Volatility and Speculation

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Volare (Latin): to fly

In the previous post we talked about getting paid in bitcoin, which led us to address its volatility. 

In this post we’re going to discuss what needs to happen for bitcoin to be less volatile going forward, and at the end we’ll take a look back at the last decade and discuss the benefits of speculation, a term too often used to criticize crypto assets. 

Will Bitcoin ever not be extremely volatile?

On a long enough timeline, the answer is yes, but extreme volatility seems to be the case for the foreseeable future. As long as Bitcoin’s utility is viewed as something that can be built on, expanded, and improved considerably with diverse opinions, its price will fluctuate considerably. An asset that has utility but has no perception of increased future utility will be remarkably stable, i.e. the US Dollar, Euro, and gold. There isn’t much to speculate about. If you want potential, you have to take on volatility. If you want stability, you have to accept stagnation. There is not much in between unless you diversify your assets.

 
Ironically, even if you’re not into bitcoin and think it’s ridiculous internet nerd money, adding bitcoin to a diversified portfolio has the potential to increase your Sharpe Ratio, a metric used in Modern Portfolio Theory (MPT) to describe a portfolio’s risk/return profile per unit of volatility. 

The measurement is complicated, but according to MPT, adding non-correlated assets to a diversified portfolio (stocks, bonds, etc) can reduce your risk and add to your potential returns. I think this misses the big picture of what’s going on with Bitcoin and while MPT isn’t my cup of tea, a lot of people that hate Bitcoin in finance use MPT religiously. If you’re a believer in MPT it seems irrational not to have a small position in an uncorrelated asset like bitcoin. 

What would make Bitcoin less volatile? 

The first way is for Bitcoin to continue to grow in absolute economic size. Right now relatively small amounts of capital flowing in and out of Bitcoin have a serious effect on the market’s structure and perception of the asset. If Bitcoin’s market capitalization is 10 trillion USD, inflows and outflows of 10 billion USD over a short duration won’t have the explosive impact inflows and outflows that 10 billion USD would have right now. It’s as simple as that.

Next, we would need the current distance between utilization rates and the market’s projection of bitcoin’s future utility to tighten considerably. We might see this in a few decades, but as long as companies and individuals like us build applications based on the future potential of the Bitcoin protocol, there will be lots of room for speculation about what that future potential might be. 

In between that time, there are a few ways in which bitcoin can become less volatile. Since we have volatile prices and Bitcoin’s supply schedule is algorithmic, the extreme price fluctuations in the short run seems to be largely determined by the psychology of demand. Selling pressure has its own psychological factors, but not only is the production of new units of bitcoin known and algorithmic, some of the selling pressure can be somewhat modeled based on what we know of the economics of mining. In contrast, on the demand side, there are large swings in demand with no real algorithmic certainty. So one way to tamp down volatility is a more predictable demand curve being formed.  

The demand schedule for Bitcoin is close to totally unpredictable because it’s almost entirely based on always shifting immediate needs and human perception. A more predictable demand curve should emerge with shifts in collective psychology and behavior. These shifts will not only help individuals at the micro level, but will also help these networks at a macro level. 

We can collectively make demand more predictable over time by providing steady and sticky demand instead of large, infrequent, and emotional trades. Investors can do this by exchanging into bitcoin somewhat frequently, such as weekly, bi-weekly, or monthly, with a steady supply of new capital. This strategy is frequently called dollar-cost-averaging.

Store of Value 

Instead of trying to time the market based on your intuition, media personalities, rumors, or charts with the perfect amount of money at the perfect time, investors can instead act more humbly and move a small amount of capital into Bitcoin on an almost algorithmic basis in perpetuity. This provides a steady floor of demand the market can pick up on and rely on. And if enough investors move into this type of behavior en masse instead of trying to time their moves perfectly, we won’t have as many wild swings in demand. If investors are saving and accumulating slowly and steadily, they provide a steady foundation of demand that the market can easily digest. Investors who behave in this manner will also likely have better returns than the person guessing about when and how much capital to put into a fundamentally unpredictable asset. Higher returns with less mental stress while helping reduce volatility is a great trio.  

Workers can also reduce volatility by accepting bitcoin for their labor hours. This, like dollar-cost-averaging, provides a steadier and more predictable demand curve for Bitcoin that can be modeled out for longer durations. As an individual you will have no visible effect on the volatility if you earn bitcoin by yourself in any immediate future. But if more and more individuals accept bitcoin for their labor on a regular basis, over time this will provide more predictability to the demand curve of Bitcoin. 

For example, the US dollar has about seven and a half trillion dollars worth of predictable demand from the yearly wages of US workers. If more of the global labor force is accepting and demanding their wages be paid in bitcoin, this will provide a large source of steady and predictable demand that can be modeled out by participants in the market. 

Match more predictable demand with an algorithmic supply schedule and the market will have a considerable amount of certainty to evaluate the financial asset bitcoin. Volatility can never be stamped out completely. Change, flux, and uncertainty are hard coded into the structure of the environment Bitcoin was built in: reality. 

Medium of Exchange

Once someone has built up some wealth in bitcoin instead of selling, they’ll be more likely to save it and seek out ways of getting goods, assets, and services with bitcoin. You’ll be surprised at what you find when you do search for places to spend and use bitcoin. By doing this, you’ll slowly be turning bitcoin into a medium of exchange, thereby closing the gap between current utilization and future utilization which leaves less room for wild volatility. 

Enough people around the world behaving this way closes the work, save, spend loop that sustains an economy. It grounds the money in the world of goods and services instead of solely flying around the abstractions and fantasies of speculation. When bitcoin is used for commerce more and more, this reduces the amount of speculation one can do to the upside or the downside. When it flows through commerce it’s harder for critics to deny its use, but at the same time speculators can no longer speculate about that level of use because it’s already happened. 

You work for bitcoin, you save it, then you spend it using a bitcoin service or bitcoin accepting individual or merchant. The individual or merchant then saves it and spends it ad infinitum repeating the loop over and over again. You now have a large, global network of people trading their labor, assets, goods, and services using bitcoin as their store of value and medium of exchange. 

Unit of Account

The final step needed to make bitcoin a less volatile global money is its use as a unit of account. Part of this is just psychological reorientation; almost a trick of perspective. The dollar has plenty of volatility and its seeming stability masquerades its slow decay. It is anything but a fixed value asset. It floats freely in financial markets and against goods and services around the world in a slow but non-negotiable negative direction.  

The Dollar is stable in the minds of Americans because that’s been their reference point for everything their entire life: food, clothing, assets, time, information, health care, taxes, etc. The US Dollar value fluctuates everyday, it’s just managed in such a way that the changes are not too drastic for the average consumer in the short to medium term. If you had to steelman the US Dollar, you could say it’s well constructed for consumers and consumerism (high-time preference). Whereas Bitcoin and other crypto assets are better suited for savers who possess a low time preference and higher tolerance to volatility. 

If you flip your perspective on the price chart from BTC/USD to USD/BTC one could also say, and have it be equally true, that the USD is wildly volatile against Bitcoin in an extremely negative direction.

1 BTC = 1 BTC

It’s funny, true, and a start, but not complete. It’s a start because the first step in a measurement being used is people using it as their reference point. So instead of just getting paid in bitcoin, you denominate your salary or your business contracts in bitcoin. This is a long way away, but it has been done on a very small scale with contractors and employees at Edge, and can be expanded once people really start demanding bitcoin for their wages. This is already starting to happen in a small way in professional sports. Negotiating salary in terms other than USD is already common with stock options which are seen as valid forms of long term, speculation-based compensation for employees and even legal settlements like the infamous Zuckerberg-Winklevii face off.    

If parties agreeing to short, medium, and long term economic contracts are making commitments to specific units of bitcoin for those transactions, and not just bitcoin with reference to another standard, bitcoin becomes a standard itself. We talked before about getting paid in bitcoin, which will make it easier to use and save bitcoin. That’s a good start, but your contract might still be denominated in Dollars. If you agree to be paid $50,000 for the year in bitcoin, that’s cool and moves bitcoin usage forward, but what if you agree to being paid five bitcoin for the year in…bitcoin, with no reference to another standard?

If someone does this on their own today they are taking on huge risk with a lot of potential for success or failure and it’ll make no meaningful effect on the volatility of bitcoin. But if millions of people and organizations are making frequent short, medium, and long term commitments in units of bitcoin, then it will have become a useful reference point for a lot of people. In turn, this reduces our perception of its volatility, and the market will be able to depend on at least a certain level of demand out into the future instead of staring into a dark abyss of uncertainty like many participants currently are. 

If bitcoin can become a standard in this manner, everything else will float against bitcoin.

Supply Shocks

The preceding paragraphs speculated about how bitcoin could be less volatile with most of the focus on the demand side. We mentioned before that a lot of the volatility, at least in the short run, is determined by the fickleness of demand. But a big reason for explosive upwards volatility over the long run for bitcoin is the supply shocks that have happened as a consequence of bitcoin’s algorithmic supply schedule. Approximately every four years the bitcoin block-reward halves. These halvenings continue until the inflation rate hits zero about a century from now. Over time these shocks will have less and less impact on supply as the block reward gets closer to zero thereby reducing the potential for massive volatility to the upside. 

To review, these are the things that need to happen for bitcoin to become a more stable asset against other assets, goods, and services:

  1. Grow in economic size
  2. Develop more predictable, dependable demand
  3. Completing and sustaining the loop of labor, savings, investment, and consumption
  4. Denominating contracts in units of bitcoin
  5. Halvenings become less of a supply shock

We are quite some time away from all of these things happening at a global scale, but each has improved considerably over the last decade and the seeds have been laid for each to come to fruition in the future. 

A Word on Speculation

The last decade has been a wildly volatile and speculative era, and appropriately so for such an immature and complex technology. Many that build their professional brands on bashing digital-assets use the words speculation and volatility over and over again as bad words, implying that bitcoin is inherently useless and only gamblers and criminals use it.  

If something like Bitcoin is ONLY used for speculation its impact will be limited. And a lot of gambling types love to speculate and trade on it. But the author, Edge, other employees at Edge, and our users around the world are testimonies that the statement “these networks are ONLY used for speculation” is an extreme over-statement. It’s amusing to hear or read “educated experts” mouth off about no one using bitcoin while I’m sitting in Edge’s office,  listening to our support team being inundated with customer support tickets from all four corners of the globe while our controller is sending bitcoin payroll and I’m sitting there buying a flight to Denver using bitcoin. And we’re just one small team in San Diego. 

Even if we accept popular criticisms of crypto assets and bitcoin’s only and highest use is and will forever be speculation, that still doesn’t invalidate its existence or minimize its importance. 

Speculation about the future is a uniquely human activity, on par with opposable thumbs and language. Speculation isn’t equivalent, but is related to imagination. Human beings take things that are known, and sometimes even unknown things, and like to speculate, imagine, and theorize what they could be. These mental processes are fundamental to our progression as individuals and as a civilization. 

If Bitcoin has done nothing else, it has inspired people all around the world to speculate and imagine a world with a different money and a different financial system. That’s the first step in building a new one. And we’re way past the first step. 

Conclusion

Getting paid in bitcoin isn’t for the faint of heart, but at Edge we stand by our decision to pay employees and contractors in bitcoin because we believe in the massive potential of the Bitcoin protocol. We encourage other companies that build on this technology to join us in these efforts, adding to the long term health and stability of the ecosystem. 

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