It has become quite standard to hear that Bitcoin is highly speculative. This assessment is generally made in the news by focusing on the daily price variation of Bitcoin, and thus, on its volatility.
It is not a secret to state that currently, speculative trading on the Bitcoin network is strongly correlated with the volatility of price returns. However, what exactly gives rise to this speculation?
First, it can be argued that Bitcoin’s future is far from being certain, and therefore the probability of a bet on Bitcoin leading to a loss of value is not negligible. In these conditions, investors willing to participate in the Bitcoin network require sizeable gains to mitigate the associated risks, which translates directly into market speculation, ultimately leading to volatility. Additionally, competition in the crypto world adds a dimension of volatility to Bitcoin since the latter must compete for market share against other crypto-currencies, called Altcoins for Alternative Coins to Bitcoin. Although some Altcoins may have interesting features, a lot of them have been using the momentum created by Bitcoin to raise money through Initial Coin Offerings (ICOs) and to create a need for which the fundamentals are weak. The consequence of this situation is that at the moment, there are too many coins out there with shaky fundamentals which effectively create a speculative shadow over Bitcoin’s future.
Second, although Bitcoin is quite revolutionary, the understanding of its fundamental principles is largely unknown to people not having a daily exposure to its technicalities. The consequence of this reality is explained through the theory of behavioural economics, whereby uninformed agents are involved in a higher degree of irrationality. Since these agents have a lesser understanding of the drivers of Bitcoin, they are more prone to act impulsively to an increase of volatility than agents who are well aware of the state of the market, thereby contributing additionally to the overall volatility. This should not be a surprise to anybody having had exposure to the efficient market hypothesis. Technological stocks are also prone to such market characteristics since their fundamentals are not as widely understood by the public as those impacting stocks related to general consumer goods, for example.
Third and last, I think it is worth mentioning again that Bitcoin is barely 10 years old, and consequently, it is not yet supported by strong and liquid mature markets. Any asset lacking proper market supports for trading will ultimately have a more volatile behaviour than assets supported by mature markets. That’s the reason why an Over-The-Counter stock is more speculative and volatile than the stock of Apple, for example. The Apple stock benefits from being listed on a well-known stock exchange and from derivative markets giving rise to other securities such as options.
To fully visualize the volatile nature of Bitcoin due to speculative pressures and its immature supporting markets contributing to its illiquidity, I have plotted its daily price return volatility for 30, 60, and 120 moving day averages along with that of other assets considered very liquid:
- S&P500 Stock Index;
- NASDAQ Stock Index;
- MSCI Emerging Market Index;
- Gold; and
- Brent Crude Oil
As can be observed in the above graphs, the volatility of Bitcoin is higher than those of other liquid and historically established assets. Note that Bitcoin’s volatility was almost at par and sometimes lower with that of the Brent Crude Oil for approximately 9 months between July 2015 and March 2016, which is quite interesting. Overall, Bitcoin’s volatility trend has been decreasing in time.
The above volatility analysis concludes that Bitcoin is currently subject to non-negligible speculative activity, and consequently, exhibits a higher volatility than more liquid assets.
What is positive from the graphs presented earlier is to notice the downward trend of Bitcoin’s volatility in time as more transactions are processed, a proxy for network participation:
Increased market participation is cornerstone in the further development of Bitcoin and is quite positive for its future since it supports the viability of Bitcoin as a renown asset.
The increase in market participation also indicates that, as more and more people join the Bitcoin network, their ability to understand the fundamentals and drivers of Bitcoin become more acute. Education through experimenting over the Bitcoin network will largely be beneficial as it will reduce irrationality behaviours, and therefore reduce speculation and volatility. As for the Altcoins, I believe a lot of them will disappear in due time following a market correction, which will lead Bitcoin to strengthen its market share, leading to an increase in market participation and a reduction in speculation.
Also, it is important to remember the important market developments of the past few years in terms of supporting the Bitcoin network. As resources are mobilized to support the Bitcoin network through exchanges, derivatives, exchange traded funds and Bitcoin payment services to name just a few, Bitcoin will become ever more liquid, and thus, less prone to speculation and high volatility since market participants will be able to engage in transactions involving Bitcoin more efficiently. Let’s also remember something very positive regarding the viability of Bitcoin in the future: the very fact that legislators and regulators, such as the US’ SEC, are debating on how to handle it proves that powerful organizations recognize the potency of Bitcoin and its revolutionary principles regarding monetary policy.
Finally, one must remember one of the most interesting features of Bitcoin: its limited supply of 21 million coins and the predictability of Bitcoin “coinage” in time. Remember this graph from our second post Bitcoin, Gold and Fiat:
The impacts of these features are unmatched by any other assets. Investors in Bitcoin can clearly understand how Bitcoin mining will be constrained in time, and how Bitcoin’s volatility and expected volatility will effectively be reduced through subsiding speculation since Bitcoin introduces the concept of certainty in supply.
Yes, 2017 re-ignited an upward trend in volatility and yes, November and December 2018 triggered another one. Let’s leave time to the technology to evolve and be adopted. It is unrealistic to believe that Bitcoin can readily compete at this point with assets as liquid as any stock traded on established stock exchanges, or with the US dollar or gold.
In the next post, I will review the volatility of Bitcoin compared to intermediate currencies in countries where monetary policy is highly politicized in order to provide an alternative and better tempered expectation of Bitcoin at this time of its short life.