Quant. Finance

Digital currency price formation

The paper investigates the long-run relationship between the bitcoin-USD exchange rate and its marginal cost between July 2010 and July 2022. We derive Bitcoin’s marginal cost of production from a model of Bitcoin mining grounded in the Bitcoin code, and show that its production cost is a function of only two variables, the electricity price and the mining hardware efficiency. We then estimate a time-varying vector error correction model, and also the cointegration between bitcoin’s price and Bitcoin network’s hash rate, a commonly used production cost proxy. Our results show that the time-varying cointegration between bitcoin’s price and its hash rate is permanently in disequilibrium, bar a short time interval between March 2017 and January 2018. Consequently, although bitcoin’s price and the hash rate are cointegrated, it is clear that the latter does not function as a stable long-run explanatory variable for bitcoin price dynamics. On the contrary, we found that bitcoin’s price and its marginal cost of production have been cointegrated since its inception, and that their time-varying long-run relationship always reverts towards equilibrium - and often to equilibrium- after long periods of divergence. These results contrast with most of the empirical literature that attempted to model the relationship between bitcoin and its fundamentals in a time-invariant framework, but are consistent with recent research showing a significant role for production cost in the determination of bitcoin’s price dynamics.

International financial regulation of cryptoassets and Asset-Backed Tokens

Cryptoassets have recently attracted the attention of national and international financial regulators. Since the mid-2010s blockchains have increasingly been adapted to automate and replace many aspects of financial intermediation, and by 2015 Ethereum had created the smart contract language that underpins the digitisation of real assets as asset-backed tokens (ABTs). Those were initially issued by FinTech companies, but more recently banks active on international capital and financial markets, and even central banks, e.g., the Bank of Thailand, have developed their own digital platforms and blockchains. A wide variety of real and financial assets underpins assets-backed tokens, viz., real estate, art, corporate and sovereign bonds, equity. Consequently, and owing to the significant market capitalisation of cryptocurrencies, the Basel Committee on Banking Supervision (BCBS) published two consultative papers delineating its approach on cryptoasset regulation. We analyse the mechanics of asset-backed tokens and their potential risks, relying on case studies of recent issuance of tokens in equity, real estate, and debt markets, to highlight their main characteristics. We also investigate the consequences of the increasingly oligopolistic structure of blockchain mining pools and bitcoin exchanges for the integrity and security of unregulated distributed ledgers. Finally, we analyse the BCBS’s regulatory proposals, and discuss the reaction of international financial institutions and cryptocurrency interest groups. ur main findings are, firstly, that most ABTs are akin to asset-backed securities. Secondly, nearly all ABTs are ``off-chain/on-chain”, i.e., the underlying is a traditional asset that exists off-chain and is subsequently digitised. The main exception is the World Bank’s bond-i that is genuinely native to the blockchain created by the Commonwealth Bank of Australia, and has no existence outside it. Thirdly, all ABTs are issued on permissioned blockchains, where anti-money laundering/anti-terrorist funding and know-your-customer regulations are enforced. From a prudential regulatory perspective, ABTs do not appear to pose serious systemic risks to international financial markets. This may account for the often negative reactions of banks, banking associations, and cryptocurrency interest groups to the BCBS’s 2021 proposals for risk-weighted capital provisions for cryptoassets, which are viewed as excessive.Finally, we found that issuance of ABTS and other smart contracts on permissionless blockchains such as Bitcoin and Ethereum could potentially generate financial instability. A precedent involving Ethereum and The DAO in 2016 shows that (i) there is a significant accountability gap in permissionless blockchains, and (ii) that the core developers of blockchains and smart contract technology, and bitcoin mining pools, exercise an unexpectedly high –and completely unregulated- amount of power in what is supposedly a decentralised network.