The economics of fintech and digital currencies: A new eBook

Antonio Fatás 05 March 2019

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In recent years, financial markets have seen the arrival of new technologies, opening a debate about the extent of their consequences (Casey et al. 2018). Are we about to witness significant disruptions to the nature of money, for example, or the way new ventures are funded? The potential for radical changes has been met with both excitement and a good dose of scepticism. Some innovations seem promising (Bordo and Levin 2017), while others do not seem fit to deal with the complexities of financial markets (Eichengreen 2018).

The rapid increase and sudden crash in the prices of major cryptocurrencies over the last two years has been a wake-up call to how optimistic views of the disruptive possibilities of these new technologies can disappoint. But, at the same time, while the Bitcoin price remains far from its record levels, there are many areas where progress is being made and new technologies are still receiving the attention of aspiring entrepreneurs and established financial institutions, as well as central banks and regulators. 

In September 2018, CEPR launched a new Policy and Research Network on “Fintech and Digital Currencies” to foster a dialogue between researchers and policymakers on all issues related to technology and financial markets (‘fintech’). A new eBook brings together eleven chapters from members of the network on the current state of the debate (Fatas 2019). It summarises current research on the impact of these changes as well as the views of policymakers on how to manage the possible disruption in financial markets. 


Download the VoxEU eBook, The Economics Fintech and Digital Currencies, here


 

Technology and governance

The first three chapters deal with both the new possibilities created by the technologies as well as the potential limits to their adoption. The chapters stress the need for some form of centralised authority to manage the requirements in financial markets. Chapter 1, by Stephen Cecchetti and Kim Schoenholtz, focuses on the changes taking place in the technology used to maintain financial records. Different technologies have different implications for governance and access rights. Both of these issues make it practically impossible to imagine the widespread adoption of open-access ledgers (such as blockchain) in financial markets. 

Chapter 2, by Katrin Tinn, discusses the benefits of the adoption of hash-linked timestamping technology in financial contracts. While the benefits are clear, the chapter also raises questions about the governance of these technologies and suggests that permissioned systems might be the right way to move forward. 

Chapter 3, by Edgardo Di Nicola Carena, Pierfrancesco La Mura and Alessandro Rebucci, analyses one particular application of timestamping technology, namely, the creation of a global patent office. In this case, transparency and the ability to reach a global community represent significant benefits. But, as in the previous two chapters, the authors also stress the need to rely on a central authority for the purpose of governance.

The economics of cryptocurrencies

Chapter 4, by Harald Uhlig and Linda Schilling, analyses the equilibrium price of a cryptocurrency under the assumption that it succeeds in the future and co-exists with a traditional currency (such as the US dollar). The analysis shows why speculation in the periods before adoption might not be possible in equilibrium. In addition, the authors explore the monetary policy implications of the future existence of such an alternative currency.

Chapter 5, by Raphael Auer, presents a pessimistic view of the viability of cryptocurrencies. In particular, the author highlights that the proof-of-work technology behind cryptocurrencies such as Bitcoin is subject to an externality similar to the tragedy of the commons. As a result, the income necessary to ensure a well-functioning consensus mechanism will fall short and liquidity will shrink. The author then discusses possible changes to the available technology that could address this imperfection.

Private and public digital money

The next three chapters delve into the question of how new technologies are changing the way we think about money and the potential competition between private and public (digital) money. Chapter 6, by Markus Brunnemeier and Dirk Niepelt, starts with a typology of different forms of money and then discusses the consequences of introducing digital central bank currency (CBDC). Under some assumptions, there is an equivalence between private and public money and, as a result, introducing central bank digital currencies would not have macroeconomic effects. 

Chapter 7, by David Andolfatto, also analyses the introduction of CBDC but in a different setting. The objective here is to understand the effects that the introduction of CBDC might have on lending as well as the stability of the financial system. The model sketched in the chapter dismisses some of the common criticisms of CBDC by showing that it would have no negative consequences on lending and it would not increase the instability of the financial system. 

Chapter 8, by Aleksander Berentsen and Fabian Schär, discusses ‘stablecoins’ – cryptocurrencies whose price is kept fixed in units of a traditional currency. Several alternatives that have been proposed and the authors suggest that the on-chain, fully collateralised option may be the best available, although it is still a work in progress because of the inherent risks in the technology being used.

Cryptocurrencies, ICOs, and regulation

One of the recent innovations in financial markets is the new funding model behind initial coin offerings (ICOs). Chapter 9, by Antonio Fatas and Beatrice Weder di Mauro, discusses some of the potential benefits and risks of ICOs. The evidence is mixed – the market has grown very fast but the high failure rate of ICOs, combined with abundant examples of fraudulent schemes, raises serious concerns about the long-term viability of this market. In addition, empirical analysis shows a very high correlation of ICO returns with Bitcoin or Ethereum prices, suggesting that the bubble-type behaviour of those cryptocurrencies was behind the hype of ICOs.

The final two chapters look at the challenges that these innovations pose to regulators. Chapter 10, by Raphael Auer and Stijn Claessens, discusses the benefits and costs of regulating cryptocurrencies. Empirical analysis shows that news about regulation affect the prices of these assets, signalling that national regulators do have some power. But regulating cryptocurrencies could imply giving credibility to these new assets. The alternative – i.e. ‘benign neglect’ – is not optimal either because of the negative consequences of an unregulated market that funds illegal activities or tax fraud. A potential solution is to enforce a minimum amount of regulation along the lines of anti-money laundering activities. 

In a related analysis, Chapter 11, by Marlene Amstad, presents the different approaches that regulators around the world have followed when it comes to fintech innovations. The two most common approaches are ignoring them (i.e. leaving them unregulated) or treating them like other traditional securities. The author suggests a third alternative that takes into account the special nature of these new technologies and designs regulation that is tailored to their specific features. 

What next?

The chapters in this eBook have addressed several of the most pressing issues in the debate over what to expect from, and what to do about, new technologies in financial markets. The hype and then crash in the Bitcoin price offers an illustration of how some of the early excitement might have been premature. The various contributors to the book have identified changes that could help these technologies move forward to become viable in an environment – financial markets – where governance and regulation are central. The reality is that efforts to incorporate new technologies in financial markets have not slowed down; if anything, they have accelerated and are likely to lead to new innovations that might address some of the early weaknesses. The academic research behind this book remains a work in progress and should, over time, help policymakers design an optimal response to changes in the technology environment of financial markets.

References

Bordo, M and A Levin (2017), “Central bank digital currency and the future of monetary policy”, VoxEU.org, 23 September.

Casey, M, J Crane, G Gensler, S Johnson and N Narula (2018), The Impact of Blockchain Technology on Finance: A Catalyst for Change, Geneva Reports on the World Economy 21, ICMB and CEPR.

Eichengreen, B (2018), "From Commodity to Fiat and Now to Crypto: What Does History Tell Us?", NBER working Paper 25426.

Fatas, A (ed) (2019), The Economics of Fintech and Digital Currencies, A VoxEU.org eBook.

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Topics:  Financial markets Financial regulation and banking

Tags:  cryptocurrencies, FinTech, ICOs, initial coin offerings, blockchain, Vox ebook

Professor of Economics at INSEAD

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