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Does mining fuel bubbles? An experimental study on cryptocurrency markets

Lambrecht, Marco ; Sofianos, Andis ; Xu, Yilong

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Abstract

The massive price bubbles of decentralized cryptocurrencies, such as Bitcoin, have created a puzzle for economists. How can a non-revenue-generating asset exhibit such extreme price dynamics, forming multiple episodes of bubbles and crashes since its creation? The answer is not straightforward, since cryptocurrencies differ in several important aspects from other conventional assets. In this paper, we investigate how key features associated with the Proof-of-Work consensus mechanism affect pricing. In a controlled laboratory experiment, we observe that the formation of price bubbles can be causally attributed to mining. Moreover, bubbles are more pronounced if the mining capacity is centralized to a small group of individuals. Analysis of the order book data reveals that miners seem to play a crucial role in bubble formation. The results demonstrate that high price volatility is an inherent feature of cryptocurrencies based on a mining protocol, which seriously limits any prospects for such assets truly becoming a medium of exchange.

Item Type: Working paper
Series Name: Discussion Paper Series / University of Heidelberg, Department of Economics
Volume: 0703
Place of Publication: Heidelberg
Edition: 1. Überarbeitung
Date Deposited: 09 Jun 2021 13:48
Date: May 2021
Number of Pages: 58
Faculties / Institutes: The Faculty of Economics and Social Studies > Alfred-Weber-Institut for Economics
Subjects: 330 Economics
Controlled Keywords: Bitcoin
Uncontrolled Keywords: bubbles, cryptocurrency, financial market experiment
Schriftenreihe ID: Discussion Paper Series / University of Heidelberg, Department of Economics

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