Essays on the Economics of Cryptocurrencies
Total Page：16
File Type：pdf, Size：1020Kb
Imperial College London Business School Essays on the Economics of Cryptocurrencies Engin Iyidogan A thesis submitted in partial fulfilment of the requirements for the degree of Doctor of Philosophy at Imperial College London, June 2019 Abstract This thesis aims to contribute to the understanding of the economics of cryptocurrency market. In the first chapter, I document the literature on cryptocurrency and the financial applications of blockchain infrastructure. Finance and economics literature on the area of cryptocurrency is relatively new and spans only the last seven years, thus this review intends to serve as a foundation to prompt future work and a deeper understanding of this field. In the second chapter, I develop an equilibrium model of proof-of-work cryptocurrencies. Equi- librium behaviour of miners and users are characterised for exogenous blockchain protocol metrics; I demonstrate that equilibrium between miners and users can be achieved in the long run. High fixed mining rewards are the reason for instability in current cryptocurrency designs. The equilibrium model has two key implications: first, decentralisation and tech- nological improvement in mining are drivers of low transaction fees and low mining costs in a proof-of-work cryptocurrency environment; and second, limited block size and mining difficulty create an incentive mechanism that achieves cryptocurrency sustainability inthe long run. In the third chapter, I study the return spillover and systemic risk in the crypto- currency market in the context of connectedness. The data illustrates that system-wide connectedness in the cryptocurrency market, commonly observed as the level of systemic risk in the literature, changes over time with respect to the adoption rate of cryptocurrencies. Cryptocurrency protocol disputes, malicious activities in the cryptocurrency environment, and negative financial regulations on cryptocurrencies are key sources of increased connec- tedness over different time periods. Instead, pairwise connectedness between cryptocurrency pairs can be explained by cryptocurrency fundamentals. 1 Contents 1 Literature Review 10 I Introduction.................................... 10 II Blockchain in Finance.............................. 12 A Blockchain Adoption........................... 12 B Finance Applications........................... 14 C Corporate Governance.......................... 15 D Market Anomalies............................ 16 III Cryptocurrency Literature............................ 17 A Classification............................... 17 B Fallacy................................... 18 C Pricing and Valuation.......................... 20 D Equilibrium Models............................ 23 E Market Anomalies............................ 25 F Tokenisation................................ 26 G Proposals and Alternative Designs................... 28 IV Concluding Remarks............................... 30 2 2 An Equilibrium Model of Blockchain-Based Cryptocurrencies 32 I Introduction.................................... 32 II Model....................................... 37 A Model Setup................................ 37 B User's Problem.............................. 41 C Miner's Problem............................. 45 D Equilibrium between Miners and Users................. 47 E Extension of Fixed Reward........................ 49 III Model Analysis.................................. 50 A Low Transaction Fee - Low Mining Cost Regime............ 51 B Sustainability of a PoW Cryptocurrency................ 52 C Numerical Analysis............................ 54 IV Discussion..................................... 56 A Cryptocurrency Protocol Design and the Future of Cryptocurrencies. 56 B An Empirical Case: Late 2017 Episode................. 59 V Concluding Remarks............................... 62 VI Appendix..................................... 63 A How Does Blockchain Work?....................... 63 B How to Mine a Block in PoW?...................... 64 C General Case of Transaction Fee Distribution............. 66 D Proofs................................... 67 3 Spillover Risk in the Cryptocurrency Market 71 I Introduction.................................... 71 3 II Data and Methodology.............................. 76 A Connectedness Index Methodology................... 76 B Data.................................... 79 III System-wide Dynamic Connectedness...................... 80 A Motivation................................. 81 B Data Selection............................... 82 C Results................................... 83 D How Do Forked Cryptocurrency Pairs Behave?............. 92 IV Pairwise Connectedness............................. 94 A Motivation................................. 94 B Secondary Regression Analysis...................... 96 C Major Cryptocurrency Attributes.................... 96 D Results................................... 98 V Concluding Remarks............................... 103 VI Appendix..................................... 104 A Tables and Figures............................ 104 4 List of Tables 3.1 The list of Cryptocurrencies........................... 104 3.2 Summary Statistics of Explanatory Factors - Early Adoption Period..... 105 3.3 Summary Statistics of Explanatory Factors - Hype Period.......... 106 3.4 Summary Statistics of Explanatory Factors - Late Adoption Period..... 107 3.5 Correlation Between Explanatory Variables - Phase I............. 108 3.6 Correlation Between Explanatory Variables - Phase II............. 108 3.7 Currency Attributes and Pairwise Connectedness: Full Sample........ 109 5 List of Figures 2.1 Timeline of Mining................................ 41 2.2 Timeline of Block Creation (Queuing Game).................. 42 2.3 Numerical Analysis - Technological improvement................ 55 2.4 Numerical Analysis - Number of miners..................... 55 2.5 Numerical Analysis - Cost of delay....................... 56 2.6 Transaction fee vs Transaction volume..................... 60 2.7 Transaction fee vs Transaction volatility.................... 61 2.8 Transaction fee vs Transaction pool rate.................... 61 3.1 Dynamic System-wide Connectedness Index.................. 110 3.2 Net-Connectedness of Bitcoin and Bitcoin Cash................ 111 3.3 Net-Connectedness of Ethereum and Ethereum Classic............ 111 3.4 The Popularity of Cryptocurrency Topic on Google Search.......... 112 3.5 Net Directional Connectedness - Phase I Currencies.............. 113 3.6 Net Directional Connectedness - Phase II Currencies............. 114 3.7 Net Directional Connectedness - Phases III Currencies............ 115 3.8 Net Directional Connectedness - Phases IV Currencies............ 116 3.9 Coefficients of Cryptocurrency Attributes - Phase I (Quarterly)....... 117 3.10 Coefficients of Cryptocurrency Attributes - Phase I (Monthly)........ 118 3.11 Coefficients of Cryptocurrency Attributes - Phase II (Monthly)........ 119 6 Declaration of originality I herewith certify that this thesis constitutes my own work and that all material, which is not my own work, has been properly acknowledged. Engin Iyidogan 7 Copyright The copyright of this thesis rests with the author. Unless otherwise indicated, its contents are licensed under a Creative Commons Attribution - Non Commercial - No Derivatives 4.0 International Licence (CC BY-NC-ND). Under this licence, you may copy and redistribute the material in any medium or format on the condition that; you credit the author, do not use it for commercial purposes and do not distribute modified versions of the work. When reusing or sharing this work, ensure you make the licence terms clear to others by naming the licence and linking to the licence text. Please seek permission from the copyright holder for uses of this work that are not included in this licence or permitted under UK Copyright Law. 8 Acknowledgements There is a long list of people to thank. I have never believed in destiny, so I prefer to state chronologically. I would like to thank my parents first; they taught me how to stand up each time Ifell. They always believed in me through every intimidating journey; and if they were not the best parents on earth, I would not be as happy as I am today. Next, I would like to thank special friends who have been with me on this journey: to Deniz Gok for allowing me to stay at his home during my ill health in Istanbul; to Adelina Barbalau, Robert Czech, Mobeen Iqbal, and Valentina Raponi for being such a caring family towards me in London; to Mete Gultekin, Mete Kilic, Gulce Kogar and Aygen Ozturk for sharing their raki with me. This thesis aims to help people. If I remain romantic and believe that academia is the only way to ensure happiness, I would like to thank people who taught me this: to Feridun Ipekci for teaching me how to go against social norms; to Ekmel Ozbay for helping me to follow my heart; to Kamil Yilmaz for being incredibly patient; to Robert Kosowski for guiding me from my first day on my PhD programme; to Andrei Kirilenko for showing me the right path in finance; to Franklin Allen for teaching how to be humble and kind; and, to Marcin Kacperczyk for teaching me how to be brave in academia. Above all, I would like to thank Cansel Sen for teaching me to love and how to be a better person. 9 Chapter 1 Literature Review I Introduction As of May 1, 2019, the number of traded cryptocurrencies reached 1,860, a figure consist- ently in growth since the launch of Bitcoin in 2008, the first cryptocurrency. Total market capitalisation of the