological trend of seeing this as something a priori problematic and something that needs to be addressed via a policy action. Examples would be Krugman (1980), Levy-Yeyati (2004) or Catao and Terrones (2000). Furthermore, two of the economists who publicised the so far broadest research of Bitcoin, Jon Matonis and Michael Suede, subscribe to the Austrian School. Even though their Bitcoin-speci(cid:28)c work has not been published by peer-reviewed journals, it is refer- enced by the European Central Bank (2012), noting that (cid:16)The theoretical roots of Bitcoin can be found in the Austrian school of eco- nomics and its criticism of the current (cid:28)at money system and interventions undertaken by governments and other agencies, which, in their view, result in exacerbated business cycles and massive in(cid:29)ation.(cid:16) 5 Nevertheless, I do not make here the argument that the Austrians are correct (and con- versely,otherschoolsarewrong). IammerelyanalysingBitcoinfroma(mainly)Austrian point of view. Furthermore, as Mises (1999) argues: (cid:16)There is no means to establish an a posteriori theory of human conduct and social events. History can neither prove nor disprove any general statement in the manner in which the natural sciences accept or reject a hypothesis on the ground of laboratory experiments. Neither experimental veri(cid:28)cation nor experimental falsi(cid:28)cation of a general proposition is possible in its (cid:28)eld.(cid:17) Therefore,scholarsoftheAustrianSchoolshouldviewmyquantitativeempiricalresearch as an amendment, rather than an argument. 6 Chapter 2 Current status of Bitcoin 2.1 Components of Bitcoin (in the narrower sense) In the narrower sense (as a clearing mechanism), Bitcoin consists of two virtual compo- nents. The (cid:28)rst one is a ledger, called the (cid:16)blockchain(cid:17). This ledger is distributed, and every computer connected to the Bitcoin network directly (called a (cid:16)node(cid:17)) has a full 1 copy. Clearing transactions are pooled into bigger chunks called (cid:16)blocks(cid:17). The blocks are ordered sequentially and this sequence is the ledger. Hence the term blockchain, a sequential order (or a chain) of blocks. The proper sequence as well as consistency is upheld by cryptography. The other virtual components are (cid:16)keypairs(cid:17). A keypair consists of two large numbers ((cid:16)keys(cid:17))thataremathematicallyrelated. Thisrelationshipallowstheapersonwhoknows oneofthesenumberstoperformanactionthattheknoweroftheothernumbercanverify, but cannot recreate themselves (as that would require calculating the other key, which is prohibitively complex). An analogy would be a special lock which allows two keys to be inserted, key A only being able to lock it, and key B only being able to unlock it. If the holder of the key A locks the lock, the holder of the key B can unlock the lock, thus verifying that the holder of the key A locked it beforehand. But the holder of the key B cannot lock the lock themselves, nor does holding of the key B make it easier to recreate key A. If one of the keys in a pair is kept secret while the other one divulged, this allows the holder of the secret key to prove to the general public that he has it. In such a case, the secret key is called (cid:16)private key(cid:17) and the divulged key is called (cid:16)public key(cid:17). This is often used to verify the authenticity of the other party. For Bitcoin, the public key identi(cid:28)es a Bitcoin (cid:16)address(cid:17) (similar to account number in a bank), while the private key allows to create transactions (cid:16)belonging(cid:17) to this address. If Bitcoin only allowed clearing transactions, it could not work, as there would be no balances to transfer. Therefore, a special type of transaction is permitted once per block, which (cid:16)creates(cid:17) new bitcoins (colloquially referred to as (cid:16)mining(cid:17)). The allowed amount of new bitcoins in each block is predetermined and degressive over time. An amount di(cid:27)erent from the predetermined one is not consistent with the blockchain rules and is ignored. Thedurationofthecreationofblocksiscontrolledbyamechanismcalled(cid:16)proof 1Strictlyspeaking,itisnotnecessaryforallthenodestohaveafullcopyforBitcointoworkcorrectly. Iamsimplifying atthecostofinaccuracies,hereaswellasinmostothertechnicaldescriptions,inordertoconcentrateontheeconomic factors. 7