April 2018 Commentary
One of my friends was asking me why Bitcoin is so volatile. I thought of taking this time to address this question. Bitcoin can be defined as a software for operating a peer-to-peer payment network with its own hard money, without having to rely on a trusted third party. Satoshi clearly understood that whenever money supply is controlled by a king or any government, it is susceptible for corruption. We can go back to Roman empire, Ottoman empire down to the current governments of the world and see this problem very clearly. Satoshi Nakamoto’s motivation for Bitcoin was to create a “purely peer-to-peer form of electronic cash” that would not require trust in third parties for transactions, and whose supply cannot be manipulated by any outside party. In other words, Bitcoin would bring the desirable features of physical cash (lack of intermediaries, finality of transactions) to the digital realm, and combine them with iron-clad monetary policy that cannot be manipulated to produce unexpected inflation to benefit an outside party (like governments) at the expense of holders.
In order to understand the volatility of Bitcoin, we need understand what unique characteristics of Bitcoin cause this behaviour. Bitcoin can also be understood as digital hard money because the number of coins awarded to miners for accurate reporting of transactions is pre-programmed to decrease every four years until it vanishes to zero around the year 2140, with the supply reaching a fixed cap of 21 million Bitcoins. Bitcoin is thus the first example of a digital object that is scarce, and the first example of a liquid and divisible good that is strictly scarce in its supply. Bitcoin achieves this remarkable feat through adjusting the difficulty of the mathematical problem whose solution is required to append transactions on to the common transaction ledger. Bitcoin is a permission-less network, where anyone can join the network at any time. As the new miners join and add to the computing power of the network, Bitcoin code automatically increases the difficulty of this mathematical problem, in order to ensure that new blocks are mined at a fixed rate of approximately 10 minutes for each block. This difficulty adjustment is critical and unique aspect of Bitcoin’s operation. This difficulty adjustment has caused the network’s hash-rate increase over a billion times in the last 6 years. According to blockchain.info site, current hash-rate is roughly around 32Exa Hashes per second (32×10 18). This number can only be seen on a logarithmic scale as the growth in the Y-axis is exponential (see Fig 1). This number is equivalent to approximately 2 Trillion laptops working together. So, the power consumed by Bitcoin network is equivalent to 6.15 million households in USA.
Whenever demand rises for any other monetary asset, the resultant price rise creates an incentive for increasing the supply of the monetary good, be it a seashell, precious metal or government debt. But when demand rises for Bitcoin, and more people try to mine it, there is no way of making more Bitcoins than that are already scheduled; instead, the mining process gets more difficult, necessitating the expenditure of far more processing power and electricity to record transactions on the blockchain and receive the increasingly valuable reward. This increased electricity and processing power helps make the network more secure, by making it continuously more expensive for an attacker to try to pass off an invalid transaction as a valid one. In other words, whereas increased monetary demand will increase the supply of any monetary asset; It is powerless to increase Bitcoin’s supply, and instead can only increase its security.
Another way to look at this is, if corn prices go up, farmers will plant more corn to take advantage of the higher prices. This new supply will invariably bring the prices down. This simply follows from the principles of economics. However, Bitcoin is a different commodity, where the supply is completely inelastic. Had Bitcoin been designed to increase the number of coins along with increase in the number of users, the growing demand would cancel out the increased supply, stabilizing the price, and providing little incentive for anyone to hold Bitcoin for the long-term. In turn, the low value of the coins and network would make attacking the network by posting fraudulent transactions relatively cheap, making the users lose money easily. This difficulty adjustment is the root cause of the high volatility in Bitcoin prices that has characterized its growth over the past few years. This difficulty adjustment leaves no room for the supply to adjust according to market demand to reduce the price volatility.
When there is an increase in demand for Bitcoin, Bitcoin miners cannot increase production beyond the set schedule like copper miners can, and no central bank can step in to flood the market with increasing quantities of Bitcoin. As of today, miners can only bring 12.5 bitcoins to the market every 10 minutes, no matter what the demand is. The only way for the market to meet the growing demand is for the price to rise enough to motivate the holders to sell some of their coins to the new comers. This explains why in eight years of existence, the price of a Bitcoin has gone from $0.000994 on October 5, 2009, in its first recorded transaction to $4200 on October 5, 2017, an increase of 422,520,000% in eight years and a compound annual growth rate of 573% per year. Even though it is volatile, its growth is heavily skewed upwards while it suffered drops of 80% in certain years. I found the following statistic at http://coin.dance site, which shows that despite several drops of 80% it has still performed very well over the years.
Please note that my comparison of the price growth started from started from 2009, whereas the above table goes only as far as 7 years. At today’s market prices, Bitcoin’s supply value will be ranked around 33rd in the world, with a value similar to money supply of Brazil, Turkey and South Africa. So, in 8 years it has grown to hold more value than is held in the money supply of most nation-states and national currencies.
Lots of people wanted to engineer Bitcoin is such a way that its volatility is removed. Even though thousands of knock-offs of Bitcoin are created none were able to get any traction in the marketplace. I think they misunderstand a key aspect of Bitcoin, which makes it so successful: the absence of any authority that has the ability to alter the money supply. Bitcoin has so far very ably resisted any attempts to alter even small technical parameters in its design, strongly driving home the point that nobody controls it. Let us assume for argument’s sake, that some group of programmers simply copied the code from Github and made a bitcoin knock-off with 21 trillion coins. That currency is going to be stable, but why would anyone trust their hard-earned money where the supply can be as much as these group of programmers want? Remember, how we got into this fiat mess where governments are printing currency trending to towards infinity and diluting the value of everyone’s money. Because Bitcoin offers no returns, and has no central authority responsible for its issuance (like Federal Reserve), Bitcoin is more similar to gold than to stocks, bonds, or national currencies. Both Bitcoin and gold share very low annual growth rate of their stockpile and proved as good store of values. Gold arrives at the position due to its chemical properties making it hard for us to find it in earth’s crust, while Bitcoin arrives at the same position due to its mathematical properties bringing about its scarcity.In contrast to gold, Bitcoin has a magical property that allows us to send value across the internet to anyone, anywhere and any amount of money for negligible cost. The below chart shows how much bitcoin can be bought with 100 units of various fiat currencies over time.
Bitcoin holders should be far more tolerant of its volatility than generations reared under the certainty of gold standard. Despite bitcoin’s volatility it consistently beat all fiat currencies. Proof of work is the cost of decentralized currency while inflation is the cost of centralized currency. Most fiat currencies are stable in the short term, but their devaluation against bitcoin in the long term is guaranteed.