The seven deadly paradoxes of cryptocurrency

John Lewis

Will people in 2030 buy goods, get mortgages or hold their pension pots in bitcoin, ethereum or ripple rather than central bank issued currencies? I doubt it.  Existing private cryptocurrencies do not seriously threaten traditional monies because they are afflicted by multiple internal contradictions. They are hard to scale, are expensive to store, cumbersome to maintain, tricky for holders to liquidate, almost worthless in theory, and boxed in by their anonymity. And if newer cryptocurrencies ever emerge to solve these problems, that’s additional downside news for the value of existing ones.

The congestion paradox

For a conventional medium of exchange, the more people who use it, the better. Like in telecoms or social media networks, network externalities mean that the more users one has, the more attractive it is for others to sign up. Additionally, most conventional platforms benefit from economies of scale: because their costs are largely fixed, spreading them over more transactions lowers average costs.

But cryptocurrency platforms are different. Their costs are largely variable, their capacity is largely fixed. Like the London Underground in rush hour, crypto platforms are vulnerable to congestion: more patrons makes them *less* attractive. Some (but not all) have very limited capacity: Bitcoin has an estimated maximum of 7 transactions per second vs 24,000 for visa. More transactions competing to get processed creates logjams  and delays. Transaction fees have to rise in order to eliminate the excess demand. So Bitcoin’s high transaction cost problem gets worse, not better, as transaction demand expands.

The storage paradox

Ironically, virtual cryptocurrencies relying on a distributed ledger may be vulnerable to a crippling diseconomy of scale through system-wide digital storage costs. Each user has to maintain their own copy of the entire transactions history, so an N-fold increase in users and transactions, means an N-squared fold increase in aggregate storage needs. The BIS have crunched the numbers for a hypothetical distributed ledger of all US retail transactions, and reckon that storage demands would grow to over 100 gigabytes per user within two and half years.

The mining paradox

Rewarding “miners” with new units of currency for processing transactions leads to a tension between users and miners.  This crystalises in Bitcoin’s conflict over how many transactions can be processed in a block. Miners want this kept small: keeping the currency illiquid, creating more congestion and raising transaction fees – thus increasing rewards for miners facing ever more energy intensive transaction verification. But users want the exact opposite: higher capacity, lower transactions costs and more liquidity, and so favour larger block sizes.

Izabella Kaminska points out this tradeoff has been *temporarily* masked by capital inflows creating subsidies via the mining rewards system. Newly min(t)ed bitcoins are purchased by incoming investors who just want to hold them long term. Investors cross-subsidise the payment infrastructure, because they are willing to buy the bitcoin created as a block reward for processing payments.  But when those buy-to-hoard inflows stop so does the cross-subsidy, and the tradeoff re-appears with a vengeance.

A private cryptocurrency must continually attract more capital inflows to mask the transactions costs (a staggering ≈1.6% of system payment volume). By contrast, most traditional mediums of exchange don’t require such sizeable capital inflows to maintain their transactions infrastructure.

The next two paradoxes relate to currencies’ use as a store of value:

The concentration paradox

Despite proponents talk of decentralisation, disintermediation and democratisation most cryptocurrencies exhibit an extraordinarily high concentration of ownership – often in the hands of miners and/or “Hodlers”. 97% of bitcoin is estimated to be held by just 4% of addresses, and inequality rises with each block. Concentrated investor appetite and polarised sentiment makes it hard for big players to cash out, because the very act of selling up may cause prices to plummet…

An asset is valued by the market price at which it changes hands. Only a fraction of the stock is actually traded at any point in time. So the price reflects the views of the marginal market participant. You can raise the value of an asset you own by buying even more of it, as your purchases push the market price up. But realising that gain requires selling- which makes someone else the marginal buyer and thus pushes the market price downwards.

For many assets these liquidation effects are small. But for cryptos they are much larger because i) Exchanges are illiquid, ii) Some players are vast relative to the market iii) There isn’t a natural balance of buyers and sellers iv) opinion is more volatile and polarised.  High prices reflect cornering the market and hoarding, rather than ability to readily sell to a host of willing buyers.  For some assets with concentrated ownership, investors sometimes fear dominant players selling up. Relative to say, China’s share of US treasuries (≈5%), or central bank holdings of gold (≈20%), the concentration of ownership  in cryptocurrencies– and risk of redemption induced crash- is way higher.

The valuation paradox

The puzzle in economic theory is why private cryptocurrencies have any value at all. The discounted cashflow model of asset pricing says value comes from (risk-adjusted, net present discounted) future income flows. For a government bonds it’s the interest plus principal repayment, for a share it’s dividends, for housing it’s rental payments. The algebra of pricing these income flows can get complicated, but for cryptocurrencies with no yield the maths is easy: Zero income means zero value.

A second source is “intrinsic value”. Gold pays no dividend but has value as a commodity for making jewelry, or industrial uses. Cigarettes circulated in prisoner of war camps as commodity money because they had consumption value. But cryptocurrency has no instrinsic value.

Some argue that the breakeven energy cost of mining provides a floor for cryptocurrency prices. But, in Jon Danielsson’s words: “the costs of mining are sunk costs, not a promise of future income”. If I waste £150 on employing labourers to find and exhume the buried remains of my childhood pet tortoise from my parents garden’, those costs don’t make the skeleton worth £150 to an investor.

What other sources of value are there? The mere expectation that in future cryptocurrencies will be worth more than they are today and so can be flipped for a profit? The problem is that if, as Paul Krugman argues their “value depends entirely on self fulfilling expectations”, that is a textbook definition of a bubble.

The anonymity paradox

The (greater) anonymity which cryptocurrencies offer is generally a weakness not a strength. True, it creates a core transactions demand from money launderers, tax evaders and purveyors of illicit goods because they make funds and transactors hard to trace. But for the (much bigger) range of legal financial transactions, it is a drawback.

It makes detecting nefarious behaviour harder, and limits what remedial/enforcement actions can be taken. Whilst blockchains can verify a payment has been received and prevent double spending (albeit imperfectly), many other problems are unsolved.

First, there’s the increased risk of market manipulation or outright fraud when trades and holdings can’t be traced back to named parties.

Second, most financial transactions involve an intertemporal element (a loan, futures contract, deposit of funds with interest). With anonymity, the person who hands over the money “up front” has no easy redress against the other party subsequently reneging on their side of the deal. This severely limits the scope for these transactions, unless there is 100% pre-funding: which is usually prohibitively expensive in terms of tied up capital, and/or obviates the need for the transaction (if I could 100% pre-fund a mortgage, I wouldn’t need one…).

Auer and Claessens demonstrate empirically that developments which help establish legal frameworks for cryptocurrencies increase their value. Keep a cryptocurrency far from regulated institutions and you reduce its value, because it drastically restricts the pool of willing transactors and transactions. Bring it closer to the realm of regulated financial institutions and it increases in value.

The innovation paradox

Perhaps the biggest irony of all is that the more optimistic you are about tomorrow’s cryptocurrencies, the more pessimistic you must be about the value of today’s.

Suppose bitcoin, ethereum, ripple et al are just the early flawed manifestations of an emergent disruptive technology. Perhaps new and better cryptocurrencies will arise to overcome all of the intrinsic problems of today’s. After all, early mobile phones were cumbersome and the first cars moved at jogging pace, but subsequent versions transformed the world.

Whereas goods derive worth from their value when consumed, currency derives worth from the belief that it will be accepted as for payment and/or hold its value *in the future*. Expect it to be worthless in the future, and it becomes worthless now. If new cryptocurrencies emerge to resolve the problems of the current crop, then today’s will get displaced and be rendered worthless. Unless of course, existing ones can adopt whatever new features the newbies come up with. But because the previous six paradoxes are so intrinsic to existing private cryptocurrencies, I just don’t think they can.

John Lewis works in the Bank’s Research Hub.

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11 thoughts on “The seven deadly paradoxes of cryptocurrency

  1. There are a few good points here, but forced into a peculiar box of bank-biased thinking. But people don’t like banks, not really. They would rather have complete control over their money, like a digital deposit box, and that’s what crypto offers, and why it will continue to grow. In terms of investment, they would rather invest in networks, communities or multiple, minute
    tokenised assets. The writer starts out by mentioning big crypto names which aren’t privacy-focused coins, but public, transparent blockchain. Finally, yes. Development across the board in the crypto-space will solve many of the issues mentioned, and will apply to today’s cryptos, not tomorrows.

    Privacy coins are another subject, and exist in the name of freedom and independence. These are difficult things to stop, or control, by any regulation. Especially when the global tech prevents this.

    Crypto is highly secure, and avoids the wasteful processes of passing through banks which come with all their risk-attracting issues.

    The only thing hindering crypto is adoption due to their complexity that right now take a while to study and appreciate fully.

    Lastly, crypto is a beautiful thing to use. It just works. Ever sent ripple or bch or stellar lumens ? It just flows. Like water.

    Adapt, or miss out. The tide is turning. Start your studying, or continue if necessary. Mainstream media will get there too. Eventually.

  2. Very best article on crypto-currencies I’ve seen! Very concise, very clear, almost complete. Only thing I would add is the the ‘availability paradox’: Crypto-enthousiasts say that forking fixed the problem of having too few bitcoins available for broad usage. However, through forking it is shown that one of the attractions of crypto’s, a forced scarcity that will prevent inflation, can and will simply be circumvented. The idea that people can reject the newly created coin is true but has shown to not be the actual way it goes: Bitcoin Cash has found users and it did feed off of the Bitcoin fanclub. The new coins can be mined, and thus miners will be mining, therefore increasing the cryptosupply and creating inflation, ad eternam.

  3. This seems to be an article about Bitcoin rather than the current generation of cryptocurrencies while Ripple is not a cryptocurrency at all – may as well store your money on Yahoo.com.

    Pension funds are building on to decentralised hedge fund infrastructures and people are taking out loans to buy goods in the real world economy from smart contracts and its all done with an absolute minimum amount of human intervention, mortgages will come to the blockchain soon enough. This specific smart contract that allows people to mint stable coins has currently got over one million ETH locked up in it that people are using as collateral.

    There is a problem with throughput on all major blockchains that are fully distributed right now. As the technology matures with the introduction of second layer scaling solutions there is already an increase in txps from 14 to 6014 on the most advanced chain. The figure promises to increase exponentially with the development of sharding bringing millions of txps and eliminating the need for users to download the entire transaction history of the block chain(if they want to run a full node, most people use light clients), enabling a plug and play approach like the Apple App Store. With plasma side chains you can root all of the worlds transactions security on the blockchain in fact.

    Financial products that could not exist in the traditional economy are being created for the benefit of the ecosystem. One group has come up with a synthetic token which takes the codebase that issues stable coins but in this new system they clone the initial codebase and run it on top of itself. Except instead of employing a volatile asset like ETH as collateral they use the stable coin created in the first layer, in the process a new kind of synthetic token that is stable relative to any reference that has a market attached to it and liquidity is created. 

There are other dangers besides congestion like the fact that a chain which employs proof of work can go into a death spiral and become untranslatable as miners abandon the chain. You can see the effects of this today with one psycho fighting against another who controls a lot of the dirty hash power that (over)secures the chains involved, the system is completely fallible in this sense so other currencies have come up with new ways of securing the network where you stake coins and earn interest on them for the computations you validate – this can be done with a Raspberry Pi.

  4. There are some very insightful issues raised here, but they largely apply to PoW (Proof of Work) cryptocurrencies. “Blockchain 2.0” cryptos such as EOS, TELOS and HOLOCHAIN operate on such a completely different crypto architecture that they render almost all of these arguments moot. The DPoS (Designated Proof of Stake) model pioneered by EOS is proving to be a lightning-fast and efficient alternative to PoW. That said, 85% of EOS tokens are held by the top 1000 accounts resulting in yet another “Concentration Paradox”. However, TELOS is a much more egalitarian version of EOS and mitigates the impact of whales (the “Concentration Paradox” found in BTC, EOS, etc.) using methods such as inverse-weighted voting. HOLOCHAIN goes even further in its efforts to decentralize and speed up the network than TELOS. So the reality is that “tomorrow’s cryptocurrencies” are already here. Innovation will never stop because it’s innately in-grained in the human psyche…and that’s a good thing. “Fear of” anything paralyses us, while the quest for knowledge and advancement has led to amazing benefits for all of humankind.

  5. A paradox is a failure of language to describe reality. It is true that some of the ‘paradoxes’ here could indeed be attributed to Bitcoin. But Bitcoin’s dominance is receding as developers learn from its shortcomings and build much better systems. There is no congestion on modern blockchains, which are designed to handle currently 1,500 to eventually millions of transactions per second. A modern crypto wallet holds only the public and private keys that provide access to the blockchain. The blockchain is stored on distributed nodes which are rewarded for this task. Modern crypto assets are not ‘mined’ by computational power but are pre-mined or mined through stakeholder agreement. Modern blockchains are highly efficient and use far less electricity than VISA. Modern crypto assets are designed to be well-distributed. Value is simply an agreement between the seller and buyer (nothing physical has ‘intrinsic’ value). A few crypto assets are designed to be anonymous, but with KYC and increasing regulation it is easier to launder money through the UK, HK and US property markets – see this week’s Bitcoin supplement in The Spectator.

  6. The Bank Underground describes itself as “a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies.”
    Its latest post, but Bank employee John Lewis, is called ‘The seven deadly paradoxes of cryptocurrency’.

    The comments to date that follow the article have immediately noted that its analysis is extremely dated: as a commentary on bitcoin rather than on the frontiers of crypto-innovation.

    Let’s start with the concept of a paradox, then go through each of Lewis’ seven deadlies.

    Paradox, definition: A paradox is a statement in which it seems that if one part of it is true, the other part of it cannot be true. (Collins English Dictionary)

    The storage paradox
    Distributed ledgers have to store so much data. Is it true of bitcoin? Yes. Is it true of later generation tokens? No. Is it a ‘paradox’? Not at all, unless you are a believer in the primacy of centralized data.

    The mining paradox
    Miners make money from congestion. Users want liquidity. Is it true of bitcoin? Sort of. Is it true of later generation tokens? No: the problem is largely and increasingly solved. Is it a ‘paradox’? No; nothing ’paradoxical’ here; simply a conflict of interests.

    The concentration paradox.
    Token systems, developed in the name of decentralization and democracy, end up with concentrated ownership. Is it true of bitcoin? Probably. Is it true of later generation tokens? Probably, just as it is for almost all classes of assets in the current world. Is a paradox? No! Concentration of wealth is a systematic social trend, and there is no reason to think that cryptoassets are immune from that.

    The valuation paradox.
    There is no basis for cryptotokens having any value, for they have no underlying assets. Is it true of bitcoin? Could be. Is it true of later-generation tokens? Could be, just as it is of intellectual capital and intangible assets generally. Is it a paradox? No! it is a statement that our conventional systems of valuation can’t deal with intangibles.

    The anonymity paradox.
    There are dangers for economic stability and market operation from the anonymity of cryptocurrencies. Is it true of bitcoin? Yes. Is it true of later generation tokens? Yes, as it is for cash, and as it is for off-shore markets and dark pools in ‘conventional’ capital markets. Is it a paradox? No this is simply selective, ‘orthodox policy’ observation that judges new forms of ‘nefarious behaviour’ as somehow less tolerable than established ones.

    The innovation paradox
    The more optimistic you are about tomorrow’s cryptocurrencies, the more pessimistic you must be about the value of today’s, because they supersede today’s. Is it true of bitcoin? Probably. Is it true of later-generation tokens? Probably, just as it is of all long positions in financial markets. Is it a paradox? No – unless you think of crypto tokens as static objects, in which case change happens to particular tokens rather than being incubated within the class of tokens generally..

    So, what do we learn from these BoE 7 deadlies? Perhaps that there is envy inside the Bank? The main thing is that the author doesn’t seem to understand what a paradox is, unless we take it as a composite new word – a parody created within prevailing policy orthodoxy – or ‘paro-dox’ for short. There is nothing ‘paradoxical’ on offer from Mr Lewis: unless the premise is that ANY financial and social innovation that claims to have positive impact, but that does not involve the Bank of England, is ipso facto a ‘paradox’.

    But to be less rhetorical, research at the Bank of England has been extraordinarily significant, especially in the aftermath of the Global Financial Crisis. It was important because it took alternative conceptions of finance, and of financial contagion, seriously. The Banks’ research on cryptotokens needs a similar seriousness, premised on acknowledging the significance of, and respect for, the cryptotoken revolution.

    This is not to deny the limitations of claims for cryptotokens as the emergent alternative to fiat currency as a means of exchange and a store of value. At the Economic Space Agency (ECSA), where I am the Chief Economist, we are focussed on the capacities that cryptotokens create for building new units of account, that enable us to value ‘output’ (creative endeavour) by new, socially chosen criteria. They are the opportunity to challenge the rule of profit calculus in value formation and make value itself a site of social innovation.

  7. The author raises the costs of proof of work but fails to mention the costs of fiat money, specifically: (1) the costs imposed on society by different political factions attempting to gain control of the printing press, (2) costs imposed by special interest groups who persuade controllers of the printing press to misuse their authority (print more money) for the benefit of special interests, (e.g. BofE QE, bank bailouts) (3) inflation-induced misallocations of resources as a result of misused monetary authority, and (4) costs incurred by businessmen in their attempts to predict what the monetary authority will do in future.

    Why is it necessary for Bitcoin to use such energy-intensive computing?

    Nick Szabo answers this question in Money, Blockchains, and Social Scalability , by pointing out that Bitcoin’s high resource consumption buys something even more valuable: social scalability. Bitcoin’s computationally costly design gives stronger resistance to forgery, inflation, and theft. This is due to the difficulty of production, and also to easy-to-verify dynamic of Proof of Work schemes.

    Additional costs borne by society under government fiat money and the resulting inflation must be taken into account when comparing monetary standards. For example, consider the dramatically cheaper debt market financing available to governments in a fiat monetary order. This debt financing in turn enables many extremely costly and destructive programs, such as the warfare & welfare state. These government programs would otherwise require increased explicit taxation of taxpayers, which is much more difficult for a politician to campaign for, relative to the hidden costs of inflation.

  8. The author fails to mention the most important characteristic of Bitcoin. That is that its supply is limited to 21 million units. Unlike fiat currency which can be printed into oblivion. Bitcoin is a superior store of value versus fiat currency. This is why it was created (see the White Paper). The author works for an organization that is threatened by Bitcoin. Upton Sinclair said it best, “it is difficult to get a man to understand something when his income depends upon his not understanding it.”

  9. Thank God! A very concise educated analysis of the crypto world. This is the first article that has described an invisible, intangible, valueless asset. Thank you!

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