Bitcoin Series 9: Five reasons that bitcoin is currently volatile and why it does not matter

One of the major ‘criticisms’ of bitcoin is its volatility in relation to traditional currencies.   I do not worry about this because it is an inevitable outcome of a brand-new asset class.   In the event that bitcoin works and becomes adopted, volatility will diminish.  If bitcoin is not adopted, who cares if it is volatile?

The main drivers of bitcoin volatility are below.   In any positive outcome for bitcoin, they will diminish over time.

(1)    Regulatory Uncertainty.   The regulatory landscape has only started clarifying in the last couple of months.   Over the next two years, every major economy will have clear guidance (positive or negative) relating to bitcoin regulation and we will no longer have positive (US) or negative (China) surprises.

(2)    Money Supply:  The total value of the bitcoin money supply is less than $10B.    M1 for traditional currencies worldwide is in the range of $30T.   So trivial movements in traditional currency markets cause tsunami-like movements in bitcoin markets.

If bitcoin gains further adoption, money supply will almost by definition increase.    To believe otherwise would suggest that, as adoption increases and volatility decreases, the price will go down, aka fewer people will want to hold bitcoins than do today.

(3)    Liquidity:  Total bitcoin trading has exploded.  It still represents less than $100M of trading per day.   Traditional currency trading is measured in the trillions of dollars daily.   As with money supply (#2), bitcoin trading volume is still too small to absorb traditional currency market shifts smoothly.   Similarly, this will alleviate itself naturally as bitcoin becomes more adopted and trading volume increases.

(4)    Market access:  There are only three major exchanges (that trade traditional currency for bitcoin) in the world right now, each with some issues:

a. Mt. Gox in Japan that has not solved its issues in redeeming US dollars

b.      BTC China that has had most mechanisms for depositing yuan blocked by the Chinese government

c.       Bitstamp, a small company in Slovenia (that 2.5 years ago ran a computer shop) that handles most of the exchange volume for the United States and the EU

Anyone with experience with financial markets will recognize the absurdity of the current situation.   Japan and China have crippled exchanges.   In the US and EU if anyone wants to buy more than a few thousands of dollars worth of bitcoin in a day, they have to wire US dollars to a small unknown firm in Slovenia.    This is in no way a criticism of Bitstamp; they have done excellent work.   But pension fund manager, hedge fund or endowment is going to wire $20M of pension money to them given the perceived counterparty risk.

This is a really important point.   Once people feel more comfortable moving institutional money in and out of bitcoin for trading purposes, it will create liquidity, start to generate a market-making and stabilize the swings.

This will also allow the development of advanced financial / hedging instruments that allowing people to take different positions vis-a-vis the currency.

(5)    Limited transactions:   Adoption of bitcoin as a payment mechanism is still in its infancy.   We are still at the stage where it is world news when a firm accepts bitcoins.   As this changes and more payments are actually conducted in bitcoin, there will be a steady stream of non-speculative buying and selling of bitcoin that will provide day to day stability and liquidity.

Summary:  So long as adoption of bitcoin continues, the factors that create bitcoin volatility will diminish in their impact.   If for some unknown reason, bitcoin is a bust, then volatility will not go away.  But, in that case, who cares?

I will concede that it is possible that bitcoin, with the lack of a central bank, will always be a bit more volatile than traditional currencies, but it will stabilize at a far more stable range than it has today.

As a side note, it amuses me to see the financial services industry so concerned about bitcoin volatility.   This is an industry that has brought us options, derivatives, junk bonds, CDOs, CDOs squared and so on and has never met a way to enhance, hide or restructure volatility that it did not like.  Similarly, I can’t imagine how volatile the tech industry would look if we valued VC portfolios by trading every early stage company 24/7/365 on a variety of exchanges worldwide, keeping in mind the majority of them will go to zero.   Yet nobody is suggesting that we can’t societally handle this volatility and even invest the pensions of working class people in it.

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Posted on December 28, 2013 and filed under Bitcoin.