• Hossein Nabilou and André Prüm

Ignorance, Debt and Cryptocurrencies: The old and the new in the law and economics of concurrent cur

Decentralized, permissionless and blockchain-based cryptocurrencies and their underlying technology are said to have as transformative an impact on value as the invention of the internet had on information. For decades, the double-spending problem was the main roadblock to the emergence of cryptocurrencies. The Bitcoin Blockchain eventually solved this problem in a highly secure, decentralized, consensus-based, and censorship-resistant manner without relying on third parties. This has harbingered the advent of a whole variety of different cryptocurrencies, with varying degrees of societal risk-reward payoffs. Although regulators on both sides of the Atlantic have taken a passive approach to regulating cryptocurrencies, with the increasing popularity and potential success of cryptocurrency experiments, it is likely that governments will take interest and involve in regulating them in the foreseeable future.

In our recent paper titled 'ignorance, debt and cryptocurrencies', building on the seminal work of Holmstrom (2015), we analyse how information economics of Bitcoin, which is built on symmetric (common) knowledge, trumps that of central bank money, commercial bank money and shadow bank money, which is built on symmetric ignorance as to the underlying collateral. We argue that this informational distinction can potentially make Bitcoin a new 'safe' asset, holding the promise of maturing into a viable store of value, a potential medium of exchange, and a unit of account. By comparing the information economics of central, commercial and shadow bank money with that of Bitcoin, we highlight important aspects of information economics of Bitcoin that can inform any pending regulatory intervention in the cryptocurrency ecosystem.

In fiat currency context, A is willing to accept a piece of paper as a method of payment in anticipation of B willing to accept it from A, and C willing to accept it from A and B, ad infinitum. For this to happen, the settlement asset should not give rise to any adverse selection problem arising from the information asymmetry as to the value of the settlement asset. In transactional terms, the more adverse-selection proof an asset, the better it is for transactional purposes (medium of exchange). To be adverse-selection proof, the asset should be information-insensitive and its information insensitivity should be common knowledge.

Fiat money, including commercial and shadow bank money, is legally constructed as a debt contract. Finance literature suggests that debt instruments have traditionally been superior to equity instruments in addressing informational problems between the borrowers (issuers) and lenders (shareholders). Debt-on-debt (debt used as collateral for another debt contract) minimizes financial market participants' incentives to produce private information about the ultimate payoffs (Dang, Gorton, Holmstrom, 2012). This makes debt the least information-sensitive instrument in financial markets. This near-information insensitivity removes adverse selection problems, contributes to the liquidity of debt instruments, helps public adoption and thereby makes them a viable instrument for both market and funding liquidity.

However, no debt instrument, including central bank money, is entirely free from adverse selection problems. There are different methods to mitigate adverse selection. Signalling and screening have traditionally been the two well-known mechanisms to mitigate information asymmetry; the root cause of adverse selection. Another way to address the adverse selection problem is to basically do away with information asymmetry by either shedding sunlight on the settlement asset so that its value would be symmetrically evaluated by both parties to a transaction (common knowledge), or by obscuring and hiding all information so that neither party to a transaction would be able to or would have an incentive to acquire information about the underlying collateral of the debt instrument (symmetric ignorance).

Since an ultimate means of payment and settlement needs to be the most information insensitive and completely free from adverse selection problems, we argue that for such an asset (money) neither signalling nor screening mechanisms provide complete information insensitivity. Instead, for such an asset to best perform its function as an ultimate means of settlement, its value and underlying mechanisms should be either common knowledge or should not be known to any financial market participant at all (symmetric ignorance). It is no surprise that governments have chosen the latter path. The residual information insensitivity of central bank money (arguably the safest asset in a given market) has been eliminated by making all financial market participants 'symmetrically ignorant' of the value of the underlying collateral (a vague promise based on the full faith and credit of the government). This symmetric ignorance of all market participants as to the value and nature of that collateral removes all incentives for participants to acquire any information about the underlying collateral (hence a state of blissful symmetric ignorance).

Commercial bank and shadow bank money use different techniques to create money, but ultimately, all those techniques explicitly or implicitly fall back on the government safety net (government credit and liquidity puts). The main techniques used to create information insensitive assets in the banking and shadow banking system are insurance, (over)collateralization, imposing prudential requirements on issuing entities, and granting preferential regulatory treatment to quasi-money instruments (bankruptcy safe harbours for repos). In all these cases, the value of a safety-enhancing external element (eg, collateral in repos, government credit and liquidity puts in deposits) removes the depositors' or investors' incentives to acquire information about the underlying debt contract, making it information insensitive.

The information economics and potential information insensitivity of Bitcoin, however, stands at stark contrast to that of fiat money, as Bitcoin relies on the common (symmetric) knowledge as to the underlying inner workings of the Bitcoin Blockchain. The proposition that ignorance can be turned into knowledge, but knowledge cannot be reversed back into ignorance, is central to the information insensitivity of Bitcoin. Full transparency in the Bitcoin Blockchain eliminates incentives to acquire new information, thereby eliminating the adverse selection problem as to the value of Bitcoin as a medium of exchange. This superior informational feature of Bitcoin can potentially transform it into a potential safe asset, a good store of value, a medium of exchange, and a unit of account.

Given the superior quality of Bitcoin as compared to fiat money and the absence of market failures in Bitcoin in terms of information economics, regulatory intervention would not be warranted. More importantly, since the cryptocurrency industry in general is in its infancy, a hard-touch regulatory approach can hinder the potential welfare-enhancing innovations coming from this ecosystem. However, this suggestion should not be mistaken for an advocacy of regulatory faineance, as the ecosystem suffers from legal uncertainty. To the contrary, this approach is a defence of regulatory sobriety, data dependency, and a deference to the virtues of experimentation, permissionless innovation, the spontaneous discovery process and evolutionary dynamics in the financial system. This being said, the fast and ever-changing cryptocurrency ecosystem should put regulators on alert as market failures and potential for abuse will likely develop swiftly.

Hossein Nabilou, University of Luxembourg

André Prüm, University of Luxembourg

This post first appeared on the Oxford Business Law Blog

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