Browsing by Subject "Cryptocurrency"

Bitcoin and other cryptocurrencies have been frequently on media lately. As these cryptocurrencies are relatively new, there are not much economic theory explaining their behavior and price developments. Due to these reasons, the goal of this thesis is to find an economic theory to study the demand for Bitcoin. In this thesis, I will write about Bitcoin applying it to Walsh’s Money in Utility function (MIU function). I will modify Walsh’s original model by incorporating Bitcoin to it. In this model, Bitcoin is used as payment method and as a store of value. Both Bitcoin and money can be used to buy any goods, but there are certain goods that are easier to buy using bitcoin. Hence, Bitcoin has transaction benefit and the households will always need some bitcoin holdings in their portfolio. Using Walsh’s MIU function, I will derive a demand function for Bitcoin. In addition to this, I will go through the working paper “Bitcoin Pricing, Adoption, and Usage: Theory and Evidence” written by Athey et Al. (August 2016). In this paper, Bitcoin is used both as a payment method and a store of value. From the findings by Athey et Al., Bitcoin seems to be mainly used as a store of value. I will present an overview of the paper including the results and then concentrate on their aggregate analysis on Bitcoin exchange rate. Based on the Bitcoin exchange rate equation presented by Athey et Al., I will study whether Bitcoin demand function derived from MIU model is able to explain the changes in Bitcoin’s aggregate demand in real market. As expected, due to the assumptions and restrictions of the model, Bitcoin demand function derived in this thesis is not able to fully explain the changes in demand for Bitcoin in real world. Nonetheless, subject to the assumptions and restrictions of the model, Bitcoin demand function can be used to study the relationship between bitcoin demand, domestic nominal interest rate and consumption. Finally, I will present an alternative approach to further study Bitcoin’s demand.

A key component of legislation aimed at preventing money laundering and the financing of terrorism is the so-called ‘travel rule’. The travel rule obliges financial institutions to keep track of the identities behind senders and receivers of fund transfers. If a transfer of funds is deemed suspicious, the institution acting as an intermediary can deny the transfer and possibly report it to the authorities. Bitcoin’s decentralised and unregulatable nature, however, poses a unique challenge to the enforcement of the travel rule. In July 2021, the European Commission published a proposal for a revision to the 2015 Transfer of funds regulation. The revision, which is currently undergoing the legislative process, would bring so-called ‘self-hosted addresses’ – crypto-asset addresses not under the control of a regulated institution – under the scope of the regulation. In the proposed revision, the legislator has chosen the approach of regulating the on- and off-ramps between crypto-assets and the traditional financial system while leaving transactions occurring entirely within the crypto-asset ecosystem unregulated. This thesis aims to analyse the effectiveness of the proposed regulation in its current form through the lens of Bitcoin transactions involving a self-hosted address and the enforcement of the travel rule. The thesis concludes that while Bitcoin transactions involving self-hosted addresses pose certain fundamental threats to the enforcement of the travel rule, the effectiveness of the proposed revision to the 2015 Transfer of funds regulation depends largely on how the Bitcoin technology is used in the future. If current usage trends continue and on- and off-ramps between Bitcoin and the traditional financial system continue to play an important role, the proposed revision to the regulation may be effective in achieving enforcement of the travel rule for Bitcoin transactions involving a self-hosted address. However, if usage of Bitcoin moves increasingly peer-to-peer and the need for on- and off-ramps is diminished, the opposite could also prove to be true. Towards the end of the thesis, one of the proposed solutions for improving the scalability of Bitcoin known as the Bitcoin Lightning Network is introduced. While the technology is still in its infancy, it is recognised that the technical properties of the Bitcoin Lightning Network pose a severe challenge to the enforcement of the travel rule. The thesis concludes that the continued development and growth of the Bitcoin Lightning Network may eventually result in the birth of two distinct Bitcoin ecosystems – one of which is regulated and one of which is not.