BoE published a staff working paper that models both the financial market for cryptocurrency and the market for blockchain space, to explore the interactions between them. The paper presents a model of cryptocurrency price formation that endogenizes the financial market for coins and the fee-based market for blockchain space. It shows that blockchain congestion leads to novel interactions between cryptocurrency speculation, monetary usage, and prices. The paper explains why blockchain usage and fees tend to be driven by speculative trading, rather than payments activity. The results of the study have implications for the long-term future of cryptocurrencies.
The paper provides an overview of the key features of a cryptocurrency that are useful for understanding the model, including blockchain technology, the trading environment, and the use of cryptocurrency as money. The paper highlights the two distinctive features of cryptocurrency: a price determined by the extent of its usage as money and a blockchain structure that restricts settlement capacity. It then describes the model and explores how speculative trading affects price formation and volatility. Next, the paper examines a variant of the model in which agents have imperfect information about the cryptocurrency technology. Finally, it concludes with a discussion of how the results may be verified empirically, also providing all proofs in the Appendix.
The results have implications for the long-term future of cryptocurrencies. Short-term speculation can crowd out usage. Hype results in speculative pressure, making cryptocurrency less useful as money and, paradoxically, hampering adoption. In the longer run, as private information is incorporated into the price, the gains from trading decrease, and speculative activity falls. Reduced competition for blockchain space then allows cryptocurrency to function better as a means of payment, and to fulfill its potential. The model cannot predict whether cryptocurrencies will eventually be adopted as money, but it does suggest that such an outcome would be consistent with the history observed so far.
By competing for limited blockchain space, speculators impose an externality on monetary users that we do not see with other forms of money. The study shows that limited settlement space creates competition between users of the currency; therefore, speculative activity can crowd out monetary usage. This crowding-out undermines the ability of a cryptocurrency to act as a medium of payment, lowering its value. Hence, higher speculative demand can reduce prices, contrary to standard economic models. Crowding-out also raises the riskiness of investing in cryptocurrency, explaining the high observed price volatility.
Related Link: Working Paper
Keywords: Europe, UK, Banking, Insurance, Securities, Cryptocurrencies, Blockchain, Fintech, Crypto Assets, BoE
Previous ArticleSRB Proposes Changes to MREL Policy Under the 2019 Banking Package
EBA published an erratum for the technical package on phase 2 of the reporting framework 3.0.
MAS amended Notice 643A that addresses requirements for banks to prepare statements of exposures and credit facilities to related concerns or parties.
ECB has published, in the Official Journal of the European Union, the Guideline 2021/565 on the euro short-term rate (€STR) and this guideline amends the previous ECB Guideline 2019/1265.
EBA launched a consultation on the draft regulatory technical standards on the list of countries with an advanced economy for calculating the equity risk under the alternative standardized approach (FRTB-SA).
PRA is proposing, via CP7/21, the approach to implementing new requirements related to the specification of the nature, severity, and duration of an economic downturn in the internal ratings-based (IRB) approach to credit risk.
The UK government launched the Recovery Loan Scheme (RLS) as part of its continued COVID-19 support for UK businesses, as announced by HM Treasury on March 03, 2021.
FSB published a letter, from its Chair Randal K. Quarles, to the G20 Finance Ministers and Central Bank Governors, ahead of their virtual meeting on April 07, 2021.
OSFI issued a letter to the deposit-taking institutions issuing covered bonds and announced the unwinding of the temporary increase to the covered bond limit for deposit-taking institutions, effective immediately.
To support recovery from the COVID-19 crisis, EU has published two regulations to amend the securitization framework, as set out in the Securitization Regulation (2017/2402) and the Capital Requirements Regulation or CRR (575/2013).
HM Treasury announced that G7 Finance Ministers and Central Bank Governors met ahead of COP 26, the 2021 UN Climate Change Conference, and agreed on green agenda.