NBER WORKING PAPER SERIES A MODEL OF CRYPTOCURRENCIES

We model a cryptocurrency as membership in a decentralized digital platform developed to facilitate transactions between users of certain goods or services. The rigidity induced by the cryptocurrency price having to clear membership demand with supply of token by speculators, especially with strong complementarity in membership demand, can lead to market breakdown. While user optimism mitigates the market fragility by increasing user participation, speculator sentiment exacerbates it by crowding users out. Informational frictions attenuate the risk of breakdown by dampening price volatility and platform performance. Furthermore, the users' anticipation of losses from strategic attacks by miners exacerbates the market fragility. Michael Sockin Department of Finance UT Austin McCombs School of Business Austin, TX 78712 michael.sockin@mccombs.utexas. edu Wei Xiong Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08450 and NBER wxiong@princeton.edu The rapid growth of the cryptocurrency market in the last few years promises a new funding model for innovative digital platforms. Rampant speculation and volatility in the trading of many cryptocurrencies, however, have also raised substantial concerns that associate cryptocurrencies with potential bubbles. The failure of the DAO only a few months after its ICO raised $150 million in 2016, together with a number of other similar episodes, particularly highlights the risks and fragility of cryptocurrencies. Understanding the risks and potential benefits of cryptocurrencies requires a systematic framework that incorporates several integral characteristics of cryptocurrencies– their roles in funding digital platforms and in serving as investment assets of speculators, and their integration of blockchain technology with decentralized consensus protocols to record transactions on the platforms. We develop such a model in this paper. Specifically, our model analyzes the properties of utility tokens, a subset of cryptocurrencies along with coins and security tokens. Utility tokens are native currencies accepted on decentralized digital platforms that often provide intrinsic benefit to participants.1 The benefits of utility tokens can range from provision of secure and verifiable peer-to-peer transaction services to the maintenance of smart contracts. Examples of such utility tokens include Ether, which enables participants to write smart contracts with each other, Filecoin, which matches the demand and supply for decentralized computational storage, and GameCredits, which finances the purchase, development, and consumption of online games and gaming contents. The development of these platforms is financed by the sale of tokens to investors and potential users through the issuance of utility tokens. In our model, a cryptocurrency serves as membership to a platform, created by its developer to facilitate decentralized bilateral transactions of certain goods or services among a pool of users by using a blockchain technology. Users face diffi culty in making such transactions outside the platform as a result of severe search frictions. The value of the platform, consequently, lies with its design in filling the users’transaction needs, and in its capability in pooling together a large number of users with the need to transact with each other. We 1In contrast, coins (and altcoins), such as Bitcoin and Litecoin, are fiat currencies that are maintained on a public blockchain ledger by a decentralized population of record keepers, while security tokens are financial assets that trade in secondary markets on exchanges, and whose initial sale is recorded on the blockchain of the currency that the issuer accepts as payment. Coins are typically created through "forks" from existing currencies, such as Bitcoin Gold from Bitcoin, and by airdrops, in which the developer sends coins to wallets in an existing currency to profit from the price appreciation of its retained stake if the new currency becomes widely adopted. Security tokens are typically sold through ICOs structured as "smart contracts" on existing blockchains such as that of Ethereum.