Musings on Bitcoin following last week’s volatility

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The chatter around Bitcoin reached frenzy levels last week as the Bitcoin:US$ exchange rate shot up and then crashed by over 50%. The chart above shows just how much volatility there was.

As many people have observed, one of the functions of a currency is to store value, and with this level of volatility Bitcoin is doing a very poor job of that. I can’t see many people choosing to own Bitcoins if the value of them might halve over a couple of days. Fiat (i.e. state sponsored) currencies experience volatility on the foreign exchange markets, of course, but not at this level, and they have the additional advantage that changing FX rates take a little while to filter through to changing prices in retail which means real world value changes more slowly. Because Bitcoins (generally) have to be changed to fiat money before they can be spent the pain is felt immediately.

My view is that if Bitcoin is to grow much from where it is today something needs to change about Bitcoin to bring more stability to the price. Put differently – the current volatility is an existential threat.

What is also becoming increasingly clear to me is that there is demand for a virtual currency, and that if Bitcoin fails we will most likely see something else rise in its place. This quote from Robert MacMillan, a former economist with the U.S. Federal Trade Commission and Stanford economist,currently Head of Portfolio Management and Director of Quantitative Research at HNC Advisors AG explains why (hat tip to Techncrunch):

The value of having an easy-to-store, hard-to-steal, and hard-to-counterfeit medium of exchange is substantial.

I would add one additional value which MacMillan doesn’t list, and that is ‘not state controlled’. I think we have seen enough examples of government mistakes undermining currencies to think it is a reasonable bet that a virtual currency controlled by a transparent set of rules and protocols that aren’t open to manipulation can have a place in the world, assuming the rules and protocols are such that it doesn’t suffer from the volatility and other problems Bitcoin is experiencing.

Finally – much of the talk about Bitcoin is of an apocalyptic nature. Most opinions are polarised, either thinking Bitcoin will fail or will amount to an amazing revolution. Whether it be Bitcoin or another virtual currency it seems to me that there is space for it to co-exist with existing currencies. If it only takes a very small percentage of the market there will be space for substantial disruption. As an example, there are a large number of startups at the moment pursuing the consumer forex market. If Bitcoin was just used for a small percentage of those transactions – e.g. salary remittance for migrant workers – then substantial value would be created. There are many small examples like this which would be good Bitcoin use cases and if they all came to pass Bitcoin would still only represent a small fraction of currency flows.