Bitcoin’s volatility isn’t excessive

Bitcoin ’s volatility is a natural function of currency adoption, and this volatility ultimately enhances the resilience of the Bitcoin network and drives long-term stability. Change is information.

Has someone you respect ever told you that Bitcoin doesn't make sense? Maybe you've watched the price of Bitcoin rise exponentially, then watched it crash. You wrote off your position, convinced your friend was right, and heard nothing about Bitcoin for a while, thinking it must be dead. But then you wake up again a few years later and Bitcoin isn't dead, and somehow it's worth a lot more. You start to think maybe your skeptical friend was wrong?

The list of Bitcoin skeptics is long and famous, but the noise directly contributes to Bitcoin’s antifragility. People who store their wealth in Bitcoin are forced to think hard about first principles to understand Bitcoin’s properties—properties that, on the surface, seem to contradict established views of money—ultimately strengthening their faith. Bitcoin’s volatility is one of these properties that is often criticized. Skeptics, including central bankers, generally believe that Bitcoin is too volatile to be useful as a store of value, medium of exchange, or unit of account. Given its volatility, why would anyone hold Bitcoin as a savings mechanism? And if Bitcoin’s value could drop by a considerable amount tomorrow, how can it be effective as a payment transaction currency?

Bitcoin's primary use case today is not as a payment instrument, but as a store of value, and those who store wealth in Bitcoin have an investment horizon that is not a day, a week, a quarter, or even a year. Bitcoin is a long-term savings mechanism, and stability in Bitcoin's value can only be achieved with mass adoption over time. In the interim, volatility is a natural function of price discovery as Bitcoin moves along its path to monetization events and toward full adoption. Additionally, Bitcoin does not exist in a vacuum. Most individuals or businesses do not have exposure to Bitcoin alone, and a diversified portfolio, like any portfolio, can reduce the volatility of any single asset.

No volatility ≠ store of value

To be fair, volatility and store of value are often mistakenly considered to be mutually exclusive. However, they are certainly not. If an asset is volatile, it does not mean that the asset will not be an effective store of value, and vice versa; if an asset is not volatile, it is not necessarily an effective store of value. The US dollar is a classic example: non-volatile (at least today), poor store of value.

Something that is volatile is not necessarily risky, and vice versa.

——Nassim Taleb (Asymmetric Risk)

The Fed has been successful at very slowly debasing the dollar, but always remember, gradually, then suddenly. Also, no volatility ≠ store of value. This is a key psychological barrier many people experience when considering Bitcoin as a currency, and it is largely a function of the investment horizon. While central bankers around the world have pointed out that Bitcoin is a poor store of value and cannot function as a currency due to volatility, they think in days, weeks, months, and quarters, while the rest of us plan for the long term: years, decades, and generations.

Volatility is one area that has particularly baffled experts, despite having logical explanations. Bank of England Governor Mark Carney recently commented that Bitcoin has “so far failed in almost all of the traditional aspects of […] money. It’s not a store of value because it’s everywhere. No one uses it as a medium of exchange,” and the European Central Bank (ECB) also mused on Twitter that Bitcoin “is not a currency,” noting that it is “extremely volatile,” while reassuring everyone that the central bank can “create” money to buy assets — effectively making its currency worthless through this very function, and why it is a poor store of value.

No one lacks self-awareness here, but Mark Carney and the ECB are not alone. From former Fed Chairs Ben Bernanke and Janet Yellen, to current Treasury Secretary Steven Mnuchin, to the President himself, everyone has, at times, been vocal about how Bitcoin as a currency (or as a store of value) is flawed due to its volatility. No one seems to fully understand, or at least acknowledge, that Bitcoin is a direct response to the systemic problem of government money creation via central banks, or that Bitcoin’s volatility is a necessary and healthy function of price discovery.

But fortunately for all of us, Bitcoin's volatility is not so excessive that it cannot be a currency, and the experts are generally not experts at all. Logic aside, empirical evidence shows that despite its volatility, Bitcoin has proven to be an excellent store of value over arbitrarily extended investment horizons. So how can an asset like Bitcoin be both highly volatile and an effective store of value?

Re-examining the value function of Bitcoin

Consider why there is a fundamental demand for Bitcoin and why Bitcoin is naturally volatile. Bitcoin is valuable because it has a fixed supply, and for the same reason, it is volatile. The driving force behind the fundamental demand for Bitcoin is its scarcity. Recalling the value function of Bitcoin in the previous article, decentralization and censorship resistance strengthen the credibility of Bitcoin's scarcity (and fixed supply schedule), which is the foundation of Bitcoin's value storage properties:

While demand is growing by orders of magnitude, there is no supply response because Bitcoin’s supply schedule is fixed. The difference in the rate of growth of demand (variable) and supply (fixed) coupled with imperfect knowledge among market participants leads to volatility as a function of price discovery. As Nassim Taleb wrote in The Black Swan of Cairo: “Change is information. When there is no change, there is no information.” As Bitcoin increases in value, it conveys information in the context of volatility; change is information. Higher value (depending on change) causes Bitcoin to become relevant to new capital accumulation and new entrants, which in turn triggers a wave of adoption.

Adoption waves and volatility

Knowledge diffusion and infrastructure drive waves of adoption, and vice versa. It is a virtuous feedback loop that is a function of time and value. As the value rises, Bitcoin captures the attention and minds of a wider range of potential adopters, who then begin to understand the fundamentals of Bitcoin. Similarly, the appreciating asset base attracts additional capital, not only as a store of wealth, but also to build incremental infrastructure (e.g. more on-ramps and off-ramps, custody solutions, payment layers, hardware, mining, etc.). Developing understanding of Bitcoin is a slow process, as is building infrastructure, but both drive Bitcoin adoption, which then further spreads knowledge and justifies additional infrastructure.

Knowledge → Infrastructure → Acceptance/Adoption → Value → Knowledge → Infrastructure

Today, Bitcoin is still in its infancy, with current adoption likely less than 1% of eventual adoption. As 1 billion people adopt Bitcoin, the amount of new adoption will be in the order of magnitude for any foreseeable period, which will continue to drive significant volatility; however, as the underlying demand gets higher with each new wave of adoption, Bitcoin's value will restart at a higher level. Bitcoin's volatility will only decrease as the holder base matures and new adoption rates stabilize. In other words, for 1 billion people to use Bitcoin, adoption would have to increase by about 20 times, but the 100 million adopters thereafter would only be 10% of the base. All the while, Bitcoin's supply remains on a fixed schedule. As long as adoption is in the order of magnitude, volatility is inevitable, but it will naturally taper off along the way.

As Vijay Boyapati explains on Stephen Livala’s podcast, “Establishment economists scoff at the fact that Bitcoin is volatile, as if you can go from nonexistent to a stable form of money overnight; that’s just ridiculous.” What happens between waves of adoption is the natural function of price discovery as markets converge to a new equilibrium, which is never static. There is an almost rhythmic pattern to the rise, fall, stabilize, and rise again in the Bitcoin hype cycle. This can also be explained naturally by speculative fear, followed by the accumulation of basic knowledge and the increase of infrastructure. Rome wasn’t built in a day; in Bitcoin, volatility and price discovery are at the heart of the process.

Historical Waves of Adoption

To explain the relationship between volatility and value more concretely, it helps to think about the latest wave of adoption from late 2016 to now (2019).

While it’s never possible to truly quantify adoption, a rough but fair estimate is that from 2016 to today, Bitcoin adoption has increased from ~5 million to ~60 million people (demand has increased ~12x), while Bitcoin supply has only increased ~10% over the same period. Of course, there are also large differences in the amount of information and capital that market participants have. As the massive wave of adoption occurred, it ran into Bitcoin’s fixed supply schedule. What would one expect to happen when demand increases by an order of magnitude but supply only increases by 10%? What happens if new entrants naturally have vastly different amounts of knowledge and capital?

The very logical end result is higher volatility and a higher endpoint value, even if only a small fraction of new entrants convert to long-term holders (which is exactly what is happening right now). New adopters who initially bought Bitcoin during its astronomical growth, slowly accumulated knowledge and converted to long-term holders, stabilizing the underlying demand at an endpoint value far higher than previous adoption cycles.

Because Bitcoin is nascent, the total wealth stored in Bitcoin is still relatively small (~$200 billion), which makes the rate of change between marginal buyers and sellers (price discovery) a large portion of base demand (volatility). As base demand increases, the rate of change as a percentage of base will start to become smaller and smaller, and volatility will only decrease over time and only after more adoption cycles.

Managing volatility

If we can accept that Bitcoin's volatility is both natural and healthy, why doesn't current volatility prevent adoption from reaching the levels needed to transform Bitcoin into a stable form of money? Very simple: diversification, portfolio allocation theory, and investment horizons. There is a global network (Bitcoin) that you can use to transfer value to anyone in the world through communication channels, and its total value is currently less than $200 billion. On the other hand, Facebook alone is worth more than $500 billion. For further reference, total U.S. household assets are estimated to be worth $125 trillion (see the Federal Reserve's Z.1 Report on U.S. Financial Accounts, Q1 2019, p. 138).

In the theoretical world, if Bitcoin existed in a vacuum, volatility would be a problem. In the real world, it does not. Diversification comes in the form of real productive assets and other currencies and financial assets, which mitigates the impact of Bitcoin's current volatility. Additionally, there is information asymmetry, and those who understand Bitcoin also understand that the white knight will arrive in time. These concepts are obvious to those who have been exposed to Bitcoin and actively consider volatility in their short-term and long-term planning, but are obviously less obvious to skeptics, who have a hard time understanding that Bitcoin adoption is not an all-or-nothing proposition.

While Bitcoin will continue to gain share in the global competition for store of value due to its superior monetary properties, the function of the economy is to accumulate capital that truly makes our lives better, not money. Money is simply an economic asset that allows coordination to accumulate capital. Because Bitcoin is fundamentally a better form of money, it will gain purchasing power relative to inferior monetary assets (and money substitutes) and increasingly capture market share in the economic coordination function, even though it exists less as a transactional currency today.

Bitcoin may also lead to the de-financialization of the global economy, but it will neither eliminate financial assets nor physical assets. In its monetization process, these assets will continue to represent diversification, which will attenuate the impact of Bitcoin's daily volatility. See the example given by Twitter account @100trillionUSD, which highlights the risk-reward ratio of a 1% Bitcoin + 99% USD portfolio compared to gold, US Treasuries, and the S&P 500. Also see "The Case for a Small Allocation to Bitcoin" by Xapo CEO Vince Casares. Both provide perspective on how to manage volatility and risk - if Bitcoin experiences a major drawdown or even fails (which is still possible).

While failure is possible and significant declines are inevitable, for every day that Bitcoin does not fail, its survival becomes increasingly likely (the Lindy Effect). And over time, as Bitcoin's value and liquidity increase due to its fundamental strengths, its purchasing power over physical assets will increase, but as its purchasing power becomes a larger share of the economy, its volatility relative to other assets will decrease proportionally.

Endgame

Over time, Bitcoin will become a transactional currency, but in the interim it makes more logical sense to spend assets that depreciate (dollars, euros, yen, gold) and store assets that appreciate (Bitcoin). Establishment economists and central bankers really struggle with this — I digress a bit. On the path to full monetization of Bitcoin, a store of value must come as a logical first order of business, and despite its volatility, Bitcoin has proven to be an incredible store of value. As adoption matures, volatility will naturally decline, and Bitcoin will become more and more of a straightforward medium of exchange.

Consider a person or business that needs Bitcoin in order to directly exchange goods and services. This person or business collectively represents those who are first to determine that Bitcoin will maintain its value over a specific investment horizon. If people do not believe in the fundamental need use case of Bitcoin as a store of value, why would they trade real-world goods and services in return? Bitcoin will only transform into a transactional currency once its liquidity gradually shifts from other monetary assets to goods and services, which will happen along the path to mass adoption. It will not be an overnight or black-and-white process. On a more standard path, adoption drives infrastructure, and infrastructure drives adoption. Transaction infrastructure is already being built, but only once enough people first adopt Bitcoin as a store of wealth will more substantial investments be prioritized.

Ultimately, Bitcoin’s lack of a price stability command and its fixed supply will continue to cause short-term volatility, but will drive long-term price stability. This is the exact opposite model that the Bank of England’s Mark Carney, the ECB (and its Twitter account), the Federal Reserve, and the Bank of Japan are pursuing. And, this is why Bitcoin is anti-fragile; without bailouts, it is a market without moral hazard, which drives maximum accountability and long-term efficiency. Central banks manage money to suppress short-term volatility, which creates instability that drives long-term volatility. Bitcoin’s volatility is a natural function of currency adoption, and this volatility ultimately enhances the resilience of the Bitcoin network and drives long-term stability. Change is information.

Nassim Taleb and Mark Blythe (The Black Swan of Cairo):

“Complex systems that artificially suppress volatility can often become extremely fragile without exhibiting overt risk.”

“This is the package of life: without noise there is no freedom – without volatility there is no stability.”

Federal Reserve Chairman Ben Bernanke (during the Great Financial Crisis):

"The Fed is not currently forecasting a recession." - January 10, 2008

"Over the past month or so, the risk of a sharp economic downturn appears to have receded." - June 9, 2008

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