Everyone seems to have an opinion on Bitcoin, the original cryptocurrency. Some say it has revolutionized financial access. Others call it a threat to financial stability, citing roller-coaster prices and illegal behavior. But no matter what you think of Bitcoin, interest in it is higher than ever.
"Bitcoin was the first cryptocurrency, and it’s still the biggest today, with the highest market cap, almost a trillion dollars now,” said a professor of finance and entrepreneurship at MIT Sloan. “It’s basically bigger than the next biggest 10 cryptocurrencies combined.”
Despite being in existence for more than 10 years, there are still many open questions surrounding Bitcoin — from the identity of its biggest investors and the location of Bitcoin miners to the structure of the blockchain ecosystem that underlies the cryptocurrency.
Amid calls from industry participants for even wider Bitcoin adoption, either as a public investment vehicle or legal tender, Schoar teamed up with Igor Makarov, a finance professor at the London School of Economics and Political Science, to shed some light on the Bitcoin ecosystem.
“A better understanding of the Bitcoin network and its participants should be the basis for any decision about how to integrate these new cryptocurrencies into the traditional financial system,” the pair write in their new working paper, “Blockchain Analysis of the Bitcoin Market.”
Among their findings:
- 80% of Bitcoin volume in an average week can be traced to exchanges.
- Illegal activity is a small fraction (3%) of what actually goes on in the Bitcoin blockchain.
- Prior to May 2021, when China cracked down on Bitcoin mining and trading, Bitcoin miners were hugely concentrated, with around 60% – 70% located in China.
Analyzing the Bitcoin network
Bitcoin and other cryptocurrencies offer a decentralized system of payments and store of value outside the traditional nexus of government scrutiny.
The blockchain technology that underlies Bitcoin replaces the reliance on a few centralized record keepers, such as banks or credit card networks, with a large set of decentralized and anonymous agents.
A typical bitcoin transaction contains a list of senders and recipients represented by pseudonymous addresses, the number of bitcoins sent and received, and a timestamp of the transaction.
Schoar and Makarov used public and proprietary sources to link Bitcoin addresses to real entities to build a database documenting the evolution of the Bitcoin market from 2015 to 2021. They downloaded blockchain data using the open source software Bitcoin Core and used the BlockSci analysis tool to parse raw data into individual transactions.
The researchers then developed algorithms that used the semi-public nature of the Bitcoin blockchain to extract information about the behavior of Bitcoin’s market participants. Doing so allowed them to:
- Analyze transaction volume and the network structure of the main participants on the Bitcoin blockchain.
- Document the concentration and regional composition of miners — the people who verify the legitimacy of Bitcoin transactions.
- Analyze the ownership concentration of the largest holders of Bitcoin.
While the research itself is specific to Bitcoin, some of what the authors found also applies to other cryptocurrencies. Here’s what they learned:
1. Illegal transactions are a small percentage of overall Bitcoin activity.
Illegal activity is a small fraction (3%) of what actually goes on in the Bitcoin blockchain.
Because the Bitcoin blockchain is a public ledger, all payments flowing between addresses are observable. However, some Bitcoin users adopt strategies to impede tracing by moving their funds over long chains of multiple addresses and splitting payments. The authors developed algorithms to filter out this spurious volume so that they could trace economically meaningful payments between real entities on the Bitcoin network.
In doing so, the authors found that about 80% of Bitcoin volume in an average week can be traced to exchanges (from Kracken to Coinbase, for example) or exchange-like entities, such as online wallets, over-the-counter trading desks, and large institutional traders.
While many have worried that Bitcoin’s price has been supported by illegal transactions, Schoar said illegal activity is just a small fraction (3% by the researchers’ estimation) of what actually goes on in the Bitcoin blockchain.
“This doesn’t mean that illegal activity isn’t problematic,” Schoar said. “It’s just saying that demand for illegal activity cannot be supporting the Bitcoin price because it’s such a tiny fraction of what actually goes on in the blockchain.”
2. Bitcoin ownership is concentrated among the rich.
The authors found that participation in Bitcoin is skewed toward the elite. Their research showed that at the end of 2020, there were 1,000 “clusters” controlling 2 million bitcoins.
The authors clustered addresses so that all addresses that sent bitcoins in any single transaction were deemed to belong to the same entity. Schoar said this often happens for the sole purpose of obfuscating the origin of funds. In addition, the top 10,000 clusters owned more than 4 million bitcoins — about a quarter of all outstanding bitcoins. This has important implications for market stability.
“Somebody who can easily spend a hundred million dollars worth of Bitcoin and sell it or buy it can have a massive price impact in the market,” Schoar said. “That's typically a situation we don't like, because it means as a regular retail investor, you might suddenly find yourself x percent down because of massive volatility, which might be created by a few large investors randomly deciding to sell some of their holdings.”
3. The interconnectedness of the blockchain makes it difficult to crack down on illegal activity.
The authors tracked Bitcoin transactions in Russia’s illicit Hydra market and found that the money still made its way from the dark net marketplace to places like Coinbase and Gemini (where it could be considered legal, even though the funds didn't originate there).
Schoar said that once funds arrive at these exchanges, they get mixed in with other flows and become virtually untraceable and can be sent anywhere. For example, between January 2020 and June 2021, Coinbase directly sent 196 bitcoins and received 126 bitcoins from the Hydra market, but it sent 530,000 and received 218,000 bitcoins via the neighboring clusters.
The anonymous nature of Bitcoin makes it difficult to track down offenders, even if some places try to curb it with KYC (“know your customer”) rules that require verification of a customer’s identity, usually by a financial institution. This is a problem throughout the industry, not just with Bitcoin, Schoar said.
“Just imposing KYC norms on individual institutions will not help regulators or the public to prevent these illegal transactions from coming back into the ‘white economy,’” Schoar said. “This is a huge global network, so interconnected that you can't just monitor one little part of it.”
4. Miners are hugely concentrated.
Up until China's crackdown earlier this year, miners — individuals who process and verify Bitcoin transactions and add them to the blockchain ledger — were hugely concentrated, with around 60% –70% located in China.
For their work, miners are rewarded with newly created Bitcoins. The authors were able to identify individual miners by tracking the distribution of mining rewards from the largest 16 mining pools to the miners that work for them.
Having miners concentrated in one specific country can easily create volatility.
“If a certain country decides it doesn't want to allow mining anymore, it can lead to a lot of upheaval in the Bitcoin ecosystem,” Schoar said — as has happened with China's decision. "Without proper regulation, this is going to be a very dangerous place for many retail investors.”
The authors also found that the concentration of miners actually goes up when the Bitcoin price drops “because it looks like some miners drop out of the game altogether because maybe it's not worth their while or they're not interested anymore, and then the capacity becomes even more concentrated,” Schoar said.
5. Requiring a capital gains tax could increase transparency.
Schoar said U.S. regulators should be thinking about the tax implications of Bitcoin.
“Right now, because Bitcoin is so opaque, you can hide your capital gains appreciation and save yourself a lot of capital gains tax,” she said, calling this “a huge subsidy to cryptocurrencies.”
For example, you could hold your cryptocurrency in an opaque account until you’re ready to send it from one account to another, thereby hiding the fact that you owned it for three years.
Stronger regulation could force people to pay capital gains tax up to the last owner who paid a capital gains tax. If individuals can’t show where they bought Bitcoin from, they will be held responsible for that entire three-year period. Making people accountable for where the money has been — not just when it came onto an exchange — would pressure investors to declare their holdings in a more honest way.
“In my opinion, that would be actually really important, because otherwise you're giving cryptocurrencies this massive tax loophole,” said Schoar.
She and Makarov plan to follow up this research with work on other crypto platforms.