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\begin_layout Title
Bitcoin and Cryptocurrencies: Or How Inflation Will Come About in Cybermoney
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Centre for Finance and Developent Student Working Paper
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\begin_layout Author
Bastiaan Quast
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PhD Candidate, The Graduate Institute, Geneva; Research Assistant, Centre
 for Finance and Development, Geneva; 
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\begin_layout Standard
In 2009 the online currency 
\series bold
Bitcoin
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 was launched by an anonymous developer known by the pseudonym Satoshi Nakamoto.
 The protocol was based on a 2008 white paper by the same author 
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, and every aspect of it is public and open source.
 This quickly led to the launching of several alternative online currencies,
 based on the Bitcoin protocol.
 These currencies have recently become known as 
\series bold
cryptocurrencies
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.
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There are some key benefits to cryptocurrencies, a few of which I will mention
 here.
 Firstly, the system is self-regulating, meaning that no government or instituti
on controls it.
 For the user that means that their holdings cannot be used as a policy
 instrument.
 Conventional fiat currencies are owned by a government, which means that
 they can be used to e.g.
 stimulate economic growth by printing extra money, which lessens the value
 of individuals holdings.
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Secondly, users control their own holdings on their own computer, which
 eliminates the need for a bank.
 This brings the advantage that users are not dependent on open hours, waiting
 lines, or e-banking websites, it also means no fees.
 Additionally a user's holdings cannot be wiped out by his or her bank bankrupti
ng after speculative investing or something of that sort.
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Thirdly, transactions are as easy, instant, and costless as sending an email.
 Bitcoin exists online digitally, which means that there is no physical
 counterpart that needs to be moved, such as with gold, or paper money.
 Additionally, it is equally valid across countries, which means that there
 is no need to exchange it.
 This makes Bitcoin an ideal mechanism for remittances, which nowadays can
 cost as much as 10 percent.
 Additionally no government can apply capital restrictions on these remittances.
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Lastly, the instant nature of transactions means it is well suited for online
 retailing.
 Credit card transactions seem instant, but in fact are not.
 A significant percentage is in fact reversed after initial clearance.
 This is very costly for retailers, this often occurs after packaging of
 shipping has started.
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From a technical perspective there are many innovative features to cryptocurrenc
ies, and I will begin by highlighting the key ones.
 After this I will focus on two economic aspects, which have been thought
 to be problematic, namely the lack of inflation and also socially wasteful
 mining.
 Although these aspects might seem unrelated, they have a common solution.
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\series bold
Bitcoin
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 is a confusing term.
 It is both a monetary unit of denomination, such as Swiss franc, euro,
 or pound sterling, as well as, a monetary system as a whole, including
 the protocol, the network, and the software.
 To distinguish between the two, the system 
\series bold
Bitcoin
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 is written with a capital letter B, the monetary unit is 
\series bold
bitcoin
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, with a small letter b.
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Bitcoin is built from the ground up to be decentralised and anonymous.
 All software is open source and publicly available.
 Anybody can perform any function within the network (user or node), there
 is no central or essential node, there is redundancy in every aspect.
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The essential principle is that every user has a piece of software on their
 computer, a 
\series bold
wallet
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, which contains a set of 
\series bold
public addresses
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 (like bank account numbers), each address is mathematically linked with
 a 
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private key
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 (like a password).
 Using this secret key, users can create a digital 
\series bold
signature
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, to prove that they are the owner of an address.
 This signature, together with a transaction is sent to a 
\series bold
bitcoin miner
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.
 The miner is a node in the network, which verifies that the address and
 signature are linked, after which the transaction is recorded in the public
 ledger, or 
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blockchain
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 and disseminated throughout the network.
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There are a number of other features which are important to highlight.
 Bitcoins are created through a process called 
\series bold
mining
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, this is a computationally intensive process used as the mechanism for
 transaction verification.
 The Bitcoins created as a reward for mining becomes incrementally smaller,
 until finally becoming zero.
 This is predicted to be around the year 2140, and at that point around
 21 million bitcoins will have been created.
 There will never be more bitcoins in the system.
 Furthermore, bitcoins will be lost if private keys are lost, these will
 never be recovered.
 The system is thus strictly deflationary.
 To keep transactions of every size possible, bitcoins are highly granular,
 every bitcoin can be divided into a hundred million 
\series bold
satoshi
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 (named after the pseudonym of the creator).
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As the value of bitcoin goes up, more people will choose to engage in the
 lucrative mining.
 As extra computational power comes in, the difficulty of mining automatically
 goes up, which means more computing power is used for the same transactions.
 This is necessary to safeguard the integrity of the network.
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Having established the key features of the Bitcoin system, we will now focus
 on two often heard economic concerns about the Bitcoin system.
 Namely the issue of deflation and the issue of socially wasteful mining.
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As mentioned above, there will only ever be around 21 million bitcoins,
 and some will be lost, this makes the system deflationary, which is troubling
 to economists.
 Deflation provides a disincentive to spend, causing economic slowdown 
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.
 Since deflation causes the price of products to fall, it incentivises people
 to save ans spend later.
 Additionally, these savings are not invested properly, since deflation
 simultaneously provides a disincentive for borrowers, by making future
 paybacks more expensive, raising the effective interest rate.
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The second issue is the value of the mining process.
 As described above, the process of mining is the solving of computational
 problems, in order to secure the integrity of the Bitcoin network.
 However, the actual social value of the arithmetic solution itself is zero,
 since it has no application other than Bitcoin integrity.
 As the number of bitcoins is limited, and more money is invested in it,
 the value can only increase.
 The increase in value will make it more lucrative to engage in bitcoin
 mining, which means more computational power will be devoted to this.
 To keep the system secure in face of this extra computing power, the difficulty
 goes up.
 However, if the extra power had not come in, this would not have been necessary.
 The extra computers which engage in bitcoin mining thus do not add any
 social value.
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It has to be noted, that the bar for social value is being set very high.
 Extraction, storage, and transfer of value is a resource intensive enterprise.
 Consider the gold mining industry (note, this is the origin of the term
 
\series bold
bitcoin mining
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).
 The extraction of gold is a very resource intensive, dangerous, and pollutive
 process.
 After the extraction, purification, and molding, most gold is stored highly
 guarded in vaults.
 Finally then, gold can be utilised to conduct transactions, which involves
 shipping bars of gold across the ocean under maximum security, only to
 be stored in another highly protected vault, on arrival 
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.
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The solution for both these lies in the multiplicity of cryptocurrencies.
 As mentioned above, every aspect of Bitcoin is open and publicly accessible,
 it is therefore relatively easy to start an alternative Bitcoin, and this
 has been done.
 There are in fact many currencies based on the Bitcoin protocol, collectively
 referred to as cryptocurrencies.
 It is relatively easy and cheap to construct a number cryptocurrency, whereby
 the number of available coins can be set by the creator.
 The most popular alternative to Bitcoin is called Litecoin, its main difference
 is that it processes transactions faster, and the total number of coins
 is four times as high.
 Aside Litecoin, there are many other alternative cryptocurrencies, most
 of which never gain momentum and the value of which remains only trivially
 above zero.
 However, a significant number does succeed.
 The momentum mechanism could perhaps best be compared with a positive variation
 on currency attacks 
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.
 Unlike the creation of new coins in an existing cryptocurrency, the creation
 of new cryptocurrencies is relatively cheap.
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The key point to observe here, is that cryptocurrencies do have value, but
 only as a transaction mechanism.
 Hereby the biggest bottleneck is probably the number of cryptocurrencies
 that merchants are willing the accept simultaneously.
 However, due to their similarity, it is very straightforward for e.g.
 merchants to accept multiple currencies.
 When we combine the value with the relatively cost-less creation of cryptocurre
ncies, we see an equilibrium in the number of cryptocurrencies that is far
 higher than in the current situation.
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Inflation is impossible within the Bitcoin network, as well as within most
 other cryptocurrencies.
 However, inflation in the cryptocurrency economy is still possible, through
 an expansion the number of cryptocurrencies.
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It is also through this multiplicity that wasteful mining will be limited.
 As noted above, cryptocurrencies have value, because they are effective
 mechanisms for transactions.
 However, this is the only source of value.
 If a cryptocurrency becomes too expensive (which causes excessive mining),
 a new, lower valued, cryptocurrency will arise.
 Since the value of this currency is lower, but it is equally effective
 in transactions, value will flow out of the overvalued cryptocurrency and
 into the undervalued one.
 This lowers the value of the overvalued cryptocurrency, and less mining
 will be done here, reducing the waste.
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In conclusion, cryptocurrencies such as Bitcoin have an enormous potential
 as a transaction mechanism, giving users control of their own holdings
 and making transactions instant and costs negligible.
 Two commonly heard issues with cryptocurrencies are deflation and wasteful
 mining.
 It can be shown that these issues are not pervasive, when the cryptocurrency
 economy as a whole is considered.
 Cryptocurrencies derive their value only from being an efficient transaction
 mechanism, if they appear to become overvalued (causing excessive mining),
 other cryptocurrencies will arise.
 This will increase the total number of cryptocoins (between all cryptocurrencie
s), which will drive down the price, and limit excessive mining.
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