Cryptocurrencies are about to disrupt the traditional financial and banking sector. How should banks react?

1. Cryptocurrencies and the
Decentralized Economy
Ilan Alon, PhD
Professor
University of Agder and Ariel University

2. Objectives
and Outline
Describe the process of creative
destruction
Context and history of money
What is money and blockchain-based
money (e.g. BitCoin)
How crypto currencies are going to
disrupt the financial industry
Understand the potential and challenges
facing peer-to-peer electronic money

5. Technology Changes the Rules of the Game

10. Internal Creative
Destruction

11. Technology Adoption: Diffusion of Innovation

13. Metcalfe’s Law: Value of a Network
Image by Woody993 on Wikipeida. CC0.
7

15. 15
Blockchain Technology
• Verifiably moves ‘data’ on a decentralized network
• The ‘data’ can represent value or computer code

16. Disruptive Innovation Theory

17. Yuval Harari
on Money
Money is anything that people are willing to use in order to
represent systematically the value of other things for the
purpose of exchanging goods or services”. Neither does it
have to be a material reality – it is a psychological construct that
works by converting

19. 26
Characteristics of “good” Money
• Durable
• Portable
• Divisible
• Uniform/Fungible
• Acceptable
• Stable - Limited supply - Hard to Counterfeit

21. Non Metal Money
Image in the public domain by Gary Todd.
Image by Bertramz on Wikimedia. Licesne: CC BY
Salt Bars - Ethiopia Cowrie Shells - Nigeria
Image by Sandsteinon Wikimedia.License CC-BY
Image by Yusuke Kawasaki on Wikimedia. License: CC BY
8
Tally Sticks - England Rai Stones - Yap
Scarce, Valuable and Hard to Make

22. Metal Money
Bronze Aes Rude - Rome
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is excluded from our Creative Commons license. For more
information, see https://ocw.mit.edu/help/faq-fair-use/.
Bronze Spade - China
Image by Mary Harrsch on flickr. License CC BY-NC-SA
Cooper Plate - Sweden
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Creative Commons license. For more information, see
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23. Minted Money
Image by Daderot on Wikimedia. License: CC0. Image is in the public domain.
Image by Scott Semans World Coins. License: CC BY.
10
Bronze Yuan - China Silver Dekadrachm - Greece Gold Aureus - Rome

24. Gresham’s Law
(‘Bad Money Drives out Good’.) The law is named after Sir Thomas
Gresham (1519-79), a leading English business pay on and financial
adviser to Queen Elizabeth I.
Under a metallic standard the “good money” can be melted down,
exported abroad and sold by weight. This cannot be done with paper
money or subsidiary coins.

25. Fiat Currency
• Social & Economic Consensus
Image by epSos.de on Wikimedia. License CC BY.
19
• Represented by Central Bank Liabilities &
Commercial Bank Deposits
• Relies upon System of Ledgers Integrated
into Fractional Banking System
• Accepted for Taxes
• Notes & Coins are Legal Tender for All Debts Public & Private
• Unique Tax Treatment

26. Central Bank and Commercial Bank Money
(Reserves & Cash) (Bank Deposits)
Cash
Bank Deposits Bank Deposits
Reserves
6
Source: Richard Gendal Brown, ‘Thoughts on the future of finance’ Image by Richard Gendal Brown. Used with permission.

27. Blockchain Financial Application
Cou1
r2
tesy of the Research Office of the Legislative Council Secretariat <www.legco.gov.hk>. Used
with permission.

28. Financial Sector Favors
permissioned blockchains vs. permissionless blockchains
?
? ?
?
?
• Known set of participants
• No proof-of-work or mining
• No need for a native currency
• Distributed database technology
• Unknown participants
• Security based on incentives;
• Native currency
• Crypto-economics
28

29. 29
Bitcoin: A Peer-to-Peer Electronic Cash System
•From: Satoshi Nakamoto <satoshi <at> vistomail.com>
Subject: Bitcoin P2P e-cash paper
Newsgroups: gmane.comp.encryption.general
Date: Friday 31st October 2008 18:10:00 UTC
•“I've been working on a new electronic cash system
that's fully peer-to-peer, with no trusted third party.”

31. Nassim Taleb
Influencer economist/quant trader
Coined “The Black Swan”
Coined the “Lindy Effect”
Moved from being pro to being against

32. What is the blockchain innovation?
timestamped
auditable database consensus protocol
append-only log
Secured via cryptography Addresses ‘cost of trust’
(Byzantine Generals problem)
• Hash functions for tamper
resistance and integrity
• Digital signatures for consent
• Consensus for agreement
• Permissioned
• Permissionless
32

34. Pizza for bitcoins?
May 18, 2010, 12:35:20 AM
• “I'll pay 10,000 bitcoins for a couple of pizzas.. like maybe 2 large ones so I have some
left over for the next day. I like having left over pizza to nibble on later
. You can make
the pizza yourself and bring it to my house or order it for me from a delivery place, but
what I'm aiming for is getting food delivered in exchange for bitcoins where I don't have
to order or prepare it myself, kind of like ordering a 'breakfast platter' at a hotel or
something, they just bring you something to eat and you're happy!
• I like things like onions, peppers, sausage, mushrooms, tomatoes, pepperoni, etc.. just
standard stuff no weird fish topping or anything like that. I also like regular cheese
pizzas which may be cheaper to prepare or otherwise acquire.
• If you're interested please let me know and we can work out a deal.
• Thanks,
Laszlo” 16

35. 35
Re: Pizza for bitcoins?
May 21, 2010, 07:06:58 PM
• “So nobody wants to buy me pizza? Is the bitcoin amount I'm offering
too low?”

36. 36
Re: Pizza for bitcoins?
May 22, 2010, 07:17:26 PM
• “I just want to report that I successfully traded 10,000 bitcoins for
pizza.
Pictures: http://heliacal.net/~solar/bitcoin/pizza/
Thanks jercos!”

37. 37
Medium of Exchange:
10,000 Bitcoins for 2 Pizzas
• Value:
• May 22, 2010 - $41
• $20.50 per pizza
• September 5, 2018 - $66 million
• $33 million per pizza

38. Today
www.coinmarketcap.com
Is it a competitive, oligopolistic or monopolistic market?
Price taker vs price maker?
In a perfectly competitive market, shares are divided rather equally
among participants. A rule of thumb is that an oligopoly exists when the
top five firms in the market account for more than 60% of total market
sales. If the concentration ratio of one company is equal to 100%, this
indicates that the industry is a monopoly.

39. CryptocurrenciesTrilemma: Vitalik Buterin
Decentralization
Scalability
Security
10

40. Macroeconomic Context
1. United States Money Supply
1. https://tradingeconomics.com/united-states/money-supply-
m2
2. United States Interest Rates
1. https://tradingeconomics.com/united-states/interest-rate
3. United States Inflation
1. https://tradingeconomics.com/united-states/consumer-price-
index-cpi
4. United States Government Debt to GDP
1. https://www.truthinaccounting.org/about/our_national_debt
2. https://tradingeconomics.com/united-states/government-
debt-to-gdp

41. 41
Assigned Case: Cryptocurrencies: Investment,
Money or Gamble (Part A)?
• Juan Perez, investment analyst
• Multilateral investment institution (MLI)
• Region: Latin America
• Year: 2018
• What is the problem facing Juan? Target Bitcoin

42. Financial Sector Challenges =>
Blockchain Potential Opportunities
• Repeated crises and instability
• Fiat currency instabilities associated with unsound policies
• Centralized intermediaries’ concentrate risks & economic rents
• Central Bank legacy payment systems
• Clearing & settlement costs & counterparty risks
• Financial inclusion
• Payment system costs: ½ - 1 % of Global GDP
• Financial sector costs: 7 ½ % of U.S. GDP 23

43. 43
Case Questions
• Is Bitcoin money, investment or gamble?
• How do you compare the risks of Bitcoin with those of other
currencies and investments?
• What is blockchain technology and why might it be a catalyst
for change for the financial sector?
• What are the opportunities and threats of crypto currencies
to the bank? (SWOT)
• What should the bank strategy be with regards to this
emerging technology? Can it afford to wait and see?

44. 44
Assigned Case: Cryptocurrencies: Investment,
Money or Gamble (Part A)?
• If you were Juan, what would you recommend to the bank?
• What are the risks and benefits to the bank? Do a cost benefit analysis
• How can Juan compare the risk/return profile vis-à-vis other currencies in
Latin America, USD/Euro, or the stock market (e.g., S&P500)
• What are the ways in which Bitcoin and crypto going to disrupt the
banking and financial sectors? How can the bank prepare?
• What the bank do now to prepare for the decentralized economy?

45. What is Bitcoin?
1. Money
2. Product
3. Commodity
4. Digital scarcity
5. Technology

48. 27
Design of Money
• Token vs. Account Based
• Physical vs. Digital
• Private Sector vs. Central Bank
• Widely Accessible vs. Wholesale

49. The Money Flower
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BIS; Central Bank Digital Currency Report; 3/18

51. Bitcoin vs Commodity

52. 52
Bitcoin and Crypto as Investment
• Global Equity Markets:
• $93 Trillion (2022)
• Global Debt & Bond Markets:
• $250 Trillion
• Global Holdings of Gold:
• $10 Trillion

53. U.S. Securities Law
•The Howey Test (1946):
Image is in the public domain.
•Is it an investment of money or assets?
•Is the investment in a common enterprise?
•Is there a reasonable expectation of profits?
•Is it reliant on the effort17
s of a promoter or others?

54. 54
The Duck Test
“When I see a bird that walks like a duck and
swims like a duck and quacks like a duck, I
call that bird a duck.”
James Whitcomb Riley, poet

55. Initial Coin Offerings
•Proceeds used to build networks
•Tokens usually issued prior to being functional
•Development, while open source, is largely centralized
•Promoters allocate themselves ‘premined’ tokens
•Tokens are fungible & transferable
•Scarcity is fostered with preset ‘Monetary policy’
•Purchasers anticipate profits through appreciation
6

58. Financial Sector Role
Moves, Allocates & Prices Money and Risk
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• Relies upon Systems of Ledgers and Trust
• Legacy Technology

59. Incumbents Eying Crypto Finance
• Exchanges – CME; Eurex; Intercontinental Exchange;
Nasdaq
• Asset Managers – Fidelity
• Investment Banks – Goldman Sachs
• Venture capital – Pantera capital
• Crypto exchanges eyeing banks
30

60. 11
Payment System ‘Pain Points’
• Costs
• Delayed Settlement
• Chargebacks
• Fraud
• Privacy
• Financial Inclusion
• Cross Border Payments
• Centralization of Ledgers
• Complexity

61. Financial Sector Currently Favors
permissioned blockchains vs. permissionless blockchains
Access
25
Client Server
Traditional Databases
Trusted Party Hosts Data
Trusted Party can Create, Read,
Update, & Delete (CRUD)
Client Server Architecture
Permissioned Permissionless
Private Blockchain Public Blockchain
Known Participants Unknown Participants
Private Write Capability No Central Intermediaries
Append Only Timestamped Log Public Write Capability
Publicly Verifiable Peer to Peer Transactions
No Native Currency Token Economics

63. Payment Systems
A Method to Amend and Record Entries on Ledgers for Money
Authorizing, Clearing and Recording Final Settlement
Access
method
Consumer
2
Consumer
1
Digital wallets:
Apple Pay Android
Pay Amazon Pay
Facebook Payments
Visa Checkout
MasterPass
PayPal Venmo
Samsung Pay
Alipay
Chase Pay
Other Pay […]
Merchant
Bank
Acquirer
Financial instrument
Bank account
Debit Card
Credit Card
Prepaid Card
Others
10
Networks & PSPs
Visa/Mastercard/etc.
First Data/Stripe/etc.
ACH
Other
Issuing
Bank Merchant
Cryptocurrency (Bitcoin)

64. Cheque clearing process in fiat

65. International Trade Letter of Credit

66. Possible Use of Bridge Crypto for Payments
Fiat Crypto Fiat
16

67. Trade Finance
• Parties:
• Importers
• Exporters
• Banks
• Shippers
• Freight Forwarders
• Customs Agents
• Document Carriers
© EdgeVerve Systems Limited.All rights reserved.
This content is excluded from our Creative
Commons license. For more information, see
https://ocw.mit.edu/help/faq-fair-use/
• Documents:
• Bill of Lading, Invoice, Bill of Exchange,
Packing List, Insurance Certificate, License,
Embassy Legalization, Certificate of Origin,
Inspection Certificate, Agricultural
Certification, Airway Bill, Trucking Receipt,
Railway Receipt, Forwarder Cargo Receipt,
Rail Consignment Note, Road Consignment
Note, Consignment Instructions, Warehouse
Receipt, Multi-Modal Transport Waybill,
Delivery Receipt, Insurance Policy, and
Insur
11
ance Certificate

68. Basket of Financial Products
Similar to Stock Market
Different combination of crypto with varying characteristics
Yield farming www.stakingrewards.com
Coinbase, Yearn, Compound, and other Protocols

69. 22
Financial Sector => Opportunities
• Legacy Customer Interface, Data, & Processing Systems
• Economic Rents
• Centralized Concentrated Risks
• Infrastructure Systems’ Costs & Counterparty Risks
• Repeated Crises and Instability
• Financial Inclusion
• Financial sector costs: 7 ½ % of U.S. GDP
• Payment system costs: ½ - 1 % of Global GDP

70. 70
Financial Sector Challenges with Blockchain Technology
• Performance, Scalability, & Efficiency
• Privacy & Security
• Interoperability
• Governance
• Commercial Use Cases
• Public Policy & Legal Frameworks

71. Evaluating the need for blockchain
1. Why not use a traditional data base?
2. Which transactions and data need recording?
3. Which multiple stakeholders need write and read access to ledgers?
4. If a permissionless application, why is native token the best solution?
5. What are Tradeoffs of Performance, privacy, security, & coordination?
6. How can broad adoption be realized?
7. What is the customer experience and user interface?

72. Technological
Notes

73. Decentralized Networks
Permissionless Blockchains -
Unknown participants
Byzantine Generals Problem
Attack!
Attack! ? ?
?
Retreat ? ?
Retreat
Security based on:
Attack!
• Consensus protocol &
• Native currency
14

74. Layers of a Blockchain

75. First Widespread Case Use of Blockchain - BTC
cryptography, append-only timestamped blocks, distributed consensus
algorithms, and networking
Problem: Bitcoin pain point is scalability (due to security)
Solution:
• Lightning network (layer 2, off chain processing, 2018)
• https://www.youtube.com/watch?v=J3cQNpOR_a0
• Multi-signature shared payment channel, multiuser, with digital IOU/receipt
• Speed of internet, hashed timelines, multicurrencies, near zero cost
• Financial infrastructure for El Salvador

76. Timestamped Append-only Log - Blockchain
13
Image is in the public domain by National Institute of Standards and Technology.

77. Hype Cycle: Where is Blockchain? NFT? Web3?

78. Economics of Blockchain Technology
• Verification Costs:
• Direct Costs
• Privacy Costs
• Censorship Risks
• Settlement and Finality Risks
• Costs of Trust
• Economic Rents
• Networking Costs:
• Token Incentive Systems - Reward, Affinity or Identity
• Start-up Costs
• Operating Costs 17

79. 9
Blockchain vs. Internet
• Both Open protocols
• Both Transport packets of data on distributed networks
• Property Rights vs. Content
• Both can have Apps built upon Protocol or Cryptocurrency level
• Both said to be Open Network Development
• Though Centralized through groups such as ICANN or Bitcoin Core Developers
• Interoperability
• A Blockchain is akin to a Private Intranet vs. the Internet
• Incentives – Registrars and Registries vs. Miners
• Origins in Relation to Governments – Coordinated vs. Limited Trust
• Significant Investment – Blockchain far earlier than Internet

80. Crypto is native to Web3

81. A new layer?: Programmable transactions
- 20xx
SSL / TLS - 1996
HTTP- 1990
TCP/IP - 1974
Ethernet - 1974
???
1998
1995
1984
1979 81

82. Public Policy – View from the Top
“Authorities need to decide whether to isolate, regulate
or integrate crypto-assets and their associated
activities.”
Mark Carney, Governor of the Bank of England
March 2, 2018
8

83. Global Approach to Crypto Finance
Still Early Stage, but Confidence is Built
upon coming within Public Policy Norms
• Guarding Against Illicit Activities
• Broad Consensus on Policy
• Inconsistent on Implementation
• Financial Stability
• General Consensus to Monitor
• Different Perspectives, though, on Level of Risk
• Protecting the Investing Public
• Wide Range of Views on ICOs & Exchanges
• Japan, U.S., & Others Moving to Regulate Exchanges
• U.S. & Canada seeking to bring ICOs w9
ithin Securities Laws 9

84. 10
10
Crypto Public Policy Challenges -
Guarding Against Illicit Activity
• Tax Compliance and Reporting
• Definition – Currency or Property?
• Tax Treatment – Mining, Exchanges, & Forks?
• Reporting – Individual, Brokers, 1099-Bs & FBAR
• Bank Secrecy Act
• Money Transmission Laws (AML, CTF) – Users vs.
Administrators or Exchangers

85. 11
11
Crypto Public Policy Challenges -
Guarding Against Illicit Activity
• Challenges
• Pseudonymous Addresses
• Privacy Coins & Mixers or Tumblers
• Compliance and Reporting
• Crypto to Crypto Transactions
• Decentralized Exchanges
• Dark Markets
• State Actors

86. Evaluating ICOs or Cryptocurrency
•Assess Viability of Token Use Case
•Potential market size
•Value creation proposition/pain point solved
•Whitepaper Details and Source Code
•The Team
•Venture Capital Involvement
•Media and Community – Reddit, Medium, BitcoinTalk, …
•Which competitors address similar value proposition?
•Monetary Policy
•Token Distribution
•Regulatory Compliance 7

87. 5
Additional Assessment of Use Cases
• What is the value creation proposition and ‘pain point’ is being solved?
• Which transactions and data needs recording?
• Which multiple stakeholders need write and read access to ledgers?
• Which costs of verification or networking can be reduced?
• What are competitors doing to address similar value propositions or markets?
• Why are append only logs and multiple party consensus the best solution?
• If permissionless applications, why is native token the best solution?
• What are tradeoffs of scalability, performance, privacy, security, & coordination
• Can permissioned blockchain or traditional Data Base adequately address use case?
• How can broad adoption be realized?
• What is the customer interface and how is it better than current interface?
• Which costs of verification or networking can be reduced?
• Why are append only logs and multiple party consensus the best solution?

88. Debate: In Defense of Bitcoin
Economic Arguments
1. Bitcoin is a Ponzi scheme
2. Bitcoin is “scarcity of nothing” with no real value or backing
3. Assuming it is a new asset class, Bitcoin is not actually a good hedge
against inflation
4. Assuming it is money, Bitcoin is too volatile to be a good store of value
and too slow to be a good medium of exchange
Socio-Political Arguments
1. Bitcoin is a big environmental disaster, not worth the damage
2. Bitcoin can undermine the global dominance of US/USD
3. Bitcoin is a channel for thieves, crooks and underground world

92. Three Key
Risks
Coin exchange risk
Change in yield risk
Foreign currency risk
•Need for Israeli digital
shekel for onboarding
and offboarding

93. Three measures to optimize
1. Maximize Alpha = Risk free rate + Beta X (Benchmark return – risk
free rate)
1. Alpha = R – Rf – beta (Rm-Rf)
2. Portion of portfolio return not related to market
2. Minimize Beta = (Fund return – Risk free rate) ÷ (Benchmark return –
Risk free rate)
1. Systemic risk
2. Beta could be calculated by first dividing the security's standard deviation of returns by the
benchmark's standard deviation of returns. The resulting value is multiplied by the correlation of the
security's returns and the benchmark's returns.
3. =1 exactly as volatile as the market. β >1 more volatile than the market. β <1>0 less volatile than the
market
4. not a fixed value over a given period of time
3. Minimize Correlations high-risk assets
1. Pearson's correlation coefficient is the covariance of the two variables divided by the product of
their standard deviations.

94. Future of
Healthy
Crypto
Ecosystem
• Digitization
• Tokenization
• Fractionalization
• Liquidity/Trading
Platform
• Security