Anonymity-Driven Demand for Cryptocurrency: Theory and Policy Implications Sophie L. Zhou* 20th April 2021 Latest version available HERE Abstract Anonymity-seeking individuals prefer cryptocurrencies for online payments, but due to know-your-customer requirements on cryptocurrency exchanges, they resort to peer-to-peer markets for purchasing cryptocurrencies. I develop a search-theoretic model capturing this phenomenon. The model allows demand for cryptocurrencies to be governed by both consumption and speculative motives, and matches empir- ical observations of Bitcoin velocity and peer-to-peer transaction share. Allowing currency competition, I show that anonymity renders fiat-money-based e-payments and cryptocurrencies imperfect substitutes. Lowering the fiat money inflation rate is insufficient for eliminating cryptocurrency demand, and raising the participation cost on cryptocurrency exchanges becomes necessary. I further analyze the optimal participation cost on cryptocurrency exchanges, weighing up the benefit of financial inclusion against the cost of illicit activities often associated with anonymity. JEL codes: E41, E42, E44, E26 Keywords: Cryptocurrency, anonymity, monetary search, currency competition *Deutsche Bundesbank Research Centre, Wilhelm-Epstein-Straße 14, 60431 Frankfurt am Main, Ger- many. Email: [email protected]. A previous version of this paper was circulated under the title: Anonymity, Secondary Demand, and the Velocity of Cryptocurrency. The views expressed in this paper are those of the author and do not necessarily represent those of the Deutsche Bundesbank or the Eurosystem. I would like to thank Randall Wright, Aleksander Berentsen, Sjak Smulders, Reyer Gerlagh, Florian Sniekers, Patricio Dalton, Jens Pr¨ufer,Burak Uras, Roberto Robatto, Lukas Altermatt, Hugo van Buggenum, and seminar participants at the 2019 and 2020 Summer Workshop on Money, Banking, Payments and Finance, University of Basel, Toulouse School of Economics, Tilburg University, University of Amsterdam, Sveriges Riksbank, and Deutsche Bundesbank for their helpful comments and suggestions. This research was made possible through financial support from PBL Netherlands Environmental Assessment Agency. All errors are my own. 1 1 Introduction The spectacular price surges of Bitcoin in recent years has put the once esoteric blockchain- based electronic money into the spotlight, and stimulated much public interest in cryp- tocurrencies. Policymakers around the world have recognized the large potential of this technology, both for increasing financial inclusion of the estimated 1.7 billion currently under- and unbanked worldwide, and for improving the efficiency of cross-border payments (G7, 2019). As central banks start to probe the idea of central bank digital currencies (Barontini and Holden, 2019), private entities such as Facebook are also attempting to launch their own cryptocurrencies. This latter development, however, has raised the alarm and ignited a wave of debates concerning the various risks cryptocurrencies pose to soci- ety due to the lack of adequate regulatory frameworks, especially at the global scale. To benefit from the potential of this new technology while limiting its risks, it is important to understand if and how cryptocurrencies differ (from the perspective of consumers) from conventional, government-issued (fiat) currencies, and what such differences imply for the various concerns raised in the ongoing debate. One oft mentioned feature that sets cryptocurrencies apart from existing electronic payment means is their transactional anonymity. Created in 2008 by Nakamoto(2008), Bitcoin, the original and most prominent cryptocurrency, is designed as a peer-to-peer electronic currency that makes use of cryptographic protocols for settlement and record keeping. As such, Bitcoin and subsequent cryptocurrencies unite the anonymity of cash with the convenience of online payments. This transactional anonymity coupled with cryp- tocurrency's online and cross-border nature attracts various groups of individuals ranging from criminals, oppressed minority groups, vulnerable citizens in authoritarian regimes, to more privacy-concerned individuals in financially developed regions.1 Indeed, anonymity and privacy concerns have been found by various studies to be im- portant for the choice of payment means. Akhter(2012) establishes that privacy concerns negatively affect the amount of money consumers spend online. Balgobin et al.(2017) show that the presence of non-bank online payment means capable of preserving financial privacy from banks and retailers increases online consumption. Using both survey data and the transaction information of German consumers, von Kalckreuth et al.(2014) demonstrate 1The anonymity and cross-border nature of cryptocurrencies has motivated the LGBT Foundation, the largest LGBT health and community services charity in the UK, to launch its own token as a way of empowering the community while allowing its members to stay anonymous. In Venezuela, citizens are using Bitcoin to evade strict financial controls of an authoritarian regime (Cifuentes, 2019; Hernandez (2019)). Schuh and Shy(2016) find privacy concerns to be important reasons for consumers adopting cryptocurrencies, while Borgonovo et al.(2018) confirm in an experimental setting that privacy matters significantly for the choice of payment instrument. To date, an accurate estimate of the relative importance of the different usages of cryptocurrencies does not exist. Take illicit use of crytpocurrencies as an example, Foley et al.(2019) estimate that approximately 23% of the total dollar value of transactions is associated with illegal activities, while according to the Crypto Crime Report by Chainanalysis (a blockchain analysis company), the share of Bitcoin economic value flowing into darknet markets has been less than 1% since 2016 (Chainalysis, 2019). 1 that the desire for anonymity is a significant factor in explaining the high usage rate of cash in Germany,2 even when controlling for payment habits. Schuh and Shy(2016) find privacy concerns to be important reasons for consumers adopting cryptocurrencies. In an experimental setting, Borgonovo et al.(2018) confirm that privacy matters significantly for the choice of payment instrument. In the case of cryptocurrencies, however, what is often overlooked is that this intended anonymity is severely limited by the presence of know-your-customer (KYC) requirements on existing cryptocurrency exchanges. Recognized by regulators as Money Service Busi- nesses, cryptocurrency exchanges are subject to existing banking regulations, requiring them to check and document the identities of their users (FinCEN, 2013).3 This restric- tion means that for those keen on preserving their online anonymity, seeking second-hand purchases of cryptocurrencies on decentralized platforms becomes a more logical choice. LocalBitcoins, a veteran peer-to-peer Bitcoin trading site active in over 1600 cities in over 240 countries and territories, is a prominent example of such anonymous platforms, through which individuals can meet in person to carry out cryptocurrency trades.4 Motivated by these observations, this paper seeks to answer the following questions: how does anonymity-motivated trading affect cryptocurrency demand and usage, and what are the implications for the effectiveness and optimality of policies aiming at regulating cryptocurrency demand? This paper addresses these questions by analyzing cryptocurrency demand and spending behavior in a search-theoretic model in the tradition of Lagos and Wright(2005). This framework is most suitable here, since it makes explicit the frictions that render a medium of exchange essential and gives a micro-foundation to money, yet is quite tractable. The standard model has a two-subperiod structure: a frictionless market opens in the first subperiod where agents balance their money holding, and a frictional market opens in the second subperiod where money is needed for goods purchases. In the spirit of that model, I interpret the frictional market as the online goods market and cryptocurrency the electronic money used, and the frictionless market as the primary cryptocurrency market. Importantly, however, I modify the standard model with three key extensions. 2Using payment diary surveys from Austria, Canada, France, Germany, the Netherlands, and the United States, Bagnall et al.(2016) show that Austria and Germany, relative to other countries in the sample, are cash intensive, with large cash balances (two times greater than in other countries) and large average withdrawal amounts. 3The Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Trea- sury, considers cryptocurrency exchanges Money Service Businessess, and subjects them to existing banking regulations related to KYC, Anti-Money Laundering (AML), and Counter-terrorist Financing (CFT), see FinCEN(2013). The KYC requirements are expected to further intensify from this point. In June 2019, the Financial Action Task Force (FATF), an inter-governmental AML/CFT standard-setting body, issued new guidelines to require cryptocurrency businesses in roughly 200 countries to verify the identities of anyone sending or receiving more than $1,000 worth of digital assets (FATF, 2019). Recommendations of the FATF are recognized as international standards and endorsed by over 180 countries. 4As of June 2019, LocalBitcoins no longer permits cash trading. Other peer-to-peer platforms including LocalCoinSwap, Paxful, and Bisq,