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1 IT UNIVERSITY OF COPENHAGEN SUBMISSION OF WRITTEN WORK Class code: Name of course: Course manager: Course e-portfolio: Thesis or project title: Supervisor: Full Name: Birthdate (dd/mm-yyyy):

2 Cryptocurrencies. An exploratory study of cryptocurrencies and the drivers impacting its diffusion. Casper Fosvang xxxx Daniel Varberg xxxx IT- University of Copenhagen Cand.it (EBUSS) 2. June 2014 MASTER THESIS Supervisor: Stefan Henningsson characters 1

3 Abstrakt Denne research har til hensigt at tage det først skridt i identificeringen og forståelsen af begrebet cryptocurrencies samt at undersøge, hvilke drivere der påvirker diffusionen og adoptionen - research som hidtil er ukendt på den akademiske scene. Dette gøres gennem en generel gennemgang af cryptocurrencies baseret på Bitcoin, hvor en kvalitativ metode i samspil med sekundært litteratur danner fundamentet for en dybere forståelse. Cryptocurrencies dækker over en decentraliseret valuta og et betalingsnetværk, der som fænomen opstod tilbage i 2009 med udgivelsen af Bitcoin. Det er baseret på open source princippet og teknikken for kryptografi. Vores research viser, at der er visse begrænsninger ved valutaen, som kun accepteres få steder som betalingsmiddel og desuden er forholdsvis volatil. På trods af dette viser betalingsnetværket tydelige tegn på potentiale med lave transaktionsomkostninger, hurtige overførsler på tværs af landegrænser, øget anonymitet samt en forbedret model til at undgå traditionel svindel med online betalinger. Ulempen ved dette er, at det potentielt kan facilitere sortbørs aktiviteter, da området overordnet set mangler reel regulering. Herudover stilles der krav til brugeren om sikker og forsvarlig opbevaring af cryptocurrencies. Som innovation bevæger cryptocurrencies sig i det finansielle, politiske og teknologiske spændingsfelt og kan derfor betegnes som en kompleks innovation. Der er derfor også mange forskellige drivere, der påvirker adoptionen, hvorfor disse med rette kan deles op i eksterne og interne. Eksterne dækker over udefrakommende kræfter som politiske, økonomiske, sociale og teknologiske, hvor interne dækker over individets opfattelse af innovationen og innovationens karakteristika. Regulering, betalingsinfrastruktur, samfundets karakteristika og teknologisk modenhed blev alle identificeret til at være eksterne drivere, der har indflydelse på diffusionen og adoptionen af cryptocurrencies. Cryptocurrency økosystemets natur har også indflydelse, da det er de individuelle services baseret på crypocurrencies, som økosystemets aktører faciliterer, der skal udbredes til forbrugerne. Økonomisk gevinst, lave investeringsomkostninger, tidsbesparing og mindre ubehag blev identificeret som værende relative fordele og derfor have en positiv indflydelse på adoptionsraten. Høj kompatibilitet grundet det værende open source har også en positiv indflydelse. Inkompatibilitet med kultur og vaner relateret til finansielle innovationer, høj teknologisk kompleksitet og lav observerbarhed blev identificeret som værende negativt relateret til adoptionsraten. Det er tydeligt, at der er et behov for cryptocurrencies, men et behov er ikke nok til at garantere en udbredelse og dermed gøre innovationen mainstream. Det er derfor nødvendigt at undersøge, hvilke drivere der har indflydelse på dets udbredelse. Keywords: Cryptocurrencies, Bitcoin, Payment Protocols, Diffusion and Adoption Theory, Diffusion of Innovations, 2

4 Table of content Preface: the start of a new paradigm? 7 Chapter 1 - Setting the stage Problem statement Delimitation Disposition 12 Chapter 2 - Research Methodology Research Approach Literature Empirics and analysis Expert interview Survey Participant observation Reliability and validity 18 Chapter 3 - Theory Diffusion of innovations Rate of adoption Innovation characteristics Hofstede's cultural dimensions theory 26 Chapter 4 - Introduction of cryptocurrencies Definition of cryptocurrencies Extracting the currency aspect of cryptocurrencies The Bitcoin Protocol - How a transaction works Creating a new address Submitting a payment Verifying the transaction (mining) Transaction verified 35 3

5 4.3 The Bitcoin Protocol and Traditional Electronic Payment Systems Challenges for Traditional Electronic Payment Systems Comparing Bitcoin with Traditional Payment Systems Security Decentralized payment protocols The technical breakthrough A potential remedy for International transfers, remittance and the unbanked The unbanked & developing countries A political statement Volatility The black market and Bitcoin Regulation of technology Taxation Legality Summary 56 Chapter 5 - The cryptocurrency ecosystem 59 Chapter 6 Drivers impacting diffusion and adoption Externalities and adoption readiness Introduction to the Philippines Political / Regulation Economic factors The poor and unbanked Remittance Social and Cultural Demographic of the Philippines Cultural Individualism Uncertainty avoidance 80 4

6 6.1.5 Technology infrastructure Internet Mobile phones Summary Diffusion of Bitcoin in the Philippines User characteristics Innovation characteristics Relative advantage Compatibility Complexity Trialability Observability 91 Chapter 7 - Conclusion and Discussion Findings and contribution Limitations Conclusion Suggestions for further research 99 References 100 Appendix 109 5

7 Figures: Figure Source: Rogers, Diffusion of innovation (Page 22) Figure Source: Coindesk, Cryptocurrencies domains (Page 30) Figure Source En.bitcoin.it, Transaction signatures (Page 33) Figure Source Tanaka, Credit Card Type (Page 37) Figure Source Tanaka, Check Type (Page 38) Figure Source Tanaka, Cash Type (Page 39) Figure Source Coinbase, Bitcoin exchange rate (Page 48) Figure Source Bitlegal.com, 14/ Legal status of Bitcoin (Page 55) Figure Source own production - The four steps of Bitcoin (Page 60) Figure Source TWE, Mobile financial service development (Page 68) Figure Source TWE, Institutional and market environment (Page 68) Figure Source FIDWG - Banking overview (Page 72) Figure Source Pickens, Mobile Money (Page 74) Figure Source Hofstede, Cultural dimensions (Page 79) Tables: Table 2.1 Source own production - Empirics (Page 16) Table 4.1 Sourcce En.bitcoin.it, Altcoins (Page 29) Table 4.2 Source Bitcoin Faktafolder, International bank transfers (Page 45) Table 4.3 Source own production - Advantages and disadvantages for Bitcoin as an innovation (Page 58) Table 5.1 Source own production - Cryptocurrency ecosystem (Page 62) Table 6.1 Source own production - Different types of relative advantage for cryptocurrencies (Page 87) Table 7.1 Source own production - Effects on the rate of adoption (Page 92) 6

8 Preface: the start of a new paradigm? One may consider what implications a new groundbreaking innovation possibly could have on the world. Throughout history, several technical innovations have proven to revolutionize societies and create norms, thereby breaking with old habits and creating new ones. Some examples include electricity, the telephone, the Internet and so on. These inventions created a foundation for further development and innovativeness, thus they contributed and shaped the society we live in today. Addressing the Internet in this context is a great example of an innovation that has created an enormous industry, fostering innovation around the world. A great example of an innovation that was built on top of the Internet is cryptocurrencies Bitcoin is commonly interpreted as a virtual currency, which is partly right depending on the contexts it s evaluated in. Despite this, Bitcoin brings something truly more revolutionizing, which does not directly have to do with the currency. That is the underlying system also referred to as the Bitcoin Protocol, that basically creates an open financial platform where low- cost transactions can be made. (Antonopoulos, 2014). It therefore advocate great potential in the financial sector by introducing a new and more cost effective system for handling and transferring funds digitally. Despite its great potential, cryptocurrencies has yet to become mainstream. Its usage as a payment solution is still limited to relatively few merchants, and only a relatively small group of users has adopted the innovation. If cryptocurrencies is to impact the way we do financial transaction and relieve its potential, it s essential that people start using it. Understanding the drivers that are affecting the diffusion and adoption of cryptocurrencies is therefore important in order to understand how cryptocurrencies can become mainstream. It is important to point out that cryptocurrencies like Bitcoin as an innovation and technology is still in its developing phase. Predicting the outcome of Bitcoin is extremely 7

9 difficult and complex. This thesis aims to evaluate Bitcoin in terms of technicality and ecosystem along with identifying possible advantages and drawbacks allocated with the innovation by addressing the attributes for possible adoption. This thesis is aimed towards individuals and businesses interested in phenomena of cryptocurrencies and adoption theory from an innovations point of view. The thesis is trying to bridge the gap between academic ideas and practical usage. 8

10 Chapter 1 - Setting the stage Virtual currency schemes can have positive aspects in terms of financial innovation and the provision of additional payment alternatives for consumers. This was concluded by The European Central Bank in an extensive report on virtual currency schemes in 2012 (European Central Bank, 2012). Ever since the release of the first cryptocurrency in 2009, the interest has been growing. Despite the increasing interest, the area has only received little academic attention, where mostly is strictly technical. Knowledge derived from this area may therefore sometimes be more or less consistent, thus resulting in uncertainty adding an extra layer of complexity to the understanding of cryptocurrencies. A greater consistent academic knowledge may lead to demystification and discourage of the general misunderstandings surrounding the area and accelerating the adoption and diffusion among users. This research does not focus on the exchange rate of cryptocurrencies or as an isolated currency. It defines cryptocurrencies as an innovation that could yield great opportunities to the established norm with its innovative system, especially for developing countries (A10:B10). Some may describe cryptocurrencies as virtual or digital currency, which is partly true, but the underlying protocol could be far more disruptive and revolutionising than the currency aspective (Antonopoulos, 2014:C3). The protocol delivers a practical solution to a more than 30- year old problem within the field of computer science, known as the Byzantine Generals Problem (Olesen, 2014). Shortly elaborated, the problem considers how to create consensus or agreement within a network of equal actors also known as a decentralized network in order to cope with the problem of double spending. Describing cryptocurrencies only as a currency can be compared to saying that the Internet is all about s (Antonopoulos, 2014). The protocol has created a whole new 9

11 financial platform based on an open source license that is fostering innovation without permission for anyone who is interested. This creates great opportunities for all types of businesses, big or small, it doesn t matter. What matters is the ability to see a potential in a new innovation that could prove to be one of this decade s greatest innovations. Cryptocurrencies is definitely contributing with something new to the domain of virtual currencies with its innovative technical features and design. Bitcoin, the first cryptocurrency introduced, seems to have attracted great interests over a longer time period and reached interest of the public in several countries. The decentralised design and the total issue of 21 million Bitcoins makes up with some of classical economic theory with issuing of money. Being able to transfer funds from a to b across borders within minutes instead of days almost free of charge or with very low fees involved, is something revolutionizing by itself that could be useful for many people and businesses across the globe (A2). Cryptocurrencies could, in the long run, provide a financial platform of banking for the third world and developing countries giving the poor the possibility to open a wallet, which is more or less equal to a bank account (A3). The protocol allows micropayments to be done digitally due to its low fees allocated with transferring funds between accounts/addresses. Furthermore, a digital wallet opens up for great opportunities for trade both domestic and international, along with being able to deposit funds and create savings. This could potentially open up for new business models (A2). Despite the promising potential, it might still take cryptocurrencies years from now to become mainstream and redeem actual potential. From a technological point of view, cryptocurrencies are still in their developing and emerging phase meaning that the possibilities for success or failure may be close to even. No matter what the outcome, cryptocurencies are an interesting innovation due to the above mentioned characteristics. 10

12 1.1 Problem statement The discussion above naturally leads to the question of: What are cryptocurrencies, and what are the drivers impacting its diffusion and adoption? This question will direct this thesis onward by assessing relevant theory, empirics and literature. 1.2 Delimitation Cryptocurrencies in general consist of two elements: a currency and a payment protocol (Andolfatto, 2014). From an innovations point of view, the payment protocol seems to bring the most innovativeness (Antonopoulos, 2013). The focus of this thesis is therefore predominantly on the payment protocol. Despite this, a separation of the currency and the payment protocol does not make sense. Hence, the currency aspect is such a vital part of the innovation and vice versa. The overall focus of this thesis is from the innovations point of view where both merchants and consumers have been included for an overall understanding in order to comply with the problem statement. Cryptocurrencies is the superior definition of virtual currencies using cryptography. The area consists of numerous different proposals for virtual currencies. Despite this, Bitcoin seems to be the most interesting phenomena since cryptocurrencies was introduced. Most other cryptocurrencies are based on the open source Bitcoin protocol with modification. In writing, Bitcoin is also the biggest cryptocurrency in terms of network size and usage. Bitcoin will therefore act as a main reference when the aspect of cryptocurrencies is addressed. Development within the field of cryptocurrencies has proven to be quite rapid. The research conducted in this thesis was executed from January 2014 until the end of May Evolvement in the cryptocurrency community and in the ecosystem of Bitcoin after this time period is therefore not considered nor included. 11

13 1.3 Disposition Chapter 1 Setting the Stage Introduction/ Problem statement / Delimitation The research area and problem statement is presented. Chapter 2 Research Methodology Research Approach /Literature / Empirics The Research Methodology used to guide this study is presented. This includes literature review, qualitative and quantitative methods and handling of empirical data along with reflections upon these areas. Interview persons and the survey is introduced. Chapter 3 Theory The theoretical foundation to this thesis i made through a literature review of existing diffusion and adoption theory of innovations. Chapter 4 Introduction of Cryptocurrencies and Bitcoin This chapter explores the phenomena of Cryptocurrencies with Bitcoin as a case in order to answer the What is cryptocurrencies of the problem statement. The exploration creates a deeper understanding of the area research and identifies advantages and disadvantages of the innovation. Chapter 5 The cryptocurrency ecosystem This chapter describes the ecosystem of cryptocurrencies in order to create a holistic view and explain the challenges that businesses in the ecosystem are facing. The businesses facilitate services based on cryptocurrencies, hence they play an important role in the diffusion and adoption. Chapter 6 Drivers impacting diffusion and adoption Cryptocurrencies is analysed based on diffusion and adoption theory, using empirical data and secondary data, as well as our exploration of Bitcoin. The analysis leads to findings on what are the drivers impacting the diffusion and adoption of cryptocurrencies. Chapter 7 Conclusion and discussion The findings from the research are discussed and the problem statement is answered. Theoretical and practical implication are presented along with contributions. Moreover, limitations of this thesis are identified and discussed, and further research is suggested. 12

14 Chapter 2 - Research Methodology This study is intended as an exploratory field study and reflections on the desired contribution of this thesis will assist in directing the research towards its objective - of making a delimited contribution to the knowledge about Cryptocurrencies by answering the research question. This chapter aims to present the research approach of the study along with the use of relevant academic literature and to introduce the empirical and analytical approach that ultimately will lead to the findings and thereby the contribution of this thesis Research Approach Research is a process of steps used to collect and analyze information to increase our understanding of a topic or issue (Creswell 2003). In relation to this research, this requires a paradigm that is suitable for exploring complex social phenomena that requires working with people and real life experiences where the researcher seeks to understand the research problem by reflecting, probing, understanding and revising meanings, structures and issues (Hirschman 1986; Orlikowski & Baroudi 1991). The aim of this research is to add to the body of knowledge of Cryptocurrencies that is more or less consistent with a positivistic epistemology, where the objective is finding truth (Miles and Huberman 1994; Yin 1994). The ontological assumption stated with this thesis is coherent and supported by the beliefs found in the philosophy of critical realism or postpositivism (Denzin & Lincoln 1994; Guba & Lincoln 1994) or neo- postpositivism (Huberman & Miles 1985). The ontological view is presented by Guba & Lincoln (1994) as reality is real but only imperfectly and probabilistically apprehensive, and so triangulation from many sources is required to know it. This view supports the qualitative method applied for gathering extensive knowledge about the subject studied in this research. This thesis is considered to be a study of information systems in the context of Cryptocurrencies. Information systems are considered to be the study of complementary 13

15 networks of hardware and software that people and organizations use to collect, filter, process, create and distribute data (Jessup & Valacich, 2008). It can therefore be perceived as IS research, spanning over the domains of Cryptocurrencies, its complex ecosystem along with its drivers impacting its adoption. Gregor (2006) made a distinction among five theory types in IS research, namely theory types for (1) analysis; (2) explanation; (3) prediction; (4) explanation and prediction; and (5) design and action (Gregor, 2006). Analytic studies analyze and describe the state of a phenomenon, rather than making predictions or generalizations; explanatory studies are concerned with how and why a phenomenon occurs, focusing on understanding of concepts rather than testing the predictions; predictive studies are focused on what will occur in the future, thus being less concerned with the cause; explanation and prediction (EP) provides understanding of the causes as well as prediction of a phenomenon; and design and action focuses on how to do something from a practical perspective. This field is especially related to the IS development process. The characterization of this research in relation to Gregor s types of IS research defines a study that is based on an analytical approach with some degree of explanation in order to comprehend the phenomenon studied. The outcome of this thesis will add to knowledge of Cryptocurrencies along with an understanding of which drivers are impacting its adoption. Furthermore, the findings will contribute to a better understanding of potential challenges for a broad and successful adoption of Cryptocurrencies. Thus, the focus of the thesis is not to predict the future development of Cryptocurrencies, but rather a deeper understanding of the phenomenon and which factors influence its adoption. 14

16 2.2 Literature The literature review of this thesis is based on knowledge gathered within various fields of literature. This includes sources that are not strictly theoretical or academic for getting a solid foundation in researching the phenomenon of Cryptocurrencies that has only received little academic attention so far. The main motive with the literature selection has therefore been conducted with the outcome in mind (Carlsson et al., 2010), which is to explore Cryptocurrencies and the drivers impacting its adoption. The informational search has lead to literature with different perspectives on Cryptocurrencies. Within this literature, few were concerned with general drivers impacting the adoption of Cryptocurrencies. Often, the search resulted in literature about a specific cryptocurrency, such as Bitcoin, Litecoin or Dogecoin as little has been written about the overall areas of cryptocurrencies. In general, literature has been approached with a certain caution and scepticism, especially with the mass media, such as news sites or portals. The main reason for this approach is in relation to the complexity of cryptocurrencies, which can be hard to grasp at once. In some cases, the so called expert pronouncement has proven not to be evident. The search for academic literature was done on a series of academic databases, such as Google Scholar, Euromonitor, EBSCOHost, ACM Digital Library, Business Source Complete. Most of these databases were accessed through the website of library of the IT- University. 15

17 2.3 Empirics and analysis Method Individuals Amount of individuals assessed (1) Expert Interviews (Qualitative) Individuals with different expertise and knowledge within the area of cryptocurrencies. (A) Lasse Birk Olesen founder Bitcoin Nordic and co- founder buybitcoin.ph (B) Pelle Braendgaard co- founder Kipochi (C) Hans Henrik H. Heming Interim CEO at Bips.me 3 (2) Survey (Quantitative) A multiple choice questionnaire with questions about behavior and habits with areas connected to the study. (3) Meetup / Participant observation Table 2.1 Source own production - Empirics Bitcoin meetup on the 5th of April in the IT- Park of Cebu City. Individuals with different incentives. Some with experience within the field of cryptocurrencies while others just been introduced Expert interview Expert interviews are used in empirical social research in order to gain knowledge within the expert field of research. Focus should rather be on the capacities as expert rather than the person (Flick 2004). This approach was mainly chosen due to two conditions. First, the area of cryptocurrencies is a rather complex one to comprehend as it covers many different aspects, such as economical, technical, legislative. Second, the high complexity and rapid evolvement makes academic literature difficult to find. Doing expert interviews with leading individuals within the scene of cryptocurrencies seemed to provide satisfying knowledge and thus coping with the mentioned 2 conditions. A common problem with expert interviews is the question of what makes an expert. Meuser and Nagel (2004) define an expert as someone who (1) in some kind of way carries responsibility for the draft, implementation or control of a problem s solution or (2) who has privileged access to information about relevant populations, social situations and decision processes. The definition by Meuser and Nagel was taken into consideration when 16

18 selecting and contacting persons for the expert interviews. All of the three persons participating in the open- ended interviews comply with Meuser and Nagel s definition. All of the three interviews were conducted as open- ended interviews (Andersen, 2008) with 11 questions as a guide (Appendix 3). The interview guide was based around the research questions of the thesis, and notes were taken during the interview and later transcribed (Appendix 4-6) Survey Bickmann & Rog (2009) state that the main motive for doing a survey is usually to collect quantitative or numerical information about the studied population. Surveys mostly focus on fractions of the population where information is collected to understand consumers preferences and interests (Bickmann & Rog, 2009). The desired outcome for doing a survey for this thesis, was to understand the habits of the average Filipino, along with studying their behavior when it comes to areas connected to the subject of the thesis, in relation to the study. The survey was also intended as complementary to the secondary data that in some cases were lacking relevant information to study. The data were collected between the 27 march and 7 april 2014 in the region of Central Visayas in the city of Tagbilaran and Cebu City. Respondents were asked to participate in a small survey with questions (Appendix 1) about their preferences and behaviour. The survey was conducted on an ipad with multiple choice questions Participant observation This method is by Jorgensen defined as a field strategy that simultaneously combines document analysis, interviewing of respondents and informants, direct participation and observation, and introspection (Jorgensen, 1989). The information gathered from the participant observation of the Bitcoin meetup is purely based on communication where openness is essential (Flickr, 2009). None of the conversations from the meetup was logged in any form. The meetup was very informal as people were firstly introduced, then joined into smaller groups for discussing subjects and experiences related to 17

19 cryptocurrencies. The main outcome of the meetup was valuable information for the practitioners of cryptocurrency based on the observations of the conversations and a better understanding of practical implications of using cryptocurrencies. 2.4 Reliability and validity The transcription was done with the same procedure for all of the interviews. All of the questions have been given a letter and numbered sequentially to create a useful overview as references when interviews were quoted in the thesis. This study aims to examine the phenomena of Cryptocurrencies along with its drivers impacting its adoption. The focus applied is a holistic perspective where the goal is to examine how things are correlated and identify causal relationships whereby certain variables may influence other variables. In order to comply with this approach, the experts were interviewed following the same interview guide and thus asked the same questions. By cross checking the answers, a certain degree of consistency in the statements was provided. Thus these few questions revealed a different view upon the subject discussed. This is certainly caused by different beliefs and experiences from the experts as some of the topics discussed have a certain degree of subjectivity. In some cases, secondary data was afterward addressed to assess statements of the respondents in order to comply with reliability to secure a high internal validity. The survey conducted is not statistically significant for the Philippines as it was only conducted in the region of Central Visayas. Participants were randomly chosen on the populated streets in front of malls and public transportation, such as ferry terminals and bus stations. This was done in order to ensure a representative sample of the population in the Central Visayas. The survey was conducted in English as most people in the Philippines are able to communicate in English. When introducing the questionnaire to a respondent, a short introduction was given with the purpose. This introduction included a short presentation of the researchers along with a disclosure stating that it s non- profit and the answers is anonymous. After fulfillment of the questionnaire, more information about the 18

20 research was given along with a short introduction of cryptocurrencies. The questionnaire was tested on five test personas reflecting the population, then feedback was given. This was done to ensure the understanding of the question and limit potential language and cultural barriers. The participants observation at the meetup in Cebu city consisted of observing conversations without interruption. None of the observations from the meetup have been used in this thesis but only served as a background knowledge. The overall structured and well documented approach followed by this thesis should ensure that the study is replicable and can be interpreted to have a high reliability. 19