EC247: Financial Instruments and

Capital Markets

Lecture 1: Cryptocurrencies

Christoph Siemroth
Why take this module?
 Careers: banking, business
 Further study in financial economics
 Finance third year modules
 Master degree programmes
 Reading the Financial Times (FT)
 Understanding the financial
crisis of 2007-09
 Understanding investment
classes and risks to
improve your savings
decisions
 New meme every lecture
Aims of this module
 Understand basics of cryptocurrencies
 Building blocks for understanding the financial system
 What are bonds, equities, options, swaps, repos, etc.?
 How are they traded?
 Cast light on 2007-09 financial crisis
 What happened?
 Why did it all go so wrong?
 How can we prevent it from happening again?
 Introduction to Behavioural Finance
 How can experiments help us understand financial decision making?
 Thaler Nobel Prize 2017, Vernon Smith 2002
Module organisation
 Lectures
 Autumn term: Wednesday 0900-1100
 Classes Thursday 1000-1100 (starting in week of second lecture)
 Do ask questions during or at the end of each lecture/class
 Academic support hours during term time:
 Drop by my office. Friday 1300-1500, office 3.204
 Slides and module related documents on Moodle
Assessment
 Midterm multiple choice exam (50% weight), summer multiple
choice exam (50% weight)
 Most questions are multiple choice
 Some questions ask you to calculate numbers (e.g., bond yields)
without giving you answer options
 Old exams are also on Moodle, but the format was different then
 There will be practice quizzes on Moodle, which are the same format as
the exams
 Already online for this week’s topic – check it out!
 New practice exams will be unlocked with every lecture
Books
 Textbook that lectures 2-8 are based on:
 Glen Arnold, Modern Financial Markets and Institutions, Pearson
Education, 2012
 This is recommended reading
 In particular, if you don’t understand something, you should look it up in the
book
 Uni library has physical and digital copies
 More readings given in each lecture when appropriate
Successfully completing this module
 Attend lectures
 Take notes
 Ask questions
 Review lectures
 Useful: Readings for each topic to deepen your knowledge
 Classes and exercises
 Exercises released in advance on Moodle
 Solve class exercises in advance, compare in class with solutions
 First try to solve them yourself. That’s how you learn and where you see
where you have difficulties
 Only looking at solutions later gives you the illusion of understanding
 Prepare for the exams (!!)
Overview of the module
1. Cryptocurrencies
2. Financial intermediation, bank runs
3. Money markets
4. Bond markets
5. Securitisation; credit rating; financial crisis
6. Equity (stock) markets
7. Derivatives I: futures and options
8. Derivatives II: credit derivatives
9. Behavioural finance I: Experiments on asset bubbles
10. Behavioural finance II: Experiments on efficient market hypothesis
and investor biases
Cryptocurrencies
Learning outcomes
At the end of the topic the student should understand:
 What a cryptocurrency is, what the initial goal in designing them
was, and how they function
 The volatility of crypto prices
 How cryptocurrencies can attain consensus and prevent some
forms of cheating
 The difference between proof-of-work and proof-of-stake
 Bitcoin: why it is so energy intensive
 To what degree cryptocurrencies are currencies, or rather
speculative financial assets
 Why crypto-exchanges may be useful, what their issues are
Literature
 Main reading:
 Halaburda, H., Haeringer, G., Gans, J., & Gandal, N. (2022). The
microeconomics of cryptocurrencies. Journal of Economic Literature,
60(3), 971-1013. On Moodle
 Background reading:
 For bitcoin functioning: Böhme, R., Christin, N., Edelman, B., & Moore,
T. (2015). bitcoin: Economics, technology, and governance. Journal of
Economic Perspectives, 29(2), 213-238.
 Murabito, E. (2019). The 51% Attack. What is it?
 On negative effects on society: Benetton, M., Compiani, G., Morse, A.
(2023). When cryptomining comes to town: High electricity use
spillovers to the local economy.
 Ethereum Proof of Stake
Cryptocurrencies by market cap
 Market capitalization: Top 100 cryptocurrencies by $-
 outstanding units * market market capitalisation, 24 Sept 2023

price, a measure of
financial size
 First bitcoin: $518 billion
 That’s $518,179,328,346
 Second Ethereum: $190
billion
 The top 5 account for more
than 75% of market cap
among the top 100 currencies
 For comparison,
S&P 500 market cap: $36,000 Bitcoin Ethereum Tether
billion BNB XRP Rest
 That’s ~72 times bitcoin
market cap
 As of Sept 2023
Crypto market cap vs public firms
 All cryptocurrencies taken
together would be 6th
largest public firm in the world
 bitcoin would be 11th largest
public firm in the world All cry
 So even by conventional pto
metrics, crypto by now has $1.2T
significant size
 As of Sept 2023
bitcoin
Motivation behind bitcoin
 Satoshi Nakamoto – an alias – published his famous bitcoin white
paper online in 2008
 Main question: How to create a digital currency that is fully
decentralized?
 That is, functions without central authority (such as central bank or
government)
 Interesting to libertarians and cryptographers alike
 No scope for traditional monetary policy, since no central bank
 Preventing cheating not easy: Anything digital can be copied
 You could double your “bank balance” with a click!
 New solution: Need consensus among participants about who spent
which coin
Basics of bitcoin
 1 bitcoin as unit of account (instead of 1 US dollar), 1 satoshi is 1
bitcoin / 100 million
 A user has a wallet (“virtual bank account”) to keep bitcoins
 Wallet is a public bitcoin address (“account number”) and a private key
(“password”)
 Wallet is free and pseudo-anonymous (owner identity unknown, but all
transactions are publicly visible)
 To send bitcoins to someone else, need address of recipient’s wallet
and own private key to authenticate
 Miners validate transaction and record into blockchain

“Biggest” wallet as of Sept 2023:

Processing transactions
 Transactions are broadcasted to the bitcoin network and processed
by miners
 Many miners in the network, each with a copy of the blockchain
 Anybody can be a miner, no entry fees or requirements
 But success needs good computer hardware
 Blockchain contains history of all transactions
 Blockchain often called “ledger”
 Someone who never transacted does not show up in blockchain
 Easy to detect cheating/tampering with record
 That’s the crypto part (hashing)
 Miner processes recent transactions in a block
 Block also contains block reward for miner, i.e., newly created bitcoins
(and voluntary transaction fees)
Transacting in a nutshell

Blockchain
lists trans-
actions, not
balances
(“flow, not
stock”).

Balances
can be
inferred by
adding up
all trans-
3 from X 3 from Alice 3 from Bob actions.
to Alice to Bob to Charlie
Attractive for criminals
Reasons:
 bitcoin does not ban any transactions (e.g., drugs)
 bitcoin does not ban any individual (e.g., sanctioned individuals or
embargoed firms/countries)
 bitcoin does not require someone to identify themselves (e.g., to
pursue money laundering)
 bitcoin is pseudo-anonymous, because identities not known, but not
anonymous, as still visible which “alias” is doing what
 bitcoin does not reverse transactions
 If someone steals your private key and transfers your bitcoin elsewhere,
you can’t get it back
 All of this is usually different at crypto exchanges!
“Money creation” in bitcoin
 Miners: Adding block to
blockchain yields newly
created bitcoins as reward
 Amount of new bitcoins set
by protocol
 Block reward is halved every
~4 years
 Every 210,000 blocks
 Total number of bitcoins is
capped at 21 million, reached
in ~2140
 Active bitcoin volume might
decrease in future, as users
lose wallets/keys
Mining is a contest
 Processing transactions and creating
new block is computationally
expensive (proof-of-work, PoW)
 First miner to “solve a puzzle” adds
next block and gets reward
 More computational power
increases chances of being first,
but doesn’t guarantee it
 Difficulty of puzzle is regularly
adjusted, so that it takes ~10 min for
each new block/puzzle
 Even if number of miners
doubles, blocks don’t get added
faster medium run
 “Losers” have equipment and energy
costs: financial losses
 Big competition for rewards, lots of
wasted energy
 Why can’t miner falsely claim to be bitcoin mining hardware
first?
 Solution easy to verify but hard to
find
Global energy use by bitcoin miners
 Miner reward is genius concept, but also a curse
 Genius: incentivises miners to process transactions; transacting parties
don’t have to pay (but can pay voluntary transaction fees)
 Curse: increases energy costs for firms and households; environmental
impact (greenhouse gas emissions, electronic waste)

Currently
comparable to
Netherland’s
energy
consumption.
[Link]
net/bitcoin-energy-c
onsumption
bitcoin usage (history)
 Early on (2009): only expert users due to tech knowledge
requirements, low bitcoin value and uncertain future
 Three stages of bitcoin (e.g., Tasca et al., 2018)
 2009-March 2012: Mining with no commercial activity
 2012-early 2014: Most activity with gambling and black markets
 2014 to now: Crypto exchanges make bitcoin accessible for
speculation / investment
 Gambling and illegal activity still about 46% of transactions, but much
lower share in terms of value (Foley et al., 2019)
 In 2018, only 3 out of largest 500 online retailers accepted bitcoin as
payment (The Economist)
 Few legal goods purchased with bitcoin due to volatile exchange rate
and slow processing of transactions
bitcoin price
 Price of BTC increased from ~$150 in mid 2013 to over $1,000 in
late 2013, then fell to $400
 2017, BTC at $19,000, then back to $6,000 in months
 More jumps later; extremely volatile price
 Price history up to Sept 2023: (
[Link]
bitcoin price
Is bitcoin a currency?
A currency should:
 Be a medium for exchange
 BTC slow but ✔
 Be a unit of account
 Could use BTC instead of $
or £ to cite prices ✔
 Be a store of value
 BTC too volatile ✘
BTC more a volatile, speculative
financial asset than a currency
 Research shows most users
hold bitcoin (presumably
waiting for price increases)
 They don’t use it often for
transactions
Does bitcoin have value?
 As financial asset: What is the fundamental value of bitcoin?
 No entitlement to interest payments as with bonds
 No entitlement to a firm’s profits as with common stock, i.e., no
dividends
 Only way to profit is to sell at higher price than you bought
 Person buying from you pays higher price only if they expect next guy to pay
even more, same for buyer after, etc.
 But what if nobody wants to buy from you?
 Holding bonds, you still get interest and a principal from issuer
 Holding stocks, you might still get dividends
 Holding crypto, you get nothing
 The only value of bitcoin comes from someone else’s willingness to buy
at positive price
 If people lose trust in bitcoin, then it loses all value
 Trust and beliefs rather than fundamentals or entitlements drive price –
possible explanation for high volatility
 Security:
Proof of Work vs Proof of Stake
PoW: How to prevent cheating?
 Many ways to cheat imaginable:
 Miner has not solved puzzle, but adds new block for reward
 Miner has solved puzzle, but changed transactions to gain coins
 Also, unintentional disagreements can happen:
 Two miners solve puzzle at same time, broadcast to network
 Some users see miner 1 block first, others see miner 2 block first.
Who should get the reward?
 Happens regularly due to network latency (delay)
 If two miners propose to add different blocks to blockchain,
then the blockchain “forks” into different “branches”
PoW: How to prevent cheating? II
 Nakamoto’s solution to get consensus:
 Miners follow the Longest Chain Rule (LCR):
 Miners choose the chain with most computational power spent (which is typically
the longer one)
 How it works:
 Suppose you want to alter the blockchain to undo a transfer you made
 Since your transaction is several blocks in past, you need to recompute the
puzzle for the original block (which now excludes your own transaction) and
for all subsequent blocks
 Recall that every block has a unique puzzle (depending on its content), so
manipulated past needs to be recomputed
 Requires a lot of computational power. Meantime, the legitimate blockchain
(more computational power) adds blocks faster
 Thus, legitimate chain will be accepted due to LCR, because it is longer
 So undoing previous payment won’t work
 Note: Transactions usually halted for 6 blocks before viewed as confirmed,
e.g., by exchanges
 The longer transactions are halted, the safer it is, as it would
require “rewriting more history”
PoW: How cheating might work
 But what if you have A LOT of
computing power?
 Known as 51% attack
 With more than 51% of
computing power in network,
you could rewrite history and
out-compute the legitimate chain
 Per longest chain rule, network
would accept yours as legit
 Can this actually happen?
 For bitcoin, likely too expensive
to get so much computing power
 You need it for a while to
add several blocks
 But for smaller currencies,
this has already happened With >50% of computing power, an
 Miners of large currency can illegitimate blockchain gets longer over
briefly switch to small time, thus eventually getting accepted
currency to get >50% of
computing power
PoW: Limits of 51% attack in bitcoin
 Can:
 Prevent transactions from being confirmed (e.g., your own payment:
double spending)
 Prevent other miners from getting block rewards
 Cannot:
 Execute transactions that were never initiated by another user (needs
their private key)
 Prevent new transactions from being broadcasted (can only block
validation)
 Generate new coins outside of block rewards
 Change block rewards (determined by protocol)
 [Link]
ting_power
Proof of Stake (PoS)
 Ethereum switched from PoW to PoS in Sept 2022
 Semantics: Ethereum is the network/tech, ether the currency
 Goals: More security, less energy consumption, easier participation
 Switch reduced network energy consumption by estimated 99.86% to
99.99% (de Vries, 2023)
 Achieved by using financial collateral, rather than computing power, to
make and verify new blocks

Proof of Work Proof of Stake

Participating nodes are called miners Participating nodes are called validators

Mining capacity depends on computational Validating capacity depends on stake in the

power network
Mining produces new coins Validation produces new coins
Miners receive block rewards Validators receive block rewards
Massive energy consumption Moderate energy consumption
How does Ethereum PoS work?
 No more miners; instead, system uses validators
 A validator has to stake some ether (ETH), it is a collateral that can be
taken away if validator cheated or misbehaved
 Validators create new blocks and validate blocks someone else
proposed
 One validator randomly chosen every 12 sec (fixed, in bitcoin
stochastic) to propose new block with all new valid transactions
 Subset of remaining validators vote on validity of new block
 The more ETH staked, the more votes you get and the higher chance of
becoming proposer
 If validated by 2/3 of stakes, new block is accepted and proposing
validator receives reward and transaction fees
 Validators are effectively saying: “I guarantee this is the right block with
my wealth. If later the blockchain omits or changes this block, then my
wealth may be taken.” Collateral
How does Ethereum PoS work? II
 It could still happen that two competing blocks are at end of chain
(e.g., due to cheating or network latency)
 How does the network reach consensus? (bitcoin: LCR)
 Essentially, the fork with the biggest weight of votes is chosen
 Thus, 51% attack (of stakes) doable, but very costly
 In PoW, you can briefly rent computing power to get to 51%
 In PoS you have to have a lot of “cash” staked to get to 51%
 Active research on other attacks that do less but also need less % of
stake
 As in bitcoin, it takes several blocks before a transaction is
considered “finalized”
 Idea is that it is harder to add multiple blocks to a manipulated chain
than just one
Does ether have value?
 Same arguments as for bitcoin (no), except:
 As a validator, holding ether, you can earn more ether
 Currently yearly return by validating estimated to be 4%
 But of course you might lose much more than 4% if the ether price drops, so
still risky
 Indeed, risk of losing trust in currency is similar to bitcoin
 What good is it to earn more ether as validator, if ether becomes worthless?
Crypto Exchanges
Why exchanges?
 Exchanges exchange crypto for other crypto or official currencies
such as $ and £
 bitcoin was built to be decentralised, whereas an exchange is a
central place to trade
 Exchanges take transaction fees, plus privacy less protected
 So why did trading predominantly go to exchanges?
 Easier to exchange BTC to $ and back
 Without exchange, would have to find trading partners yourself,
negotiate prices, exchange BTC for $ at same time (theft risk)
 Easy to use for beginners
 Offer derivatives (new financial products)
 Same for stocks, could potentially trade “peer to peer” without
exchange, but retail investors rarely do
 Large financial institutions do trade off exchange, however
Crypto risks
 Many exchanges have ceased operations, went bankrupt, or “ran
away with the money”
 Theft of crypto / security breaches at exchanges happen regularly,
compared to banks
 Exchange security might be worse than cryptocurrency security
 Exchanges typically require identity, so not anonymous
 Off-exchange transactions non-reversible, so mistakes are costly
 Volatile prices: Majority of investment can be lost quickly
 For smaller currencies: Selling a lot quickly is difficult and costly
(price moves against high volume seller)
 bitcoin wallet is digital file. If hardware storing file is destroyed/lost,
then coins are lost