INTRODUCTION

The cryptocurrency market has evolved erratically and at unprecedented speed over the
course of its short lifespan. Since the release of the pioneer anarchic cryptocurrency,
Bitcoin, to the public in January 2009, more than 550 cryptocurrencies have been
developed, the majority with only a modicum of success. Research on the industry is
still scarce. The majority of it is singularly focused on Bitcoin rather than a more diverse
spread of cryptocurrencies and is steadily being outpaced by fluid industry developments,
including new coins, technological progression, and increasing government regulation of
the markets. Though the fluidity of the industry
does, admittedly, present a challenge to
research, a thorough evaluation of the cryptocurrency industry writ large is necessary.
This paper seeks to provide a con
cise yet comprehensive analysis of the cryptocurrency
industry with particular analysis of Bitcoin
, the first decentralized cryptocurrency
.
Particular attention will be given to examining theoretical economic differences between
existing coins.
Section 1
of this paper provides an overview of the industry
.
Section 1.1 provides a brief
history of digital currencies, which segues into a discussion of Bitcoin in section 1.2.
Section 2 of this paper provides an in-depth analysis of coin economics, partitioning
the
major currencies by their network security protocol mechanisms, and discussing the long-
term theoretical implications that these classes entail.
Section 2.1 will discuss network
security protocol.
The mechanisms
will be discussed in the
order that follows. Section 2.2
will discuss the proof-of-work (PoW) mechanism used in the Bitcoin protocol and various altcoins. Section 2.3
will discuss the proof-of-stake (PoS) protocol scheme first
introduced by Peercoin in 2011, which relies on a les
s energy intensive security
mechanism than PoW. Section 2.4 will discuss a hybrid PoW/PoS mechanism. Section
2.5
will discuss the Byzantine
Consensus mechanism. Section 2.6
presents the results of a
systematic review of 21 cryptocurrencies. Section 3 provi
des an overview of factors
affecting industry growth, focusing heavily on the regulatory environment in section 3.1.
Section 3.2 discusses
public perception and
acceptance of cryptocurrency as a payment
system in the current retail environment. Section 4 concludes the analysis.
A note on sources: Because the cryptocurrency industry is still young and factors that
impact it are changing on a daily basis, few comprehensive or fully updated academic
sources exist on the topic. While academic work was of cours
e consulted for this project,
the majority of the information that informs this paper was derived from White Papers or
synthesized using raw data.
A note on terminology: When used in its conceptual or possessive sense, “Bitcoin” will
be capitalized, but when used in its unit sense, it will not be (i.e., “Bitcoin protocol”
versus “2,000 bitcoins”). The abbreviation “BTC” will also be used to refer to Bitcoin
units. All other altcoins will be referenced by their capitalized names.
SECTION 1: INDUSTRY OVERV
IEW
1.1 A BRIEF HISTORY
Although the concept of electronic currency dates back to the late 1980s, Bitcoin,
launched in 2009 by pseudonymous
(and still unidentified)
developer Satoshi Nakamoto,
is the first successful decentralized cryptocurrency
. In short, a cryptocurrency is a
virtual coinage system that functions much like a
standard currency
, enabling users to
provide virtual payment for goods and services free of a central trusted
authority.
Cryptocurrencies rely on the transmission of digital information, utilizing cryptographic
methods to ensure legitimate, unique transactions.
Bitcoin took the digital coin market
one step further, decentralizing the currency
and freeing it from h
ierarchical power
structures
. Instead, individuals and businesses transact with the coin electronically on a
peer
-
to
-
peer network. It caught wide attention beginning in 2011, and various altcoins
–
a
general name for
all other cryptocurrencies post
-
Bitcoin
–
soon appeared.
Litecoin was released in the fall of 2011, gaining modest success and enjoying the
highest cryptocurrency market cap after Bitcoin until it was overtaken by Ripple on
October 4th, 2014. Litecoin modified Bitcoin’s protocol, increasing t
ransaction
speed
with the idea that it would
be more appropriate for day
-
to
-
day transactions. Ripple,
launched in 2013, introduced an entirely unique model to that used by Bitcoin and
currently maintains the second highest market capitalization of approxim
ately $255
million (April 22)

. Another notable coin in the evolutionary chain of
cryptocurrency, Peercoin, employs a revolutionary technological
development to secure
and sustain its coinage

. Peercoin merges the PoW technology used by Bitcoin and
Litecoin
along with
its own
mechanism
, proof-of-stake (PoS), to employ a hybrid
network security mechanism.
More recently
NuShares/NuBits
have emerged
, introduced
in August 2014, which rely on a dual currency model almost entirely divorced from the
single currency model used by previous coins.
At the time this paper was written, the cryptocurrency industry consisted of over 550
coins
with varying user bases and trade volumes
[
1
]
. Because of high volatility,
the
market capitalization of the cryptocurrency industry changes dramatically, but is
estimated at the time of this paper to be just over $3.5 billion, with Bitcoin representing
approximately 88% of the market cap
[
1
]
.
1.2 IN THE BEGINNING WAS BITCOIN
Bitcoin is an open source, peer
-
to
-
peer digital currency first proposed in a 2008 white
paper
published under the name of Satoshi Nakamoto
.
Nakamoto
begins his paper by
stating that “Commerce on the Internet has come to rely almost exclusively on financial
institutions serving as trusted third parties to process electronic payments. While the
system works well enough for most transactions, it still su
ffers from the inherent
weakness of the trust based mo
del”
[
2
]
. Further, the
existence of
a trusted intermediary
increases transaction costs, “cutting off the possibility for small casual transactions
.”
Additionally, the trusted intermediaries are pressured to gather as much information
about the parties as possible in order to control transaction costs. Hence, Nakamoto
sought to create a coin that completely removed any trusted central authority and repl
ace
trust with cryptographic proof
.
This system would have the added benefits of having low
transaction fees, low latency (time to make transactions), and pseudo
-
anonymity.
A bitcoin, and every subsequent cryptocurrency, is merely “a chain of digital
signatures”
where “Each owner transfers the coin to the next by digitally signing a hash of the
previous transaction and the public key of the next owner and adding these to the end of
the coin” so that ownership can dynamically b
e programmed into the coin
[
2
]
. Further,
these lines of computer code are stored in a program called a “wallet” on personal hard
drives and/or via online wallets like Coinbase.
Li
ke cash or commodities, bitcoins
can be
lost, stolen or destroyed. One British man became famous for throwing out his hard drive,
and with it his wallet containing over 7,000 BTC, which had a market value of
approximately $7 million at the time
[
6
]
.
The prominent B
itcoin exchange, Mt. Gox, had
nearly $350 million worth of bitcoin stolen in February 2014, forcing the exchange to
declare bankruptcy and highlighting security issues within the cryptocurrency world
[
7
]
.
Bitcoins can only be sent or received by logging the transaction on the public ledger, also
known as the “blockchain.” Bitcoins lack intrinsic value; rather, Bitcoin’s value is purely
a function of supply and demand
[
8
]
. Unlike paper “fiat currency” that derives value from
a government, Bitcoin is neither created by, nor backed by, any government.
Bitcoin
protocol seeks to solve the double
-
spending problem (essentially, spending the
same
coin
more than once) inherent in non
-
cash payment systems resulting in the need for a trusted
third party (such as a bank or credit card company) to verify the inte
grity of the
transaction. Double
-
spending occurs when an asset is duplicated, and thus can be spent
multiple times. This problem does not exist in physical currencies, since transactions
involve changing possession of property. However, a digital file has
the potential to be
copied. The security of cryptocurrency, however, and its ability to safeguard against such
digital copying, is inherent in its blockchain or public ledger systems. These systems
keep records of ownersh
ip and transaction timestamps,
elim
inating the possibility of
digital copying and, thus, double
-
spending. The mechanism used to secure the network is
discussed deeply in section 2. In the case of Bitcoin, a transaction is only complete and
added to the blockchain once a required amount of c
omputational power is used so as to
satisfy the proof
-
of
-
work (discussed in section 2.1). The transaction at this point is
considered complete, and ownership of the coin has been absolutely transferred, without
fear of double
-
spending, because the entire n
etwork becomes informed of
wh
ich wallet
the coin currently resides in.
Bitcoin was introduced to the public on January 3rd, 2009, but traded for less than a
dollar until February 2011
[
1
]
. Bitcoin
reached an all
-
time high of $1151/coin on
December 4th, 2013, and has since steadily declined
(see figure 8
)
. Despite this decline, it
is apparent that
daily trading volume has held steady
for the past year (see figure 5
).
Further, the number of
unique
transactions,
including (see figure 1) and
excluding
popular addresses (
see figure 2
), is increasing steadily, despite a sliding price
[
9
]
.
SECTION 2: COMPETING CRYPTOCURRENCIES
According to coinmarketcap.com, there are just over 550 distinct cryptocurrencies at the
time this paper is written
[
1
]
. Thus, the cryptocurrency industry includes much more than
just Bitcoin, although Bitcoin has a market capitalization of approximately 3.3 billion
compared to the total market capitalization of the cryptocurrency industry of 3.8 billion
(86%)
[
1
]
. This section seeks to analyze how competition in the cryptocurrency industry
has evolved since the inception of Bitcoin in 2009. Specifically, it explores the evolution
of network security protocols and changi
ng trends in coin economics.
2.1 NETWORK SECURITY PROTOCOL
Perhaps Bitcoin’s greatest technological achievement (and the sine qua non of every
altcoin) is building a peer
-
to
-
peer transaction system that relies on “cryptographic proof
rather than trust”
[
2
]
. However, replacing a central authority presents a unique problem
with a solution that is not obvious. First, the coin needs to be able to change ownership.
Transactions are recorded by combining the di
gital signatures of each party and a
timestamp, so that the transaction date is recorded. This new code represents the coin and
its path through the network. This code is then broadcasted to all nodes (computers
connected to and running the cryptocurrency
network software) on the network.
However, it is necessary that the majority of the nodes agree on transactions that have
occurred, otherwise double
-
spending and denial
-
of
-
service (DoS) attacks can occur. The
mechanism used to reach consensus among nodes p
uts integrity in the system by
verifying that the transaction is indeed legitimate. Hence, transactions are verified, and
the system made secure, by implementing certain mechanisms that make it too costly to
violate the integrity of the system. Larry Ren,
developer of Reddcoin, notes, “The
underlying principle of such a mechanism is the necessity of expending resources when
confirming transactions”
[
10
]
. Various cryptocurrencies have developed novel reso
urces
to use as a means of network security. The resource can be a combination of electricity,
time, or temporary surrender of coinage, and represents the cost to secure the network.
Miners
-
those who own the underlying resource, and thus expend it
-
secu
re the network,
and are compensated for their work in the form of either transaction fees or newly minted
coins. The mechanism used to secure the network determines the resource chosen and the
method used to pay the miners. Thus, the underlying network sec
urity mechanism of each
coin has a significant impact on the underlying economics of the coin. Sections 2.2
through 2.5 explain the most widely used mechanisms in the industry. Section 2.6
presents the results of a systematic literature review of 21 coin w
hite papers and resulting
conclusions.
. Once a node
finds a solution to the problem, the PoW requirements are considered satisfied, and the
new (block+nonce+hash
) is added to the blockchain and broadcasted to all nodes.
Because only one block can be verified at a time, the probability a node will solve for the
correct hash increases proportionally with the amount of CPU power expended. Hence,
the resource
s consume
d in this instance are
electricity and time, which
are
indeed scarce.
2.2.2 BITCOIN MINING
The entire process undergone by each node is called mining, because in each block that is
verified, the node (now the miner) receives a payment for his service. Mi
ners are rational
profit seekers,
so in order to incentiviz
e individuals to mine, the Bitcoin protocol offers
rewards in two forms: transaction fees and newly minted coins, called mined coins
[
2
]
.
Each bl
ock that gets verified under the Bitcoin protocol introduces new coins to the
market, which are given to the miner as payment fo
r the energy and time expended
[
2
]
.
This number decreases with time so that
there will never be over 21 million BTC in
existence
[
2
]
. In this way, Bitcoin functions similarly to commodities like gold: “The
steady addition of a constant amount of new coins is analogous to gold min
ers expending
resources to add gold to circulation”
[
2
]
. Hence, in the long run, transaction fees will
likely have to increase to compensate miners appropriately. A major criticism of the PoW
mechanism is
the massive amounts of energy it consumes, with no other benefit than to
verify transactions. Thus, as the mint rate slows in the Bitcoin network, “eventually it
could put pressure on raising transaction fees to sustain a preferred level of security”
[
13
]
.
It is already evident that miners’ revenue has been declining dramatically (see figure
6).
2.2.3 HASHING ALGORITHMS
In addition to the network security mechanism, hashing algorithms also affect the coin.
For PoW mechanisms, the hashing algorithm and the target difficulty of the hash dictate
how many hashes
-
how much energy
-
is expected to be spent. Because miners are
incentivized to find ever more powerful computing equipment, this has created a mining
arms race. For instance, mining originally was carried out by CPU (Central Processing
Unit)
;
however, the same functions could be carried out by GPU (Graphics Processing
Unit) at a much faster rate. GPUs then gave way to Application Specific Integrated
Circuits (ASICs), designed to carry out PoW mining at incredible speeds
-
magnitudes
higher than could be done through GPUs. The SHA
-
256 algorithm used in Bitcoin and
vario
us altcoins felt the brunt of this arms race, and many coins have introduced
2.6 RESULTS
This section presents the results of a systematic review of
coins which meet two criteria:
they have a market capitalization, as measured by coinmarketcap.com, of at least $1
million as of April 2015, and they were released prior to J
anuary 1
st
, 2015, so as to allow
a maturity time. There were 21 coins that met the
se parameters. The primary method of
review was through their white papers, although several coins did not have white papers,
in which case the material was gathered from the coins’ websites. Answers to the
question “how has network security mechanisms in
the cryptocurrency industry evolved
since the inception of Bitcoin in 2009?” can now be drawn from the information that
follows. The table below summarizes the major characteristics of each coin, listed in
descending order of market capitalization