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Does bitcoin have a big volatility problem?

Posted by
November 18, 2015
in Blog

Jim Harper recently described purchasing power volatility as “a well-recognized impediment to the success of Bitcoin as a currency.” It is well recognized, but also overplayed.

There’s no denying that the purchasing power of bitcoin is relatively volatile (though less so over the last year or so) or that a volatile exchange rate makes bitcoin risky to hold. However, most people know bitcoin is volatile. Those wishing to transact with bitcoin despite the volatility usually take steps to mitigate the downsides while some in the bitcoin community are compensated for (knowingly) bearing the risk.

Consumers and businesses need not risk much of their wealth to use bitcoin as a low-cost means of payment. Intermediaries, like Coinbase, permit users to convert traditional currencies into bitcoin at the time of making a payment and permit the conversion of bitcoin into traditional currencies at the time a payment is made. A relatively simple transaction might involve a dollar to bitcoin exchange, a bitcoin transfer from payer to payee, and a bitcoin to dollar exchange. In such a case, the payer can spend bitcoin and the payee can receive bitcoin without either having held any wealth in bitcoin. The payer would incur a fee to convert into bitcoin and the payee would pay a fee to convert out of bitcoin. These fees are quite low, though. At the moment, exchange fees are in the neighborhood of 1% of the transaction value—less than traditional merchant accounts.

The pseudononymous nature of bitcoin makes it difficult to produce reliable data on the subject. However, based on conversations with those using bitcoin regularly, I would venture a high-end estimate (read: guess) that most consumers transacting with bitcoin hold less than one month’s pay in the volatile cryptocurrency. A more realistic estimate would probably put the figure closer to one week’s pay. Merchants accepting bitcoin are even less likely to hold it. Coinbase advertises its Instant Exchange option to businesses. “Most merchants,” it reports, “set prices in their local currency and receive payouts in their local currency.”

The available data support the view that most people holding any bitcoin are not holding much. One analysis suggests two thirds of bitcoin users hold less than one bitcoin (worth roughly $256 today). An earlier analysis estimated that more than ninety percent of bitcoin users held less than one bitcoin.

If neither payer nor payee holds bitcoin, they need not be concerned with—and will not suffer losses from—the fluctuating exchange rate. The less one holds, the less one is affected by the volatility. On the other hand, holding a small balance of bitcoin allows one to enjoy the novelty or discounts associated with bitcoin transactions while minimizing transaction fees. It is a tradeoff: some are willing to risk a very small portion of their wealth to avoid transaction costs.

Of course, someone must be holding bitcoin and, in doing so, bearing the risk of a fluctuating exchange rate. Intermediaries hold large quantities of bitcoin, enabling them to meet the fluctuating demands of transactors at a moment’s notice. Why would they bear the risk? Simply put: they are in a better position to bear this risk and it enables them to charge higher fees from those wanting to transact with bitcoin but not in as good of a position to bear the risk.

Unlike routine bitcoin users, intermediaries conduct a large number of transactions. Sometimes they incur losses. Other times they experience gains. The losses and gains from a fluctuating exchange rate will tend to cancel out. The gains from fees and a general tendency for the value of bitcoin to increase over time with the size of the network makes intermediating transactions a profitable venture. So, as long as they expect demand for bitcoin to grow over the long run and they will be able to charge fees for their services, they will continue holding bitcoin—and bearing the risk that entails.

Harper is right that bitcoin is volatile; that this volatility makes it less desirable to hold; and that its volatility will continue to decline as the demand for bitcoin increases. Nonetheless, concerns about its volatility are often overstated. A more sophisticated understanding of bitcoin’s volatility would help one decide whether (or, to what extent) it makes sense to hold bitcoin. It would also help policymakers decide whether (or, to what extent) bitcoin should be regulated on the grounds that it is volatile.