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Harvard Mason Scholar Chuanwei Zou: Bubbles and Opportunities – Nine Questions on Digital Cryptocurrencies and Blockchain Finance
Harvard Mason Scholar Chuanwei Zou: Bubbles and Opportunities – Nine Questions on Digital Cryptocurrencies and Blockchain Finance

Harvard Mason Scholar Chuanwei Zou: Bubbles and Opportunities – Nine Questions on Digital Cryptocurrencies and Blockchain Finance

Disclaimer: This article is purely an academic discussion and is not sufficient to form an investment opinion on any digital cryptocurrency or ICO project.

Nine Economic Issues with Digital Cryptocurrencies and Blockchain Finance

Since 2017, digital cryptocurrency speculation has swept the world, and there has been a proliferation of blockchain financial innovations associated with it. rogoff (2017) and Schiller (2017) have written that digital cryptocurrencies are clear asset bubble, a view shared by luminaries such as Warren Buffet, Joseph Stiglitz and Paul Krugman. Nevertheless, the market is flooded with various specious views on digital cryptocurrencies and blockchain finance. In order to clarify the understanding, direct the financial innovation activities in a socially beneficial direction, and introduce the corresponding regulation, it is necessary to study the fundamental issues of economics related to digital cryptocurrencies and blockchain finance. This is the origin of writing this paper.

This paper is divided into ten sections, the first nine of which discuss nine economic issues of digital cryptocurrencies and blockchain finance in turn. The first section discusses the pricing of digital cryptocurrencies using Bitcoin as an example. Sections two and three discuss two directions that attempt to reduce the price volatility of digital cryptocurrencies – bitcoin futures and stable tokens (STTs). Sections four through six discuss the main current channels for generating new digital cryptocurrencies – forks, token economies, and initial coin offerings (ICOs). Sections 7 and 8 discuss the two mainstream directions of blockchain applications in finance other than digital cryptocurrencies – central bank digital currency and blockchain applications in financial post-transaction settlement. Section IX discusses the risks and regulation of digital cryptocurrencies. Section X concludes the full paper and presents issues for further research.

I. Pricing of Digital Cryptocurrencies

According to data from the CoinMarketCap website, as of January 18, 2018, the market capitalization of the 1,465 digital cryptocurrencies it tracks was $599.5 billion, slightly higher than the market capitalization of Facebook Inc. on that day ($5,192); 24-hour trading volume was $61.7 billion, equivalent to 80% of the volume on the Shanghai and Shenzhen exchanges that day (RMB 486.3 billion); Bitcoin accounted for 33.5% of the market capitalization of all digital cryptocurrencies, at $2008 billion.

Figure 1 shows bitcoin prices and volatility between January 1, 2011 and January 18, 2018, where the average annualized return was 349% and the average annualized volatility was 176%. According to research by Convoy Investments, Bitcoin may be one of the largest asset bubbles in history, as measured by the speed and magnitude of price increases, having surpassed the Mississippi Bubble of 1718-1720 and the South Sea Bubble of 1719-1721. Digital cryptocurrencies represented by Bitcoin should be the first asset bubble on a global scale, and much of the individual and group irrational behavior of behavioral finance research can be observed in the crypto-digital currency market.

Data source: Yahoo Finance and author’s calculations

Figure 1: Bitcoin price and volatility

There are many studies of asset bubbles in economics, and interested readers can refer to Scherbina’s (2013) review, which will Without going into detail, I will only respond to two popular views. The first view is that demand from the underground economy is driving up the price of bitcoin. There is some validity to this argument. Bitcoin’s anonymity, decentralization, and existence in electronic form make it more suitable for use in the underground economy (this point is discussed in depth in Section 9). There are no credible numbers on how much bitcoin is used in the underground economy. However, there are many indications that a significant portion of bitcoin is being hoarded by holders because of the upward trend in bitcoin prices. Hoarding is, of course, a common phenomenon in all types of speculative activity and can fuel an asset’s rise by reducing the effective supply.

The second argument is that the price of bitcoin is supported by the cost of “mining” bitcoin, and that as the cost of “mining” gets higher, the price of bitcoin should go up as well. This argument is hardly valid. The supply of bitcoins at a given time is determined in advance by the algorithm (currently averaging 12.5 bitcoins every 10 minutes) and has nothing to do with how much computing power (measured by the number of hash operations) is put into “mining”. If the price of bitcoin rises, more computing power will be devoted to “mining”, but the supply of bitcoins will not increase, and the price of bitcoin will not be flattened. Because more computing power is competing for a given number of new bitcoins, the cost of “mining” (the number of hash operations needed to generate a new bitcoin) will go up. Similarly, if the price of bitcoin falls, less computing power will be devoted to “mining”, but the supply of bitcoins will not be reduced and the price of bitcoin will not be supported. At this point, less computing power is competing for a given number of new bitcoins, and the cost of “mining” goes down. In contrast, there is a closer relationship between precious metal prices and their production costs: if precious metal prices are higher than their production costs, profit-driven production activity will increase, pushing up the supply of precious metals and thus depressing precious metal prices; conversely, if precious metal prices are lower than their production costs, production activity will decrease, reducing the supply of precious metals and thus pushing up precious metal prices.

二、Can bitcoin futures stabilize the price of bitcoin?

The volatility of the bitcoin price is too high to be suitable as a medium of exchange or to develop inter-period financial transactions denominated in bitcoin. For example, suppose A borrows 1 bitcoin from B on December 1, 2017, with the agreement thatRepayment was made 1 month later, at which point the price of bitcoin was $10,861. By January 1, 2018, the price of bitcoin rose to $13,445. In dollar terms, A’s debt burden has increased by 24% in 1 month, which naturally affects his ability and willingness to repay.

Figure 2 compares the volatility of the bitcoin price and the S&P 500 since 2011. During this period, the average daily volatility of the bitcoin price was 10.88% and the average annual volatility of the S&P 500 was 14.25%, meaning that the degree of volatility of the bitcoin price in a day is close to the degree of volatility of the S&P 500 in a year. In addition, bitcoin trading costs are relatively high. For example, buying bitcoin with a Coinbase account costs 1.49%, which means that to buy $1,000 equivalent worth of bitcoin, you pay $14.90 and it takes 3-5 business days to close, while buying the S&P 500 index fund with a Charles Schwab account costs $4.95 for a single transaction, which can be done quickly. Therefore, the S&P 500 index fund is a better medium of exchange than even Bitcoin.

Data source: Yahoo Finance and author’s calculations

Figure 2: Comparison of Bitcoin price and S&P 500 volatility

Price stability is a necessary condition for Bitcoin to be an effective medium of exchange. One direction of experimentation is bitcoin futures. on December 10 and 18, 2017, the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched bitcoin futures, respectively. In addition to providing price discovery and risk management functions, bitcoin futures facilitate institutional investors’ participation in the bitcoin market, which was a major driving force behind the sharp rise in bitcoin prices between October and mid-December 2017. In addition, a bitcoin ETF could easily be developed based on bitcoin futures, which would facilitate general investor participation in the bitcoin market via mainstream stock exchanges, rather than digital cryptocurrency exchanges or wallets.

In terms of actual data, the CBOE and CME’s bitcoin futures serve some price discovery and risk management functions (Figure 3), but the volatility of bitcoin prices has not been significantly reduced either (Figures 1 and 2). Indeed, as seen in commodity futures and financial futures markets generally, futures trading does not necessarily reduce the volatility of the underlying asset.

Source: CNBC, Yahoo Finance

Figure 3: Bitcoin Futures at CBOE and CME (in USD, Bitcoin is traded daily, but Bitcoin futures at CBOE and CME are only traded on weekdays)

Bit The trading volume of bitcoin futures is not significant. As of January 13, 2018, the CBOE January bitcoin futures had an open interest of 2,918 lots (1 bitcoin per CBOE lot) and the CME January bitcoin futures had an open interest of 727 lots (5 bitcoins per CME lot), both corresponding to around 3,000 bitcoins, while the there were over 16.79 million bitcoins in circulation. This suggests both that bitcoin actually plays a very limited role as a risk hedge and that institutional investor interest in bitcoin futures is still minimal.

III. The Feasibility of Stabilization Tokens

Some practitioners are experimenting with stabilization tokens, and there are two types of representative approaches. The first is represented by Tether, which claims to issue a token USDT at a 100% reserve, 1:1 exchange rate to the U.S. dollar. this is equivalent to adopting a currency board system. According to the CoinMarketCap website, USDT had a market capitalization of $1.65 billion as of January 18, 2018. However, it is not known whether Tether has full reserves. If investors realize that a stable token like Tether does not have full reserves, a run will quickly occur (in fact, a December 5, 2017 article on Bloomberg’s website questioned the adequacy of Tether’s reserves and its relationship with the Bitfinex exchange).

The second category, represented by Basecoin and MakerDAO, is still in development and both claim to mimic central bank open market operations, controlling the supply of digital cryptocurrencies by issuing and recycling bonds denominated in digital cryptocurrencies, thereby maintaining the exchange rate of virtual currencies against fiat currencies.

I think it is very difficult for the second type of stable tokens to succeed. The “impossibility triangle” holds for this type of stable tokens – they can achieve at most two of the three goals of fixed exchange rates against fiat currencies, free convertibility with fiat currencies, and independent monetary policy at the same time. The stabilization tokens that are currently being tested adhere to the first two goals, implying the abandonment of the goal of independent monetary policy. Not only that, but such stable token experiments are attempting to implement monetary policy through algorithms, which amounts to a complete abandonment of camera choices. This would be the first time in human history that a fixed exchange rate has been experimented with based entirely on rules. However, the mechanism of exchange rate determination is complex and there are many unresolved issues (interested readers are referred to mainstream textbooks in international finance, such as Caves et al. (2006)). More complex rules or models are only approximations of the real economy, may miss important mechanisms and factors influencing exchange rates, and are difficult to cope with unanticipated shocks, so exchange rate policy cannot be completely replaced by rules or models. This type of stabilization token experiment is equivalent in difficulty to requiring interest rate policy to follow Taylor’s rule exactly.

iv. fork normalization

fork was initially seen as a serious challenge to the blockchain consensus mechanism. in April-May 2016, after the DAO financing project on Ether was attacked, the organizers of the DAO financing project chose to abandon the project, resulting in the first fork of the Ether blockchain. In August 2017, Bitcoin forked to create Bitcoin Cash. Cash. Since then, various forked coins have emerged. Theoretically, anyone can create a fork as long as they have the computing power to do so. There is usually a cap on the number of forked coins, with some being “pre-mined” by the founders, some being given to the original coin holders, and some being set aside for the fork’scommunity development, which is the equivalent of a primary market for forked coins. In the secondary market, forks are traded independently of the original coins.

The economics of the relationship between forks and original coins is more complex. In many currency forks, holders of the original coins receive fork coins for free, and the number of these forks is proportional to the number of original coins they hold. This makes cryptocurrency forks look like stock splits or dividends. However, giving fork coins to original coin holders is not technically necessary, sometimes in exchange for original coin holders’ support for the currency fork, or to grow the fork community based on the original coin community. Therefore, it is not an inherent right of the original coin to receive forks for free. In this way, many currency forks amount to a changeover from the old to the new, where the new version of the currency is already available for use, but the old version is still in circulation. This effectively creates an increase in currency issuance and weakens the binding nature of the cap on the number of original coins. If there is no moderation in the fork, there is the potential for currency abuse.

There is a competitive relationship between the original and forked coins, close to the situation envisioned by Hayek (1976) where private currencies compete with each other. The digital cryptocurrency that wins the competition will have the following characteristics (this also holds for the general competition between digital cryptocurrencies, not limited to the original coins and forks): 1. low transaction costs and high efficiency; 2. high security of infrastructure such as wallets and trading venues; 3. more stable prices, thus better able to assume monetary functions such as medium of exchange and store of value. Because of the network effects inherent in cryptocurrency, only a few digital cryptocurrencies can win out.

V. Token Economy

The token economy represents a promising class of blockchain application projects. In these projects, there is a real demand for transaction behavior, but these transaction behaviors were originally constrained by incentives, transaction costs or payment constraints, which made it difficult to carry out effectively; by introducing tokens, these projects not only solve their own financing problems, but also alleviate the constraints of incentives, transaction costs and payments faced by transaction behaviors. It remains to be seen what successful projects in this area will be. I believe that many token economies can be built in the following three steps.

(i) exchange economy kernel

Token economies generally have an exchange economy kernel around which other activities within them revolve. The exchange economy is a fundamental concept in economics, which means that the product has been produced and is in the hands of the people involved, and the only problem is how to exchange it between different people. The exchange economy abstracts away the concrete production and consumption processes from economic activities, and its existence is rooted in the fact that people are not equally endowed with resources or have a different division of labor. E-commerce, sharing economy, browsers, portals and search engines all have exchange economy characteristics.

Xie, Ping, Zou, Chuanwei, and Liu, Haiji (2014) Chapter 11 establishes an analytical framework for the Internet exchange economy. First, the Internet exchange economy possesses three elements: the subject matter of exchange, the medium of exchange, and the exchange participants. There are two types of exchange participants, one is the supplier of the subject matter of exchange and the other is the demander of the subject matter of exchange. The medium of exchange is generally legal tender, which can be an Internet currency (see the analysis in Chapter 5 of Xie, Ping, Chuanwei Zou, and Haiji Liu (2014), where digital cryptocurrencies fall under the category of Internet currencies), but can also not have any monetary characteristics (see below).

Second, the Internet exchange economy has three pillars. The first is the transfer of ownership of the subject matter of exchange, the medium of exchange, between the two types of exchange participants, which in reality often manifests itself as a logistics and payment process. The second is the information processing of exchange participants, such as figuring out what exchange objects are available, who are the participants, with whom to exchange, what to exchange, how much to exchange, etc. The third is the resource allocation mechanism, the goal of which is to efficiently match supply and demand by taking into account the endowments and preferences of exchange participants.

(ii) tokenization

The meaning of tokenization is to replace the medium of exchange in the Internet exchange economy with a certain token, assuming first that this token is issued and managed by a central entity. This token should have the six characteristics proposed in Chapter 5 of Xie, Ping, Chuanwei Zou, and Haiji Liu (2014):

1. issued and managed by the network community where the token economy is located;

2. in digital form;

3. the network community has established an internal payment system;

4. are generally accepted and used by members of the online community;

5. can be used to purchase data or physical goods in the online community;

6. can put a price tag on data or physical goods.” There are two types of

tokenization scenarios. First, when the medium of exchange is legal tender or Internet currency, it is straightforward to replace the medium of exchange with a token because of the existence of a price mechanism. E-commerce and the sharing economy fall into this scenario.

Second, when the medium of exchange does not have any monetary characteristics, because no price mechanism exists, tokenization means at the same time the introduction of a price mechanism. This is the case of browsers, portals, search engines, etc. Through them, Internet users get news and information for free, but at the same time, personal information such as hobbies, interests and needs are displayed, and browsers, portals, search engines, etc. then push advertisements to Internet users based on these personal information. However, is the exchange relationship between personal information, news information and advertisements fair and reasonable? Is it possible for Internet users to display too much personal information and passively accept too many advertisements for very little news and information? Although we do not know the exact answers to these questions, we can imagine another market mechanism: 1. Browsers, portals, search engines, etc. can only collect personal information from Internet users and push advertisements with their consent, and they must pay a certain amount of tokens to Internet users as the consideration; 2. Internet users then buy news information with tokens; 3. Browsers, portals, search engines, etc. buy tokens from Browsers, portals, search engines, etc. buy tokens from the producers of news information. By introducing the price mechanism, the exchange relationship between personal information and news information and advertisements is made visible. The price mechanism can effectively aggregate market information and improve resource allocationefficiency and social welfare.

(c) blockchain overlay

Blockchain overlay means:

1. the tokens issued and managed by the central entity in the second step are generated by the blockchain instead to realize the decentralization of tokens;

2. Solve the problems of registration and change of assets related to the exchange economy as well as the confirmation, recording and archiving of exchange activities through the distributed ledger of the blockchain (the impact of the distributed ledger on the credit assessment of token economy participants is complicated: on the one hand, the distributed ledger can improve information transparency to a certain extent; on the other hand, participants may choose to disclose less personal information and some information may not be disclosed to the whole chain due to confidentiality requirements) (the logic and challenges of blockchain to address these issues will be discussed in Section 8, using the application of blockchain in financial post-transaction settlements as an example);

3. Design a set of compatible (compatible

3. The

blockchain overlay demonstrates the triple property of blockchain in economics: decentralized payment systems, distributed ledgers, and incentives. These attributes enable blockchains to support market-based economic activities in a decentralized, self-organizing environment. However, the application of blockchain to achieve this goal is accompanied by very complex issues of transaction costs and governance structures. Section 10 will briefly discuss these two issues that have a significant impact on the prospects for blockchain adoption.

vi. the unresolved issues of ICOs

There are two financing channels for blockchain projects: equity financing and ICOs. starting from the second quarter of 2017, ICOs began to significantly overtake equity financing globally, becoming the main financing channel for blockchain projects at present (Figure 4). However, ICOs are chaotic both at home and abroad, as reflected in the following three aspects.

Data source: CB Insights

Figure 4: Global blockchain project financing amount (in USD billion)

First, the economic connotation of the tokens given to investors by ICOs is unclear. In theory, tokens have three possible connotations: 1. medium of exchange, which is the connotation of tokens used in Section 5; 2. equity credentials in the balance sheet sense, and ICOs that issue such tokens are close to equity crowdfunding; and 3. credentials to acquire goods or services, and ICOs that issue such tokens are close to commodity crowdfunding. Many tokens have multiple connotations, making it difficult to value them and making the corresponding ICOs both commodity crowdfunding and equity crowdfunding. However, many tokens go straight into speculation without the economic connotations being fully revealed or discussed.

Second, the problem of token speculation after ICOs. Unlike crowdfunding financing, after many ICOs occur, tokens can have secondary market trading, especially into digital cryptocurrency exchanges. In theory, if the token is a certificate of interest, goods or services, its valuation should be “anchored” to some fundamental factors. In reality, however, many tokens have been speculated to be priced well above fundamentals. ICOs are difficult to ensure investor suitability, and ICO projects are very risky in their early stages. In theory, ICOs should, like crowdfunding, be open only to qualified investors with a certain level of risk identification and tolerance, and the amount of investment by qualified investors should be limited. However, some ICO projects are effectively open to the public through digital cryptocurrency exchanges. in December 2017, the SEC called off several ICO projects because they were suspected of issuing securities to the public without approval.

Third, ICOs distort the incentives for blockchain startup teams. The secondary market for tokens allows blockchain startup teams to hold tokens that quickly have liquidation channels, at a time when blockchain startups may still be at the stage of white papers. In contrast, in the venture capital industry, it takes much longer for entrepreneurs to go from securing venture capital investment to IPO. the quick cash-out mechanism of ICOs distorts the incentives of blockchain startup teams. Token holders are often in a more ambiguous position in the governance structure of blockchain startups, lacking strong measures to ensure that startup teams align with their interests over time.

Finally, in the digital cryptocurrency space, ICOs form a positive feedback mechanism between “central currencies” such as bitcoin and ethereum, and tokens in general. The price of bitcoin, ethereum, etc., in turn often becomes the benchmark for valuing tokens issued by ICOs. This creates a mutually reinforcing positive feedback mechanism between bitcoin, ethereum, etc. and tokens in general. This is a major reason for the general price increase in digital cryptocurrencies since 2017. But once the price of bitcoin, ethereum, etc. enters a downward path, this positive feedback mechanism also accelerates the price of tokens in general.

vii. central bank digital currencies

Central bank digital currencies involve very complex monetary theory issues, and many studies have been done on these issues by major central banks around the world. Interested readers can refer to the articles included in the “Central Bank Digital Currency Research and Discussion” feature in the 17th issue of China Finance magazine in 2016, CPMI (2015), and Barrdear and Kumhof (2016). The main points in the literature are summarized as follows:

First, in terms of economic connotation, central bank digital currency replaces cash. Central bank digital money is an electronic currency issued directly to the public by the central bank, which is a liability of the central bank, a form of legal tender, and can pay interest to the holder. In comparison, the interest rate on cash notes is always 0.

Second, in terms of technical means, central bank digital currencies do not necessarily adopt blockchain. The system flexibility and stability offered by distributed ledgers are the most important considerations for the use of blockchain for central bank digital currencies. However, the public chain represented by the Bitcoin blockchain (free entry and exit of nodesout) and workload validation would result in a waste of social resources (mainly computing power and electricity consumption, which is discussed in Section 9). Therefore, central bank digital currencies tend to take the form of a federated chain, where the central bank maintains the distributed ledger together with some specific institutions.

Third, in terms of monetary policy, central bank digital currencies would provide new monetary policy tools – central banks regulate the macroeconomy by regulating the supply of digital currencies and interest rates. In addition, central bank digital currencies can pay negative interest rates, thus helping central banks to break through the zero lower bound on nominal interest rates during economic crises and increase monetary policy stimulus. A negative nominal interest rate, on the other hand, is not possible with paper money still in circulation because the people will withdraw their bank deposits and hoard paper money.

Fourth, in terms of financial stability, a central bank digital currency would have a greater impact on the payment clearing system. Payment clearing would not necessarily go through the secondary bank account system and could take place directly on the central bank’s balance sheet. Thus, a central bank digital currency would help to strip commercial banks of their special status in the payment system and the resulting “too big to fail” problem. But it could also create instability in bank deposits, as people could withdraw them and exchange them for central bank digital currencies. This was a major consideration in January 2018 when the Bank of England said it was holding off on experimenting with a central bank digital currency.

viii. blockchain in financial post-transaction settlements

Benos et al. (2017) and CPMI (2017) analyze the logic and challenges of blockchain applications in financial post-transaction settlements. Financial post-transaction settlement has 3 main component steps: 1. trade order management (including transaction validation); 2. clearing, which is the calculation of the financial obligations of both parties to the transaction; and 3. settlement, which is the final transfer of assets.

Central Security Depositories (CSDs) play a key role in settlement, undertaking three main functions, including 1. authentication, i.e., the impartial and trusted maintenance of records of issued securities; 2. settlement, i.e., the transfer of ownership of securities from the seller to the buyer; 3. account maintenance, i.e., the creation and updating of records of ownership of securities. Central securities registries sometimes also perform functions such as securities custody, asset servicing, financing, reporting, or securities lending.

In financial post-trade settlement, a transaction involves multiple intermediaries. Each intermediary uses its own system to process, send and receive trade orders, reconcile data, and manage errors, as well as maintain its own transaction records. The data standards used by each intermediary are also not uniform. All of this incurs significant costs.” The

blockchain is used in post-trade financial settlement to replace the clearing and book maintenance functions of a central securities registry, as well as to create and maintain a shared, synchronized book to simplify the transaction reconciliation process. The settlement industry is currently discussing the introduction of a private, access-constrained blockchain system for financial post-trade settlement. In this case, each node plays a different role and has different permissions to read information on the blockchain, and a group of trusted participants takes on the authentication function.” The potential benefits of the

blockchain for financial post-trade settlement include: 1. simplifying and automating post-trade settlement through a distributed, simultaneous, shared record of securities ownership, reducing transaction reconciliation and data management costs; 2. reducing the time required for settlement and reducing settlement risk exposure; 3. facilitating automated clearing because information about the transaction is shared by both parties to the transaction 4. shorten the custody chain so that investors can hold securities directly, reducing the legal and operational risks borne by investors as well as intermediary costs; 5. good traceability and transparency; and 6. decentralization and multiple backups can improve system security and resilience.

However, blockchain applications still face many challenges in financial post-trade settlement:

First, how to implement the authentication function? Although blockchain can guarantee the accuracy of the distributed ledger, a trusted authority is also needed to ensure the authenticity of the information on issued securities.

Second, how to achieve the depository function? In particular, how can assets held by custodians and depositories be transferred to the blockchain. One possible option is to use electronic credentials (digital token) to represent assets that are not on the blockchain, but a trusted authority is needed to ensure correspondence between the electronic credentials and the assets.

Third, how to implement delivery versus payment (DvP)? This requires the blockchain to be able to handle cash accounts at the same time.

Fourth, how to ensure settlement finality? For example, the Bitcoin blockchain system can only ensure settlement finality in a probabilistic sense (although the probability tends to 1 over time) because of the possibility of bifurcation.

Fifth, can the records on the blockchain constitute proof of ownership in legal terms?

Sixth, transaction matching and error management. Blockchain still faces a number of obstacles in comparing data in different dimensions and dealing with contractual mismatches and exceptions.

Seventh, how to ensure the confidentiality of transaction information with multiple parties involved in verification. One option is a trusted institution and only two parties to the transaction can participate in the consensus mechanism related to the transaction. Another option is to distinguish between transaction data and the data required for validation. Zero-knowledge proofs (ZKPs) are also a possible solution tool.

eighth, operational-level issues, including identity management, system scalability, and compatibility with existing processes and infrastructure (interoperability).

Similar to in financial post-transaction settlements, blockchain applications face many challenges in general asset registration, change, and confirmation, recording, and archiving of transaction activity. For example, 1. how to map assets (including physical assets) outside the blockchain to the blockchain? 2. how to ensure that assets and transactions outside the blockchain are consistent with their mapping and recording on the blockchain, both at the operational level and in a legal senseAnd synchronized updates? An analogy can be used to illustrate the difficulty of the 2nd question. Imagine a pond (equivalent to a blockchain) with a flower (equivalent to an off-blockchain asset) growing on its edge, and the flower forms a reflection in the pond (equivalent to a mapping of the off-blockchain asset on the blockchain), and a fish in the pond bites the reflection of the flower (equivalent to a transaction recorded on the blockchain). So, how to ensure that the flower in reality has also been bitten (equivalent to a consistent and synchronized update inside and outside the blockchain)?3. How to deal with errors and exceptions? Obviously, it is not possible to always respond to such scenarios with forks as digital cryptocurrencies do. All of the above questions reflect the general challenges that blockchain currently faces for large-scale applications outside of digital cryptocurrencies.

ix. regulation of digital cryptocurrencies

speculation in digital cryptocurrencies directs limited social resources to non-productive areas. Once the speculative bubble bursts, it will definitely have a negative impact on social wealth distribution. Speculative activities are also accompanied by obvious irregularities, fraud and even illegalities. Therefore, there is no doubt that regulation should be strengthened. In addition, digital cryptocurrencies cross national borders and speculative activities are global in nature, so global regulatory coordination should be strengthened.

(i) Production chain and primary market

The production chain of digital cryptocurrencies consumes a lot of electricity, especially digital cryptocurrencies that use proof of work. According to data from the Digiconomist website, as of January 18, 2018, the Bitcoin blockchain consumes 42.7 billion kWh of electricity a year, equivalent to the annual electricity consumption of the entire country of Peru, and it is still growing rapidly. Considering the pollution caused by thermal power generation (for example, the large number of bitcoin “mining pools” in Inner Mongolia, which consume a large amount of electricity generated by burning coal), the bitcoin blockchain is actually causing serious environmental pollution. According to the Digiconomist website, as of January 18, 2018, the Bitcoin blockchain’s carbon consumption or “carbon footprint” amounted to 20.92 million tons a year. in January 2018, the Chinese government requested an orderly withdrawal of mining companies in the country.

Section 6 has pointed out that some ICO projects are suspected of illegal securities activities, which will become the focus of ICO regulation.On December 11, 2017, SEC Chairman Jay Clayton argued in an open letter that some ICOs have the characteristics of securities offerings.

(ii) Circulation link and secondary market

Digital cryptocurrency exchanges are widely distributed around the world. For example, the CoinMarketCap website tracks 400 exchanges that offer Bitcoin trading services. Exchanges provide liquidity for digital cryptocurrencies. Once listed on an exchange, the price of digital cryptocurrencies generally increases significantly, which is essentially a liquidity premium effect – all else being equal, the better the liquidity, the lower the expected return and, correspondingly, the higher the current price. For example, Coinbase’s launch of Bitcoin Cash trading in December 2017 played this role in the price of Bitcoin Cash. In addition to the expansion of trading venues, the liquidity premium effect of digital cryptocurrencies comes from the diversification of trading instruments. Section 2 analyzes the impact of bitcoin futures and bitcoin ETFs. Many U.S. institutions have applied to issue bitcoin ETFs, but all have been rejected by the SEC.

Digital cryptocurrency exchanges fuel speculative activity and take on high risk themselves. First, as with ICOs, digital cryptocurrency exchanges have essentially no investor suitability checks for account holders, and many allow anonymous accounts. Second, the issue of leveraged speculation. Some digital cryptocurrency exchanges offer leverage to investors, which can amplify the price volatility of digital cryptocurrencies. Once there is a general and significant decline in digital cryptocurrencies, the high leverage overlaid with the high cost and time consuming nature of digital cryptocurrency trading (see Section 2 for details) will further amplify the downward trend through a positive feedback mechanism. Third, the problem of market manipulation. Many digital cryptocurrencies have very concentrated holdings. For example, about 40% of bitcoins are held by 1,000 people, and the “pre-mining” mechanism of ICOs and forks can also result in a concentration of these token holdings. This, coupled with the fact that digital cryptocurrency exchanges do not have the same disclosure system as stock exchanges, makes market manipulation possible. gandal et al. (2018) found bitcoin price manipulation on the Mt Gox exchange between February-September 2013.” The typical technique of

market manipulation is (so-called “pump and dump”), where several large digital cryptocurrency holders conspire to drive the price up, attracting retail investors to enter, and then the large holders concentrate on reducing their holdings, and retail investors who do not “escape the top ” of retail investors will suffer losses. Fourth, liquidity risk problem. Because it takes a very long time to confirm transactions on the blockchain, many digital cryptocurrency exchanges actually maintain a “cryptocurrency pool” and some of the transactions occur in the “cryptocurrency pool” rather than on the blockchain. These digital cryptocurrency exchanges then bear significant liquidity risk. Fifth, there have been numerous incidents of digital cryptocurrency exchanges suffering hacking, theft of customer assets and even bankruptcy and collapse.

digital cryptocurrencies have been associated with illegal or gray trading from the beginning because of their anonymity. In December 2017, The Economist reported that marijuana growers in California were planning to launch PerksCoin, a token that would help them trade without banks and be safer than cash, gold, etc. in the event of a California fire. gold, etc. Digital cryptocurrencies are objectively helping to finance ISIS terror. Digital cryptocurrencies have also been used to circumvent capital controls.

In summary, regulatory measures that should be strengthened in the circulation and secondary market of digital cryptocurrencies include: 1. Know Your Customer (KYC), anti-money laundering and counter-terrorist financing requirements for digital cryptocurrency wallets and exchanges; 2. Taxation of digital cryptocurrency transactions; 3. Investor suitability requirements; 4. Combating fraud and market manipulation; and 5. The exchange link between digital cryptocurrencies and legal activities, which is the area where regulatory authorities should and are most capable of strengthening regulation. However, as Rogoff (2017) points out, regulation in this area needs to be strengthened globallyCoordination, as long as there exist countries that are lenient with digital cryptocurrency exchanges, like Japan, objectively provides a “gateway” for illegal transactions based on digital cryptocurrencies.

(iii) Global regulatory coordination

Our country has adopted a very prudent and necessary regulation of digital cryptocurrencies. In January 2018, our government further called a halt to over-the-counter trading of digital cryptocurrencies and “offshore to domestic sales”.

However, many countries have very weak regulation of digital cryptocurrencies, especially Japan and South Korea. in April 2017, Japan passed legislation to determine the legal tender status (legal tender) of bitcoin. Japan is also the most lenient country in the world for digital cryptocurrency exchanges, with 15 licenses issued by the end of 2017. South Korea, on the other hand, has faced a popular backlash over tighter regulation of digital cryptocurrencies, which has evolved into a political issue. As of Jan. 16, 2018, more than 210,000 South Koreans signed a petition to stop the government’s overhaul of digital cryptocurrencies.

There is currently no unified position on digital cryptocurrency regulation across the U.S. government. The U.S. Treasury Department is primarily concerned with issues such as tax evasion and illegal transactions caused by digital cryptocurrencies. The SEC is very cautious about both ICOs and Bitcoin ETFs. After the U.S. Commodity Futures Commission allowed two major exchanges, CBOE and CME, to go live with bitcoin futures through a self-certification process (self-certificate) in December 2017, it was questioned by industry groups such as the North American Securities Administrators Association (NASAA) and the Futures Industry Association (FIA), and a special meeting is planned for January 31, 2018 to discuss the self-certification procedures.

In January 2018, Germany and France plan to present proposals on bitcoin regulation at the G20 summit in March. Follow-up progress remains to be seen.


There is no doubt that blockchain is promising for applications, but there are many significant challenges to large-scale applications outside of digital cryptocurrencies. Perhaps the market’s attention will return to these challenges only after the speculative frenzy subsides. But whether the market is frenzied or lukewarm, there is intrinsic value in the study of fundamental issues. In addition to the nine issues discussed earlier, I believe the next steps in the development of digital cryptocurrencies and blockchain finance are influenced by the following issues:

First, the issue of transaction costs, mainly from the cost of running the blockchain consensus mechanism. According to Digiconomist website data, it currently requires running 1.18*10^22 hash operations for every bitcoin block generated. Given the nature of the hash function as a random oracle, the process of generating a bitcoin block is equivalent to rolling a die with 1.18*10^22 sides until a particular side is rolled. Does it necessarily cost this much to run the consensus mechanism? I don’t think so. First, imagine that all the “miners” in the current Bitcoin blockchain agree to reduce their arithmetic power to a level equal to 1% of their current arithmetic power. Because the supply of bitcoins is determined in advance by the algorithm (see Section 1), cutting arithmetic would not affect the rate at which new blocks are created or the performance of the bitcoin blockchain. In this way, the increase in arithmetic power looks more like an “arms race” driven by a “prisoner’s dilemma”. Pareto improvements can be achieved if there is some sort of coordination mechanism for “arms reduction”. Second, unlike Bitcoin, which uses a public chain, central bank digital currencies and financial post-transaction settlements tend to use a federated or private chain (see Sections 7 and 8), with a number of trusted participants running the consensus mechanism, which is equivalent to introducing external trust relationships into the blockchain consensus mechanism. This can save a lot of costs compared to building consensus completely from scratch. Finally, low-cost consensus mechanisms exist. For example, Chen and Micali (2017) proposed the Algorand blockchain system based on cryptographic sortition (cryptographic lottery) and Byzantine protocol. Although blockchain consensus mechanism design is beyond the scope of this paper, it is important to note that market evolution has been toward low transaction costs, not the other way around.

Second, the issue of governance structure. Even though the blockchain system is initially set to be decentralized, over time, participants will form different interest groups based on their own positions of interest and form an informal governance structure within the blockchain system (readers interested in the governance structure within the Bitcoin blockchain can refer to the November 2, 2017 report in Caijing magazine: http://magazine. ). Informal governance structures are created, to some extent, to make up for the design deficiencies of algorithms or rules in blockchain systems, but the actual effect is still subject to time testing and case-by-case analysis.

January 22, 2018, first draft completed in Cambridge, Massachusetts


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[4] Chen, Jing, and Silvio Micali, 2017, “Algorand”, working paper (

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[12] Schiller, Robert, 2017, “What is Bitcoin Really Worth? Don’t Even Ask”, New York Times, Dec. 15, 2017.