The digital currencies issues and challenges

The number of digital currencies is counted as 1584 currencies with total market cap of more than 380
billion U.S dollar. However, the top 10 leading currencies represent 80% of the total market cap of all
the digital currencies already issued. This technical note tackles the data of top two currencies: Bitcoin
and Ethereum that represent together 55% of the total market cap with shares 39.5% and 15.5%
respectively. Most of digital currencies witness a huge range of volatility making this investment very
risky in addition to the speculation opportunities in this field.

This note tackles an outlook over the new crypto-currency market, especially Bitcoin, and the
challenges faced by the world economy as result of the quick rise of the importance of the digital
currencies in recent days. Moreover, it represents some of the characteristics and the possible risks
associated to the crypto-currencies new market.

Some characteristics of digital currencies with examples for Bitcoin and Ethereum:

I) Volatility:

An issue the digital currencies new market characterized by is the huge volatility of this market. Bitcoin
witnessed several bubbles and many peaks and downs since its issuance until today. The reason of the
high volatility is the restricted amount of issued coins that until now is about to hit the 17 million coins
from the maximum coins supply of 21 million coins. This limit of coins keeps the price very sensitive to
the demand curve that can shift easily from one point to another according to several factors. These
factors could be the public acceptance of the currency, pieces of news, and sometimes the marketing
and the positioning strategies by the issuer. Some examples could be: The jump of Bitcoin price in one-
month, October and November 2013, jumped from 150 USD in mid-October to 1,150 USD at the end of
November 2013. In addition, more recently, there were three bubbles occurred in the year 2017, with a
peak of 19000 USD in December, 2017.

II) The quantity of coin supply:

Coin supply of bitcoin is stable. Given an approximately stable coin supply with an increasing demand,
started from the mid of 2017, led to a massive hike in the price of bitcoin and the market cap increased
as a result. The number of coin supply is restricted because of the difficulty of the coin mining by using
the difficulty rate. The difficulty rate moderates the supply of the digital currency. For example, bitcoin
uses the 10-minute block interval in restricting the currency supply. Between each block to be mined, 10
minutes on average should be respected to mine a new block. The block is rewarding a certain number
of coins. Before December, 2012, the block was rewarding 50 coins. After each 210 thousand blocks are
created, the rewarding factor is halved. This procedure happened twice. Once in 2012, when the
rewarding coins per blocks were reduced to 25 coins and then in 2016, it was halved to 12.5 as well.

III) Mining profitability:

The mining profitability, has been shrinking since July, 2011. The shrinkage of mining profitability for
bitcoin led investors to look for other currencies to have higher possibilities to have high gains. The
mining profitability as indicated by the algorithm is getting difficult by time. Moreover, the massive
increase in the price and the lower mining profitability of bitcoin makes other digital currencies seem to
be more rewarding in the future. Since the mining profitability reward decrease by time, investors will
seek new currencies to mine searching for opportunities to have more reward. This property of digital
currencies creates an endless continuation of mining new currencies seeking the profitability at the
beginning. In comparison with Ethereum, the latter seems to still be more rewarding in terms of USD for
each Hash/s mined. The mining profitability of Ethereum tends to have a volatile range.

IV) Mining difficulty:

The mining difficulty rate tends to have a massive increase with time. In the case of bitcoin, the difficulty
rate increased from 2009 from the value 1 reaching around 4 trillion times more difficult. The limited
amount of bitcoins can be mined, 21 million of which 17 million are already mined, increases the
difficulty of bitcoin mining. Both properties, mining profitability and difficulty index, also lead to a switch
to mining other currencies. In the case of Ethereum, it is extremely very difficult relative to bitcoin to
mine. The difficulty index of Ethereum is one thousand times more than bitcoin difficulty of mining, in
the recent year, using the same indicators of difficulty.

V) Transaction cost:

The average transaction fees of bitcoin boomed during the bubble in December, 2017 and tend to
decrease substantially until its average reached 1 USD in recent days. The transaction cost is paid to the
block miners where the transaction is processed.

Absence of regulations on speculation and the anonymity of transactions could lead to major risks of
volatility. The lower the transaction cost could lead to higher risks of speculation and lower price
stability.

Bitcoin transactions process depends completely on the miners’ blocks that is occurred within the
blockchain ledger. The transactions fees are collected by the miners who had mined the blocks. This
creates incentives for the miners to keep mining and enlarge their block size that is restricted to
maximum one megabyte. The higher the size of the block, the higher the number of transactions and,
hence, the higher the profitability of it. The profitability depends on the type of the mining device used,
the energy consumption, and other costs, as the initial investment.

VI) Number of transactions per day:

The number of transactions per day is, for sure, affecting the transaction fees. It leads to increasing the
size of the blocks which, in deed, makes it less likely for miners to carry out transactions without earning
transaction fees. The block size is limited which makes the number of transaction is limited.

Heading towards other crypto currencies:

The huge hike in bitcoin price pulled all of other crypto currencies’ market cap to that peak. The reason
is the convertibility between the bitcoin to the other crypto currencies based on the value in a central
bank currency (e.g. the USD or the JPY) in addition to the increasing interest in that new field. Any
fluctuations in the price of Bitcoin cause a positive effect on the volatility of the price of all other crypto
currencies. However, due to the increasing mining hash rate leads to an increasing mining difficulty, by
definition of the difficulty rate, and, thus, leads to a low reward from that currency. It leads people
heading for other currencies that have more reward. In comparison between Bitcoin and Ethereum, the
latter’s difficulty rate, although, is a way much higher than Bitcoin. The market cap for all crypto
currencies but bitcoin, is dependent on Bitcoin’s market cap. Some governments are trying to issue new
digital currencies that would be backed either by the domestic currency by making a free convertibility
one-to-one or by a certain product.

The effect of digital currencies on the economy:

I) Seigniorage:

Bitcoin is a fiat currency which is not backed by any material good. Thus, the volatility of the currency
and the growth of its market cap almost without changing the quantity supplied, makes the issuer and
the initial holders of the currency enjoying a significant Seigniorage that led to no real economic growth.
On contrary, the value of central banks fiat currencies is backed by the efficiency of the state’s policies
and the debt and fiscal deficit ratios to GDP. The Seigniorage enjoyed by the central bank is devoted to
the overall economy. Thus, increasing the monetary supply leads to: either increasing inflation or non-
inflationary growth according to the economy monetary stabilizers and other economic factors.

Can digital currencies increase inflation?

If we look at the nature of the digital currencies we find that at the beginning, as what happened with
bitcoin, the price of the coin against the USD started to increase from scratch, from as low as zero in
2010, until its recent peak in December 2017 to 19k USD. This huge gap was collected by several
holders, traders, and speculators of the currency. This makes the currency like gambling which it is as
world “harmonized” wide exchange of money - in reality, it depends on the share of holdings of each
country’s members- some suffer losses and others enjoy gains. However, this could be turned into
bubble as what happens in the stock market. The great depression in 1930 was a result of a huge bubble
in the stock market that investors were not aware of stocks real value. However, the risk is not
associated to the real economy unless financial institutions start to have holdings of digital currencies
which will transfer the risk to the real economy. The only difference between a rising crisis because of a
digital currency crisis or a stock market bubble is the interdependence between the financial institutions
in a certain country and the stock market.

The interdependence between the real economy and bitcoin risks:

The risks come from the digital currencies’ price fluctuations can be transferred to the real economy
when there is interconnectedness between the financial market and the digital currencies. The holdings
of financial institutions of the crypto-currency can lead to the exposure of these financial institution to
the risk of volatility and thus, transferring it to the whole economy. Moreover, it should be clear to know
the source of the money used to buy digital currencies. If the money used to buy it are borrowed, it
expose the real economy to risks. In the digital currency technology, the anonymity of the transactions
makes it impossible for regulators to identify or observe the required information about the exposure to
risk of the players in that new market. Hence, investors, speculators, or high risk lovers, can’t be
distinguished by regulators in order to isolate the risks from being transferred to the real economy.
Fiat currencies versus crypto-currencies:

The Japanese Yen is the leading currency and after comes the USD in trading against bitcoin amounting
together on average 85% in the recent period. These currencies’ values are dependent on digital
currencies risks. For instance, a breakdown in the digital currency market would lead to a loss in “FDI in
bitcoin” which will have a similar effect of losing investment outside the country of the domestic
currency. However, the international foreign exchange market can make any investor in the world buys
bitcoin in any currency. More differently than central bank currencies, the digital currency still holds
risks of acceptance and the volatility. More important, an increase of daily transaction value leads to an
increase on the demand of the buying currency against bitcoin. Consequently, the increased, or
decreased, demand for bitcoin, leads to a change in the value of other fiat currencies.

Monetary policy implementation:

Most important, the monetary policy implemented by the central bank is widely affected. The market
cap of digital currencies is amounted today around 382 billion USD, and it is outside the regular
international banking system which adds complexity to the central banks in implementing monetary
policy. This makes changes to the economy stabilizers and adjusting mechanism. Unfortunately, digital
currencies can’t, until the moment, be kept in regular banking systems or in central banks as foreign
reserves. Thus, they are not under the control of the monetary policy keeping a significant amount of
liquidity that is approximately in the size of the volume of the whole Norwegian economy locked in this
new digital currency market.

Mining costs and electricity waste:

The electricity cost associated with the mining and the transaction process is largely debated. There is
no doubt that the energy cost is increasing with the increasing hash rate and difficulty rate. The more
mining devices used to hold transactions and to keep the whole system running, the higher the energy
consumption and the electricity waste. An efficient miner with 14 Tera hash/s has power consumption
of 1370 watt. There could be solutions in using the solar power in running the mining devices, however,
it requires a larger initial investment compared to the regular devices. The large initial investment can
be divided by several miners who can create the so-called pool. The pools can help in increasing the
overall profitability of the group.

Is Bitcoin a currency or an asset?

There are several characters that distinguish any currency, most important: medium of exchange, store
of value and long history of acceptance.

The medium of exchange requires low transaction cost which in the recent period, seemed to be a bit
high in bitcoin in order to transact from one address, wallet, to another. On the other hand, the price
instability and the volatility of bitcoin value makes it seemingly very far of having the storing the value
property. Bitcoin is being accepted as a way of payment in several places, however, it is still far from
enjoying the property of widely acceptance.
 Charts and graphs:

I) Market cap of all digital currencies including and excluding Bitcoin:

The graph shows the total market cap of all digital currencies. The importance of the digital currencies’
rose after the signinficant increase in the market cap starting from October, 2017.
(Source: coinmarketcap.com)

The graph shows the total market cap of all digital currencies excluding Bitcoin. The graph indicates the
dependency of other digital currencies on Bitcoin. (Source: coinmarketcap.com)

The share of each crypto-currency’s market cap in the total market cap:

Bit coin has had the dominance until the increase of other digital currencies in mid-2017.
(Source: coinmarketcap.com)
 II) Bitcoin Charts:
a) Price:

Bitcoin Close Price in USD

25000

20000

15000

10000

5000

0
4/28/2013 4/28/2014 4/28/2015 4/28/2016 4/28/2017

The graph shows a huge bubble increase in bitcoin price in late 2013 and three bubbles in 2017, in
addition to a recent bubble at the beginning of 2018. (Source: coinmarketcap.com)

b) Market cap and trade value in USD:

Bitcoin: Market Cap and Trade Value

30000 350000

25000 300000
Million USD

250000
20000
Million USD

200000
15000
150000
10000
100000
5000 50000

0 0

Market Cap Volume (RHS)

(Source: Bitcoin.com)
 Bitcoin: Daily Market Cap and Volume for last 8
months
350 30
300 25
250 20
Axis Title

Billion
200
15
150
100 10
50 5
0 0

Market Cap Volume (RHS)

The two curves follow a similar pattern, increasing the market cap or the price leads to increasing trade
volume. However, during some downturns of the market cap, the trade volume increases causing the
fall in the price. (Source: coinmarketcap.com)

Bitcoin: Monthly price and total

transaction value
18000 450
16000 400
14000 350
Billion USD

12000 300
Unit USD

10000 250
8000 200
6000 150
4000 100
2000 50
0 0
May-14

May-15

May-16

May-17
Jan-14

Sep-14
Jan-15

Sep-15
Jan-16

Sep-16
Jan-17

Sep-17
Jan-18

Average monthly price Total monthly volume (RHS)

This graph shows that the exchange volume is the main indicator that moves the price of Bitcoin. The
trade volume jumped from 58 billion USD in October, 2017 to 416 billion USD driving up the price to a
peak of 19,000 USD in December, 2017. With a certain limit of bitcoin supply, the demand curve plays
the main role for shifting the curve upward or downward, thus, shifting the price level.
(Source: coinmarketcap.com)
 c) Price and market cap:

Bitcoin: Monthly average price and market cap

18000 300
16000
250
14000

Billion USD
12000 200
Unit USD

10000
150
8000
6000 100
4000
50
2000
0 0
Apr-14
Apr-13

Apr-15

Apr-16

Apr-17

Apr-18
Aug-13

Aug-14

Aug-15

Aug-16

Aug-17
Dec-13

Dec-14

Dec-15

Dec-16

Dec-17
Month

Average Monthly Market Cap (RHS) Monthly average price

The graph shows the stagnation of Bitcoin supply and the substantial increase in both starting from Mid-
2017. (Source: coinmarketcap.com)

Bitcoin:% change in average monthly prices

300
250
200
150
%

100
50
0
May-13

Nov-13

May-14

Nov-14

May-15

Nov-15

May-16

Nov-16

May-17

Nov-17
Feb-18
Aug-13

Feb-14

Aug-14

Feb-15

Aug-15

Feb-16

Aug-16

Feb-17

Aug-17

-50

Date

monthly change in price three months moving average

Huge monthly price fluctuations range up to 250%. (Source: coinmarketcap.com)

 d) Bitcoin supply:

Bitcoin: Coin supply and Hashrate

18 35
16 30
Million bitcoin

14
25

Exa hash/s
12
10 20
8 15
6 10
4
2 5
0 0

Time

coin supply Hash rate

The coin supply curve has several changes in the slope. The slope decreased in late 2012, and finally
decreased again in mid-2016. The slope change is due to the block reward at each point of change.
Despite the increase in the hash rate, or “hash Power”, used for mining, Bitcoin supply is still restricted
to a smooth pattern. The increasing hash power means increasing difficulty and, thus, less rewarding.
(Source: Bitcoin.com)

Bitcoin: Change in bitcoin supply: first drop

0.14
0.12
0.1
0.08
% change

0.06
0.04
0.02
0

2012-2013

The average daily bitcoin supply after the first drop, after 1st December, 2012 until 11th July, 2017, is
3979 coins. (Source: Bitcoin.com)
 Bitcoin: Change in bitcoin supply: second drop
0.035
0.03
0.025
% change

0.02
0.015
0.01
0.005
0

2016-2017

The average daily bitcoin supply after the second drop, after 11th July, 2016 until today, is 1906 coins.
(Source: Bitcoin.com)

e) Number of transactions, fees, and block size

Bitcoin: Transaction fees and average block size

1.2 700
1 600
Satoshi per byte

500
Megabyte

0.8
400
0.6
300
0.4
200
0.2 100
0 0
12/30/2013 12/30/2014 12/30/2015 12/30/2016 12/30/2017
Axis Title

7 days moving average of the block size

7 days moving average of the transaction fee rate (RHS)

The larger the block size, the more transaction it holds which requires higher transaction cost. The block
size is limited to one megabyte. Bitcoin has approached the full capacity block size many times.
Recently, the average block size reaches 80% of the capacity. However, in this graph the correlation is
very weak between both, block size and transaction rate. The transaction rate is calculated as satoshi,
0.00000001 BTC. The transaction cost increases by the increase in bitcoin value (e.g. in USD). The satoshi
per byte cost, depends on the number of transactions per day. (Source: Bitcoin.com)
 Bitcoin: Blocksize and number of transaction
1.2 600

Thousand transaction
1 500

0.8 400
Megabyte

0.6 300

0.4 200

0.2 100

0 0

7 days moving average of block size Number of transactions

The blocksize is dependent on the number of transactions. (Source: Bitcoin.com)

Bitcoin: block size and transaction fees in USD

1.2 70
1 60
50
Megabyte

0.8
40

USD
0.6
30
0.4 20
0.2 10
0 0

Date

7 days moving average of block size Average transaction fees in USD (RHS)

There is no clear relationship between both variables. The correlation coefficient is around -0.04 which
is very weak to infer the dependency of transaction fees on the block size only. (Source: Bitcoin.com)
 Bitcoin: Number of transactions and
transaction fees in USD
600 70
500 60
400 50
40
300
30
200 20
100 10
0 0

Number of transactions Average transaction fees in USD (RHS)

As number of transactions increases, the block size increases and the associated USD transaction fees
increase. (Source: Bitcoin.com)

f) Mining profitability:

Mining profitability: Bitcoin and Ethereum. The mining profitability is measured in dollar for each
Mhash/s mined. Mega hash per second is the mining power for crypto currency miners.
(Source: bitinfocharts.com)

Bitcoin average transaction fee:

The average transaction fees boomed during the bubble in December, 2017 and tend to decrease
substantially until its average reached 1 USD in recent days. The transaction cost is paid to the blocks’
miners where the transaction is processed. (Source: bitinfocharts.com)
 g) Transaction cost and price Bitcoin versus Ethereum:

The transaction cost has a strong relationship with the price of bitcoin. Data collected for one
year2017/2018. The transaction fee is a function of the price of Bitcoin. (Source: bitinfocharts.com)

One month weighted moving average of the transaction fees and the price of Ethereum. Data collected
for one year 2017/2018. (Source: bitinfocharts.com)

f) Difficulty rate:

Bitcoin: Difficulty rate of bitcoin mining (2009=1)

4.5E+12 0.16
4E+12 0.14
3.5E+12 0.12
3E+12 0.1
2.5E+12
0.08
2E+12
1.5E+12 0.06
1E+12 0.04
5E+11 0.02
0 0

Difficulty 6 weeks MA of % change in difficulty (RHS)

The difficulty index, is very consistent with mining profitability graph. The mining difficulty index has
been increasing from 1 in 2009 until it reaches around 3.9 trillion.

Source: https://bitcoinwisdom.com/bitcoin/difficulty
 Bitcoin: Hash power and difficulty rate
35

30

25
Exa hash/s

20

15

10

0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
Tera

A linear relationship could be inferred from this graph. Any increase in the hash rate leads to a linear
increase in the difficulty rate and thus an increase in the energy consumption. (Source: Bitcoin.com)

Estimated average annual energy consumption of bitcoin:

(Source: bitcoinenergyconsumption.com)

(Source: Bloomberg.com / SurveyMonkey.com)

Other sources:

• coinmarketcap.com
• Bloomberg.com
• bitinfocharts.com
• surveymonkey.com
• bitinfocharts.com
• bitcoinwisdom.com
• bitcoin.com
• bitcoinenergyconsumption.com
• bitcoin.org/en/developer-guide
• coinhils.com