Athey et al. (2016): Bitcoin Pricing, Adoption, and Usage: Theory and Evidence | Article Review
This is a non-technical review of the paper "Bitcoin Pricing, Adoption, and Usage: Theory and Evidence" by Susan Athey, Ivo Parashkevov, Vishnu Sarukkai, and Jing Xia. The paper is a working paper available on SSRN, but to my knowledge it hasn't yet been published in a peer-reviewed academic journal. (SSRN is a distribution network and not a peer-reviewed journal.) However, Susan Athey is a well known economist from Stanford with serious technical chops, and her work is considered highly credible.
The review was motivated by this post by @siggy47: #726129

Overview

This is a "theory and evidence" type paper with the goal of understanding what gives Bitcoin "value", and what drives the exchange rate between Bitcoin and fiat (e.g. the "price.") The authors first develop a very simple model with two main forces:
  • The force which motivates Bitcoin adoption is that it can be used for cross-border payments more cheaply than the traditional financial system.
  • The force which motivates against Bitcoin adoption is the risk of network failure. You can think of this as a major problem being discovered in the protocol, an effective ban by the government, or any other external event which would kill the use of the network.
Expectations about the future exchange rate (e.g. price) is also a motivating factor in adoption. But the exchange rate is "endogenous"--meaning it's determined by the model. The fundamental forces are Bitcoin's utility in cross-border payments and the risk of technological failure.
The main result of the paper is that the steady state (i.e. long run) price of Bitcoin is determined by the ratio of its transaction volume to its supply. In other words, if long-run usage is higher then long-run price will be higher, which is not surprising. The price is also expected to increase over time as beliefs about the viability of the technology evolve. This seems consistent with the historical record.
It should be noted that the long-run price dynamics in this paper are not driven by a decline in the real worth of fiat. It is assumed in the paper that the real value of fiat remains constant. Thus, if we assume that the real worth of fiat goes down over time we should expect an even faster growth rate of the Bitcoin price than the adoption rate described by this paper's model.
After describing the model, the paper goes on to do two empirical exercises (i.e. data analyses):
  1. Is the Bitcoin price correlated with transaction volume as the model predicts?
  2. What share of Bitcoin activity appears to be from investors/speculators, what share from illicit activity, and what share from international payments?
Unsurprisingly, they find that the Bitcoin price is correlated with transaction volumes, except in brief periods of extreme price action. Also unsurprisingly, they find that most Bitcoin owners are hodlers who do not spend their Bitcoin. They thus conclude (accurately, in my opinion) that the primary use-case for Bitcoin currently still appears to be as a store of value / investment vehicle. However, they do show evidence that Bitcoin is being used for cross-border payments, and they also show that illicit activity is only a small fraction of the network activity.

Do the authors understand Bitcoin?

One of the first questions Bitcoiners have in their heads when they read an article about Bitcoin is whether or not the author seems to understand Bitcoin. I think these authors do. Here are some quotes from the article that show a solid understanding:
Even defining Bitcoin is complex: it can be described as a protocol, a currency, a payment system, and a technology platform.
--
Unlike a bank balance that can be viewed or manipulated digitally, an individual's Bitcoin is not an IOU or a promise to provide funds on demand; the individual with the passcode associated with an address has full control over its disposition; and that Bitcoin balance is not linked to anything else.
--
One individual can transfer Bitcoins to another anywhere in the world, without relying on counterparties or trust relationships beyond the trust in the software, and indeed without getting authorization to do so from any company or government. All that is ncessary to transfer value elctronically is the passcode to authorize a ledger entry to move the Bitcoins to another address.
--
On the other hand, if the recipient wants to obtain value from the Bitcoins in the short term, she must either find a merchant who will accept them, find an individual buyer for the Bitcoins, or sell them on an exchange. This creates frictions and risks in using Bitcoin.
--
[Studying individual behavior on Bitcoin] is posible because the ledger is public, although Bitcoin is "pseudonymous," meaning that identity information is not attached to addresses, addresses can be followed over time. However, since individuals typically have multiple addresses (due to some details of how addresses are managed, in "wallets"), it is not trivial to identify which collections of addresses are individual users or Bitcoin businesses.
Overall, I'd say the authors have a pretty good understanding of Bitcoin.

Main takeaways for Bitcoiners

This article provides some useful takeaways for Bitcoiners.
  • First, they could only detect 1% of the transactions as being related to contraband or other illicit activity. Assuming their methodology is reasonably accurate (which I don't have the bandwidth to check right now), this is a good counter to the argument that Bitcoin is primarily used by criminals.
  • Second, they show that (as of 2016), the share of the network being used for payments isn't growing over time. This suggests that in 2016, Bitcoin was still in a phase where price dynamics are driven primarily by evolving beliefs, investor sentiment, and speculators, and less so by usage as a medium of exchange (MOE). That's still likely the case today, I'd wager.
  • Third, they showed evidence that Bitcoin is being used for cross-border payments. However, I found this part fairly hard to understand. As a referee, I would have asked them to explain it more clearly.
  • Finally, they came with an algorithm to try and detect business users, illicit users, illicit payments, and cross-border payments on-chain. I'm sure there's much to criticize here, but people interested in chain analytics may be interested in checking out their approach.
Keep in mind that this article was written in 2016. Much has changed since then, including the growth of the Lightning Network. I suspect that if they were to repeat their analysis today, including both on-chain and lightning transactions, they sould find that Bitcoin is being used more often now for actual e-commerce (though still likely a minority use case.)

Concluding thoughts

I liked the paper. I think it gave a fair and accurate description of Bitcoin. I think the paper was correct to highlight Bitcoin's utility in cross-border payments as a primary source of its value. One could also envision a model in which government confiscation or money printing is a risk, which would create another source of Bitcoin value. The empirical work is interesting, though one would have to believe in their chain analysis algorithm to truly believe the results.
Whether from these authors or someone else, I'd love to see follow up work looking at the Lightning Network has changed some of these adoption metrics and use cases.

Some interesting charts

Below I present some interesting charts from the paper. I present them without comment, as you'll have to read the paper to really understand how to interpret them.
102 sats \ 1 reply \ @Golu 2h
It's interesting! A lot of to analyse. Thanks for the article.
reply
15 sats \ 0 replies \ @nym 1h
It tells me we should keep developing tools to make Bitcoin useful for everyone.
reply
Good paper to start with.
It's hard to know what to take away from most of these price dynamic papers, because so much has changed in such a short period of time. To whatever degree Bitcoin was a purely speculative asset in 2016 or earlier, it's very different now. Plus, I don't know what these standard classifications would make of hodlers. I'm guessing they show up as speculators, but that's not what someone like Darth is.
reply
It's hard to know what to take away from most of these price dynamic papers, because so much has changed in such a short period of time
Agreed. I think one of the cool things about the paper is that it shows a non-zero steady state price of Bitcoin when the only use case is international payments.
As long as their is some transaction for which Bitcoin has less friction than fiat, Bitcoin will not "go to zero" as the critics claim.
I think another interesting implication of the paper is that the main force mitigating against Bitcoin is risk of failure. That risk can actually be used to explain why you can't simply clone Bitcoin---the clone has too high a risk of failure when the main network is still operational and useful.
reply
That risk can actually be used to explain why you can't simply clone Bitcoin
That is an interesting point.
As I was reading through the literature survey, I started thinking about how valuable bitcoin will be for international tourism. I'm sure plenty has been written about that already, but I had mostly thought about cross-border payments like trade or remittances. Being able to bypass currency exchanges by just spending bitcoin when you're travelling is going to be huge, eventually.
The thing that made me realize bitcoin will never go to zero was just seeing that there will always be at least some fringe weirdos who keep using it and mining it.
reply
Thank you very much for the fee split, which was very generous, and for the article. I will definitely be including this in the index as an article review, but if more stackers begin writing these bitcoin academic reviews I will start a new category. I didn't absorb everything you wrote on a first pass, but I will get back to it. One thing that did occur to me is that it adds weight to the Parker Lewis article posted this morning that in the long run bitcoin must be a means of exchange, because that is its value case. I think of it as the anti-Saylor argument, though I'm sure I'm oversimplifying it.
reply
Assuming Saylor's view is that Bitcoin can forever be a SOV - I think it could also be. This article focuses only on one use-case: international payments.
But in a world where governments are constantly devaluing fiat, Bitcoin as a fixed asset could have a forever increasing exchange-rate with fiat.
This particular model doesn't really tell us yes or no to that, because it didn't include that force in the model.
BTW, this discussion highlights the economics discipline: being precise about what economic forces give rise to what conclusions.
reply
I see. I think what Saylor seems to be saying is that bitcoin need not be a means of exchange, but can function solely as a store of value asset. Others have argued that its use as money is needed so that its store of value continues. That's not really what this article is about, obviously.
reply
Not specific to this article, but many of the papers draw conclusions like "Bitcoin cannot be a currency, because it is driven by speculation."
I think that misses the point that people are speculating in it as something that will become a prevailing currency. I don't know if the authors are just being very precise with present vs future tenses (I doubt it), or if they are totally missing the point.
reply
Yeah, I'm sure I'll run into papers that I disagree a lot with. i was pleasantly surprised that the first paper I chose gave a very fair shake to Bitcoin. I didn't know Athey's views on Bitcoin so I didn't really know what to expect.
reply