The Economics of Cryptocurrency

Abstract

Cryptocurrencies claim to be the future of money and payments, the lifelines of any business. An informed evaluation requires understanding both the economics and the computer science behind the technology. Designed for an MBA elective on money and banking, this technical note guides students through the building blocks of cryptocurrencies using the one that launched them all: Bitcoin. To provide a logically consistent framework for interpreting future innovations, the technical note digs deeper into the technological ingredients of Bitcoin than is typical in economics, while also connecting the technology back to a core set of economic principles, all in an accessible way. Excerpt UVA-GEM-0190 Rev. Jan. 26, 2022 The Economics of Cryptocurrency May 2021 was a rough month for cryptocurrencies. In a matter of weeks, Bitcoin—the oldest and largest cryptocurrency by market capitalization—lost over one-third of its value relative to the US dollar. The next-largest cryptocurrency, Ether, fell nearly 40%, while Litecoin, colloquially known as the silver to Bitcoin's gold, lost over half of its value. The optimist may point out that Bitcoin was still worth more than it had been at the beginning of the year (Exhibit 1), but that would be small comfort to anyone who had traded USdollars for Bitcoins just prior to the crash. Volatility has long been a hallmark of the cryptocurrency market. Exhibit 2 compares volatility in the USdollar price of Bitcoin to volatility in the US dollar prices of gold, the euro, and the Brazilian real, and volatility in the S&P 500 Index. Gold is a commodity, the euro and the real are currencies, and the S&P 500 is a common target for index investing. Bitcoin is far and away the most volatile. Billionaire investor Warren Buffett has vowed never to own any cryptocurrencies and Bank of England Governor Andrew Bailey recently quipped, “Buy them only if you're prepared to lose all your money.” Perhaps the surprise isn't that Bitcoin dropped so precipitously in May 2021, but rather that it still has a market capitalization above USD500 billion. To make sense of where we've been, where we are, and where we might be going, we need to take a deep dive into the economics of cryptocurrencies. . . .