Bitcoin Mass Adoption, a Pipe Dream?

Posted Under: In-depth
3 years ago

Anton Badev and Matthew Chen’s Bitcoin: Technical Background and Data Analysis from 2014 might seem outdated but the data presented therein are worth pondering.

Executive Summary

Broadly speaking, Bitcoin is a scheme designed to facilitate the transfer of value between parties. Unlike traditional payment systems, which transfer funds denominated in sovereign currencies, Bitcoin has its own metric for value called bitcoin (with lowercase letter \b”, and abbreviated as BTC1). Bitcoin is a complex scheme, and its implementation involves a combination of cryptography, distributed algorithms, and incentive driven behaviour. Moreover, recent developments suggest that Bitcoin operations may involve risks whose nature and proportion are little, if at all, understood. In light of these considerations, the purpose of this paper is to provide the necessary technical background to understand basic Bitcoin operations and document a set of empirical regularities related to Bitcoin usage. We present the micro-structure of the Bitcoin transaction process and highlight the use of cryptography for the purposes of transaction security and distributed maintenance of a ledger. Our empirical analysis is based on publicly available transaction-level data. We examine patterns of general usage together with usage by Satoshi Dice, the largest online gambling service using Bitcoin as the method of payment. Our analysis suggests that less than 50 percent of all bitcoins in circulation are used in transactions. About half of these transactions involve less than U.S.$100 equivalent, and for the period for which we have data for Satoshi Dice, most of these small-value transactions were related to the online gambling service. Relatively less frequent large value transactions drive the average transaction value to levels above U.S.$40; 000 equivalent value, and are not likely to involve payments for goods and services.

Bitcoin exchange rates exhibit somewhat complicated dynamics. In the past 24 months, the USD-BTC exchange rate increased more than 50-fold. Unnoticed by the public, however, the daily variance of the USD-BTC exchange rate remained remarkably stable for this same period, once the variance calculations account for the changing exchange rate level.2 We also document that the exchange rates between bitcoin and other major currencies are not well aligned. We interpret this as lack of depth of the exchange markets and as costly exchange rather than as unexploited arbitrage opportunities. Finally, the appendix provides more details on updating the ledger, including a quantitative examination of the economic incentives for the participants in the distributed implementation of the Bitcoin system.

Introduction

The period after February 2013 witnessed developments of unprecedented scale for Bitcoin a scheme that facilitates the transfer of value between parties and that, unlike traditional payment systems, has its own metric for value (called bitcoin, with lowercase letter \b”, and abbreviated as BTC3). As of October 7, 2014 more than 64; 000 businesses were reported to accept payments in bitcoins around the world, and the exchange rate was more than U.S.$300 to the bitcoin, which is more than 50 times higher than 24 months earlier. In contrast to these positive developments, Mt. Gox, the largest bitcoin exchange, led for bankruptcy in February 2014 after the announcement of a mysterious disappearance of bitcoins valued at almost U.S.$500 million. These developments suggest that the apparent lucrative opportunities which Bitcoin presents may be surrounded by risks whose nature and proportion are little, if at all, understood. Bitcoin, like cryptocurrencies generally, is a complex scheme. Its implementation involves a combination of cryptography, distributed algorithms and incentive driven behaviour. Moreover, these are recent phenomena and there is thin academic literature, a nascent policy debate, and limited understanding from the public about cryptocurrencies overall. The purpose of this paper is to provide the necessary technical background for understanding Bitcoin’s basic operations and to document a set of empirical regularities related to Bitcoin usage. It is important to emphasize that the goal of our empirical analysis is to be informative yet not dogmatic. In particular, we provide a series of observations with the aim of motivating substantive research, not of providing definitive assertions on the future of Bitcoin. Similarly, although we hope to inform the policy debate, our analysis does not focus on the legal, regulatory, and policy implications of Bitcoin.

In the first part of the paper we discuss the micro-structure of the Bitcoin transaction process. The discussion pays special attention to the use of cryptography in the Bitcoin protocol. Specifically, the protocol uses cryptographic algorithms for the security of transactions and for the implementation of distributed maintenance of a public ledger. Our interest in cryptographic algorithms is also motivated by their use to enable distributed record keeping which has been noted to have potential applications, independently of the success of Bitcoin, to a broader set of economic practices reaching beyond the payment industry.

The second part of the paper presents an empirical analysis of transaction-level data which are publicly available from the Bitcoin system. The starting point of our analysis is identifying general patterns of usage. While we cannot tightly estimate the number of daily users, we note that it is likely to have grown exponentially. Our estimates suggest that the number of daily users has doubled every eight months. Despite this growth, the daily transaction volume is still negligible compared to the domestic volume of U.S. payment systems, and even more so as compared to the overall volume of international payments. Looking at the composition of transactions, we note that about half of the transactions involves more than U.S.$100 equivalent value and drive the average transaction value to U.S.$40,000 equivalent value. For the period for which we have data for Satoshi Dice, most of the transactions involving less than U.S.$100 equivalent value can be attributed to the online gambling service. These observations all together suggest that Bitcoin is still barely used for payments for goods and services.

The empirical analysis concludes with a set of observations which are broadly related to the use of Bitcoin for investment and payment purposes. In particular, we discuss the speed of recycling of bitcoin addresses and the nature of risk associated with holding bitcoins. More than half of the bitcoins in circulation have not been used in transactions the past three months and about a third have not been used in the past year. These overall statistics constitute an estimate of the proportion of bitcoins in circulation which are held for \investment” purposes. Next, we examine the dynamics of the bitcoin exchange rate. We argue that the vigorous growth in bitcoin value in the past 18{24 months has been accompanied by almost unchanged daily variance of the exchange rate once the variance calculations account for the changing exchange rate level.9 This point has remained largely unnoticed because it cannot be readily inferred by the raw exchange-rate trends (typically reported by the media). Finally, the exchange rates between bitcoin and other major currencies are not well aligned. We interpret this as lack of depth of the exchange markets and costly  exchange rather than as unexploited arbitrage opportunities.

The appendix contains additional materials related to the Bitcoin scheme, including more technical details on updating the ledger. The appendix also includes a quantitative examination of the incentives for participation in the distributed implementation of the Bitcoin system. Our analysis of past developments in the magnitude and the structure of the rewards lends support to recent concerns regarding the cost efficiency and the sustainability of the Bitcoin scheme (see Levine, 2014).

Full Bitcoin: Technical Background and Data Analysis work could be found here.

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