Cryptocurrencies and Blockchain: Hype or Transformational Technologies?
Overview
• The emergence of cryptocurrencies and blockchain technologies is part of a broader wave of technologies that facilitate peer-to-peer (P2P) commerce, individualization of products, and the flexibilization of production methods. For a variety of reasons, this wave gained traction after the global financial crisis a decade ago. Large digital platforms, such as Alibaba, Amazon, Uber, and Airbnb, are replacing many brick-and-mortar stores, service companies, and long-term employment relationships.
• Blockchain technologies aim to go one step farther. They organize P2P transactions and P2P information flows without companies that operate digital platforms. Whether these technologies will completely eliminate middlemen or whether new forms of trusted intermediaries will emerge remains to be seen.
• Cryptocurrencies are the first—and therefore most developed—application of blockchain technologies. They create money without central banks and facilitate payments without financial institutions. The success of several cryptocurrencies puts competitive pressure on transaction methods by existing financial institutions. However, serious limitations have become apparent. Decentralized organization of markets without trusted intermediaries can be very costly, and the volatility of the value of cryptocurrencies is a big obstacle to their becoming an alternative to legal tender.
• Other potential applications of blockchain technologies, from smart contracts to decentralized databases and open source social networks, could well become more transformational than cryptocurrencies. Current experiments are likely to result in lasting innovations, even if current applications do not stand the test of time.
• The emergence of blockchain technologies has triggered a flurry of activities in Europe and Central Asia (ECA), where people use cryptocurrencies for cross-border transactions and as speculative investments. Start-up companies are mining cryptocurrencies and providing blockchain services. Governments are experimenting with blockchain technologies to make their services more secure and more transparent.
• Many factors provide a fertile ground for these activities in ECA. Several governments actively support innovation by start-ups. Governments are eager to digitize and streamline their services. Lack of trust in existing financial intermediation makes cryptocurrencies an interesting alternative in some countries. Cryptocurrencies are also used to sidestep oversight of cross-border transfers. Cheap electricity (in Iceland and Georgia, for example) entices the mining of cryptocurrencies.
• Cryptocurrencies and blockchain technologies pose a range of policy challenges. They include the need to (a) apply rules of financial oversight, consumer protection, and tax administration while at the same time encouraging and facilitating innovation; (b) deal with the massive volume of electricity used to mine cryptocurrencies; and (c) determine whether governments and central banks can use blockchain technologies to improve their services. Policymakers should find a balance between curbing the hype and unleashing potentially transformational new opportunities. International coordination is needed to share best practices, avoid regulatory arbitrage, and explore how to regulate global decentralized networks.
Introduction
Ten years after an ingenious experiment to create a cryptocurrency that allows
secure and anonymous digital transactions to take place without the involvement of central banks or commercial banks, cryptocurrencies have become a
multibillion-dollar industry. By December 2017, the average price of one bitcoin
(the first cryptocurrency) had risen from just a few cents in 2009 to $15,000, doubling its value in a single month. These gains attracted many investors across the
world. On December 1, 2017, the U.S. Commodity Futures Trading Commission
approved trading in bitcoin futures. Although the price of a bitcoin had declined
to about $8,000 in April 2018, the value of bitcoins in circulation was about $150
billion as of April 10, 2018.
Big companies, and individuals working together in large pools, are competing for the right to add new transactions to the existing chain of transactions.
Their revenues, in the form of new bitcoins and transaction fees, are close to $20
million a day.
In the wake of bitcoin’s success, hundreds of alternative cryptocurrencies
have been created. Digital tokens have been issued as general currency; for specific purposes (for example, to rent computer capacity or cloud storage); and as
an alternative to traditional shares in companies.
Cryptocurrencies have evoked strong reactions. Critics call these virtual currencies a bubble, a scam, and even evil (Krugman 2013; Popper 2018). Supporters
predict that cryptocurrencies will ultimately replace money (Rooney 2018).
There is less disagreement about the underlying blockchain technology, a protocol to achieve decentralized consensus about the validity of a common database, stored in multiple locations. Many recognize that the blockchain protocol
can lead to tamper-proof, secure information systems without the need for a
single administrator. But even here views differ markedly about how transformational this technology is. Believers foresee utopian societies of self-regulating individuals, without government or trusted intermediaries. Doubters argue that
the number of useful applications has been exaggerated, that lack of regulation
can have disastrous effects, and that in most cases trusted intermediaries will
continue to provide useful services.
It is unclear how these technologies will develop in the long run. Conceivably,
they could be absorbed by existing institutions, with central banks issuing digital
cash, governments using blockchain to maintain information systems, and commercial banks putting payment systems on the blockchain.1 Many intermediaries
might become obsolete, and many new financial instruments might be created by
companies that do not yet exist. The main legacy of cryptocurrencies may not be
the blockchain technology but standardized digital IDs using a combination of
public and private keys on open-source software.2 Such a development would
allow individuals to own more of their data, instead of participating in proprietary information networks (Johnson 2018).
Whatever the future brings, cryptocurrencies and blockchain protocols are
part of a tidal wave of new technologies that are changing the way production and
commerce are organized. Digital platforms, the sharing economy, apps, and 3D
printers are fragmenting production and facilitating P2P transactions.
Many of these new applications originated soon after the global financial crisis of 2008 when the bankruptcies of established companies convinced many
people that the economy would never be the same again. Investors were looking
for new investment opportunities. Workers who had lost their jobs were willing
to accept more flexible working relations. Consumers were persuaded to use
some of their underutilized assets commercially.
The fact that bitcoin was created in 2009, soon after the crisis, was probably no
coincidence. Trust in financial institutions had eroded, and the time was ripe to
explore fundamentally different approaches. Whatever the future of cryptocurrencies and blockchain technologies may be, the trends toward decentralization
and P2P transactions are unmistakable.
Cryptocurrency and blockchain activities are widespread in Europe and Central Asia (ECA). Massive mining of cryptocurrencies takes place in Iceland, Sweden, and Georgia. Many Russians own digital wallets, and experiments are ongoing in Serbia and Tajikistan to use blockchain technology to make sending remittances more efficient (UNDP 2018). Estonia is using blockchain software in
registries and plans to extend its use to medicine (https://e-estonia.com/). Start-ups in many countries in ECA are contributing to these technologies, attracting
finance for their activities via initial coin offerings (ICOs).3 Household investments in cryptocurrencies are not insignificant. Switzerland aims to become a
cryptocurrency and blockchain hub and is leading in adjusting regulations to
these new technologies.
Comprehensive, global information on cryptocurrency and blockchain activities is not available. But anecdotal evidence suggests that ECA is more active than
many other parts of the world, likely because of a combination of factors. Governments of many countries—from Estonia to Georgia and Slovenia—are experimenting with blockchain technologies. In many countries in the region, a supportive business climate encourages start-ups. And, especially in the eastern part
of the region, the relatively new financial sector provides fertile ground for experiments. The lack of legacy technologies in the financial sector—and the lack of
trusted intermediaries—makes exploring new financial instruments attractive.
The rest of this chapter is organized as follows. Section 2.2 looks at the successes and drawbacks of cryptocurrencies, examining whether there is a future
for money not issued by central banks. Section 2.3 looks at the possibility of smart
contracts. It assesses whether markets can be organized without intermediaries
and explores the possibility of secure decentralized databases. Section 2.4 summarizes some of the activities in ECA, with an emphasis on the experience in
Georgia, which has been particularly active. Section 2.5 addresses the many policy challenges these new technologies have triggered
Creating digital money without central banks
Since the emergence of e-commerce, myriad attempts have been made to develop
electronic payment systems.4 Many successful and unsuccessful attempts were
linked to credit card systems.
Attempts to create digital cash are especially thought-provoking. Like coins
and banknotes, digital cash should be anonymous and counterfeit-proof. People
should be able to use it without the intermediation of banks, in the same way, traditional cash is used outside the banking system. But unlike traditional cash,
individuals, rather than a central bank, would create these digital coins. Private
parties rather than the government would thus accrue the seigniorage.
The white paper that started bitcoin in 2008 outlined a way to create and operate a decentralized electronic cash system (Nakamoto 2008). The payment system
would not be under the control of a bank or a central authority. Rather, a large
number of independent participants would operate it. The paper used existing
cryptographic techniques of public and private keys to create anonymous and
secure IDs. It used existing cryptographic timestamps, based on hash functions,
to make past transactions irreversible. With those elements, electronic cash could
become (pseudo)anonymous and counterfeit-proof.5 But the main contribution
of the white paper was the method it proposed to keep track of past transactions
without a trusted intermediary. It would be done through an automatic process that would achieve consensus among most participants about the cumulative
history of transactions, even if a minority of participants sent erroneous messages
to the network
The solution to this so-called distributed consensus problem was to let participants compete for permission to add a new batch of transactions to the decentralized database. Participants use their computer power to solve a difficult puzzle.
The solution, which is considered proof of work, is impossible to find analytically; it can be reached only through trial and error. The first person who solves
the puzzle can add a block of new transactions to the chain of existing transactions—hence the term blockchain—and broadcast the new block to the network,
so that all participants can update the blockchain in their own copy
Although the puzzle is difficult to solve, its solution is easy to verify. Therefore, the nodes in the bitcoin network can easily determine if a proposed block is
valid and should be added to the chain. Even if a node goes offline for a period
of time, the network is not jeopardized. When the node goes back online, it accepts the longest valid chain is the correct one. If most of the computer power is
owned by honest participants, the expectation is that they will create the longest
chain, as the probability that they add new blocks is proportional to their computer power. As a result, the longest chain can be considered the consensus view.
If a dishonest participant adds a block that is not accepted by others in the chain,
that block will not become part of the longest chain, because the participant will
not have enough computer power to add more blocks to the chain quickly
enough. The difficulty of the puzzle is adjusted every two weeks, in order to create about one block per 10 minutes. Limiting the addition of a new block to the
blockchain to one every 10 minutes (on average) prevents the network from being overwhelmed and keeps the size of the blockchain manageable.
Competition for the right to add a block to the blockchain also solved the
problem of the creation of new electronic coins. People who solve the puzzle receive a combination of newly minted coins and transaction fees.7 With every
block, new coins are created. Every four years the number of new coins per block
is cut in half until the maximum number of 21 million bitcoins is reached. Most
of the remaining bitcoins will be added over the next 15 years. The creation of
new digital coins is like unearthing gold, which is why the puzzle solvers are
called miners in the world of cryptocurrencies.
Ten years after the publication of the white paper, the concepts underlying
bitcoin have proven successful. Blockchain technology is working and secure. Seventeen million bitcoins have been created, with an aggregate value of
$137 billion in 2018. Numerous alternative cryptocurrencies have emerged, and
many companies and research groups are exploring additional blockchain applications. Cryptocurrencies have unleashed a wave of financial innovations,
putting competitive pressure on the financial sector, especially its facilitation of
cross-border transfers
Bitcoin’s biggest success has also become its most worrisome weakness. The
proof-of-work concept that ensured the achievement of a decentralized consensus
has become excessively costly and wasteful. Attracted by the reward of newly
minted digital coins, investors have created massive computer power with specialized chips to compete for permission to add a block to the blockchain. Over the past few months, the reward for solving the puzzle ranged from $100,000 to
$250,000, depending on the price of bitcoin, the fees per transaction, and the
number of transactions in a block. As more computer power was added to the
network, the puzzle automatically became more difficult (figure 2.1). As a result,
more and more electricity was needed to solve the puzzle.
The system currently consumes an estimated 53 TWh of electricity a year—
almost as much as the entire country of Bangladesh consumes (Digiconomist
n.d.). The cost of electricity used to process a single average transaction (about
$20) can power about five households in a high-income country for a day.
These electricity costs are likely to rise. Because miners’ profits are still
large, more computer power is being added to the network, increasing the difficulty of the puzzle. People who use the network to transfer bitcoins do not directly experience these costs, because miners are paid mainly through seigniorage rather than fees. But the costs in terms of electricity use, and the resulting
burden on the environment, are real.
A paradoxical side-effect of the rapid increase in computing power is that
computer power has become more concentrated. A few companies have installed
huge computer capacity in large dedicated factories, using specialized chips.
Their exploitation of economies of scale leads to the concentration of market power.
Participants with less computer power started working together in pools (figure 2.2). With limited computing power, the probability of being the first to solve
the puzzle is very small, and the income stream is irregular and thus unpredictable. By pooling forces, participants can generate a small but steady income stream
This concentration of computer power makes the network more vulnerable to
malicious attacks. Even without attacks, if the market becomes an oligopoly, miners could manipulate transaction fees, refuse to process certain types of transactions, or deny service to users.
FIGURE 2.1 As the price
of bitcoin soared in 2017,
so did competition
among miners
Note: The bitcoin difficulty index measures the difficulty of finding a new block on the blockchain. The greater the difficulty, the longer the time it
takes on average for a miner to find a valid block. The difficulty in the first block of the bitcoin blockchain was 1. The difficulty is adjusted up or
down every 2,016 blocks. If the previous 2,016 blocks take less than two weeks to generate, the difficulty is increased (and vice versa).
FIGURE 2.2 Three large
mining pools provide
half of all network blocks
Note: Data are for March 2018.
The danger of market concentration is likely to increase. As the number of
newly minted bitcoins declines, the income of miners will increasingly depend
on fees. Lower profits will discourage new investors from entering the market,
and smaller, inefficient miners are likely to exit. The sustainability of a completely
decentralized payment system will be tested if miners must forgo the large profits coming from seigniorage.
An advantage of declining profits because of disappearing seigniorage is that
electricity use will no longer increase and might even decline. Box 2.1 models the
long-term mechanisms determining the degree of difficulty of the puzzle, energy
use, user fees, and even the price of bitcoins. The model is simplistic, particularly
as it ignores adjustment lags and speculative bubbles, which likely play a significant role in reality. But it sheds light on balancing mechanisms in the cryptocurrency market and provides a framework for exploring the consequences of the
disappearance of seigniorage.
As of spring 2018, the total reward a miner received per transaction was just
below $100 (figure 2.3). Most of it comes through seignorage (the bitcoin block
reward) rather than fees. The impact on the demand for bitcoin if this reward
shifts away from seignorage toward fees may not be dramatic. Large international bank transfers can involve similar levels of fees (through the SWIFT international payment system)
FIGURE 2.3 Most mining
revenue comes from the
seignorage (block reward)
of the network
The lack of scalability of the bitcoin payment system is another limitation. The
proof-of-work concept prevents malicious participants from overwhelming the
blockchain, ensuring its veracity. But it limits the addition of new blocks to one
every 10 minutes and each block to a maximum size of 1 MB. The average number of transactions that can be included in a block of this size is 2,000. In its current form, the bitcoin payment network can thus process only three transactions
per second. By contrast, credit card companies process thousands of transactions
per second. This constraint makes it impossible for bitcoin to substitute for large-scale digital payment systems.
Many attempts have been made, through new cryptocurrencies or additions
to the bitcoin network, to avoid the electricity-consuming puzzle and to increase
scalability. A leading concept is proof of stake, which could replace proof of
work.
8 In this concept, participants are elected to add a new block to the blockchain on the basis of the number of own coins they want to attach to the contract.
This proof-of-stake concept is like putting coins in escrow to earn permission to
intermediate and charge transaction fees. Selection would still be probabilistic,
but richer participants would have a higher probability of being selected. Ethereum, which runs a popular cryptocurrency, may adopt this approach. It represents a shift back in the direction of trusted intermediaries. The concept is not
very different from existing financial institutions that are trusted because they
have a stake in preserving their company.
Another experiment to reduce electricity costs is to design a simple, albeit less
secure, system for small transactions and to put only the balances of many small
transactions on the blockchain. Lightning Network is taking this approach, as an
addition to the bitcoin blockchain (Poon and Dryja 2016)
Most of the discussions in the cryptocurrency community are about mechanisms to make trusted intermediaries superfluous. But another important question is how well cryptocurrencies perform the traditional functions of money.
Money is useful because it can serve as the medium of exchange, a unit of account,
and a store of value. Like other forms of electronic money, cryptocurrencies have
advantages over physical commodities like gold or banknotes. They are easier to
store and easier to transfer over large distances. However, some inherent drawbacks of cryptocurrencies make them less optimal than legal tender in most
countries.
The most important drawback is the volatility of the purchasing power of
cryptocurrencies, as illustrated by their exchange rate vis-à-vis legal tender (figure 2.4). That volatility in purchasing power makes them very risky to accept as
a medium of exchange. It also makes them suboptimal as a store of value, as there
is no guarantee that their value will not drop to zero. Advocates argue that cryptocurrencies cannot be inflationary, because their supply is fixed or at least limited. In fact, cryptocurrencies can be extremely inflationary if demand for the
FIGURE 2.4 Daily price
movements of bitcoin
continue to be large
Note: Panel a shows the percentage difference between the opening and closing price for the day. Panel b shows the percentage difference between the highest and lowest price in a day
drops (because, for example, customers prefer alternative cryptocurrencies that
are more user-friendly, are more scalable, or provide more privacy). The volatility
of their purchasing power also reduces the value of cryptocurrencies as a unit of
measurement. With large overall price swings, it becomes difficult to discern
movements in relative prices.9
In fact, there may be a natural limit to how stable the price of bitcoin can become. Unlike other commodity-type assets, bitcoin does not have a feedback loop
from the supply side
In fact, there may be a natural limit to how stable the price of bitcoin can come. Unlike other commodity-type assets, bitcoin does not have a feedback loop
from the supply side
The blockchain has proven to be very secure, but it is impossible to avoid security concerns altogether. Cryptocurrencies have been stolen by hacks into ex-changes, where they are exchanged against the legal tender or other cryptocurrencies, and hacks into mining pools. Users can protect stored cryptocurrencies by
keeping their wallets offline. These offline wallets are called cold wallets; wallets
that are online are called hot wallets. Exchanges cannot be avoided; they remain a
weak link.
Many of these problems are already being addressed. The security breaches of
exchange sites forced many exchanges to use hot and cold wallets. This practice
involves storing most deposits in an offline wallet, whose private keys are secure
and are never stored on a network-connected device. A small portion of the deposits attractiveness of cryptocurrencies will be tested once governments extend
their financial oversight to cryptocurrencies in their efforts to fight money laundering, tax evasion, and illicit transactions. Doing so will challenge the (pseudo)
anonymity of cryptocurrencies. This oversight will be easier if the concentration of mining power continues to increase. To the extent that current use is motivated partly by the desire to avoid oversight, increased surveillance will reduce
demand for cryptocurrencies. However, it is also possible that oversight may
make the use of cryptocurrencies more attractive, as it becomes easier to incorporate them into the overall financial infrastructure.
is transferred to the hot wallet, which is used for daily transactions and
payments. If there is a security breach, potential losses are limited to the amount
stored in the hot wallet; at least in theory, most deposits should be protected
The attractiveness of cryptocurrencies will be tested once governments extend
their financial oversight to cryptocurrencies in their efforts to fight money laundering, tax evasion, and illicit transactions. Doing so will challenge the (pseudo)
anonymity of cryptocurrencies. This oversight will be easier if the concentration of mining power continues to increase. To the extent that current use is motivated partly by the desire to avoid oversight, increased surveillance will reduce
demand for cryptocurrencies. However, it is also possible that oversight may
make the use of cryptocurrencies more attractive, as it becomes easier to incorporate them in the overall financial infrastructure.
The innovative power of cryptocurrencies has been impressive. They have
already put some competitive pressure on cross-border payment systems. The
concept is promising because it potentially improves financial access for people
who live in remote areas that are not covered by financial institutions.
The original designer of bitcoin and blockchain technology wrote that “the
main benefits are lost if a trusted third party is still required” (Nakamoto 2008).
In fact, the future benefits may appear precisely because the networks shift back
to trusted intermediaries. It is even conceivable that the most successful cryptocurrencies will be linked to legal tender and issued by central banks
Creating digital markets without intermediaries
The ability to achieve distributed consensus, and to store immutable information
in a decentralized database, makes a wide variety of P2P contracts possible without a centralized authority. Enthusiasm about other possibilities is enormous. As
one observer put it, “The paradox about Bitcoin is that it may well turn out to be a revolutionary breakthrough and at the same time a colossal failure as a currency” (Johnson 2018).
Smart, or self-executing, contracts are examples of blockchain applications
that go well beyond instantaneous transfers of funds with cryptocurrencies. Such
contracts could be used on a blockchain platform to engage in commitments over
time, without the help of middlemen. Ethereum, which has been operational
since the summer of 2015, enables the creation of P2P contracts that outline the
conditions under which future payments occur.
One example of such a smart contract is a parametric insurance contract, such
as a contract that insures farmers against drought. The seller commits to pay a
certain amount if rainfall remains below a certain threshold. The contract is pre-programmed to read the realized rainfall from a trusted weather data feed at a
point in the future. The buyer purchases the contract with a one-time payment.
The seller commits funds equal to the maximum payout in case of a drought. As
the contract is fully collateralized, there is no counterparty risk. At the expiration
date, either the buyer or the seller can execute the contract to check if the trigger
condition has been met. The contract distributes the funds between the buyer and
the seller and terminates itself. This type of contract could be handled without
intermediation (although insurance companies could also provide such contracts). Storing these contracts on the blockchain makes them immutable and
guarantees their enforcement.
Smart contracts could also be used for financial instruments other than insurance. Entrepreneurs already sell tokens to fund new companies through ICOs
and promise future dividend payments in a smart contract on a blockchain. The
tokens are similar to shares issued in an initial public offering (IPO), but there are
key differences. Shares are sold on stock markets and are typically given the right via
shareholder representation to participate in decision-making. In contrast, tokens
are traded on a P2P blockchain with no privileges outside what is written in the
smart contract. Regulators across the world are working on directives that would
extend oversight to ICOs. Doing so would increase the similarities between ICOs
and IPOs, but the financial smart contract would provide a new, innovative, instrument to fund start-ups. It creates relatively liquid new financial instruments
that can be used to finance small-scale risky ventures.
The potential advantages of such P2P contracts are obvious. They could be
available to people who have no access to financial instruments (box 2.2). They
could also increase access to financial services that are now limited because of
distrust in financial institutions. Currently, enforcement of contracts is not
straightforward in parts of ECA. Smart contracts are secure, even if the counterparties do not know each other. Blockchain platforms could make these financial
products more liquid if the new products could be traded outside specialized
markets.
There are potential disadvantages of smart contracts. Adjustments to the current blockchain platforms are likely required for them to work in a user-friendly,
efficient, and scalable way. These drawbacks may be the reason why, outside
ICOs, there have not yet been large-scale applications of smart contracts.
The first disadvantage of existing platforms is the volatility of the value of
cryptocurrencies, which is especially inconvenient with contracts that span many
years. Parties to the contract likely want security in terms of the purchasing
power of payments. That goal could possibly be met by linking the contracts to
futures markets, but it seems more promising to use tokens that are linked to legal tender. Doing so would be a major step away from the original concept of
cryptocurrencies, as it requires a trusted party that can guarantee the value of the
token. Still, it could be a natural development of the smart contracts.
Fizzy is a parametric insurance application by the insurance company AXA
(https://fizzy.axa/), in which passengers purchase insurance by sending funds
to the smart contract along with their flight information. If their flight is delayed
for more than two hours according to a publicly accessible database, the smart
contracts pays out compensation in euros. Fizzy could be developed into an
Ethereum-based smart contract, but the volatility of the Ether token is likely to
prove too much of a drawback for a large-scale application.
If contracts shift to tokens that are linked to legal tender, the market can no
longer operate without a trusted intermediary. Such an intermediary must sell
additional tokens in exchange for legal tender if demand for tokens increases.
The intermediary must hold part of the legal tender in reserve, so that tokens can
be repurchased if demand declines. Such reserves are similar to the reserves financial institutions must hold when they create electronic accounts or mobile
payment systems. In the case of tokens linked to legal tender, participants who
maintain the blockchain would no longer be rewarded with the seigniorage of
new coins; the reward would consist only of fees paid by the parties in the contract. These fees might not be enough to attract enough participants who want to
compete with one another. It is plausible that such a system would naturally
converge to a permissioned blockchain, in which several preselected servers update the blockchain, eliminating the need for costly competition among servers
and making the maintenance of the platform more efficient.
A second disadvantage of smart contracts is that they are collateralized by
freezing potential payouts on the blockchain. The blockchain provides security,
but it is also inefficient (like putting money in escrow, where it cannot be used
productively). Insurance companies can pool risks and invest the cash flow. As a
result, they should be able to provide cheaper services than offered in P2P contracts, in which investing the cash flow is not possible. Cutting out insurance
companies could thus increase costs.
There may be a trade-off between efficiency and independence from intermediaries. Higher costs may be worth paying where the public does not trust that
normal contracts will be enforced. Where trust exists, the public might prefer to
deal with insurance companies rather than anonymous peers. If blockchain contracts are used, trusted intermediaries will likely offer contracts without freezing
the assets in the contract, reintroducing trust into these transactions.
A similar argument holds for standard financial intermediation by banks. Because P2P contracts likely have a broader reach and can create innovative instruments, they could provide competitive additions to existing banking products.
However, commercial banks have a big advantage in financial intermediation. By
pooling risk, they can turn short-term liabilities into long-term assets. Because
intermediation between savings and investments is much more difficult in independent P2P contracts without risk pooling, smart contracts are likely to be combined with or even integrated into, existing financial institutions, rather than
replacing them. Risk pooling could also be explicitly programmed in smart contracts, implying that these contracts will not be completely risk-free.
A third potential disadvantage of following the original blockchain design for
smart contracts is the public nature of the blockchain. Transparency is attractive
because it makes it easy to audit the validity of contracts by virtually anyone with
an Internet connection. But participants in transactions may want more privacy.
Therefore, it is plausible that smart contract applications will develop in the direction of more encryption, more restricted-read access, or both.10
Many governments are experimenting with blockchain to digitize their services. Experiments with land and real estate registries are popular. One objective
is to avoid the vulnerabilities of a centralized server. Decentralized storage of
data means that several servers are always online, making it more difficult to
alter data.
Another objective is to prepare for a link with smart contracts so that real estate could be sold online without the help of notaries, as ownership could be verified on the blockchain. Governments would still take responsibility for the information, including information about zoning and restrictions on sales. The goal is
thus not to purge governments from transactions but rather to make government
services more efficient and more trustworthy.
In these applications, the registry can be updated by a limited, selected number of servers (a permission approach). There is no need to let an undetermined number of miners compete for the updates. There is, however, a need for
full transparency. Not everyone should be able to write on the system, but everyone should be able to read the registry. The reading provides the actual service
and is also a mechanism for double-checking the veracity of the information.
Another government application could be public procurement. The central
government could issue a token backed by the national currency. Each ministry
or municipality could be issued an address and allocated tokens as part of the
budget process. They would use the tokens to pay contractors for public purchases; contractors would redeem their tokens with the central government. This
mechanism would make all purchases not only fully transparent but also instantly auditable by anyone, reducing graft. Social protection transfers could
benefit from a similar set-up, although privacy concerns would have to be
addressed.
Large companies are also exploring blockchain applications. Companies need
to be online all the time, for internal communications and communications with
clients. One central server is not reliable in this respect; a system that provides a
common view of information through communication between independent
servers is superior to a central server. Decentralized information is also more difficult to alter through hacks because hackers would have to break into more than
one server.
Companies are experimenting with different versions of the blockchain protocol to transition toward a more decentralized information strategy. Experiments
are moving toward permissioned systems, with a preselected number of servers
maintaining the decentralized database. Decentralizing reduces the probability
that participating servers become malicious, makes it easier to secure them, and prevents the costly competition that is needed in a permissionless system. The
decentralized consensus problem is easier to solve than in the original bitcoin
application. However, with a small number of servers, data systems other than
blockchain could be used. The advantages of a permission system may be the
reason why there are no large-scale blockchain applications yet in these companies, despite the many experiments.
Blockchain technology could also be used to manage vast and diverse data
systems, such as health records, that are too complicated for a central server. They
could benefit from decentralized servers that communicate with one another and
always reflect the latest update of treatments and test results. The existence of
secure, decentralized digital health records could significantly increase the efficiency of the health care industry.
The main challenge for these kinds of data systems is privacy. Both reading
and writing of health records should be limited. This requires adjustments to the
original blockchain design, which is public, in the sense that everyone can read
it. A health record application would be private, with secure encryption to protect the confidentiality of medical information.
These examples show the broad range of potential applications of blockchain.
They also suggest that many of them could be very different from the original
blockchain design. Instead of a public database, with an unlimited number of
participants that maintain the blockchain and an independent cryptocurrency to
be used in transactions, the most successful future applications could work with
private information, a limited number of permissions servers, and a token
linked to legal tender for transactions.
The most important components of those future applications could become
the cryptography behind personal IDs, the timestamps that make data irreversible, and the open-source character of the platform. These applications would not
eliminate trusted intermediaries, they would make more competition between
intermediaries possible. Digital platforms like Facebook, Uber, Airbnb, and Amazon use proprietary software and organize their own user IDs; the veracity of
their data is not protected through decentralized storage. All these platforms can
gain natural monopoly power because of network effects because the platforms
become more useful and more powerful if more people participate. A standardized
system of digital IDs and open-source networks could break that monopoly and
increase entry opportunities. Experiments with P2P digital interactions are very
important for this reason. Even if current applications do not stand the test of
time, the ultimate result could well be transformational.
Blockchain applications in Europe and Central Asia
Many countries in ECA have provided fertile ground for cryptocurrencies and
blockchain technologies, especially since late 2016. When cryptocurrencies
emerged, almost 10 years ago, activities were small-scale. As everywhere else in
the world, early transactions were used largely for gambling or for the purchase of illegal products on the dark web (figure 2.5).1
Source: blockchain.info.
Note: Each link (“edge”) in the figure represents a bitcoin transfer between nodes. The size of the nodes represents the total inflows of funds (one
entity can have multiple addresses).
Source: World Development Indicators and localbitcoins.com.
Note: As bitcoin is traded on a global network, it is difficult to determine the geographic origin and destination of transactions. This analysis uses
the currency denomination on a popular P2P bitcoin exchange (localbitcoins.com). The vertical axis shows the speed of adoption of bitcoin, measured by the average weekly growth of the volume of bitcoins exchanged on this exchange. The institutional variables are sourced from the World
Bank’s Governance Indicators database.
existing legal tender. It has resulted in much lower savings at banks than in other
parts of the world (Gould and Melecky 2017). Households are looking for alternative saving options.
Another reason for the use of blockchain technologies in ECA is the desire to
develop alternative means of transferring large funds. Russia is the largest issuer
(more than $956 million)—followed by the United States ($811 million) and Switzerland ($514 million)—because of the $850 million raised for the TON blockchain.13 One of the goals of that ambitious project is to provide an alternative to
the SWIFT international interbank payment system (Aris 2017). Russia also has
the largest number of users of the digital wallet on blockchain.com (UNDP 2018).
Despite these examples, it is doubtful that ICOs will have a broader application
as venture capital if security is not built-in for investors.
Established financial centers are striving to adjust to meet the competition
from a disruptive technology like blockchain. Switzerland is leading in adjusting
financial regulations to cover ICOs, ensuring that they are incorporated into the
existing financial architecture rather than developed as an outside alternative
(see Atkins 2018a, 2018b; Financial Times 2018). Its aims to become a cryptocurrency and blockchain hub are reflected in its vibrant ICO activities. For example,
Sirin Labs raised $157 million for the development of a blockchain-based smartphone. In line with these developments, a Swiss foundation, advised by Jacob
Frenkel, chairman of JPMorgan Chase International, and Nobel laureate Myron
Scholes, raised $50 million to develop a cryptocurrency backed by Special Drawing Rights (SDRs). Saga would have a stable value and be integrated into the
existing financial sector, including anti-money-laundering checks, with deposits
in the International Monetary Fund’s SDR holdings. France is also planning a
regulatory framework for ICOs (Aris 2017).
Governments in ECA are accumulating in-house experience with blockchain
pilots to improve government services. Estonia, Georgia, and Ukraine have experimented with blockchain to set up land and real estate registries. They are still
searching for more specialized and more efficient designs, but the experiments
have given a boost to efforts to digitize government services.
Some government banks in ECA are seeking to improve their services through
the use of blockchain technologies. The Russian state-owned VEB bank is piloting a new blockchain-based payment system with the regional government of
Kaliningrad (Milano 2018). Another state-owned bank, Sberbank, is partnering
with Russia’s federal anti-monopoly service to use blockchain technologies to
store and transfer documents.
Official bodies in ECA are investing in blockchain research to improve services. The European Commission has funded a blockchain observatory to encourage blockchain technologies and help formulate policy recommendations,
especially for smart contracts and the improvement of government services
(Young 2017; Nicholson 2018). Lithuania has opened a blockchain center to incubate start-ups, partnering with similar centers in Melbourne and Shanghai (MediTelegraph 2017). Separately, the central bank of Lithuania offers a one-year sandbox environment for start-ups that develop new digital financial technologies.
Estonia is exploring opportunities to use blockchain technologies in medicine https://e-estonia.com/). Georgia is investigating the possibility of supporting
smart contracts. Serbia and Tajikistan are experimenting with remittances on the blockchain, in cooperation with the United Nations Development Programme
(UNDP 2018). Azerbaijan is experimenting with digital IDs for banking using
blockchain (SputnikInternational 2018). The Swedish central bank is considering
launching its own digital currency (Aris 2017).
Small ECA countries with a supportive business climate and the absence of
legacy financial instruments are well placed to introduce new financial instruments based on blockchain technologies. Tokenization and ICOs enable small
start-ups, which lack easy access to finance, to raise funds in global markets.
Dynamic start-ups in the Baltic countries and several other small countries, including Georgia, have issued ICOs (figure 2.7). These examples are instructive for
other economies in the region that have long been dominated by state-owned
enterprises and have grown primarily through the nontradable sectors. For many
of those economies, the challenge is to unleash new growth potential in
internationally competitive sectors. The new P2P technologies provide a gateway
to these markets. More specifically, activities on and contributions to blockchain
networks are automatically exposed to international competition Seemingly more than in other parts of the world, governments in ECA are
restraining natural monopolies of tech giants. People in the region show strong
privacy concerns when data become proprietary and are captured by tech companies. The open character of the blockchain architecture could break the monopoly on data. Several governments and the European Commission are looking
at the possibility of using the new technologies to reduce the power of large digital network companies. The anecdotal evidence presented here suggests that there may be multiple
explanations for the blockchain activities in Europe and Central Asia:
• In the eastern part of the region, market-based financial sectors are relatively
new and have not fully matured. Insurance and capital markets are underdeveloped. Land registration and cadasters of real estate can still be improved.
Blockchain technologies could help fill these gaps.
• Vulnerabilities in the banking sectors after the transition in 1991, the global
financial crisis in 2008, and the plunge in oil prices in 2014 have eroded trust
in financial institutions. In the eastern part of the region, bank deposits are
exceptionally low, and consumers are looking for alternative ways to invest
their savings (Gould and Melecky 2017)
• Throughout the region, banks dominate financial sectors. Venture capital that
does not require collateral is scarce. New forms of fundraising could help tech
start-ups that have the potential to grow quickly in competitive global markets.
• Demand for new ways of making cross-border transfers is strong. Remittances are large in the region; the high transactions costs associated with them is
onerous. The region also has a large share of illicit financial flows, linked to
money laundering, tax evasion, and the circumventing of capital controls or
sanctions.
• Governments in the region provide a broad range of services. They oversee
elaborate social security systems, and most of them play an integrating role in
health care, pensions, and education. There is a continuous demand to make
these services more efficient and more transparent. Many governments are
experimenting with blockchain technologies to achieve those goals.
• Governments in the region are looking for ways to break the power of large
tech companies and increase privacy
It is unclear which experiments will have a lasting impact. The transformational impact may come from applications that are very different from the original blockchain design. The blockchain experiment has already boosted innovation and competition, in both the private sector and government. For that reason
alone, blockchain experiments deserve support.
ECA is active in the mining of cryptocurrencies. Georgia is home to one of the
largest mining companies in the world (Bitfury) as well as many smaller miners
(box 2.3). Bitfury, which is building additional facilities in Canada, Iceland, and
Norway, controls about 10–15 percent of global mining.
Cryptocurrency mining is also booming in Iceland (Perper 2018), which is on
track to use more electricity for mining than it uses to power all of its residences.
Armenia is set to be home to a 50MW mining farm (Murphy and Stafford 2018).
Slush Pool, a bitcoin mining pool with a market share of about 7 percent and
many participants from all over the world, is run by Satoshi Labs, a mining company based in the Czech Republic. KnCMiner is a mining pool in Sweden. Another mining pool is in Russia.
Cryptocurrency mining thrives in a cold climate (avoiding the need for cooling) and in areas where electricity costs are low. En+ Group, a Russian energy
company, is preparing to offer electricity to cryptocurrency miners at five plants
in Siberia (Marson 2017; Helms 2018). The electricity capacity available for miners could well dwarf the capacity of existing mining facilities in ECA. EN+ could
attract Chinese miners, who are currently dominant players in the global market
but find a less and less hospitable environment in China.
These mining activities illustrate the dynamic response to new opportunities
by entrepreneurs in the region. They bode well for the development of other applications of these technologies. But the heavy electricity use by companies that
compete for the right to mine cryptocurrencies is a growing problem. How to
accommodate and mitigate growing electricity demand from cryptocurrency
miners and prepare for future declines in demand if mining activities relocate or
mining stops altogether in its current form are the most urgent challenges as
these markets develop
There are multiple approaches to meeting these challenges. The cryptocurrency community is looking for more efficient ways to update the blockchain.
Governments are reconsidering their tariff policies; in order to curtail energy use,
they need to raise electricity tariffs for miners or create more market-based mechanisms to determine tariffs. If unchecked, electricity use could rise before alternatives are found, possibly resulting in long-term damage to the environment. In
addition, the fiscal costs of investments in power plants (or contingent liabilities,
where new power plants are developed in partnership with the private sector)
could threaten public finances if demand for electricity driven by cryptocurrencies collapses.
Policy challenges
Cryptocurrencies and blockchain technologies pose difficult challenges for policymakers. There is no regulatory framework for transfers made with cryptocurrencies or smart contracts. Transfers occur outside anti-money-laundering compliance programs, and smart contracts are not subject to consumer protection
laws or financial oversight.
Tax codes do not fully cover the new markets if cryptocurrencies are not recognized in the law as payment systems but are instead viewed as commodities.
It is difficult to determine the geographic location of the value-added created by
cryptocurrency mining. Tax legislation, therefore, has to be adjusted to incorporate
these new activities into direct and indirect tax systems.
Another ambiguity for policymakers is whether these new activities should
be supported or constrained. Should they be encouraged because of positive externalities and first-mover benefits? Or should they be constrained, because they
crowd out investments with the greater social return?
Another pertinent question for policy makers is whether and how they can
use these technologies to improve their own services.
t is too early to offer specific advice because there is still great uncertainty
about the future of cryptocurrencies and blockchain technologies. But experiences with other digital technologies—such as e-commerce, digital platforms,
and the sharing economy—suggest that the following general guidelines should
be followed.
• Give the new technologies space, and avoid imposing restrictive legislation before
initial ambiguities are resolved. Even if these technologies are ultimately unsuccessful, the experiments can help develop entrepreneurial skills, put competitive pressure on more traditional activities, and trigger innovations in other sectors. A dynamic business climate should encourage innovations, experiments, and risk-taking.
• Make implicit subsidies explicit, and be clear about risks. If activities are not yet
covered by the tax code or are undertaken in special economic zones, the implicit subsidy and its temporary nature should be calculated and made public.
Consumers should be warned about risks, such as the risks associated with
volatile cryptocurrencies
• Start planning for leveling the playing field. If these technologies become successful, they should be integrated into the formal economy. Tax codes and regulations should be adjusted so that both old and new technologies operate on a
level playing field.14
• Innovate as government. The corporate motto “think big, start small, quit soon,
and scale fast” is relevant for governments, too. Blockchain technologies provide a stimulus to further digitize government services. Most successful governments are bold in their ideas, know when to terminate experiments that are
not successful, and have the professionalism to quickly scale small experiments that are promising.
An undesirable side effect of cryptocurrencies is the outsized use of electricity in mining. If mining companies pay a lower electricity price than the marginal cost of supplying more electricity, governments should consider raising
tariffs or at least calculating the implicit subsidy. The sharp increase in electricity
demand might be an opportunity to develop an electricity market with intra-day
price fluctuations, so that price differentiation reflects actual costs. Uncertainty
about future electricity demand for cryptocurrency mining warrants a rethinking
of contingent liabilities of governments where additional power plants are built
by public-private partnerships. Guarantees related to future demand for electricity used in cryptocurrency mining are riskier than for other electricity demand.
At some point, electricity tariffs for mining could be used as indirect taxation of
the value-added created by miners. Although it is difficult to determine the geographic location of the output of these activities, it is easy to locate the inputs.
Ultimately, financial oversight will cover cryptocurrencies and smart contracts. This process will be a gradual one of trial and error, and it will depend on
the direction in which blockchain applications develop. First steps have already
been taken, in the United States (where bitcoin can be traded on futures markets),
in Switzerland (where regulation of ICOs was proposed), and in the Netherlands
(where guidance was provided about the tax treatment of cryptocurrency holdings). Oversight to prevent money laundering, tax evasion, pump-and-dump
schemes, and illicit cross-border transfers focuses on transactions in which cryptocurrencies are exchanged for legal tender.15 At some point, this oversight could
extend to miners and other companies that update the blockchain. The ultimate
goal of all these efforts is to create a level playing field so that blockchain applications can be integrated into existing markets. The long-term outcome could be that
supervision becomes much more effective because the transparency of the blockchain could provide supervisors and courts with access to real-time information.
This access would also make it easier to develop valuable early-warning systems The many experiments and brainstorms by governments and central banks
throughout the region are inspiring. Just as blockchain opportunities put competitive pressure on private financial sectors, they also trigger creative thinking
in governments. It is important that these experiments not consider current
blockchain designs as the full universe of possibilities. Even if decentralized
maintenance of digital government data can have major advantages, a permission system seems much more appropriate and efficient for governments than
the original system that maintains the blockchain for cryptocurrencies. The ultimate conclusion might even be that other data systems are better suited for specific applications than blockchain technologies, including in the creation of digital currencies by central banks (box 2.4). The flurry of experiments shows the
success of the blockchain revolution, but it also illustrates that progress may
come from innovations that are quite different from the original design and objective of the blockchain protocol
Notes
1. Electronic accounts are much more popular than cash. Central banks do provide electronic accounts to banks; they do not yet provide digital cash or electronic accounts directly to the public.
2. The public-key functions as a pseudonym in communications. The private key is used
to prove one’s identity. If this digital ID becomes a standard on open-source platforms, it
could make IDs and passwords on proprietary platforms like Facebook or Google redundant.
3. See, for example, the Georgian start-up Golden Fleece (https://goldenfleece.co/).
4. Clark (2017) describes the early history of digital payment systems.
5. A bitcoin address is an identifier of 26–35 alphanumeric characters that are equivalent to
unique IDs. Every transaction is recorded on the public blockchain, so anyone can view
each address involved in each transaction. However, it is difficult to know the real identity of the people involved in the transactions. For this reason, the bitcoin network is often described as being pseudo-anonymous rather than completely anonymous.
6. In the bitcoin protocol, a block can contain about 2,000 new transactions.
7. The block rewards are hard-coded, but there is no guidance on what the fee should be.
As miners have discretion over which transactions to include, they select the transactions
with the highest fees. As the size of each block on the blockchain is limited to 1 MB
(roughly 2,000 transactions), if a user wants her transaction to be included in the next
block, she has to offer a high enough fee so that her transaction is among the approximately 2,000 that are selected.
8. Other new concepts, often variations of the proof of stake, are proof of activity, proof of
burn, proof of capacity, and proof of elapsed time (Rooney 2018).
9. The Austrian school and Keynesian economists have long debated the pros and cons of
private, decentralized money versus government-sanctioned legal tender. What is an
attraction for one group of economists (no reliance on governments, which are inclined
to impose an inflation tax) is a nightmare for the other (financial instability, lack of monetary instruments).
10. ZeroCash (http://zerocash-project.org/) is a good example of a platform that provides
more encryption.
11. Silk Road, an online market for illegal drugs that used bitcoins, started in 2011. The FBI
took it down in 2014.
12. The vulnerability of banks in oil-exporting countries after the fall in oil prices was one
of the reasons for the formation of the Blockchain and Cryptocurrency Association
(Dyussembekova 2017).
13. This project is spearheaded by Pavel Durov, one of the founders of the Russian social
media platform Vkontakte, and the encrypted messaging app Telegram (Khrennikov
and Voitova 2018).
14. Carstens (2018) strongly advocates this point.
15. Levin, O’Brien, and Zuberi (2015) discuss the regulation of cryptocurrencies. Bal
(2015) discusses tax issues. He and others (2016) provide a comprehensive overview of
all oversight measures.
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