Adverse selection of bitcoin? adoption rates, network effects and switching costs

Bitcoin is a digital currency operating as an open-source, peer-to-peer network that enables a decentralized digital payments system.  Its unique property is that it functions without the need of intermediaries (e.g., PayPal) to solve the “double-spending” problem.  Accordingly, this accounts for its growing success in attracting both legal and illicit transactions from pseudonymous users.  As of Fall 2013, the total market capitalization of the Bitcoin economy exceeds $2 billion (U.S.), and continues to grow rapidly.  Yet digital currencies have, to date, not been perceived as a legitimate threat to supplant national currencies as a medium of exchange.  Indeed, economists have generally ignored virtual (cyber) currencies despite claims about their potential advantages expressed by hobbyists and computer scientists.  Following the introduction of Bitcoin in 2008, policymakers and regulators have sharpened their interest in this synthetic commodity money.  This heightened concern arises both because of problems that it may create, but also from the belief that this unique currency might actually gain widespread acceptance.  Clearly, economists need to explore scenarios where specific agents and user groups overcome switching costs in order to exploit the unique benefits of this currency.  For example, these types of digital currencies offer advantages for international transactions because they obviate foreign exchange risk and capital controls.  Accordingly, users may adopt such currencies to facilitate international trade and investment flows, even if they remain committed to local currencies for domestic transactions.  Also, consider that the pseudonymous nature of Bitcoin may facilitate a migration of illicit transactions away from traditional currencies by money launderers and terrorist groups.  These currency transition scenarios represent major regulatory challenges to policymakers, not the least of which is the reluctance of governments to relinquish control of their monetary base. 

The present paper is concerned with the potential for this currency to gain acceptance amongst particular user groups, organizations and countries.   We utilize a model that incorporates network effects, user benefits, and switching costs to examine the intensity of currency acceptance across various sub-populations.  The model explains the phenomenon of “partial” adoptability, recognizing that currency switching need not be an “all or nothing” proposition.  The specific focus of this research concerns the potential for advantageous or adverse selection, as Bitcoin may achieve higher adoption rates for international payments, illicit money flows, and currency transfers that suffer from high transactions costs.