How ‘Bitbanks’ Could Solve Bitcoin’s Volatility Problem

aEverywhere in modern society, money is plagued by political problems. The fact that Bitcoin has been able to avoid these problems, with no help from anyone and in fact against many political authorities around the world, just shows how valuable it is.

However, as important an innovation as cryptocurrency is, it has its own unique problems. Bitcoin in particular is notoriously volatile in value, which makes its success all the more remarkable. Since its inception, it has often fallen by more than 20% against the US dollar in a single day, and sometimes by almost 50% (see chart below).

In contrast, the USD/EUR exchange rate has never changed more than 2.5% in a single day over the same period. Bitcoin is already so successful, imagine how much more successful it would be if its value could be more stable.

A crash course in monetarism

To determine what is behind Bitcoin’s stability issues, we will use the most important formula in monetary economics, the equation of exchange: MV = PQ.

This means that the amount of money (M) multiplied by the speed at which it is spent (V for speed) equals the purchase price of everything (P) multiplied by the quantity purchased (Q for quantity).

This simple formula holds true for any definition of a monetary system at any time, so it's a great tool for figuring out what happens when one of these variables changes.

In Bitcoin, M converges to 210,000 Bitcoins on a predetermined path, so it is essentially fixed in terms of other variables, leaving V, P, and Q to fluctuate.

In a modern economy, prices take a long time to adjust to the stresses of the system, i.e. inflation or deflation. So the formula tells us that if V or M suddenly falls, Q must fall until P catches up, resulting in unemployment and recession.

Fortunately, people still prefer to use dollars as the unit of account rather than Bitcoin, and this is also the case when trading Bitcoin.

Since the value fluctuates so much, the simplest thing a seller can do is to price the item in USD and figure out how much it is worth in Bitcoin at the point of sale. You will see the same thing happen in countries with hyperinflation. For example, during the Argentine crisis, you could pay in Pesos (a unit of currency), but the price would be in USD.

This means that compared to the dollar, Bitcoin’s P is extremely flexible. Q doesn’t take a hit, so recessions and job losses can’t happen in a Bitcoin economy. But since this flexibility relies on the dollar being a relatively stable unit of account, we have to figure out how to make Bitcoin’s value stable if we want it to be a self-sustaining currency.

Unstable demand

If Bitcoin's M is basically fixed, its Q will fluctuate while Q is relatively stable, and the exchange equation tells us that V must fluctuate. In other words, the demand for Bitcoin is very unstable.

This is not surprising: when people don't want your currency to be stable, and it is profitable, they will be suspicious of it, which makes it unstable. For this reason, we cannot expect the stability level to be reached when demand grows.

On the other hand, when you credibly promise a stable value, in fact speculation reinforces the stability. The UK, under the gold standard, enjoyed this kind of speculation for most of the time. The problem with Bitcoin is not only that its price is unstable, but there is no way to convince people that it will be stable.

The general advice is to make sure M changes in the opposite direction of V. If the left side of the equation (MV) doesn't change too much, then there won't be much pressure on prices and Q won't fall.

That is why central banks try to expand the money supply during recessions and contract during booms. And while P is stable, speculation reinforces stability.

In fact, there are two possibilities to stabilize MV: the traditional way through regulation by the banking system, or through automatic regulation of the money supply.

Bitcoin and Banking

In fact, Bitcoin is very similar to another successful currency whose supply is essentially fixed in the short term: gold. So the question now is, why doesn’t gold have the volatility problem that Bitcoin has?

In feudal times, money wasn’t that important. V was low and stable, so strict demand for gold and silver wasn’t too difficult. When the Industrial Revolution arrived, economic growth began to explode, but except on a European scale, we can also expect dramatic financial explosions, just like we’ve seen with Bitcoin.

The transition, at least in terms of money, turned out to be remarkably smooth. Fortunately, the industrial and banking revolutions were contemporary.

Once people started using paper money and checks instead of gold coins, that gave banks the ability to expand M beyond the relatively fixed supply of gold. In places where banks were regulated (like Scotland), lending on a fractional reserve basis actually kept MV fairly stable.

Likewise, we may see banks emerge on the Bitcoin platform, issuing paper money ('bitnotes'?), and making loans to eventually stabilize the value. Unfortunately, Bitcoin banking faces some obstacles that gold banking does not.

Technical and regulatory barriers

First, there is a technical hurdle. If we want the money supply to be flexible, Bitnote cannot be Bitcoin, even if they are exchanged one-to-one. Because implementing a new payment system requires more effort than just accepting paper money, "bitcanks" will face an uphill battle to get people to accept and transact with their currency.

Since this is a technical problem, we can expect smart people to overcome it. More difficult are the legal hurdles. Banks are centralized, so by using bitnotes you lose a lot of the benefits that make cryptocurrencies attractive.

It also gives hostile governments a bigger target. It would be too expensive for the Securities and Exchange Commission (SEC) to prosecute every user of Bitcoin, but it would be easy to shut down an institution.

Therefore, under the current legal environment, the governments of these countries are more willing to take such actions to protect their own currency monopoly.

Internal stability

What if we could take advantage of cryptocurrencies and automatically adjust changes in M ​​to compensate for changes in V? This is actually quite possible, remember that V is the rate at which units of currency are spent. Since all transactions happen in the blockchain, the protocol knows V.

If the reward for mining varied to compensate for a varying V, rather than against a fixed supply channel, it could stabilize MV with greater precision than any central bank in history.

Based on this idea, quite a few proposals have been circulated. Unfortunately, the issue of quantity is not the only issue to be addressed. The most important issue is who gets the new money when you adjust the money supply.

Normally, these changes are registered through the banking sector, where they can be distributed through loans to those who value them most. If this does not happen, that is, if the increase is distributed to miners, then the currency will not actually be more stable.

In fact, cryptocurrencies are the first currencies that are not regulated through the banking sector. This actually presents us with an unfortunate paradox: the macroeconomic benefits of banking are only relevant in conjunction with the microeconomic function of banking (through the allocation of lending liquidity).

Lending decisions are not something that can be automated by computers. As the recent financial crisis demonstrated, bad things can happen when you fail to check to make sure borrowers can afford to repay their loans. This is irreducible.

Economist Ricardo Cavalcanti puts the problem starkly: “While anonymity preserves money, it excludes all forms of credit.”

If there is really no way to meet the banking needs of the Bitcoin economy, the most important obstacle to the future of cryptocurrency will be political struggle.

On the one hand, a cryptocurrency banking system governed by the SEC would be difficult to improve on under the current banking system. On the other hand, without a banking system, Bitcoin remains vulnerable to destabilization and cannot gain a foothold as a currency independent account.

Without these institutions, cryptocurrencies will undoubtedly continue to innovate on a technological level but will not replace today’s legally privileged currencies.