EU’s ECON Committee published a report on FinTech including cryptocurrencies issues

ECON, the European Parliament Committee on Economic and Monetary Affairs, a committee overseeing the decisions made by the European Central Bank (ECB), published an analysis of major competition issues the financial technology area. The report also includes issues of cryptocurrencies.

Crypto-tracker proposes you some abstracts about cryptocurrencies and blockchain from this document:

Business models: from mining to exchange services

According to the Bank of England (BoE), a digital currency is ‘a means of payment that only exists electronically. Like traditional money (such as banknotes), they can be used to buy physical goods and services.’.
The BoE distinguishes between private digital currencies, those not issued by a central bank, and central bank-issued digital currencies; both of them rely on distributed ledger technologies, like blockchain. Examples of private digital currencies are Bitcoin, Ethereum, LiteCoin, and Ripple. The main difference between e-money and a digital currency is that the former is based on the conventional bilateral settlement with a trusted central party, and the latter is based on the underlying peer-to-peer structure operated without any central party.

Another term for digital currency is cryptocurrency, which refers to the fact that
cryptographic techniques are used to preserve the essential features of any currency, namely ensuring authenticity and preventing double spending.

The value chain of the cryptocurrency ecosystem could be described as follows:

Blockchain

The substantive element of digital currencies providing these requirements is the so-called blockchain or DLT, used as an embedded decentralised payment mechanism that registers any payments between parties. The specific blockchain platform used by any cryptocurrency is the central element integrating the different activities of the value chain.

The operating characteristics of the DLT platform condition the whole ecosystem of the cryptocurrency; in particular, whether it is open, thus permission-less, or private, therefore permissioned. More specifically, in the case of a cryptocurrency promoted by traditional banks, the DLT implementation implies defining the participation of the central banks, the traditional banks, or the supervisors of the different markets involved (securities market, bank supervisor, …).

Blockchain is the central element of the cryptocurrency ecosystem because it specifies who can participate in the cryptocurrency system operation and how. Nevertheless, it should be kept in mind that regardless of the specific DLT implementation, the essential feature of DLT is that it is a decentralised system based on a peer-to-peer network of nodes collaborating to maintain the ledger of currency transactions. If the cryptocurrency DLT is open, or permission-less, everyone can develop any of the activities without requiring any market entry authorisation, even leaving the system without any regulation. Most of the known cryptocurrencies follow this type, like Bitcoin, Ethereum, or Litecoin. In contrast, closed cryptocurrency systems, or permissioned ones, require a supervisor authorising the entry, operation and eventual departure. The central banks or traditional banks could be planning to use those permissioned cryptocurrency systems in an attempt to complement or substitute the permission-less currencies already in use. Any blockchain system is identified by five components: (1) cryptography algorithms used; (2) rules of the P2P network; (3) consensus mechanism; (4) ledger; (5) validity rules. The basic operations that can be performed in any blockchain are read,

write, and commit.

Mining

The activity of committing (updating or changing) the state of the blockchain is known as mining. It consists of appending a new block with the last transaction held after calculating and discovering its hash code, which includes the one resulting from the last block that was closed (resulting in ‘a chain’ of blocks and codes). The miners or miner pools compete against each other trying to be the first in discovering the hash code, therefore requiring huge computational resources and energy consumption. The miner that ascertains the current block hash code receives a reward, in the form of new cryptocurrency units added to the existing monetary base. Nowadays, in the Bitcoin model, the reward per block is BTC 12.593. The mining sub-activities are: silicon design; specialised mining hardware design and manufacturing; self-mining; hosting, housing or cloud mining services for third parties; and mining pools (pools of miners collaborating with their computational

resources).

Wallets, exchanges and payments

The transactions appended to the preceding and current blocks come from wallet or payments agents. The wallet96 is the final user application used to securely manage and use their coins. Each cryptocurrency has its own wallet reference

implementation (e.g. Bitcoin Core) to be used by developers. In turn, payment services are related to the transfer of cryptocurrency units and payments to other holders or ecommerce parties. The final users need exchange services99 to buy and sell cryptocurrencies, exchanging it from and to their national currencies (i.e. EUR/Bitcoin exchanges), or from and to other cryptocurrencies (Bitcoin/Ethereum exchanges).

Smart contracts feature

An important additional element of the cryptocurrency value chain is the smart contract feature which allows the parties to implement any contract payment covenants to be selfexecuted when the event succeeds. For example, a monthly payment of a house rental, or the guarantee release linked to the rental contract when the flat is let out according to the stipulated conditions.

Finally, the value chain also includes banks and credit card processors as key players in the cryptocurrency value chain, as they play a very active role in developing closed or permissioned blockchains, like Enterprise Ethereum Alliance, Hyperledger project, R3 Consortium with Corda, UBS bank and its Utility Settlement Coin (USC), JP Morgan and its Quorum project or Ripple collaboration with Santander Bank and American Express. They keep relations with central banks and regulators as a way to provide their own solutions to the cryptocurrency world.

Competition issues in the business processes: diverse markets with different competition issues

The desk research conducted has found very few literature references dealing with current market restrictions to competition in the cryptocurrency ecosystem. This is mainly due to the fact that cryptocurrency is a new, sophisticated and fragmented market. Therefore, the following analysis can be considered as an exercise of envisioning potential problems based on the existing data and trends and the market structure. Competition issues can be analysed according to their impact on: concentration (market share), contestability (network externalities, entry barriers) and composition (bundling of services). Competition in the cryptocurrency markets has been characterised in the context of competition between currencies and competition between exchanges. Therefore, two

different markets can be identified: the inter-cryptocurrency market, where different cryptocurrencies compete against each other with diverse strategic behaviours, and the intra-cryptocurrency market, where different service providers (mining, wallet, exchange and payment services) compete.

Inter-cryptocurrency market: potential market problems

Some data can help set the stage for the analysis of inter-cryptocurrency market competition issues. According to a recent study109, competition between cryptocurrencies is still limited, although it is growing. While Bitcoin accounted for 86 % of the total cryptocurrency market capitalisation in March 2015, it decreased to 72 % in March 2017. Ethereum accounted for 16 % of the market capitalisation in March 2017, which is the only data we have since this cryptocurrency did not exist in 2015110. Nevertheless, these two cryptocurrencies accounted for 88 % of the total cryptocurrency market capitalisation in March 2017, a relevant indicator of the current market concentration. Competition problems of the inter-cryptocurrency market are quite sophisticated, given the complex activities that are part of the value chain. One of the most significant is the presence of network effects111 related to the network and platform nature of cryptocurrencies. This prevents a currency from being substituted by another competing one and resulting in ‘a substantial barrier to entry and, at the same time, give incumbents large market power’. An increasingly higher number of users of a cryptocurrency and its use as a payment instrument create barriers of entry to new cryptocurrencies due to the lack of adhesion to its use in merchants, wallets, or exchanges. In the future, network effects may lead to potential collusive agreements between members of hypothetical cartels. The question of the implementation of vertical integration strategies, either in intracryptocurrency and inter-cryptocurrency markets, comes to mind when considering additional concerns. Exchange, wallet and payment providers may design behaviour practices to exclude each other from the market, e.g. by receiving incentives from miners favouring a specific cryptocurrency, or from certain dominant players trying to exclude competitors in other activities. The arrival of permissioned cryptocurrencies promoted by banks, even by central banks, will reshape the current competition level in the inter-cryptocurrency market, broadening the number of competitors113. A potential inadequacy of traditional competition policy to address competition issues in the cryptocurrency markets can be found, suggesting direct public participation through a central-bank digital currency as a remedy. The international nature of cryptocurrency markets115 is also a challenge to competition policy at the European level. Many of the players operate from global locations outside the jurisdiction of European competition authorities, which makes investigation or prosecution on anticompetitive behaviours more difficult. Europe leads, at international level, the supply of wallet and exchange services, with 42 % and 37 % in terms of number of players.

It is also the principal actor in payments (33 %). Nevertheless, the main weakness of Europe is the concentration of the mining activity on non-European countries (Europe only capture just 13 % of the current mining market). Mining is the most strategic, sophisticated and technology dependent activity in the cryptocurrency market, and there currently appears to be a significant concentration of mining activities occurring in certain Chinese provinces.

Intra-cryptocurrency market: potential competitive misconducts

Market power of incumbent banks might be used to limit competition in the intracryptocurrency market through pre-emptive acquisitions or predatory pricing schemes. Incumbent banks may also engage in anticompetitive practices by denying access to their gateways for exchange or wallet services, such as bank payment and transfer systems or card processor schemes. This denial of access may be conducted by means of low service quality, delays in negotiation, proprietary technical standards or excessive pricing. These practices may deter consumers from using the permission-less cryptocurrencies in favour of the permissioned ones promoted by banks.

Another potential anticompetitive factor is the standardisation of DLT and other technical protocols. Private or public consortia agreements in relation to technical standards may affect the market entry or impact current costs. In fact, 70 % of the large miners rate their influence on protocol development as high or very high.

The mining market

The mining market has evolved from ‘a hobby activity in the early days to a professional industry where large amounts of capital are at stake’118. The mining market cannot be considered a truly traditional market where prices would be determined by supply and demand, because price — mining reward — is self-scheduled by the cryptocurrency own algorithm at fixed rewards per four-year periods. Thus, there is not an efficient pricing system of mining activities. Their lack of cost orientation or market pricing creates disincentives to miners, either by having excessive pricing or by pricing below real costs. Mining can currently be considered a non-contestable market because of the presence of high barriers of entry derived from the existing economies of scale in processing power, energy efficiency (intra-cryptocurrency market) and scope (inter-cryptocurrency market). Cartels may arise in mining pools, but the lack of price coordination due to the use of a short-term fixed mining reward is a negative proof of their existence. The market is currently dominated by a low number of mining pools — the five leading

mining pools accounted for 79 % of the total market share in Q4/2016121 — , although none of them exert a dominant position (the leading mining pool, AntPool, accounted for 23 % of the total market share). Thus, future horizontal mergers and acquisitions between mining firms should be assessed in terms of market competition and efficiency gains.

The wallet, exchange and payment market

Wallet and payment markets are characterised by a high number of providers122, thus it demonstrates that, nowadays, there are low barriers to entry. The exchange market presents the highest number of providers of all cryptocurrency markets123. The exchange market, however, presents a high degree of concentration, with five providers accounting for 75 % of the total Bitcoin exchange market share and the leader reaching a market share of 30 %. Nevertheless, as explained before, the three markets are subject to potential network effects which can deter competition. A general competition problem of excessive pricing as a result of market power can arise in any of these markets if users cannot easily move their currencies from one supplier to another (exchange services when buying or selling a cryptocurrency, in wallet maintenance or payment transactions). These competition problems arise in relation to multi-homing or single-homing sceneries if switching costs or technical restrictions prevent users from moving from one wallet or exchange app to another. Albeit the wallet, exchange and payment markets may be considered separated markets, the boundaries between them are increasingly blurring. For instance, 52 % of wallets

provide an integrated currency exchange feature126. Thus, vertical integrated players ranging from wallet to mining activities may design anticompetitive exclusionary practices to foreclose the individual markets, for instance, by cross-subsidising their mining activities with their rewards. In this sense, vertical mergers should be paid attention to.

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Originally published at crypto-tracker.com on July 22, 2018.