BitCoins are a hybrid of two currency models, namely the current world standard of fiat currency (I.E. BitCoins only have value because other people will accept them in exchange for goods and services) and the traditional gold standard due to the availability being limited. Combined with the other properties such as transaction anonymity (within reason), no central system regulating transactions and worldwide reach BitCoins have all the features it needs to be a great vehicle for the transfer of wealth. Long time readers will know that there are some issues that plague the BitCoin ecosystem, mostly due to its relatively low transaction volume and misclassification as an investment vehicle by some, but these are things that can be solved with time and more investments.
One thing that always gets to me though is any time that BitCoins start to trend upward nearly every news outlet looking for a story will herald it as a second coming of BitCoin after the devastation wrought by the speculative bubble last year. I’ve made the case several times over that an increase in price is no indication of health within the BitCoin economy and in fact any sharp uptick in price is actually quite hurtful as it signals that BitCoins are better left unspent as it makes no sense to spend them when simply waiting will give you a discount. This hoarding mentality is what led to the speculative bubble last year as supply dried up and prices went through the roof. It didn’t last long however and the price came crashing back down to reality (and then some).
I don’t discount that all growth within the BitCoin economy is a bad thing however, just the volatility. Indeed there was a good period of 6 months this year when BitCoin’s price was relatively stable and that’s what it needs to be in order for commerce to take the currency seriously. Taking this idea further there has to be a price equilibrium where the exchange rate is truly representative of all the wealth contained with BitCoins and this is the point where the market should aim towards. Figuring out that particular price isn’t easy though and I can only really give a semi-education guess as an answer.
The longest time that BitCoin spent in relative stability was around the $5 mark from around May this year. Since then there have been another 1.2 million BitCoins added into circulation, an approximate 13% increase. In a completely stable exchange this would have put a downward pressure on the exchange rate which would have decreased the real value by a similar percentage. To keep the value “ideal” then, I.E. the real purchasing power the same, the exchange rate should go up by that rate instead giving us a new price of $5.65.
Of course this completely ignores the amount of potential wealth that could be contained within the BitCoin economy. A country’s currency is usually a reflection of the health of its underlying economy and BitCoin is no exception to this but we don’t have other metrics like GDP in which to get a good idea for how much wealth is backing it. Transactions volumes, exchange rates and total coins in circulation are only rough metrics and we’ve seen in the past how these things aren’t great indicators for the health of BitCoin.
Realistically the best exchange rate for BitCoins will be the one that it ultimately settles on once transaction volumes ramp up again and the investor market segment starts to become more and more irrelevant. Whether this is above or below the current rate is really anyone’s guess however we should still abstain from saying that the rising price of a BitCoin is a sign of market health as it’s simply not. Whilst the price rise is no where near as rapid as it was last year it’s still light years ahead of any other currency on the planet and as history has shown that kind of growth just isn’t sustainable. The next 6 months will be very telling for the BitCoin economy as we’ll see if this growth levels out into a new stable equilibrium or if it’s just the beginning of another speculative bubble.
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.