Cryptocurrency, Imperfect Information, and Fraud

Abstract

We study cryptocurrency in a monetary economy with imperfect information. The network imperfection provides traders opportunities to engage in double spending fraud, but the trackability of transaction messages allows us to impose proof-of-work (PoW), proof-of-stake (PoS), and currency exclusion to mitigate fraud incentives. However, PoW consumes energy, and PoS requires extra cryptocurrency to be held as deposits, so deterring fraud may not be optimal. We find that forks can serve as signals to detect double spending fraud and to trigger punishments. If the probability is high that forks appear under double spending, imposing PoW and PoS to deter fraud is optimal; otherwise, it is optimal to save the cost but allow for double spending. Finally, by endogenizing the incentives to double spend and the size of PoW and PoS, we show that cryptocurrency economy can achieve efficient allocation as the imperfectness of the internet is sufficiently low.