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
The three European Supervisory Authorities (ESAs) issued a letter to inform about delay in the Sustainable Finance Disclosure Regulation (SFDR) mandate, along with a Call for Evidence on greenwashing practices.
The Financial Stability Board (FSB) and the Network for Greening the Financial System (NGFS) published a joint report that outlines the initial findings from climate scenario analyses undertaken by financial authorities to assess climate-related financial risks.
The Financial Stability Board (FSB) published a letter intended for the G20 leaders, highlighting the work that it will undertake under the Indian G20 Presidency in 2023 to strengthen resilience of the financial system.
The International Sustainability Standards Board (ISSB) of the IFRS Foundations made several announcements at COP27 and with respect to its work on the sustainability standards.
The International Organization for Securities Commissions (IOSCO), at COP27, outlined the regulatory priorities for sustainability disclosures, mitigation of greenwashing, and promotion of integrity in carbon markets.
The European Banking Authority (EBA) issued a statement in the context of COP27, clarified the operationalization of intermediate EU parent undertakings (IPUs) of third-country groups
The European Union has finalized and published, in the Official Journal of the European Union, a set of 13 Delegated and Implementing Regulations applicable to the European crowdfunding service providers.
The Office of the Superintendent of Financial Institutions (OSFI) published an annual report on its activities, a report on forward-looking work.
The Australian Prudential Regulation Authority (APRA) finalized amendments to the capital framework, announced a review of the prudential framework for groups.
The Bank for International Settlements (BIS) Innovation Hubs and several central banks are working together on various central bank digital currency (CBDC) pilots.