Fidelity Research: A Deep Dive into Bitcoin’s Volatility

Instead of analyzing the events and drivers of recent volatility, we’ll explore volatility at a more fundamental level, exploring why Bitcoin moves so volatile and how to think about it.

Why is Bitcoin so volatile?

Almost everyone who holds the currency is familiar with Bitcoin’s price fluctuations, which are certainly why they always make headlines. But why is Bitcoin so volatile? And what, fundamentally, causes this phenomenon?

First, it is helpful to distinguish between short-term and long-term volatility. Short-term volatility factors can include things like news reports (especially negative ones), major changes in macroeconomic indicators or conditions, and the state of Bitcoin futures and leverage, all of which we have discussed and analyzed in past newsletters. These factors also cause short-term volatility in stocks and other assets, so it is not difficult to understand.

Yet, the question remains: Why does Bitcoin remain volatile over the long term? Why do we see Bitcoin’s price rise by thousands of percentage points over months and years, only to fall by 50% or more? Part of the answer lies in Bitcoin’s unique characteristics, namely its fixed supply and issuance schedule.

Unlike other commodities, Bitcoin’s supply curve is fixed

Bitcoin is unique in that it is a commodity whose supply is completely inelastic to price changes. In other words, supply does not (and cannot) change with changes in price. Bitcoin's token issuance policy is pre-programmed. Therefore, all changes in demand for Bitcoin are reflected through changes in price. Changes in supply cannot dampen the impact of price changes, even in the long run.

An example of a different good or commodity can help illustrate this point, such as oil. The world’s demand for crude oil has been growing almost constantly, with only brief dips during recessions. However, long-term prices have not followed a similar pattern of rising prices. In fact, over the past 15 years, the inflation-adjusted price of WTI crude oil has actually fallen by nearly 9%, while demand has risen by about 14% (based on prices at the end of 2021, according to Bloomberg data).

Going back to economic principles, we know that when the demand for a good increases, the price will rise in the short term. However, higher prices will incentivize suppliers to produce more. More supply will then drive prices down. The United States witnessed this when oil prices were high enough to make previously uneconomical hydraulic fracturing profitable, which then increased supply. In summary, if demand increases, prices are likely to rise, and high prices will incentivize increased supply, which will drive prices down. The ability to change supply can have a stabilizing effect on prices.

For Bitcoin, supply does not change regardless of price. Therefore, any changes in demand, whether short-term or long-term, must be reflected by changes in price. This means that prices will be more volatile.

Bitcoin’s value and volatility are inextricably linked

This also illustrates a deeper point about Bitcoin and volatility, which Bitcoin evangelist Parker Lewis succinctly summed up: "Bitcoin is valuable because its supply is fixed, and it fluctuates for the same reason." In other words, one of the reasons Bitcoin is valuable is that it has scarcity, but that scarcity comes from its fixed supply, which in turn makes it more volatile, as we explained above. Therefore, you can't eliminate Bitcoin's volatility without eliminating its fundamental value proposition.

Putting Volatility into the Right Frame

While volatility is not usually something investors want, it is helpful to know if it is important to the core investment thesis. For example, suppose an investor's investment goal is to allocate a certain percentage of capital to an asset class that will maintain its value over the long term (say, at least 10 years).

Furthermore, suppose there are two very different asset classes. The first has very low volatility but is not expected to maintain value in terms of purchasing power. The second has incredibly high volatility but is considered to have the ability to store value. For the investor, the second asset class would be the right choice because it is more likely to achieve the investment goal of preserving value over the stated timeframe. While volatility is undesirable, it is not part of the goal and will not matter in 10 years. What matters is whether the goal is achieved at the end of the decade, not necessarily at any point throughout the decade.

These two asset classes show the actual performance of the U.S. dollar against Bitcoin over the past 10 years. For example, measured by the Consumer Price Index, the purchasing power of $10,000 10 years ago is only $8,070 today, a depreciation of more than 19%.

Of course, Bitcoin was trading at just over $5 a decade ago, so any calculation of returns on Bitcoin captures some of its most amazing performances, even when it was a nascent or barely-there asset class. However, looking back over the past five years, we can still see that the dollar remains a poor store of value proposition compared to Bitcoin:

The dollar is not volatile, but it's also not a very good store of value in terms of purchasing power, whereas Bitcoin is considered very volatile, but it has been a much better store of value over the last decade or even five years. The point is that something with low volatility is not necessarily a good store of value long term, and something with high volatility doesn't mean it can't be a good store of value long term.

Emerging asset classes are not immune to volatility

We know that Bitcoin has a market cap of about $700 billion today, having reached the status of an emerging or small asset class in the eyes of many investors. We also know that Bitcoin started out with a market cap and value of zero. But what happened in between? How did we get from point A to point B? And how did Bitcoin become a larger, more mature asset class?

At a macro level, the answer may seem simple: more and more people are adopting Bitcoin and buying it at higher and higher prices. But a deeper look at the microeconomic processes reveals some key roles of volatility.

Investors are no doubt very familiar with the efficiency of the markets at a macro level and are used to seeing the price of just about everything on their screens, as well as the value of their holdings or portfolios. What is often forgotten is that the "market" is not a monolithic machine that is good at finding value in securities and investments, but is made up of billions of individuals. The incorporation of new information and the "market" that reflects that price information is a process, not a static or one-time evaluation.

Markets are made up of individuals who act, and a large portion of these individuals now see the value of Bitcoin and buy it accordingly. But this group of people did not form this belief at the same time or in the same way. Everyone must go through the process of understanding Bitcoin and its value proposition. Some may buy and hold at different times, while others may trade before choosing a long-term allocation.

Therefore, the process of individuals adopting Bitcoin in different ways and time frames is bound to produce volatility. Volatility is a byproduct of price discovery, and in a free market, there is no other way to achieve price discovery.

Gold as an example of an emerging asset class

If this sounds too esoteric or all theoretical, a recent example of the emergence of gold as an asset class may help. Until 1971, gold was used as a currency in various forms, or at least pegged to the U.S. dollar, so that gold was tied to a certain amount of dollars.

In 1971, President Nixon abandoned all links between the dollar and gold, removing the peg or fixed exchange rate between gold and the dollar and adopting a free floating exchange rate.

This has created a gold market where the price of gold is now determined by free supply and demand forces. Investors are now faced with the question: how much is gold really worth? Today, the total value of gold in the world is estimated to be around $12 trillion, making it a large and mature asset class in the eyes of many investors.

As the chart below shows, gold has not moved into this established asset class in a consistent, easily predictable, or low-volatility manner. Additionally, it is interesting to see how Bitcoin has roughly followed a similar pattern. However, please note that a simple overlay or comparison of charts should not be used as a model or indicator of any kind. We are simply highlighting here a historical example of an emerging asset class that went through very volatile periods as it went through its own price discovery process.

Historical and Future Volatility

As gold went through a major price discovery process in the 70s, which led to a larger investor base, volatility naturally declined. We believe Bitcoin will go through the same process, and indeed, the limited historical evidence we have so far seems to suggest that volatility has declined over the long term.

In summary, we believe that during periods of high volatility, it is helpful for investors to revisit some of Bitcoin’s seemingly fundamental properties and why it is so volatile. Bitcoin’s volatility is also what makes it valuable, and while it can be unsettling at times, this volatility suggests that Bitcoin is emerging as an asset class and may therefore be achieving its ultimate investment goal of long-term value preservation.

original:

https://www.fidelitydigitalassets.com/articles/understanding-bitcoin-volatility