Bitcoin Volatility And Mainstream Acceptance
Bitcoin, the 7-year old cryptocurrency, is steadily gaining popularity. There are several million people who own bitcoins and usage is doubling year after year. This is great progress, but I don’t think anyone would suggest that Bitcoin has reached the mainstream. To get there, Bitcoin will need to be easier to use, and there most be more highly demanded services built on top of the currency. I contend that there is one last challenge Bitcoin must surpass to achieve wide-scale, global adoption: reducing its price volatility.
I am sure that many of you are Bitcoin skeptics because of everything you’ve heard in the media. In particular, you are probably thinking that Bitcoin is:
a.) primarily a payment method for terrorists, pedifiles, drug dealers, and crooks
I thought the same until a few months ago when I took a closer look at the currency. So before getting into the volatility analysis, let me address (a) and (b) points now.
In the early days, Bitcoin was sensationalized in the news as THE currency for black markets The fact of the matter was that during a 6-month period from Feb 2012 until August 2012, an average of 7,665 bitcoins per day (equals 2.8M bitcoins per year) were transacted on Silk Road, which was in its time the dominate black market in the Bitcoin economy. The estimated transaction value of all bitcoins (or “Bitcoin GDP”) during that year 55M bitcoins, so black market purchases represented 4.4% (= 2.8M/55M) of the Bitcoin GDP.
This isn’t as devastating a statistic as the media would lead you to believe but still very high, right? Well, let’s compare it to the U.S. dollar. In 2012, the estimate for the U.S. black market was $602B for illegal drugs, counterfeiting, and human trafficking. The U.S. GDP that year was $16.1 trillion. $602B / $16.1T = 3.8%. That is very similar to the 4.4% for bitcoin. (Of course this 3.8% goes much higher if you add the greenbacks that are used for illicit transactions overseas [over 70% of all $100 bills are outside of the U.S.]) The conclusion is clear:
In relative terms, a bitcoin and U.S. dollar are equally likely to be used in a black market transaction. In absolute terms, someone is 40,000 times more likely to pay for something illegal with dollars.
This brings me to the second issue- hackability. The media often conflates Bitcoin exchange hacks with Bitcoin hacks ( for example). The reality; however, is far more mundane than the headlines:
Bitcoin has never been hacked since its inception 7 years ago.
Unfortunately this reality either escapes the media’s understanding of Bitcoin or it simply isn’t an interesting enough headline to get clicks.
Several exchanges that store bitcoins have been hacked, but the Bitcoin infrastructure has proven to be resistant to hackers. The situation is akin to a thief being able to rob a bank but not able to hijack the Federal Reserve or take over the U.S. Bureau of Engraving and Printing.
I don’t want to imply that Bitcoin security is entirely without problems. There does remain the possibility of denial of service attacks (“Consensus Attacks”) that could delay upcoming or recently initiated transactions from being completed. Theoretically, there is also a possibility of a “51% attack” in which a group of people collude to become a 51% majority of the network’s computing power enabling them to double spend their own bitcoins or initiate a denial of service attack as described above. That said, even if one or both of these attacks take place, your bitcoins will remain safe.
So with those two myths debunked, let’s get on to the discussion of volatility.
The total value of all bitcoins in circulation at the time of writing is over $10 billion and there are more than $50M worth of bitcoins traded or spent every day. In the 7 years of Bitcoin’s history, the value of one bitcoin has skyrocketed from fractions of a penny to over $700. Ironically, this large increase in Bitcoin’s valuation actually dissuade consumers from using it for daily purchases.
Why? Well, imagine that you have one bitcoin to spend and you think its value will go up from $400 today to $700 in a few months. Now let’s also say that you you are in the market to buy a smartphone. You could spend your bitcoin today to buy a $400 ZTE phone or wait the few months and buy the $700 iPhone. Thus, you wait.
On the other hand, if you think the value of a bitcoin will drop precipitously, then you would probably refrain from buying bitcoins altogether.
The result of the actual (or expected) volatility is that consumers sit on the sidelines and this slows Bitcoin from entering the mainstream.
In order for a currency to succeed, it must not only serve as a medium of exchange, but it must also be a reliable and relatively steady store of value.
At this point, I am sure many of you are wondering exactly how volatile is bitcoin and how does it compare to the major global currencies today?
To answer that question, I recorded bitcoin’s daily closing price for the past 6 years and measured the percentage increase or decrease each day. I then made a histogram plotting those daily changes for 2011, 2012, 2013, 2014, 2015, and 2016.
(Some statistical hocus pocus reveals that there is a very high degree of certainty that all of the histograms follow a normal curve distribution.)
In 2011, one standard deviation for the daily change in closing price was 10.3%. This is a huge spread that would scare all but the most diehard Bitcoin believers or their speculating brethren.
By 2016, the standard deviation shrank to 2.6%.
So, is 2.6% still a big number? Let’s compare it to three other currency pairs– the British Pound-US Dollar, Euro-US Dollar, and Yen-US Dollar– during the relatively volatile 2016:
As you can see, the standard deviations for those other 3 currency pairs range between 0.6% to 0.9%.
It is clear that Bitcoin volatility is shrinking but it is still a ways off from the more stable major currency pairs.
Next, I wanted to see how quickly Bitcoin volatility is shrinking, and make some basic assumptions for how long it would take for its volatility to equal that of the other currency pairs’.
Therefore, I plotted a graph with the annual Bitcoin volatility on the vertical axis and the number of transactions per year on the horizontal access.
The resulting equation gave a very high R2 value of 0.81361 meaning that it explains just over 81% of the variance of the data points to the line. In other words, the number of transactions and volatility are closely linked.
Intuitively this makes sense- the more transactions per day there are in a market, the more liquid it is. Higher liquidity means less of a spread between the bid and ask price, and thus makes the volatility a little less chunky.
Finally, I wanted a rough forecast to see how long it would take for the bitcoin-USD volatility to converge that of the other 3 currency pairs. To calculate this, I made two assumptions:
- The curve above would hold true even for many, many more transactions per year.
- The average number of bitcoin transactions per year would continue to increase at 150% per year (a figure similar to the past few years’ rate of increase).
The points in red represent the actual figures from 2011 through 2016; the points in grey are the forecasts for 2017 through 2024. As illustrated above, the plot converges to 1% by 2024– a figure close to the 0.6%-0.9% range for the other 3 currency pairs.
This means that it would take 8 more years before Bitcoin’s volatility reaches parity with the Pound’s, Euro’s, and Yen’s volatility. But of course, real life isn’t so simple. This forecast doesn’t address several factors that play major roles in a currency valuation:
- Geopolitical shocks & shifts
- Volatility in other asset classes and cryptocurrency competitors
- Bitcoin’s acceptance by wall street (institutional investors)
- Bitcoin’s acceptance by main street (wholesale and retail)
These assumptions and omissions can skew the forecast a lot. Still, the historical evidence points to the fact that there is a positive feedback loop in that Bitcoin is gaining ever-greater acceptance and this is continually driving volatility down which sparks even more acceptance.
If this trend holds, we are less than a decade away from Bitcoin becoming a real alternative currency for consumers.