DEFINITION

In order to discuss the place of cryptographic, peer-to-peer coins in the financial archi- tecture, it is important to have clear understanding of their identity and their functions.

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Frame and White (2004, p. 118) define a financial innovation as “something new that reduces costs, reduces risks or provides an improved product/service/instrument that better satisfies participants demands. Financial innovations can be grouped as new products (e.g., adjustable rate mortgages, exchange traded index funds); new services (e.g., online securities trading, internet banking); new ‘production’ processes (e.g., electronic record-keeping for securities, credit scoring); or new organizational forms (e.g., a new type of electronic exchange for securities, internet only banks)”.

Defining altcoins is a necessary first step3before considering their possible contribution in the payment system and the challenges posed for issuers, users, and regulators. Analytic scrutiny serves a further important role to establish the defining characteristics of cryp- tocurrencies (more than 400 at the time of writing) that allows for a uniform study. The terms “cryptocurrencies” and “altcoins” are going to be used interchangeably in the chapter to describe platforms that rely on the blockchain and on double-key cryptogra- phy and employ a peer-to-peer structure, to “issue digital cash,” usually called “coin,” with the aim of transmitting economic value across the Internet. The analysis of crypto- currencies is going to fall back on the study of the bitcoin, which at the time of writing is by far the most visible, popular, and larger in terms of market capitalization.4Bitcoin is also where the innovative technology of the blockchain was first introduced, and this cryptocurrency developed the source code the other altcoins adopted through a process of replication and variation. This chapter is also going to take into consideration other accepted altcoins, but because of their variation and their number, not all them can be accurately represented and described by the basic characteristics listed earlier.

Before describing and defining cryptocurrencies, it is important to note that none of them, including bitcoin, is money proper. Cryptocurrencies are legally defined as “con- vertible digital currencies” (according to the US Financial Crimes Enforcement Network directive issued early in 2013) or as a “digital equivalent of cash” (according to the European legislation EC/2009/110 on electronic money). The legal definition applies to the cryptocurrencies that are directly convertible to official currencies employing digital marketplaces and exchange sites. Despite its convertibility, digital cash cannot be considered money (Evans, 2014; Hanley, 2013; Yermack, 2014). Money in econom- ics is defined by its functions, primarily as a means of exchange according to the reigning commodity theory of money (Menger, 1892) or as a standard of abstract value for the state theory of money (Knapp, 1924). The two functions are interrelated, since the dominant means of exchange tends also to be the main unit of account and vice versa. In order for an asset or a payment vehicle to be money, it has to be the universal means of exchange and standard of value at least in the geographic area of a state or the economic area of a market; neither is the case for any of the altcoins in circulation. On the contrary, the operation of bitcoin and of other digital cash relies heavily on official currencies that serve the function

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“Proponents can’t easily explain what a cryptocurrency is. If you can’t explain what you are and how you fit into the current legal and regulatory scheme, you are at the mercy of the ignorant. The ‘what this is’ answer needs to address not just things like ‘is it money transmission?’ but more mundane yet important questions like ‘where is a bitcoin located?’ and ‘where and when does a transaction take place?’ Cryptocurrency supporters should address whether crypto-currency is a currency/store of value or a payment system or

a hybrid of both” (Middlebrookt and Hughestt, 2014, p. 839).

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Bitcoin market capitalization was around 7.6 billion USD, more than 10 times the capitalization of all the

other cryptocurrencies aggregated together. Data according tohttps://coinmarketcap.com/quote for the

26th of July 2014.

155 Blockchain and Digital Payments: Analysis of Cryptocurrencies

of the standard of value and of means of final settlement of payment (Evans, 2014, p. 9; Yermack, 2014, p. 10). Even if there is nothing that prevents altcoins from replacing the state currencies and their “moneyness” or not is an empirical question, it is important to keep in mind that bitcoin and other cryptocurrencies are designed as protocols that trans- mit economic value across the Internet and not as money. As Satoshi Nakamoto claimed in the inaugural Bitcoin design paper, “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party” (Nakamoto, 2009, p. 1).

David Evans argued that the important innovation of Nakamoto was the blockchain, an encoded, distributed, digital ledger of transactions. Evans (2014, p. 2) described the bitcoin and the other “virtual currencies” like it as “decentralized public ledger platforms” capturing the distinguishing characteristic of these payment systems. Anyone who holds altcoins also has the exact copy of the blockchain, making all transactions visible to the users of the system, eliminating the information asymmetries that characterize the traditional hierarchical system of financial intermediation, and enhancing the security of the public ledger of the transactions. More importantly, the existence of the blockchain makes inter- mediation from third parties like commercial banks or credit card companies obsolete by delegating the verification of transactions to a distributed peer-to-peer network and rewarding the nodes that are successful in verifying transactions. The verification process and the consequent reward of the effort and the infrastructure involved in solving the math- ematical equations related with the processing of transactions and the verification of the blockchain are described as “mining.”5Mining is also the way that new digital cash comes to existence, providing an automatic mechanism for the supply of the cryptocurrencies.

Cryptocurrencies combine a high degree of identity protection with a decentralized system of verifying transactions that does not rely to a third party, making the use of alt- coins for digital transactions equivalent to cash payments. Most of the altcoins employ a double-key cryptography, which is based on a hashing algorithm (the most popular is the SHA 256) that protects the privacy of the payers and the payees (DuPont, 2014); while altcoin transactions are recorded in public ledgers and are accessible by everybody, the privacy of the participants of the system is safeguarded and only their alias is recorded in the blockchain.6 The relative anonymity of transactions represents a comparative

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“The node that succeeds in solving the cryptographic puzzle starts a new block by submitting its ‘proof of work’ to the network. Solving the puzzle is a computationally demanding process, and it becomes more demanding each time, requiring increasing amounts of computing power to decipher. The node in the network that ‘wins’ the race to decode the next block receives as its reward the ability to create a fixed quantity of new bitcoins for itself. Via this incentive, the algorithm effectively harnesses the computing power of all the Bitcoin holders to the process of verifying all the Bitcoin transactions in the world” (Maurer et al., 2013, pp. 264–265). 6

“Bitcoin is frequently described as anonymous, because while every transaction is recorded in the public ‘block chain,’ parties are identified only by a Bitcoin address.’ It is possible to trace transactions although it may be

advantage to other digital payment platforms. Especially after the NSA affair and the increased awareness that Internet activity is monitored by governments and corporations, privacy protection has assumed more importance for Internet users. Nevertheless, privacy is always a matter of degree and not a binary concept.7The importance is how much privacy is provided by the system, and here, cryptocurrencies offer different methods and different degrees of protection. The main questions concerning privacy that also are resolved differently by different altcoins are as follows: Who controls the process and the technology of encryption? Is this process reversible by the administrators of the system? and What is the cost for a third party to uncover the identity of a user or a transaction? All these issues are extremely important for regulation, since money laun- dering, financing of illegal activities, and tax evasions are top priorities of the oversight institutions in the payment industry.

The innovative technology of cryptocurrencies and its resilience are supposed to explain the appeal of such platforms and account for their economic value. Technology, it is argued, can replace the state or the commodity as the guarantee for the future value and the acceptability of cryptocurrencies.8Nonconvertible fiat money is enacted by law as legal tender and is the only acceptable means of paying taxes. Cryptocurrencies are not able to offer a comparable guarantee for their future acceptance, so technology is advertised as their ultimate source of reliability and trust. Again, a leap of faith is nec- essary for accepting the value of cash, be it digital or material. Technology should func- tion not only as an agent of cryptographic verification of transactions but also as the foundation of a system of values that can carry the expectations of suppliers and users of cryptocurrencies. Expectations are of the essence since present value “depends on expectations concerning demand and supply of the asset over time [and] like any asset we would expect that market participants would engage in speculation over the future value of the asset” (Evans, 2014, p. 6). The cryptocurrencies are not an exception, and the volatility of their price is both an indication of the high uncertainty concerning the future performance of technology and a symptom of their novelty. The fact that the emission of new coins is automatic, hardwired in the protocol as a reward

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Even if the use of cryptocurrencies provide complete identity protection for its users, privacy can be compromised in other points of the transaction, for example, when an amount in cryptocurrencies has to be converted. Third-party intermediaries can function as identity “check points,” when one has to rely on third parties to convert cryptocurrencies to official currencies, then government regulation can be implemented on and through these intermediaries. If you have to have an account with a third party like bitcoin.de that you need to follow their payment instructions.

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“The monetary value of Bitcoin rests as much in the future potential that its users imagine for it as on its current, relatively limited capacity to act as a medium of exchange. Similarly, its semiotic value grows out of the aspirations of Bitcoin adherents. The point is not whether Bitcoin ‘works’ as a currency, but what it

promises: solidity, materiality, stability, anonymity, and, strangely, community” (Maurer et al., 2013,

p. 263).

157 Blockchain and Digital Payments: Analysis of Cryptocurrencies

mechanism to the miners, contributes further to their volatility, by making any interven- tion to fine-tune supply and demand impossible.9

Cryptocurrencies offer an alternative to the established digital payment instruments, likePayPal or the digital applications of credit card companies and commercial banks. Their decentralized architecture and the privacy safeguards make them attractive to users that look for a payment method similar to cash for their digital payments. Still, crypto- currencies can only exist in virtue of a network of programmers and miners that offer their services and resources in order to run the system, fix possible bugs in the code, and propose improvements. In the next section, we will look closer how the networks that support altcoins operate, their incentives, and the rewards for the producers and the consumers of the services that altcoins provide, and we will compare them with other organizations in the digital payment industry and other open-source projects.

7.3 THE STRUCTURE AND THE INCENTIVES BEHIND THE SUPPLY