Understanding Bitcoin Volatility
Bitcoin is touted as a long term store of value and a future medium of exchange, but as we have seen it has very volatile price history. This is a common criticism of Bitcoin with folks like Ray Dalio, stating that Bitcoin cannot function as a store of value or medium of exchange due to its volatility. Therefore, they claim Bitcoin is failing at what it was designed to do. This is a reasonable criticism of Bitcoin at the surface. Currently, Bitcoin is volatile and it cannot properly act as a medium of exchange (its use as a medium of exchange will come when its reached mass adoption, true price has been discovered, and its volatility has dampened). However, as I discuss later in this article — short term volatility does not negate the asset from functioning as a long term store value. Ray is correct in his analysis that Bitcoin is not yet a store of value in the traditional sense, compared to something like gold or real estate. Bitcoin is actually an emerging store of value. For that reason, you have to expect it to be accompanied by speculation and periods of rapid growth during this phase of its evolution. The Director of Research at Fidelity Digital Assets, Ria Bhutoria put this perfectly in her article Addressing Persisting Bitcoin Criticisms by stating “the trajectory of a new asset from negligible awareness and adoption to a global store of value is unlikely to be linear”. It is simply just not plausible to think something that didn’t exist 10 years ago can go straight to being a stable global asset overnight. There is a process to this, an evolution if you will.
This picture shows the evolution path Bitcoin will need to take to become “Global money”. I believe we are edging closer and closer to the “Reliable Store of Value” point on the axis, however we are not fully there yet. In my first article I talked about how this new form of money is the best money humankind has ever encountered. Through studying history we can see, when left to the free market, new forms of money typically evolve in a similar fashion. First starting out as a collectible due to a scarce supply of the good in society. If society continues to value the scarce good, it is then able to store that society’s value over time. If and only if this scarce good continues to be valued by society and it possess the characteristics of money, it can then begin to function as a medium of exchange as well as a unit of account. The closest comparison we can draw to Bitcoin is gold, which followed this exact path thousands of years ago to become the best money in human history. Gold took thousands of years to evolve through these functions of money, where Bitcoin is moving through these phases in decades. This can be attributed to things like network effects, global knowledge sharing, and more specifically I argue its volatility. The volatility has helped put Bitcoin in the spotlight of the entire world on multiple occasions, which for better or worse makes people aware of the asset. The volatility is inherent to Bitcoin while in its infancy and for good reason. Once you understand the technical underpinnings of Bitcoin you will start to see the volatility is actually a feature built into the system. A feature that aligns all parties’ incentives to bootstrap adoption and ensure its evolution as money.
The Reason For Volatility
When you dig deeper and understand why the volatility is occurring you can see that it is actually a feature of the protocol designed to help it gain mass adoption and evolve through the functions of money in an expedited process. Through inherent supply shocks, the protocol was configured to have periods of large price appreciation while in its infancy. The cause for this becomes clear when understanding the technical aspects of Bitcoin as well as some basic supply and demand principles.
Bitcoin has a set issuance schedule meaning a certain number of coins are mined each day, and in total there will only be 21 million Bitcoin. Every four years the amount of Bitcoin mined per day gets cut in half (This is called a halving). To help visualize this - see the picture below (picture is outdated and we are now past the 3rd halving which took place in May 2020).
In the first few years of its existence, roughly 7,200 Bitcoin were mined per day (50 per block at 10mins per block each day). After the first halving in 2012 roughly 3,600 Bitcoin were mined per day (25 Bitcoin per block at 10mins per block each day). Following the 2016 halving 1,800 Bitcoin were mined per day and now after the recent halving only 900 Bitcoin are mined each day. So, as of May 2020 around 18.5 million of the 21 million Bitcoin have been mined. The remaining 2.5 Million Bitcoin will be mined by the year 2140. The main point I need you to understand from that information is the incoming supply of Bitcoin gets cut in half every four years, while the total supply of Bitcoin is capped at 21 million. This is where Economics 101 comes into play. If you have a good with steady or increasing demand but a flow of supply that is decreasing you are going to find a higher equilibrium price. Bitcoin is a little more nuanced than this basic econ 101 example because it tends to not just find a new higher price but it finds a significantly higher price, which is then trailed by a heavy correction.
Why is it that these price swings are so large? Well, in the history of mankind we have never had something with a truly finite supply. If demand for Bitcoin stays steady after a halving, where incoming supply is decreased, it is certain we will see the price start to increase. When the price increases, more and more people demand Bitcoin as they see the potential for massive gains, BUT there is nothing that can be done to increase the supply to catch up with the demand. Mix the booming demand with decreasing supply flow and you get parabolic price movements. Now mix all of this with the fact that Bitcoin is only a mere $350 Billion market and it is easy to see why these extreme price movements occur.
As I mentioned above the periods of price appreciation are typically followed by heavy blow off the top downward corrections. This is because many of the people buying Bitcoin during these times are not buying it because they believe it to be a superior form of money, nor do they intend to store their wealth in it long term. They are buying it because they want to speculate and get rich quick. As the price runs up, more and more people are sucked in to do this and eventually we reach a point of buying exhaustion. This is when the major selling starts and Bitcoin then falls back down to a relative level that it should be (given real adoption i.e. people/organizations who have long term conviction in the success of the assets evolution).
Why Volatility is Good for Bitcoin in Its Infancy
Bitcoin operates in such a way that aligns the incentives of adoption with the incentives of all the parties involved. What do I mean by this statement? As we learned above, historically, the volatility induced by the four year supply shocks causes extreme price appreciation. This price appreciation then drives more and more people into Bitcoin, like an opening and closing black hole on a four year time schedule. Many of the people sucked in during the extreme price appreciation phases, sell as Bitcoin falls back down and dismiss the asset as just a speculative bubble. However, a portion of newcomers become Bitcoin believers also referred to as Hodlers or people with long term conviction in the asset. They get brought in by greed but then begin to ask questions like “what is money” or “what is the US dollar” or “what are cryptocurrencies” or “how can the government print dollars out of thin air” or “what is monetary/fiscal policy” etc… to try to understand what Bitcoin truly is. Those who go down this rabbit hole usually come out the other end with one conclusion — Bitcoin is better money and they are willing to hold it as it evolves through the functions of money.
I like to draw a comparison to my own experience here. I was introduced to Bitcoin during the 2017 bull run and didn’t care at all what it was, I even remember telling my roommate “that’s so dumb why would I ever need something other than dollars”. I didn’t believe in Bitcoin but I thought I could get rich quickly if I bought some (Boy was I wrong). Once I had some skin in the game, even after the crash, I felt compelled to look into Bitcoin more and I fell down the proverbial rabbit hole studying things like monetary policy, economics, the history of money, game theory, network effects, etc… This ultimately led me to believe in Bitcoin and what it could mean for society. I have seen this same story happen over a handful of times for friends and family, just in the last few years. Ultimately what I am getting at here is that these price swings drive demand for Bitcoin which expedites the education and learning process required around Bitcoin, which then leads to more demand. These adopters are considered healthy adoption for Bitcoin because they begin to use the asset as a long term store of value and essentially become the “early adopters” of the store of value evolution phase for Bitcoin.
The increase in demand not only pulls in more people but it also increases the infrastructure around Bitcoin like its mining (which makes the network more decentralized and secure), financial products/services (helps lower volatility), and a whole host of other infrastructural necessities (fiat on/off ramps, safer custody, additional payment layers, etc). We can see this if we look at the infrastructure around Bitcoin before the 2016 halving versus after. Mining hash rate has continually hit new highs following the halving meaning there are more miners and the network is becoming more decentralized and secure. There are large financial institutions offering exposure to Bitcoin like Fidelity, the CME futures, Paypal, etc. There are even companies putting Bitcoin on their balance sheets while supporting the development of the system. All of these examples (there are plenty more) were brought in by the price volatility. Yes I am referring to the volatility to the upside for the most part, but you don’t see these companies just leave the space when we see the volatility to the downside. They gain knowledge on Bitcoin and see it as something they want to continue to invest time and capital in which then leads to more demand and a more robust system. This is the beautiful incentive cycle that is Bitcoin.
The thesis that volatility is good for Bitcoin can be quantified with a few different metrics. This is not an exact science but there are some trends that show us significant increases in healthy adoption around periods of volatility. If you look at the chart below we can see the yearly lows for Bitcoin have been higher every year except for 2015.
We can also see this yearly low is significantly higher the two years following the recent halvings (2012, 2016). This effectively means that more people have bought Bitcoin and held it through the heavy downswings. This indicates the market building a bottom and at that bottom are people with strong conviction in Bitcoin who believe it will continue to evolve through the functions of money. Now, we can’t assume all of these people are long term believers in Bitcoin, but it does give us a rough idea of who is actually adopting Bitcoin for the purpose of storing their wealth. Again, this is considered healthy adoption as these are people using Bitcoin for its current intended purpose — storing value over long periods of time.
Another metric we can use to measure adoption is the amount of Bitcoin addresses holding at least 0.1 Bitcoin or 10% of a Bitcoin (currently around $1750). As you can see this metric grew significantly following the first halving in 2012 and even more so after the 2016 halving.
This data highlights that the upside volatility around the halvings is drawing more people in and the downside volatility is not actually drawing everyone out. In fact earlier this year around 60% of all Bitcoin had not been moved in over a year. Together this data shows the people who stick around after the halvings are using Bitcoin as a longer term store of value and are providing a demand base for the asset. Given this trend continues with the current halving period, we can be fairly certain Bitcoin will reach a level of mass adoption sometime in the next 10 years (this is conservative in my opinion). Does any of this guarantee that Bitcoin will succeed and evolve through the functions of becoming global money? Of course not. Only time will dictate the truth of that statement and the current volatility will have to significantly decrease for that to happen. However, in the meantime, it is safe to say the volatility does help drive adoption while Bitcoin is in its infancy.
As I have highlighted in this article, volatility is a feature of Bitcoin due to its supply schedule which is designed to bootstrap adoption while the protocol is in its infancy. This volatility is useful in the short term as it draws in new users, infrastructure, and capital, but over time the volatility will need to steady out. Especially if Bitcoin is to be used as a medium of exchange (I think we are still about 10 years away from this reality). Understand, I am not blind to the fact that if the current volatility persisted forever Bitcoin would struggle to successfully evolve through the functions of money. I cannot say for certain the volatility will ever go away but as I have done throughout this article, I can continue to use the current trends and data to draw inferences about the future. The chart below shows Bitcoin price and its historical volatility (blue line).
As you can see the volatility of bitcoin has continually declined over the past decade, while the price has gone up. As the emerging store of value continues to mature and as natural price discovery occurs throughout the world, we can infer the volatility will continue to decline. There are a multitude of reasons why this may be. The first being the size of the overall market cap. Currently the market cap for Bitcoin is $350 Billion dollars ($19,000/Bitcoin X 18.5Million Bitcoin). That is an extremely small number for an asset that is being traded and used all around the world, thus making the price more susceptible to volatility. If and when the market cap reaches levels closer to gold ($10 Trillion) we can assume the volatility will be much less severe. If an asset reaches a market cap of that size it can also be assumed that the market has matured, meaning large institutions and financial products have been engrained in the system to help level out volatility (we are already starting to see this in Bitcoin).
The second reason I believe volatility will continue to decline over time is the severity of the supply shocks will also decrease over time. Currently the supply shocks are massive and they hit the market like a freight train. Going from mining 3600 Bitcoin per day to only 1800 per day is quite a drastic change to an asset with inelastic supply and growing demand. Even going from 1800 mined per day to 900 per day is quite a shock to the system. However, by the year 2028 about 20.2Million of the 21Million Bitcoin will have been mined. So, at that point about 96% of the total supply will be out in circulation to be bought and sold. The chart below shows a great representation of this. The blue line represents the supply base of Bitcoin while the red line represents the inflation rate (The supply issuance schedule).
This effectively means the halvings will no longer lead to such intense supply crunches, as the majority of the supply is already being valued on the market. At this time the world market will already understand and be able to effectively price in the finite scarcity of Bitcoin. This will allow the market to act more rationally than it currently does today where halvings are misunderstood and more intense. In summary, as the supply shocks become less impactful and if Bitcoin reaches a market cap similar to gold we can therefore conclude the volatility will be a thing of the past.
The Store of Value Case for Bitcoin
I am not here to give investment advice and I simply wrote this article to highlight why the volatility is happening and why I believe the volatility is beneficial to Bitcoin. However, I would like to use the current historical data to show that Bitcoin does store value over long periods of time very well. Again, I think Bitcoin has a little ways to go before it can be classified as a “reliable store of value” similar to how gold or real estate is looked at today, but that doesn’t mean it is not already serving this function to some degree. When you take a step back and view Bitcoin on longer time frames you can see the asset does truly act as a store of value.
This chart is showing the Bitcoin price since its inception (The price is the blue line in the middle). As you can see the price is consistently trending up and to the right. So, when a person buys Bitcoin and holds it over long periods of time the volatility fades to the backdrop. This emerging store of value is not something that should be bought and sold intermittently. It is a savings vehicle where wealth should be parked for long term storage.
To strengthen this argument let’s look at what a simple dollar cost average (DCA — buying a set amount periodically) strategy would have done for an average person over the past 3 years. In the example below we are purchasing $100 of Bitcoin every two weeks (Essentially $100 a paycheck). I chose a start date of the 2017 price top at roughly $20K to December 2020. As you can see this portfolio would still be up almost 50% since doing so. Had you started doing this a year prior to the 2017 top, your portfolio would be up almost 120%.
On the flipside, if you followed this same strategy and bought $100 of Bitcoin with every paycheck starting at the price top in December of 2017 to December of 2018, you would be down 50%. This all goes to show how Bitcoin stores wealth over LONG periods of time, given you use the asset like a store of value or more simply an excess savings account. When I say excess savings account I mean only money you can afford to lose. This asset still has a lot of risk associated with it and it is not guaranteed to only go up. Bitcoin investors are willing to take this risk on in order to get access to a rising form of money that has yet to tap into an extremely large addressable market. As Bitcoin continues to grow and tap into this market we should see the asset mature and with it the volatility should dissipate.