March 5, 2021

Understanding Bitcoin Volatility

Bitcoin is touted by many as a long-term store of value and a future medium of exchange, but as we we know from historical data, it is peculiarextremely high volatility. On this aspect, people such as Ray Dalio base their criticism of Bitcoin, arguing that Bitcoin cannot act as a store of value or a medium of exchange due to its volatility. From this, they conclude that Bitcoin is not capable of performing the function for which it was designed.

At first glance, such criticism seems reasonable.Currently, Bitcoin is volatile and cannot properly act as a medium of exchange - this will become possible when it reaches mass adoption, its true value is determined, and volatility decreases. However, as I will show later in this article, short-term volatility does not at all prevent an asset from playing the role of a long-term store of value.

Ray Dalio is correct in his assessment that Bitcoin is not yet a store of value in the traditional sense, compared to something like gold or real estate. Bitcoin is emerging a store of value, it is still in the making. Therefore, it should be expected that this phase of its evolution will be accompanied by active speculation and periods of rapid growth.

Research Director at Fidelity DigitalAssets Ria Bhutoria summarized this beautifully in her article, noting that "the trajectory of a new asset's development from awareness of a negligible circle of people to acceptance as a global store of value can hardly be linear." It’s strange to even assume that something that didn’t exist 10 years ago can become a stable global asset overnight. This is a long process, evolution, if you will.

The picture above shows the evolutionary path,which Bitcoin has yet to go through to reach the status of "global money". I believe that we are gradually getting closer to the state of "reliable store of value", but have not yet reached that point. I am convinced that Bitcoin is a new form of money, the best that humanity has ever had. There are many examples of history where new forms of money, when left to the free market, usually evolved in a similar way. They started out as a collectible, thanks to a meager supply. If the community continues to value this scarce commodity, then it is capable of retaining value over time. If and only if this scarce commodity continues to be valued by society and at the same time has the characteristics of money, it can begin to function as a medium of exchange and unit of account.

The closest analogue of Bitcoin we know isgold that followed the same path thousands of years ago to become the best money in human history. It took gold thousands of years to evolve into the function of money. Bitcoin has gone through the same phases over the decades. This acceleration can be explained by the network effects of Bitcoin, global knowledge exchange and, in my opinion, its volatility. Volatility has repeatedly helped Bitcoin to be in the spotlight of the whole world, which, in one way or another, contributes to the spread of knowledge about it and an increase in the number of people who understand it. Volatility is inherent in Bitcoin early on, and for good reason. By understanding the technical fundamentals of Bitcoin, you will see that volatility is actually a function of the system. A function that evens out incentives for all parties to accelerate the adoption of an asset and ensures its evolution as cash.

The reasons for volatility

Digging deeper and understanding the causes ofvolatility, you will see that this is actually a feature of the protocol that helps it gain mass adoption and accelerates its evolution to cash status. Through its initial supply shocks, the protocol was configured in such a way as to provoke periods of significant price increases in the early stages of the network's formation. The reason for this becomes clear by understanding the technical aspects of Bitcoin coupled with some of the basic principles of supply and demand.

Bitcoin has a fixed schedule and total volumeemissions. This means that only a certain number of coins can be issued per day, and their total supply is limited to 21 million bitcoins. Every four years, the amount of bitcoins mined per day is halved. This event is called halving (tracing from English halving, which literally means "halving", approx. Translator). The visualization of the halving effect is shown in the graph below (however, it is somewhat outdated, since in May 2020 we already passed the 3rd halving).

Bitcoin halving

In the first few years of existence per dayabout 7200 bitcoins were issued (50 BTC / block with an interval of 10 minutes). After the first halving in 2012, about 3,600 bitcoins were issued per day (25 BTC / block with an interval of 10 minutes). After the 2016 halving, 1,800 coins per day, and now, after the 2020 halving, only 900 bitcoins are mined every day. Thus, as of May 2020, about 18.5 million of the 21 million bitcoins were mined. The remaining 2.5 million bitcoins will be mined by 2140.

The main thing that I want you to take away from this isit is that the new supply of Bitcoin is halved every four years, with the total supply of Bitcoin being capped at 21 million coins. This is where basic economic principles come into play. If there is a certain product with a stable or growing demand, then when the inflow of its supply decreases, the market will find a new equilibrium price for it at a higher level. Bitcoin has a few more nuances than this basic principle takes into account, as it tends to find not just a higher, but a much higher price, followed by a severe correction.

Why are these price swings so sweeping?Well, in the entire history of mankind, we have never had anything with a truly finite and strictly defined sentence. If the demand for bitcoins remains stable, then after the halving, when the increase in its supply is halved, we are guaranteed to get an increase in its value.

When the price rises, more and more peoplestart to want to buy it because they see its potential for profit, BUT there is no way to increase supply to balance this demand. Superimpose surging demand on a dwindling supply and you have parabolic price movements. Now add to this the understanding that Bitcoin is a market with a volume of only $ 350 billion, and you can easily see why the price swings that are occurring are so extreme.

As I mentioned, growth periods are usuallyaccompanied by periods of deep correction. This is because many people who buy bitcoin during a period of strong growth are not buying it because they think it is the best form of money and are not going to store their fortune in it for the long term. They buy bitcoins out of speculative interest in order to get rich quickly. As the price continues to rise, more and more people are drawn into this, and eventually we reach the buy-side depletion point. Then a big sell-off begins and the price of bitcoin drops back to relatively fair values ​​given the level of actual adoption of bitcoin (i.e. people and / or organizations convinced of the long-term success of the asset).

Why volatility is good for Bitcoin early on

Bitcoin functions in such a way thataligns incentives for acceptance with incentives for all parties involved. What I mean? As we discussed above, historically, volatility caused by once every four years supply shocks has been the cause of extreme price increases. This growth, in turn, is attracting more and more people to Bitcoin - like a black hole that opens and closes on a schedule every four years.

Many of those who have been drawn into this market inthe phase of active growth, at the subsequent fall, they sell their coins and henceforth reject this asset as a speculative bubble. However, some of the newcomers subsequently become convinced bitcoiners and hodlers, confident in the long-term success of the asset. They are driven into this market by greed, but then they start asking questions such as "what is money" or "what is the nature of the US dollar" or "what are cryptocurrencies" or "how the government can print money from nothing" or "what such monetary and fiscal policy ”and so on and so on - to gradually begin to understand what Bitcoin really is. Those who dive down this rabbit hole usually come from the other end with one conclusion: Bitcoin is the best money, and they are willing to hold onto their coins as the asset continues to evolve into a global medium of exchange.

In this respect, I like to comparedescribed from my own experience. I learned about Bitcoin during the 2017 bull rally and didn't care what it was. I even remember saying to my roommate, “This is so stupid! Why do I need anything other than dollars at all? " I didn’t believe in the future of Bitcoin, but I thought that I could make quick money on it (God, how wrong I was!). After investing in bitcoin and feeling a personal interest through it - even after the crash - I felt obligated to learn more about Bitcoin and set off down the proverbial rabbit hole, exploring things like monetary policy, economics, history of money, game theory, network effects, etc. etc.

Ultimately, this research led me todeep confidence in Bitcoin and what it can mean for society. In the past few years alone, I have seen the same story happen to many of my friends and family. My main point here is that these sharp fluctuations stimulate the demand for the asset, which speeds up the processes of gaining knowledge about Bitcoin, and this then also leads to an increase in demand. This adoption of Bitcoin can be described as healthy, because these participants are starting to use the asset as a long-term store of value and, in fact, become pioneers in this, contributing to the onset of the corresponding phase of Bitcoin's development.

Technology adoption curve

Increased demand not only attracts morepeople, but also contributes to the growth of infrastructure around Bitcoin, such as mining (which makes the network more decentralized and secure), financial products and services (helping to reduce volatility) and a number of other infrastructure needs (depositing and withdrawing fiat money, safer storage, additional calculation levels for payment processing, etc.).

A striking example of such a change can be seen ifcompare the infrastructure around Bitcoin before and after the 2016 halving. The network hashrate time after time sets new highs after halving, which means that there are more miners, and the network is becoming more decentralized and secure. There are large financial institutions that provide access to investments in bitcoin, such as Fidelity, CME with its futures market, PayPal, etc. There are even companies that buy bitcoin as their reserve asset, thus also supporting the development of the system.

All these examples (and there are many more) have becomepossible due to price volatility. Yes, I mean mostly volatility in the direction of growth, but note: these companies are in no hurry to leave the crypto market even when they fall. They increase their knowledge of Bitcoin and find something in it that they want to keep investing their time and capital in, which subsequently leads to increased demand and increased system reliability. This is how the wonderful incentive cycle that Bitcoin embodies.

The thesis about the benefits of volatility for Bitcoin can becheck and quantify using multiple metrics. This cannot be attributed to exact scientific knowledge, but there are some trends that tell us about a significant increase in the healthy adoption of Bitcoin during periods of high volatility. In the chart below, you can see that the yearly lows in the price of bitcoin every year, with the exception of 2015, have been set at a higher level.

Bitcoin's yearly lows

We also see that the annual minimum two years after each of the recent halvings (2012, 2016) was set to much higher level.This effectively means that more and more people who bought Bitcoin continued to hold onto it during severe price drops. This indicates that the market is bottoming out, and the remaining bitcoin holders at that price level have a lot of confidence in the future of the asset and that it will continue to evolve into a cash function.

We can assume that all these people arelong-term and staunch supporters of Bitcoin, but it also gives us a rough idea of ​​how many people use Bitcoin to save their own money. Again, this is healthy adoption as it is about people using bitcoin for its current intended purpose - as a long-term store of value.

Another metric that can be used likethe acceptance rate is the number of bitcoin addresses containing at least 0.1 BTC, or 10% bitcoin (at the time of writing, this is equivalent to $ 3,500). As you can see, this figure increased significantly after the first halving in 2012, and then even more after the 2016 halving.

Bitcoin addresses with a balance of at least 0.1 BTC

These data show that the associatedWith halvings, upward volatility attracts more people, and with downward volatility, not all of them are washed out of the market. It is worth noting that as of early 2020, about 60% of the issued bitcoins had not moved in over a year. Together, these metrics show that people who stay in Bitcoin after the halving use it as a long-term store of value and provide a base of demand for the asset.

Considering that this trend continues inthe current halving period, we can be fairly confident that Bitcoin will reach the level of mass adoption in the next 10 years (and in my opinion, this is a conservative forecast). Does any of this guarantee Bitcoin's future success as a globally used currency? Of course not. Only time will tell if Bitcoin can achieve this status, and for that to happen, its current volatility will need to drop significantly. For now, however, it is safe to conclude that volatility is indeed helping to drive adoption of Bitcoin in its current stages of development.

Decreased volatility

As I already emphasized in this article,Volatility is an important feature of Bitcoin, a consequence of its issuance schedule, and is intended to foster Bitcoin's adoption in the early stages of its protocol development. This volatility is useful in the short term as it attracts new users, infrastructure and capital, but over time the price of bitcoin will need to stabilize. Especially if Bitcoin will be used as a medium of exchange (I think that we are at least 10 years away from this reality).

Understand correctly:I do not deny the fact that if the current volatility persists forever, then Bitcoin will hardly be able to successfully claim the role of money. I can't say with confidence that volatility will ever disappear, but as throughout this article, I can draw on current trends and data and draw conclusions about the future from them. The chart below shows the bitcoin price and its historical volatility (blue line).

Historical volatility of bitcoin

As you can see, the volatility of bitcoin inthe last decade has been steadily declining, while its price has risen. As an asset matures as a store of value and as price is determined globally, volatility can be expected to continue to decline.

There are many reasons why this mighttake place. The first is the size of the total market capitalization. Bitcoin is currently capitalized at over $ 667 billion ($ 35.9K / BTC * 18.6M Bitcoin). This is very small for an asset that is traded and used around the world, making its price more susceptible to volatility. When and if Bitcoin's market capitalization reaches the $ 10 trillion gold levels, it can be assumed that its volatility will be much less. If an asset reaches such a capitalization, then with a high probability its market can be characterized as mature, which means that large organizations and financial products have already integrated into its system, which also contributed to a decrease in volatility (we are already beginning to observe this in Bitcoin).

The second reason I believe isvolatility will decrease over time, is that the severity of supply shocks will also gradually decrease. Now supply crises are huge and they hit the market like a freight train. Going from mining 3,600 bitcoins per day to just 1,800 is a pretty drastic change for an asset with inelastic supply and growing demand. Even a reduction in mining from 1,800 to 900 bitcoins per day is a huge shock to the system. However, by 2028, of the 21 million bitcoins, 20.2 million will be mined. Thus, by this time, about 96% of the total issue will have been put into circulation. The diagram below illustrates this well. The blue line represents the supply base of bitcoins, and the red line represents the supply inflation rate (emission graph).

Supply base (blue) and supply inflation rate (orange chart) of Bitcoin

In fact, this means that halvings are no longerwill lead to such a significant reduction in supply, since most of the coins will already be released into circulation. By this time, the global market will already understand and will be able to effectively reflect the finite supply and scarcity of Bitcoin in the price. This will allow the market to act more rationally than today, when halving is misunderstood by many and affects the market more intensely. In summary, it is safe to assume that as supply shocks become less severe and as Bitcoin reaches a market capitalization comparable to gold, such high volatility will be a thing of the past.

Bitcoin as a store of value

I do not want to give any investment here.recommendations. I wrote this article only to reveal the reasons for the high volatility of Bitcoin and to explain why I find such volatility to be beneficial for its development. However, I would also like to refer to the available historical data to show that bitcoin does very well retain value over long periods of time.

Again, I think Bitcoin has yet toa long way to go before it can be classified as a "safe store of value", similar to how gold or real estate is perceived today, but this does not mean that it does not fulfill this function to some extent even now. Taking a step back and looking at bitcoin from a longer perspective, you will see that it actually serves as a store of value today.

Bitcoin Price Chart: Log Growth Curves

This chart shows the price of bitcoin (blueline in the middle) since its inception. As you can see for yourself, the price is consistently moving up and to the right. Thus, if a person buys bitcoin and holds it for a long time, then the volatility of the asset recedes into the background. It is an emerging store of value, not something to be bought and sold periodically. This is a savings instrument designed for long-term preservation of funds.

To further strengthen the argument, let'slet's see what result a simple dollar-value averaging strategy could bring for the average person over the past three years. In the example below, we are buying $ 100 worth of bitcoins every two weeks, spending $ 200 a month. As a start date, I chose the top of the 2017 bull market, about $ 20,000.The end of the period is December 2020. As you can see, during this period, the value of the invested funds increased by 50%. And if you started applying the same strategy a year before the peak of 2017, then the value of your portfolio would increase by almost 120%.

Dollar Averaging Scenario

On the other hand, if you were following the samestrategies that bought $ 100 worth of bitcoins from each salary between the peak of December 2017 and December 2018, then they would lose 50% of the portfolio value. All this shows that Bitcoin retains the value of the investment for exactly long periods of time if you use the asset as a store of value or, more simply, as an additional savings account.

And under a supplemental savings account I haveI mean an account where you only deposit money that you can afford to lose. Investments in this asset are still associated with many risks and there is no guarantee that its price will rise exclusively. Bitcoin investors are willing to bear these risks in order to gain access to an emerging form of cash that hasn't even begun to really enter the huge target market yet.

As Bitcoin continues to grow and gradually take its place in this market, we must see the asset mature and at the same time its volatility decreases.

The article does not contain investment recommendations,all the opinions expressed express exclusively the personal opinions of the author and the respondents. Any activity related to investing and trading in the markets carries risks. Make your own decisions responsibly and independently.