Lecture 4: Introduction to Cryptocurrencies

Functions of Currencies

  • Medium of exchange: Facilitates transactions, avoiding the inefficiencies of barter systems.
  • Unit of account: Provides a standard for pricing goods and services, enabling comparisons.
  • Liquid store of value: Allows for the accumulation of wealth in a readily accessible form.
  • Standard of deferred payment: Enables lending and business on credit.

Characteristics of Currencies

  • Linked to a country: Typically, each independent country has its own currency, representing monetary sovereignty.
  • Legal Tender: Must be accepted as a means of payment within the issuing country.
  • Convertible currency: Can be exchanged for foreign currencies.
  • Controlled by government/central bank: The issuing and management of a currency are usually overseen by a central authority.
  • Quantity issued: Controlling the quantity of currency is essential to maintaining its value.
  • Used for monetary policy purposes: Currencies are used as tools to implement monetary policy.
  • Used to control exchange rates: Governments manage exchange rates to influence the competitiveness of their economies.

Brief History of Currencies

  • Bretton Woods Agreements: After World War II, countries aimed for stable exchange rates.
  • Currencies were convertible into the US dollar, which was convertible into gold at 3535 per ounce.
  • Collapse of Bretton Woods: In August 1971, the US suspended the dollar's convertibility into gold.
  • European Exchange Rate Mechanism (ERM): Europe attempted a similar system within the EEC from the 1970s until the introduction of the Euro.
  • Euro: Introduced in 2000, with Malta adopting it in 2008.

Environment Leading to Cryptocurrencies

  • Internet and E-commerce: The rise of digital transactions created a demand for digital currency.
  • Need for privacy: Traditional banking and credit cards do not guarantee privacy.
  • Cryptography offers a solution, drawing on techniques like the Enigma machine used in WWII.
  • Anonymity: Cryptocurrencies offer anonymity, appealing to those seeking to avoid surveillance, including for illegal activities.
  • Collapse of traditional financial system (2008): The crisis led to a desire for systems outside government control.
  • Loss of trust: Loss of trust in governments, banks, and traditional financial systems.
  • Decentralization, blockchain, and transaction validation were proposed as solutions.

Bitcoin

  • Creation: Bitcoin was created in 2008 by Satoshi Nakamoto.
  • Limited supply: The total number of Bitcoins is capped at 2121 million.
  • Decentralization and Blockchain: Uses blockchain for transaction validation.
  • Security: Difficult to hack due to its decentralized nature.
  • Verification: All transactions can be verified on the blockchain.
  • Double-spending problem: Blockchain solves the issue of potentially copying digital currency.
  • Anonymity and privacy: Guaranteed through cryptography.
  • Bitcoin miners: Paid in bitcoins for validating transactions and hosting the blockchain.
  • Wallet: Requires a public/private key for transactions.

Bitcoin Milestones

  • 2010:
    • A meal purchased for 10,00010,000 BTC, now considered the most expensive meal ever.
    • Anonymous payments made to Wikileaks.
  • February 2011: Parity reached where 1 BTC = 1 USD.
  • 2011: Silk Road (darknet) used BTC for payments.
  • James Howell: Lost 7,5007,500 BTC on a hard drive.
  • December 2017: First peak of BTC at around 19,50019,500 USD.
  • 2019: Facebook and Libra project raised privacy concerns.
  • November 2021: Second peak of BTC at around 69,00069,000 USD.

Altcoins and ICOs

  • Altcoins: All cryptocurrencies other than Bitcoin.
  • ICO (Initial Coin Offering): Similar to an IPO but largely unregulated.
  • Many altcoins attempted to copy or improve on Bitcoin, while many others were scams.
  • Number of Currencies: Approximately 21,90021,900 currencies existed as of the end of 2022, with around 10,00010,000 still active.

Stablecoins

  • Volatility Problem: Cryptocurrencies are known for high volatility.
  • Stablecoin Definition: Stablecoins are private currencies designed to maintain a stable value.
  • Pegging: Typically pegged to a traditional currency, such as 1 stablecoin = 1 USD.
  • Examples: Tether, USD Coin, Terra.
  • Bank Run Risk: Subject to traditional bank run risks if reserves are not proven.
  • Terra USD crash: Terra USD plunged by more than 60% in May 2022.

Advantages and Disadvantages of Crypto/Digital Currencies

  • Advantages:
    • More efficient than traditional payment methods (faster).
    • Potentially cheaper costs for payments.
    • Attractive as a store of value, especially in countries with high inflation.
  • Disadvantages:
    • Huge electricity costs to maintain blockchain.
    • Subject to the same risks as traditional financial assets.
    • Operates largely outside regulated ecosystems.
    • Issues of fraud.

Regulation and Financial Intermediaries

  • Traditional financial markets: Clear segregation of functions to avoid conflicts of interest and fraud.
  • The crypto world lacks this segregation, with most players operating outside regulatory frameworks.
    Customer Custodian Exchange and Auditor.

Dangers of Cryptocurrencies

  • Subject to same risks as traditional financial markets.
  • Easier to operate cross-border, increasing fraud risks.
  • Lack of transparency in corporate structures.
  • Misuse of customer funds due to lack of oversight.
  • Money-laundering issues.
  • Facilitates illegal activities.
  • Lack of safe-keeping of assets, leading to hacks.
  • Lack of compensation for investors in case of losses.
  • No level-playing field with traditional financial operators.

Issues related to trading crypto currencies

  • Illusion of liquidity/lack of liquidity.
  • Pump and Dump schemes.
  • Front-running.
  • Wash trades (especially with NFTs).
  • Spoofing.
  • Trading with clients’ money.
  • Trading against own clients.
  • No consolidated tape.
  • Restrictions on withdrawals during stress.
  • Relatively high fees.
  • All result from lack of/no regulation.

The FTX bankruptcy was one of the largest so far with No contagion to traditional financial markets.
Failure of Silvergate Capital (March 2023).

FTX Creditors by size

FTX Creditors Source: Delaware Bankruptcy Court filings

1 Million Creditors: Total Claims Unknown

50 Biggest Unsecured Creditors Owed $3.1 billion

"oh fuck, people wired $8bn to Alameda and oh God we basically forgot." Sam Bankman-Fried in Vox 16/11

Recent Developments

  • 2024 SEC approving 1st Bitcoin ETF:
    • January 2024 (Blackrock)….
    • UK is considering doing the same.
  • 2025 Donald Trump Election and him favouring cryptos.
    • US Bitcoin Reserve (but nothing more than keeping the approx 200k bitcoin seized from criminals)
  • Sanctioned jurisdiction
  • FTX creditor claims (fraud)
  • Special measures
  • Terrorism financing
  • CSAM
  • Sanctioned entity
  • Malware
  • Ransomware
  • Stolen funds
  • Online pharmacy
  • Cybercriminal administrator
  • Scam Darknet market
  • Fraud shop

Binance 4.34.3 billion USD settlement with CFTC over AML and sanctions violations (February 2024)

SBF found guilty on all 7 counts of fraud and conspiracy to defraud investors and customers of FTX (November 2023)

Regulation of Cryptocurrencies

  • MICA 2024 (Market in Crypto Assets):
    • Since January 2024 fully applicable.
  • EU Markets in Crypto Assets (MICA) Regulation:
    • In force 12-18 months after Q1 2023 publication of final text
  • MICA defines the perimeter of crypto regulation as a distinct asset class:
    • Crypto Asset (CA) is "a digital representation of a value or right which may be transferred or stored electronically, using distributed ledger or similar technology."
    • Exceptions: Non-Fungible Tokens (if not identical series); Third Country CAs if exclusively at customer's initiative; derivatives subject to MIFID
    • Asset-Referenced Token (ART) is a CA that is not an EMT "and that purports to maintain a stable value by referencing to any other value or right or a combination thereof, including one or more official currencies."
    • Significant if 2.5m transactions, €500m daily value, other criteria
      Size Cap if 1m transactions, €200m daily value 'widely used for means of exchange' or threat to monetary policy
      Electronic Money Token (EMT) is a CA "that purports to maintain a stable value by referencing to the value of one official currency"

MICA Regulation of Crypto Asset Service Providers: Scope

  • Crypto Asset Service Providers (CASP) provides one or more of these crypto-asset services to third parties on a professional basis:
    • custody and administration, operation of a trading platform, exchange (CA vs CA or fiat money), execution of orders, placing, transfer services, reception and transmission of orders, providing advice, portfolio management
    • "or more" implies ok to bundle services in same legal entity
      DeFi" exemption but only if fully decentralised and no intermediary
      Note: Lending not is not a CA service
  • Banks and investment firms can be CASPS
  • No grandfathering for licences
  • National Competent Authorities are supervisor but important ESMA roles
    MICA Crypto Asset Service Providers: Key Requirements
    CASPS gain EU-wide passport rights
  • Corporate Structure and Governance
  • CASP must have legal entity in EU
    Corporate structure, jurisdictions must not prevent effective supervision
    Corporate governance, conduct and capital requirements
    Client asset safekeeping rules and custody loss liability
  • Crypto Hacking Losses
    33 billion (Year to 12 October)
    2.12.1 billion (2021)