Wed. May 12th, 2021

Credits: www.forbes.com

For many people, the main obstacle to using cryptocurrencies is that they are volatile; their value fluctuates sharply across time depending on, apparently, many different factors.

To put the issue in context, the original paper on bitcoin was published in late 2008 and the first transaction in early 2009: since then, its value in dollars or euros has risen by more than 15,000%.

The evolution of the bitcoin in relation to both dollar and euro.

In contrast, over the same period of time, the parity between the dollar and the euro, has varied by a few percentage points up or down. No surprise therefore that bitcoin is seen as highly volatile and unsuitable for transactions, and at best, a store of value, subject to the systemic risk that arises every time the authorities or a government make decisions that could affect it. China talks of banning bitcoin mining and its price falls. Elon Musk uses part of Tesla’s reserves to buy bitcoin? Bitcoin rises. Janet Yellen calls bitcoin extremely inefficient? Bitcoin falls again. This instability has encouraged speculation, while others are wary of the risk.

Why is bitcoin so volatile? In a sense, the issue is structural and part of a process: bitcoin, by the very nature of its algorithm, consists of a fixed number of units, twenty-one million, of which, as we see in the graph, about 90% have already been issued. During this time, the bitcoin adoption process is subject to social and legislative factors of all kinds and conditions, which, while not affecting the currency’s mechanism per se, do cause, as we have already seen, temporary fluctuations, sometimes significant. However, its algorithm continues doing its job, based solely on mathematics, and nothing that any legislator says can really affect it in the long term. A country could ban bitcoin, but in practice, this is the same as trying to limit the use of any technology: if its value proposition attracts a sufficient number of users, such bans are a waste of time. And since the value proposition of bitcoin in the long run — a currency with self-contained rules, monetary policy and consensus rules implemented by software and with an independent value unaffected by the actions or decisions of any particular actor — is evident, it will remain in use.

In short, bitcoin’s volatility is simply a reflection of adoption mechanisms. Since not everyone understands how it works or has accepted that it is the future of money, it remains subject to volatility, which will continue as long as its process of price discovery does not stabilize.This has not happened yet, because on the one hand, not all bitcoins have been issued, nor has it been adopted en masse yet. What happens when all bitcoins have been issued and more and more people and entities become aware of its value proposition? Its use increases, the value-setting process converges, and it becomes valuable as a transactional currency. We are, quite simply, witnessing that process in real time.

What will happen to currencies such as the dollar or the euro? Their volatility is of a different order. These are currencies that respond to the decisions of the governments of a country or countries, which in many cases are dealing with natural catastrophes, pandemics, bailouts, other spending priorities, or simply the need to “reactivate the economy”, and which, therefore, form part of an imperfect system in which it is necessary to continue generating money and stoking supposedly “healthy” inflation, with all that this entails in terms of increased inequality. In reality, currencies such as the euro or the dollar, although they provide us with a false sense of stability — in part because we mistakenly believe there are reserves behind them — they are much more unstable and subject to random factors that are impossible to control.

So yes, bitcoin is volatile, but a different type of volatile. Bitcoin is convergent in the long term and a price will be established by mathematical means, while traditional currencies are subject to hard-to-predict political decisions and processes, as well as structural inflation, and governed by rules that are, as such, contradictory.