The Bitcoin Volatility Problem, and Possible Solutions
Can the BTC Vol Problem Be Overcome?
Bitcoin is easily one of the most significant economic experiments in history. It represents hope for a world led by fiscally reckless politicians. But there are several logical hurdles that Bitcoin will have to jump through in order to become anything close to a practical money. Its volatility and endless uncertainty currently make it unsuitable as good money.
Can it overcome those hurdles with time? Let’s take a look at some graphs and see just how far Bitcoin will have to go. I have included the data in this article from my Excel workbook, it is linked at the end of this article.
The Volatility Problem
If Bitcoin can ever be a practical money, its value has to stabilize. Long-term contracts depend on a money’s stability to satisfy all parties involved.
To put this in perspective: let’s say that last year, you took out a loan in Bitcoin when its price was just below $8000. Today, your debt would have increased by over 7 times, as of this writing in February 2021. You went from a debt valued at $8000 to now owing the value of $58,000. That’s how this works. That is one of the main reasons why governments love devaluing their currencies. Inflation, or depreciation, of currency makes paying back debt significantly easier. Deflation, or appreciation, makes paying back debt significantly harder.
As a rule, money that appreciates with time is more practical than a money that depreciates, but both inflation and deflation can undermine an asset’s role as money.
Over Bitcoin’s lifetime, the volatility has trended downwards. But this also includes Bitcoin’s discovery period— that initial blastoff that rocketed Bitcoin from near 0 to triple digits around 2013. But if we take a look over the last 5 years, we see the opposite:
This makes sense. Bitcoin’s volume has trended upwards with time, and it’s a well-known phenomenon in finance that an increase in volume tends to increase volatility. That’s not to say it’s a law, it’s a phenomenon — it tends to happen. Generally speaking, an increase in volume = increase in volatility.
So how does this volume compare to other currencies? What about the dollar?
Bitcoin is, on average, 12.5x more volatile than the dollar.
The dollar, despite politicians’ best efforts to plunge its value, is fairly stable when compared to other currencies and commodities.
On the Concept of Adoption
Generalizing the common Bitcoin maximalist argument, they claim that once Bitcoin nears or reaches “adoption,” the value should begin to stabilize.
No one seems to have a clear idea of what “adoption” means. If “adoption” means, accepted and enforced by governments, then perhaps there is a solid footing in that argument. But this is highly unlikely to happen. I’m inclined to think that many governments would go to war, perhaps even on their own citizens, or enact Orwellian commerce controls before they ever allowed their currency to be overtaken by something they have such little control over. It is the national currency that grants a government financial power over its populace. We should never underestimate how far they will go to secure that.
Going further, there are currently ~100 million Bitcoin users total, as well as ~200m Bitcoin wallets, (if the figures of this source are correct).
Just by users alone, that makes Bitcoin users equivalent to the 15th most populated country on the planet. If “adoption” means some optimum amount of users, (that no one would dare specify), is it possible we’ve already passed that hypothetical point?
Is it really the number of users, and the resulting arbitrage that makes an asset stable?
I used to think so, but I now believe it may be more complicated than that. There are currencies with far fewer users, and lesser total valuation than Bitcoin, but they maintain a far more stable price.
For instance, the Thai Baht makes up 0.5% of foreign exchange trading, and there are only roughly 70 million people in Thailand itself.
Using Bitcoin’s transaction volume data from blockchain.com, it appears Bitcoin transaction volume for 2020 was $626.51B.
Based on this report from bis.org, the Thai Baht roughly saw $32B in forex volume for 2019.
That means Bitcoin has roughly 20x the transaction volume of the Thai Baht. Yet Bitcoin is still 16.4x more volatile than the Thai Baht.
According to coinmarketcap.com, Bitcoin is currently the 14th largest currency in the world by market cap. The Thai Baht is #16.
The Baht is even 1.3x more stable than the dollar, despite the dollar making up over 80% of global trade!!
That seems to throw a wrench in the idea that total arbitrage tends to bring stability. It seems stability is far more complex a phenomenon than we imagine.
Bitcoin’s Inherent Uncertainty
How exactly do you value something that can potentially be anything?
It’s pretty straightforward to set a price on a lump of coal. Coal has certain chemical properties that make it excellent for heat and combustion — but you can’t craft a sword from it, you can’t shoot it from a gun, you probably shouldn’t eat it, and you can’t store it online. It has physical properties that are inherent to its existence; these properties can be manipulated but not easily changed. It has clear limitations.
As investor Jim Rogers puts it, when valuing commodities, the only thing you really need to know is, is there too much of it, or too little of it? That is to say, is there a surplus or a shortage? Companies are more abstract concepts, they are potential energy, and are therefore much harder to value. Millions of indicators are used in the pursuit of valuing companies, from P/E ratios, to EPS , to free cash flow per share. The same cannot be said about commodities, most commodity indicators are simply indicators of supply and demand. Apple may not always be around, but gold, on the other hand, is indestructible.
The Bitcoin payment network can be forked endlessly. The technology will continue to evolve. In this sense, valuing Bitcoin is not unlike trying to value a company.
Bitcoin has inherent uncertainty, and speculators realize this. This uncertainty gives a never-ending reason to bet against it, creating the same engine of volatility that stocks tend to experience.
That begs the question, have we ever tried using stocks as money? Well, somewhat. One famous example comes from the Mississippi Bubble of 1720 in France, a fascinating time in history, (with many parallels to today I would argue). Economist John Law convinced the French government to buy shares of his Mississippi Company as a scheme to refinance the nation’s massive debt. The government then began issuing paper bank notes, redeemable in gold and silver. But these notes weren’t really based on gold or silver, they were primarily based on Mississippi Company stock. The crown would buy Mississippi Company stock, which encouraged investors to buy stock as well, which would then allow Law to sell more shares; he could then use that capital to refinance the French debt.
The scheme ended with hyperinflation of the French livre, and roughly 50 people were trampled to death as frightened French citizens rushed to exchange their banknotes for silver.
Nevertheless, how does Bitcoin’s vol compare to that of some of the most popular stocks on the market, say… Apple and Microsoft?
Apple is currently the most valuable public company in the world, and it has 3 times less volatility than Bitcoin. Seeing as Bitcoin shares a similar uncertainty as Apple, this may be the best we can hope for any natural stability Bitcoin might obtain with time.
How well would Apple stock fair as a currency?
It would currently fair better than Bitcoin in terms of stability, but since 2016, Apple stock has nearly doubled every year. Would you want to see your debt obligations double every year?
The Tradeoff of Competing Currencies
Competing currencies are a necessary evolutionary process, but they’re not without their tradeoffs. The cryptocurrency market has become a highly competitive landscape, a vast laboratory of ideas. How will this effect Bitcoin over the long run?
As a rule, competing currencies degrade the value of one another.
Currency markets are zero-sum games. This runs in stark contrast to most markets, but currencies have a very unique property: they only work well if everyone agrees on them. Since currencies all essentially do the same thing, there’s little reason to own multiple kinds of currencies. So when one currency rises, another currency tends to fall.
Competing currencies can also make accounting a nightmare. The accountant has to have a fixed point to which to measure value; this is one of the main problems with a barter economy. If the accountant is trying to determine if the company has made a profit at the end of the month, and they look to find they own 3 cows, 2 chickens and an ox, but they traded 30 ounces of copper, and 50 pounds of aluminum, how much value have they produced? It is only because we’re so used to having a fixed point like the dollar that we can intuitively make that estimate. That fixed point of value degrades with increased competition of currencies, which is why a commonly accepted money is beneficial for a society.
Currency traders know this phenomenon well. This is how some traders have made fortunes, buying one currency while simultaneously shorting another.
And of course, this competition does not help alleviate Bitcoin’s volatility problem. We don’t know how long the crypto wars will last. What makes Bitcoin immune from the same phenomenon that killed Myspace?
Over the long-run, theoretically the more stable cryptocurrencies should become more widely-used. I get the impression the Federal Reserve thinks the same thing, which is why they haven’t addressed Bitcoin as a threat to the dollar but they do seem to believe that stablecoins are.
The hyper-competitive landscape of the cryptocurrency market will cause major disruptions; it will improve the technology at the expense of a core tenet of money, to be a stable, agreed-upon, medium of exchange.
Possible Solutions
I am not the first person to address this problem, but I appear to be one of the few. The vast majority of thinkers on this subject seem to be under the impression that this problem will simple solve itself with time. I totally admit it’s possible this is just a time-based issue, my position is that it’s highly unlikely.
And hypothetically speaking, even if this is a problem that will solve itself with time, do you really think the Fed won’t have their own cryptocurrency before then, and that they won’t force you to use it? Keep in mind, the currency market is a zero-sum game; if the Fed issues their own crypto before Bitcoin’s vol problem is solved, that is not good at all for Bitcoin.
There is one service I came across that may help alleviate the issue, it’s a concept called the hedge-lending service by a company called Digits. To be clear, I am not affiliated with this company at all; never even spoken to anyone at this company, this is just one of the few solutions I came across. Here is an article on the concept, it essentially creates automatic debt obligations with every transactions so that any volatility fluctuations in the transaction can be paid off with time, (or at least that’s my understanding of it).
But I don’t think this is the best answer. The debt obligations will still be subject to volatility problems. So far, I have not found a great answer, but I’ve been thinking about the possibility of automatic hedges with smart contracts.
To be clear, I have not entirely fleshed this idea out, in fact I’m not even sure if it makes much sense with Bitcoin. Here’s the basic idea: if you buy a stock, and then you short the same stock… what happens? Perfect stability. There is no increased or decreased value of your position, and your position remains at the price at you bought the stock . This is called Shorting Against the Box and it used to be perfectly legal, but regulators hate anything that may alleviate the extraction of your wealth through taxes, so it was banned years ago.
Could this concept be applied to the Bitcoin vol problem? I honestly don’t know. If you think I’m wrong, or if you have another possible solution, or if you’re just as fascinated with these ideas as I am, please feel free to reach out to me any way you can; I’d love to connect with you.
Here is the Excel workbook I used in this paper. Hope you enjoyed it.
