Cryptocurrency and Blockchain: an Introduction
to Digital Currencies
Introduction and Summary
Jessica Wachter, Professor of Financial Management, Professor of Finance
Module Goals
• More than 11 years after the distribution of Satoshi Nakamoto’s famous
white paper, some things are clear
1. Cryptocurrency, and the associated technology of blockchain, has
staying power
2. Cryptocurrency is inherently a hard subject, as it combines the
knowledge base of computer science, cryptography, finance, and
economics
• The barrier to entry to cryptocurrency is understanding
Helpful Background
• These lectures are designed for a listener with a background in finance
• No background in computer science is necessary (though the concepts
introduced in the second module are challenging)
• The most important requirement is a strong interest in the subject
Summary
• Module I: Basics of cryptocurrency — What is it and what are the problems
it is designed to solve?
• Module II: Basics of blockchain — How does it relate to cryptocurrency?
What is it and how is it used?
• Module III: Cryptocurrency as an asset class
Cryptocurrency and Blockchain: an Introduction
to Digital Currencies
Course Introduction
Jessica Wachter, Professor of Financial Management, Professor of Finance
Cryptocurrency and Blockchain: an Introduction
to Digital Currencies
Introduction to Cryptocurrency
Jessica Wachter, Professor of Financial Management, Professor of Finance
“ A fraud, worse than tulip bulbs.”
— JAMIE DIMON, JP MORGAN CEO
SEPTEMBER 12, 2017
“ Probably rat poison squared. If I could buy a five-
year put on every one of the cryptocurrencies, I’d
be glad to do it but I would never short a dime’s
worth.”
— WA R R E N B U F F E T, B E R K S H I R E H AT H AWAY C E O
M AY 5 TH , 2018
“ Crypto is the mother of all scams and (now busted)
bubbles; While Blockchain is the most over-hyped
technology ever, no better than a
spreadsheet/database.”
— TITLE OF NOURIEL ROUBINI’S CONGRESSIONAL TESTIMONY
OCTOBER 2018
What is Cryptocurrency?
Or…
• Is it the future of money?
• Will our grandchildren or great grandchildren be asking, “What were you
doing when money was being created?”
What is Cryptocurrency?
• Consider Bitcoin
• It is not an actual coin
• It is a unit of exchange:
• Currently trading at $3,772.38/ 1 bitcoin (as of Sunday 2/24, 2:47
EST)
• The smallest unit to trade bitcoin is one satoshi, or 0.00000001 of a bitcoin
In This Module
1. Transacting in Bitcoin
2. What exactly is currency?
3. Cash-alternatives currently in use
4. Why, then, cryptocurrency?
5. Concluding thoughts
Cryptocurrency and Blockchain: an Introduction
to Digital Currencies
Transacting in Bitcoin
Jessica Wachter, Professor of Financial Management, Professor of Finance
Transacting in Bitcoin
• First, you need a wallet
• Wallet – a place to store your bitcoin credentials: namely your private key
• Private key – a 256-bit number, expressed as a hexadecimal
E9873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA3326
• Generated using cryptography
• When people say that they have lost their bitcoins, they mean their private
key
Transacting in Bitcoin
• No way, without the private key, to access Bitcoin
• If someone has your private key, or can infer it, then you have given them your
bitcoins
• Your private key can generate your unique address (which is public)
Transacting in Bitcoin
• Ways to transact in Bitcoin
• Third-party software (example, Coinbase),
• Provides the wallet and the access to a bitcoin exchange
• Can separately choose a wallet and an exchange
• You can buy with cash using a bitcoin ATM
• Will then receive a hard copy of your private key, which you can
transfer to a digital wallet for security and ease of transactions
Transacting in Bitcoin
• Once you own bitcoin, you can:
• purchase goods or services from other users of bitcoin using third party
software, or directly
• trade bitcoin back to dollars
• Bitcoin is a currency, like any other
Transacting in Bitcoin
• Bitcoin is nothing but a currency
• It is not:
• a stock, which is a claim to ownership in a company
• a treasury bill, which is a claim to the income of U.S. taxpayers
• Unless people believe that it can eventually function as a medium of
exchange, in some states of the world, bitcoin has no inherent value
Transacting in Bitcoin
• Might Bitcoin function someday, as a generalized medium of exchange?
• Some people clearly think this is impossible
• To really answer that question, we need to consider what we mean by currency
What Exactly is Currency?
• The US dollar is fiat money
• Legal tender for all debts public and private
• The requirement to accept dollars for private debt is by “fiat”
• Backed by the power of the sovereign
What Exactly is Currency?
• The fiat of the US government does not extend:
• to private businesses accepting dollars for payment
• to all of the transactions, both legal and illegal, that take place around the
world using dollars.
• These transactions do occur, and apparently more frequently than ever.1
1See Rogoff (2014).
What Exactly is Currency?
• The self-fulfilling equilibrium:
• Everyone agrees to take US dollars because they believe that everyone will
take US dollars
• Rests on the following fundamentals:
1. Dollars can pay taxes and discharge debt
2. The rule of law
• Bottom line: what makes a currency a currency are the common beliefs of the
individual users
What Exactly is Currency?
• Directly using cash is sufficiently cumbersome that a profitable industry has
arisen to allow us to avoid it
• Nearly all merchants accept Visa and Mastercard
• Most merchants accept 4 major credit cards: those two plus Discover and
American Express
• Very costly for the merchants due to a fee that can be over 2% of the
transactions
• By law, they are not allowed to offer a discount for cash
• These cards are very profitable for the credit card companies
• They are nice for consumers because consumers receive (tax-
free) benefits
What Exactly is Currency?
• Customers demand these cards, so merchants lose business if they do not
accept them
• Merchants are not allowed to price discriminate, which implies that these
card companies form an oligopoly
Cash Alternatives
• Centralized intermediary
• Transactions are still done in terms of dollars
• But the credit card company keeps track of the accounts and verifies the
legitimacy of the transaction
• Maintains a centralized ledger
• Credit cards avoid keeping track of which customers’ checks are good and
which are not
• Allows internet transactions when you don’t know the customer on the other
side
Summary
• Bitcoin is a currency like any other
• Can function as a medium of exchange or a store of value
• In the U.S. we already have a medium of exchange – dollars
• The functionality of dollars as a medium of exchange is through common
beliefs
• A profitable industry of centralized intermediaries has grown up to facilitate
dollar transactions without the direct use of the currency
Cryptocurrency and Blockchain: an Introduction
to Digital Currencies
Why Cryptocurrency?
Jessica Wachter, Professor of Financial Management, Professor of Finance
Why Cryptocurrency?
• Bitcoin allows:
• online transactions (and offline transactions without cash)
• any transaction for which a credit card is used could be a Bitcoin
transaction
• It accomplishes this while still being decentralized
Why Cryptocurrency?
• Reason 1: A centralized intermediary has a lot of power
• Should we worry about the potential for abuse given the near-monopoly
power of intermediaries?
• These companies might tamper with this ledger, perhaps to punish
enemies or reward friends
• Probably not: it is very profitable to be a centralized intermediary
(franchise value)
Why Cryptocurrency?
• Reason 2: You do not like centralized intermediaries for philosophical
reasons
• i.e. you are an extreme libertarian or perhaps an anarchist
• Most likely will not lead to widespread adoption
Why Cryptocurrency?
• Reason 3: You need to hide from the centralized intermediary because you
are engaged in some activity you do not want the government to know about
• Perhaps you do not trust the government, or you are doing something
specifically against the law
• A solid reason to use Bitcoin
Why Cryptocurrency?
• Multiple equilibria for Bitcoin
1. No one uses it, ever, so it is worth zero
2. Used by a narrow group (this seems to prevail currently)
3. Is a dominant medium of exchange
Why Cryptocurrency?
• There may be a deeper reason behind the appeal of cryptocurrency
• What if dollars themselves were to become untrustworthy?
• The value of the dollar rests (in part) in the hands of the Federal
Reserve
• The Federal Reserve is in principle independent
• The President of the United States is also the commander-in-chief
• The value also depends on everyone’s expectations
Why Cryptocurrency?
• Two problems from relying on fiat money
1. What if there was, say, 5% inflation?
• Because of the fiat, investors need to hold cash for transaction
purposes
• If there is inflation, those dollars erode in value
• Similar to a tax in that the government gets to spend the extra money it
prints
• Having a competitor to dollars, residents are not trapped by the
seigniorage
Why Cryptocurrency?
• Two problems from relying on fiat money:
2. What happens should the currency become truly unstable
• Weimer Republic 1921–1923
• Venezuela 2016–present
• Bitcoin is designed (to some extent) with protections against problems 1 & 2
Summary
• Bitcoin is a currency like any other
• Not recognized as legal tender by any sovereign, zero is always a possible
answer to the question: what is its value?
• Depends on whether it can be used as a medium of exchange
• Or whether people believe it can be used as a medium of exchange
• Or whether people believe that people believe it can be used as a medium
of exchange
Summary
• Bitcoin derives its potential value from two sources
• Ease of transactions without relying on a centralized intermediary
• Currency that is not prone to manipulation by a central bank
• Will Bitcoin remain a niche product, or might it be widely adopted?
• It is not enough to have advantages; there must be a critical mass of users
who see these advantages as important
