Why Bitcoin’s Volatility Problem May Soon Be Solved

Just weeks ago, media outlets like Bloomberg and TechCrunch were all but declaring an end to bitcoin’s price volatility.

Posts like "Bitcoin’s Emerging Price Stability" were widely circulated on the bitcoin forums, and research from Wall Street analysts like ConvergEx Group asserted that bitcoin was “on the road to stability”.

Then, overnight, all was quickly forgotten.

CNBC, the Wall Street Journal, Bloomberg, BusinessWeek and Business Insider pounced on the bitcoin ‘crash’ due to Mt. Gox’s technical issues. Further, outlets like the LA Times rushed to dig up quotes from outspoken bitcoin critics like, Mark Williams, who issued the follow statement to the New York State Department of Financial Services BitLicense panel:

Here’s the thing. These critics are right, bitcoin is failing as a currency today.

That’s why I believe the next major bitcoin innovation won’t be a wallet app or a merchant tool, but rather a product or method that effectively separates bitcoin, the currency, from bitcoin, the speculative investment.

Sometime, hopefully soon, some person or company is going to figure out how to securitize the holding risks of bitcoin and guarantee the underlying purchasing power of consumer and merchant bitcoin deposits.

I’m not talking about ‘instant conversion’ tools offered by companies like BitPay and Coinbase, but rather products that allow depositors to safely and securely hold bitcoins that won’t fluctuate wildly in price. Ideally, depositors wouldn’t even know it, but they would be using this innovation to offload price volatility onto professional speculators with a higher risk tolerance.

In the process, bitcoin could begin acting like a currency for those who wish to use it as a unit of account for payments, while still preserving its properties as a high-beta investment. It’s a simple idea with a complex solution and a potentially lucrative payout.

Someone is bound to crack the problem eventually.

Bitcoin’s price swings stem from the fact that it is simultaneously ‘e-cash’ (a currency) and ‘e-gold’ (a means of investment). This is problematic because combining the two usually means that one isn’t acting as it should.

A stock with a 0% return is a poor investment, and a currency that can swing 10%+ or more in a day is a poor currency. Yet the ratio of bitcoin held for those vastly different purposes changes constantly and unpredictably.

Expectations of good news underpin investors’ rationale for treating bitcoin as a speculative investment that could skyrocket in value, and yet good news itself depends on consumers and merchants using bitcoin as a stable unit of account. It’s a circular reference.

A single bitcoin may end up with a value of $100,000 or it may crash to $0, but one thing is certain – it will not trade at a constant level in the long term. In that respect, critics are correct to say that bitcoin fails as a currency today. But will this always be the case?

Many believe the fix is a stronger derivatives market, but Coinbase’s Fred Ehrsam told Wired in January that the current “derivatives, futures, and options market is largely underdeveloped”, making today’s “counter-party risk unacceptable”.

In other words, today’s derivatives products are garbage.

And they could be for some time. Speaking from Munich at the DLD Conference, Circle’s Jeremy Allaire suggested that hedging products wouldn’t improve until central governments provided better regulatory clarity. Only then can large, well-capitalized financial institutions from financial meccas like New York and London build their own market-making platforms.

I’m sceptical, however, that a healthy, liquid derivatives market could materialize in the near-term to help individuals and smaller companies properly hedge against volatility. It is unlikely that small depositors would buy their own bitcoin futures, and even if they did, their coin would likely be expensive enough to offset any value gained from using the cryptocurrency as a payment system in the first place.

Besides, most of us consumers are used to low inflation, ‘sticky’ prices and stagnant wages. We simply aren’t conditioned to go the extra mile to protect the purchasing power of our savings.

What will really drive down bitcoin volatility are better methods for connecting bitcoin wallets to Wall Street banks and their abundant investment capital.

In an environment where some bitcoin-related startups struggle to open checking accounts, volatility innovators won’t face any shortage of hurdles (or critics from within the bitcoin community), but you can bet those challenges won’t dissuade them from trying to solve such an important problem.

Algorithmic trading platforms are already being built, which will improve liquidity and mop up some of bitcoin’s excess volatility, and it’s just a matter of time before a new intermediary builds the pipes that allow Wall Street to securitize all of bitcoin’s volatility.

There are ways to effectively separate bitcoin into both a currency and a volatile investment. There is an institutional market hungry to absorb the risks and soak up the rewards of bitcoin. There are talented teams of bitcoin technologists and finance entrepreneurs eager to build new products. And there is a clear regulatory framework slowly emerging from government authorities.

The table is set to truly change the way ordinary people interact with the underlying bitcoin technology. It’s no longer a question of whether these innovations are possible. Instead, it’s just a matter of when they will be available.

Ryan Galt is a blogger, entrepreneur and freelance opinion writer for CoinDesk. His opinions do not necessarily reflect CoinDesk’s. You may email him at [email protected], or follow him on twitter @twobitidiot.

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