There seems to be a prevailing idea that the price of BitCoins is somehow intrinsically linked to the overall confidence in the use of the nascent cryptocurrency. If you’ve read any of my previous articles on BitCoin you’ll know that I strongly believe that that isn’t the case and indeed a rising price is usually a signal of speculative investors gaming the market to turn a quick profit more than it being an indication of market confidence. Indeed I was most bullish on the idea of BitCoin when its price stop fluctuating which meant it was far less risky for people to use it as a wealth transfer vehicle, especially for those who are taking the risk of using them in their business.
Now I’ll be completely honest here, when I saw the first stirrings of an upward tick in BitCoin’s price I wasn’t too worried that it would lead to a speculative bubble. Sure it was dangerously close to the same ramp up just a year previous but I felt that the higher transaction volume, larger amount of wealth contained in the BitCoin network and hopefully the market’s long term memory would ensure that any growth in the price was purely organic and sustainable. Of course this discounted external actors with larger amounts of capital working to skew the market in order to turn a profit but I felt that the speculators had had their fun last year and had moved onto other, more lucrative endeavours.
Looks like I was wrong.
As you can see from the above graph the BitCoin price took a turn for the volatile side around the middle of July. Since then there’s been several spikes in trading volume most of which have coincided with a jump in the price. Whilst there appears to be islands of stability that last about a week it never lasted long before another trading bout would push the price upwards. This culminated in a peak price of about $14 late last week quickly followed by a swift downward correction in price with it stabilizing around the $10 mark. As I’ve said before this kind of price volatility is very much at odds with BitCoin being a proper currency and it’s unfortunate to see history repeating itself here again.
Interestingly though the correction in price may actually be due to dwindling confidence, but not in the BitCoin idea itself. The first lawsuit involving BitCoins and the failed wallet service Bitcoinica was lodged just days prior to the value taking a swift nose dive. This was most likely exacerbated by people attempting to cash out at the current peak as you can see the transaction volume on that day was several times higher than the average for the preceding couple of months. Bitcoinica, unfortunately, isn’t the only story of BitCoin based services that have endured failure and this could have very easily shaken the market enough to attempt to dump out early to avoid losing all their value.
The underlying cause to much of the volatility that the BitCoin market experiences is the relatively small amount of value that it captures. Whilst as a whole the BitCoin market is valued at some $97 million (total number of BitCoins in existence multiplied by current price) the total transaction volume on any given day usually only averages $800,000. That’s incredibly open to manipulation and showcases just how crazy those peak trading days, the ones where the value changing hands is on the order of 3 times the average, really are.
Now I don’t pretend to have a solution to this but a new startup called BitInstant might have the right idea when it comes to injecting more value into the market and hence (hopefully) reducing its volatility.
BitInstant is a clever little idea using prepaid MasterCard debit cards which are then backed with either real US currency or BitCoins. The cards can be recharged either by traditional means or by using a BitCoin address that’s printed on the back of the card. They make this even easier by also including a QR code on the back which would enable users to transfer BitCoins between them using things like BitCoin enabled apps on their smart phones. The details on it are still being finalized but this has the potential to take BitCoins from their current niche operations to a much larger scale and hopefully with that bring a lot more stability to the BitCoin price.
BitCoin purists will probably detest the cards since they will require some level of formal identification for them to be able to use it, thus eliminating the benefits of anonymity, but I don’t believe BitInstant’s product is aimed at them. Indeed it seems to be more of a way to make BitCoin function more like a traditional currency as currently it really is only for the technical elite or those who have a need to transfer funds in a completely untraceable manner. Giving people a physical card they can use anywhere will go a long way to making BitCoins much more palatable for the masses, something that all the current BitCoin services I feel have failed to do.
BitInstant is just one piece in the larger puzzle though and realistically its going to take many, many BitCoin enabled services to make it viable as a currency. Good news is that appears to be happening with BitInstant being just the latest contender to throw their hat into the BitCoin ring. Hopefully this means that the peaks and troughs in BitCoin’s trading price will soon be a lot more tame and then I’ll stop harping on about how BitCoin’s price is the last thing we should be thinking about if we’re serious about it being a currency.
In the short time that Bitcoin has existed the amount of press, controversy and debate that it’s managed to stir up has been quite staggering. Back at its inception many jumped on it as a way to make a few bucks on the side without having to actively participate in anything but it soon quickly grew from there into a stable little economy that had a mix of both wealth seekers and believers in the idea. The start of this year saw Bitcoin undergo a massive meteoric rise to fame, drawing the critical eye of economists and arm chair financials like myself. The speculative bubble soon burst sending millions of imaginary worth into the digital ether and the confidence in the currency was shaken. Still I saw this as a Bitcoin coming of age as if it could survive this it could potentially become the currency everyone was hoping it to be, once it had some stability.
Since then it appears that the Bitcoin market had hit the bottom of the bursting bubble, tapping out around the US$2 range. It’s since then recovered a little more to be around the US$4 range which, whilst still not being the dizzying heights we saw back in June, is still quite respectable and lot higher than it’s value in years past. What’s truly interesting however is Bitcoin’s transaction volume over the past couple months, it’s actually remained quite high:
Looking at that graph you can draw the conclusion that whilst the value of a Bitcoin has dropped significantly it’s actually still seeing quite a lot of use as a transactional currency. The trading volumes of some of the days in recent months dwarfs that of the speculative bubble and yet the Bitcoin price has remained somewhat steady. This graph would then indicate that the speculators which drove the bubble to it’s crazy highs have well and truly left the market and the majority of currency conversions are from people actively using it as a commodity rather than an investment.
This was one of the biggest challenges facing Bitcoin: it’s liquidity with other currencies. Whilst it’s all well and good to think that we could do all our transactions in this new medium the fact is we can’t and thus Bitcoin’s utility is directly linked with our ability to exchange it for real world currencies. Indeed Ars Technica gives a good view on how Bitcoin’s could market itself as a better wire transfer service and this new found liquidity definitely plays a part in making such an idea come into reality. There is one nagging problem however and that’s the underlying volatility of a commodity with such a small trade volume.
The chart above would lead you to believe that the Bitcoin price had been relatively stable for the past 2 months but that’s just a function of how the graph is presented. Instead of showing the daily average price and transaction volume over the past year if we instead take hourly price and transaction volumes we see a very different picture:
What we can see here is just how volatile the value of the price really is. Whilst it’s nothing compare to the speculative bubble you can still see that transaction volumes on the order of 20K to 40K can swing the price of a Bitcoin considerably, on the order of US$1 or more. Granted there does appear to be periods of low transaction volume with steady growth (between the 17th of November and 1st of December) but the only time that Bitcoin enjoys true value stability is when the transaction volumes are below 10K per hour, and that’s got to change if Bitcoin can be considered as a stable currency. Right now anyone with $120,000 could swing the market one way or another, which is chump change for almost any investment firm.
The takeaway from all this then is that whilst Bitcoin has definitely taken a step forward in terms of liquidity it’s still far too volatile to be considered as a good transactional currency. Whilst I believe the actual value of a Bitcoin is largely irrelevant what does matter is how stable it’s value is over a long period of time. Right now Bitcoin still has the same inherent instability that allowed speculators to create the huge bubble back in June and until it manages to stabilize itself I can’t see getting past the technical novel stage. Whether it’s capable of doing this I can’t comment on as whilst it’s a technically elegant solution economically the challenges it faces are quite large and I’m not sure they have a simple solution.