“How can Bitcoin be a good store of value if its price is so volatile?”

I am oh so reluctant to repost old material, which is how bloggers fall from grace.  Nonetheless I don’t think I can do better than to repeat my take from 2013:

“What a day:

Bitcoin is now 44 percent off its intraday high of $266.

Maybe it’s in the nature of Bitcoin to have volatile prices (and Megan comments here).

But that’s part of the point, isn’t it?  (Have we ever posted on the two envelopes problem?  I think so but I can’t find it through search.)  Imagine you hold a currency which, over the next period will either double or halve in value.  The expected return of such a Bitcoin is in fact (0.5 x .5) + (0.5 x 2) = 1.25.

What a good deal that is!  Holding a single Bitcoin — a very volatile Bitcoin that is — seems like a lot of fun.  It’s unlikely that simple risk aversion will take away the expected gain there.

Does this not mean that exchange rate variability is desirable per se, a kind of automatic utility machine?  The party holding the other currency reaps a comparable gain from the ex ante volatility.

Fischer Black was obsessed with this problem for a few years, though I don’t think he ever quite nailed it.  The mathematics behind Jensen’s Inequality are relevant here, but again that’s not the same as an explanation of the puzzle.  My preferred path is to start with the Sumnerian “never reason from a price change” insight, but in any case this is a good brain teaser for your evening.”

Volatility is a feature of Bitcoin, not a bug, and that is in part for reasons that have nothing to do with speculation or bubbliness, but rather follow from the contours of the utility function.  It’s that latter point that hardly anyone understands.

Comments

To assess the desirability of exchange rate movements between fiat and bitcoin, we should ask about the movement of resources towards mining, as well as the effects of bitcoin price oscillations on the rest of the economic system. To me it seems immediate that indefinite price rises are undesirable if we care about energy conservation as well as a waste of resources on mining hardware. Some commenters have noted that so far there are not a lot of leveraged bets on bitcoin, especially by entities that are central to the financial system. Hopefully this means that bitcoin oscillations don't propagate very far to the rest of the financial system.

" indefinite price rises are undesirable if we care about energy conservation as well as a waste of resources on mining hardware."

The more we mine, the greater the downward pressure on the price. Correct?

The price isn't to be blamed for energy expenditure. The price is merely an indication of the progressively hard nature of mining.

Not really: fixed number of coins, and we're already mostly to the end of them

Mining returns a fixed (and shrinking) number of new bitcoins per unit time. These bitcoins are divided up between miners depending on how much hashing they do. So the number of bitcoins mined doesn't change with price but the number of miners does.

While there is a lot of talk on the energy expenditure in mining, I think it needs to be put into perspective by comparing the costs of mining other assets.

Is the cost of mining bitcoins worth $100K higher or lower than the cost of mining $100K worth Gold?

I am trying to think in terms of equilibrium: resources will flow into bitcoin mining until there is nothing to be gained from additional investments. In that respect, it is no different than gold. I don't know how the algorithm adjusts the difficulty level, but I don't see these adjustments following a good pattern for society as a whole. Early investors in bitcoin are making huge gains as the price shoots up, but this draws lot of society's resources towards increased mining effort.

Other currencies are managed by central bankers who want the inflow of resources to currency area to correspond well to the growing potential for these resources to be used productively. Bitcoin isn't managed that thoughtfully. The mining isn't even supporting current transaction processing, it is merely a gold rush.

The early investors deserve huge gains for placing their faith in an asset, when nobody else did. First movers deserve all plaudits. Tyler was right in comparing the early investors to the early disciples of Jesus - the apostles are famous for a reason. Later Christians were / are just part of a herd.

Central bank managed currencies are not a reliable store of value. In fact they lose their value every day with inflation. Bitcoin in contrast is a reliable, tradeable, divisible, fungible store of value - the best discovered since Gold. Are there any rivals?

It is a social innovation of enormous import. And the resources consumed are a fair price to be paid for an innovation of such enormity.

Honest question, not trying to be snarky: do you own any bitcoin or other crypto?

How can an asset that goes up 10% in one day be called a reliable store of value?

@shrikanthk: Me neither. And I'm kicking myself daily. If you are so convinced of the importance, why aren't you participating, even a little?

I may be wrong here, but it was explained to me by a bitcoin miner that bitcoin mining is finite. It will not continue indefinitely. Indeed, it’s projected to be exhausted within a few years at which point no more bitcoin will enter the market, regardless of price.

That is how things are now, but it is possible to change such features by forking the blockchain. The bitcoin community decides collectively which of the forks survives.

"The bitcoin community decides collectively which of the forks survives."

Presumably the bitcoin community is the holders of bitcoin. Or is the community the people who profit from selling bitcoin to the stupid.

Not only are bitcoins limited to 21 million many of them have been lost (people lost the ability to spend or transfer them).

Fiat currencies are the opposite because they are continually expanding (thus deflating their value). US government spends an extra trillion and there is an extra trillion dollars in the economy. And if you put $1,000 in a bank some banks can loan out $10,000 - $9,000 new currency created.

Think about the value of things that are limited.

A simple thing I think about are cars which are now collectors because their numbers were limited. Acura Integra Type R is one I'm familiar with. They keep going up in value and are not easily traded or divided.

I wish I would have gotten into crpto much earlier than this year but I continue to invest believing most people have not and that they are going to become more popular.

I also have a mining rig setup for Etherium - mining bitcoin isn't easy or cheap to get into - you need ASIC machings and lots of power. Eth and others can still be mined with GPUs and CPUs. I wish I would have put the $1,200 into Bitcoin instead of the mining rig 6 plus months ago.

Mining is weird. I may be behind many of you, but I was surprised to see how much the pc industry has adapted for it. Not only do old line "graphics card" makers have special mining cards, but famous old motherboard makers have special products to control many graphics (really) mining cards as well.

The best mining cards, with the best hash to power ratio, seem sold out everywhere. So there is definitely a good rush, and people are definitely selling "picks and shovels."

This bubble could pop, but as we were told in a previous thread, new technology (proof of stake?) could obsolete expensive mining pretty quickly. I mean, Bitcoin obviously works, but in the long run are more energy and computationally efficient solutions possible?

Grr. Gold Rush.

Those graphics processors have been around for image processing tasks. Games, Photoshop, etc. A bit of rebranding an existing product.

Given short product cycles and consumer interest, I see no reason do disbelieve this:

https://news.bitcoin.com/asus-and-nvidia-announce-purpose-built-cryptocurrency-mining-gpus/

Oh course, if you buy a card with no video out, you have a rather dedicated use.

Like GPGPU?

How would you go about bootstrapping sound money from zero to the potential in the double-digits $Ts, without heavy volatility throughout the journey?

It would need to start off on the back of already sound money, as the USD was with gold or the Euro was built on established European currencies, which no longer exist.

What makes bitcoin so much more volatile than Gold? Both are assets whose supply is heavily constrained. Is the former's volatility mainly got to do with its "novelty"? Will volatility come down once the novelty wears out?

Compared to bitcoin, the supply of dollars is infinite because the dollar value is based on total quantity of labor which is unbounded in comparison. The Fed increases dollar quantity slightly faster than labor quantity to maintain a slight dollar price increase in labor price over time.

Even the quantity of gold is unbounded compared to quantity of bitcoin. Long term, the additions to gold stocks is constant. Bitcoin has a hard upper bound of 21 million or so. As labor supply increases, gold mining increases. Gold mining productivity is long term constant.

(Gold is a complement to most metal mining, eg copper, so as labor supply drives copper demand, that increases gold production at no effective cost on global scale.)

I regard gold as long term volatile, and the "periodic mania" model may apply here.

I found a guy who priced gold in bread, and who started out with a bible quote of something like 350 loaves of bread to the ounce. He then figured the price in loaves in Australia at 300 plus loaves of bread over a period of years, so that shows no long term volatility.

Loaves of bread are produced sustainably with labor. Marginal additions to gold stocks are produced sustainable with labor. Labor productivity apply equally to both at global scale.

Unlike oil or coal, gold mining is no where near depleting the massive quantities of gold in the accessible portion of the earth, primarily because all gold consumed can be mined, ie, your gold fillings are mined from your waste at every point discarded. No one can mine oil from your car gasoline consumption waste. Gold quantity increases with labor supply because complements like copper mining add to copper, and thus gold, stocks as labor supply increases at global scale.

There are many ways to own gold. Think ETFs, many thing that there isn't enough real gold to represent all the ownership of paper gold (ETFs). Many see this as manipulation.

Gold isn't really consumed and more and more of it is being dug up.

Was the price of gold stable back in the gold rush days?

The crypto market is rather new and small making it easier to swing the prices. Right now in December of 2017 there is tremendous interest so much so that it takes days to get an account at the exchanges setup so as you can deposit funds.

You question about volatility makes me wonder if some percentage of the the population will buy into the market once it is more stable.

The price of bitcoin is not volatile at all. It's completely stable at BC$1=BC$1 at all times.

It's the value of US$ and gold assets that has been volatile and crashing over recent years. No wonder with the stock market in a long term recession as it is. Some speculate that unstable assets like stocks and dollars will come roaring back. If they do, that just proves again that they are ridiculously unstable compared to rock-solid bitcoin.

> The British Columbia Real Estate Association is out with its fourth-quarter housing forecast, and it’s predicting residential sales will decline by 10 per cent in 2018, after an expected drop of 8.8 per cent in 2017.

So the utility of bitcoin is a place to move cash out of China? Replacing the purchase of real estate in Vancouver and Toronto and other places in the US?

Valid question.

its a wonderful scam. they give us products in exchange for dollars, then we take the dollars back in exchange for fake internet money

Except most bitcoins are mined by the Chinese

Tulip bulb prices have been quite stable throughout all our lifetimes.

And the part about falling from grace. Apparently not an issue back in 2013, after all - 'Have we ever posted on the two envelopes problem? I think so but I can’t find it through search.' (It was a commenter that mentioned it here - http://marginalrevolution.com/marginalrevolution/2007/05/how_do_numbers_.html)

Bitcoin is in very good way to store money but at the same time it is a big big opportunity for criminals to do their businesses. above that mining crypto currency is is very bad for the environment which is already damaged a lot . To regain confidence it is absolutely necessary that the governments are acting now. Why not higher the price of an ounce of gold to 20.000 USD if it is possible to higher the price of a bit coin from 1USD to 20,000 USD. So link the value of money to the new gold price which is an international standard and is in favour of anyone not only the people who want to speculate on cryptocurrencies.

https://www.forbes.com/sites/laurashin/2017/10/03/how-to-explain-cryptocurrencies-and-blockchains-to-the-average-person/#2602938f324d
In this episode of Laura Shin's podcast, Unchained, regarding criminal money, it's easier to track a cryptocurrency whose blockchain is transparent than a bag of cash.

Megan comments have not aged well especially on lack of btc liquidity. We are reaching the point where nation states can move billions into Bitcoin to evade western sanctions

First, volatility matters only if it occurs on timescales longer than the requirement to access the value. If everyone can afford to wait a week to get the value out, then daily fluctuations actually wash out.

Second, we shouldn't be comparing the energy costs of maintain the blockchain (mining) to gold mining, for example. We should be comparing them to the costs to maintain other kinds of financial resources; for example, the banking system, including its various security and transaction systems. Stock trading centers (compute centers proximate to the NYSE for reasons of latency) in NYC appear as huge thermal signatures on the buildings visible from brooklyn (or probably even space) because of the energy requirements.

Why do people go to stores of value that are not value-based investments?

It's not to hedge against inflation, which gold does badly. It's to have an asset that is not someone else's liability. It's a crisis hedge, an investment for (sorry) paranoid cranks.

Can Bitcoin compete in the market for paranoid cranks' money? Well, gold has been around for millennia, BItcoin for less than a decade. Gold isn't likely to have the regulatory risk Bitcoin has. There probably isn't going to be another precious metal being invented tomorrow, but other crypto currencies are arising every day.

Also, the most dedicated gold cranks keep it in their home. Holding actual Bitcoin and keeping it safe is technically challenging, so people do it through companies like Coinbase. So we are back to holding IOUs when the world blows up. (And of course, there is storage risk at Coinbase too.)

The one use case for Bitcoin that has ever become widespread, illegal purchases, has been prosecuted away. Bitcoin is not a good substitute for gold. It is purely a speculative instrument right now.

If you're making money on it, good for you! But realize this is what it is so you can find a chair when the music stops playing.

Gold value is stable. The labor for the marginal ounce is about 350 loaves of bread, a function of labor. The dollar is a proxy for labor, with the dollar price of labor increasing by government policy.

An hour of labor is an hour of labor. An ounce of gold is an ounce of gold. The labor to add a marginal ounce of gold is globally constant over thousands of years.

What changes is the dollar or pound or yen or euro price of an hour of labor.

The level of proud ignorance surrounding this phenomenon grows tiresome. Holding bitcoin safely is not even a little bit technically challenging; it's just novel. You can literally print the stuff out and lock it in a box, which means that it can not possibly be more challenging to store than gold (of course it is easier, since it is easily concealed, weighs nothing, and occupies negligible physical space). Of course you are also free to outsource this responsibility to Coinbase et al, as we are all accustomed to doing with our stock/commodity portfolios. And of course there are special mostly political considerations surrounding bitcoin that would make one more interested in storing it himself.

Almost all practical criticisms of bitcoin would have applied equally to paper or metal currency upon the introduction of those things. Techniques and institutions are already well on their way to maturity which recapitulate earlier developments in banking technology (eg vaults, checking, https://en.wikipedia.org/wiki/Time_lock, whatever). One can imagine primitive people saying, "Coins?! You want me to give you a meal in exchange for this useless metal portraiture?" We got used to it.

I’ll accept your point about paper storage; I’ll admit that’s a new one on me.

I don’t hear you fully refuting the value of bitcoin as a crisis hedge. What I’m hearing is a proposal to use bitcoin as a currency replacement. What is its comparative advantage there, as you see it?

Cowen compared early investors in Bitcoin to the disciples of Jesus? Oh, my! Of course, the disciples of Jesus quit their day jobs because Jesus told them the End was imminent. Well, that was bad enough for the saps, but even worse was the outcome for Peter, James, and John, who led the Jewish Jesus movement in Jerusalem, only to have Paul wrest control of the movement and shift it to Gentiles. Peter, the first Pope according to the Church, suffered an unpleasant death: he was crucified upside down. But all was not lost: Peter died a martyr because of his faith. So what, Peter was dead, martyr or not. But there is a very big difference: martyrs go straight to Heaven, while everyone else has to wait until the End and the resurrection of the body. For them, it's been a long wait. As for James and John, the evidence they were martyred is less certain, although one would expect that James, who was the brother of Jesus, would have been martyred for his faith if not for his kin. Which brings me back to the early investors in Bitcoin. Will they be martyred for their faith, faith in Bitcoin that is, if Bitcoin continues to gyrate, or if Bitcoin collapses? Will they go straight to Heaven, or will they have to wait until the End like the rest of us saps?

About a week ago our older son bought a $200 "portfolio" of three crypto currencies for our younger son. An early Christmas present. Last night the "value" was at $496.

I told them "nice, but don't expect this kind of thing every time you invest."

What will be the value of bitcoin when the government places itself in the middle as a node in the chain?

FYI

The Continuing Legal Education course on Blockchain technology and cryptocurrencies I took last week talked about how blockchain could and will be used by banks to comply with know your customer rules.

https://news.bitcoin.com/japanese-investors-fx-trading-bitcoin/

"A growing number of Japanese retail investors are switching from leveraged FX trading to leveraged cryptocurrency trading, thus driving the crypto market, according to a recent Deutsche Bank’s research. Operators of Japan’s largest FX platforms are launching their own crypto exchanges, offering leverage of up to 25x."
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Blockchain does any to any FX exchange with no need for the US Swift system. Thus, it is one step less, and offers immediate availability. Bitcoin uses blockchain specifically for this purpose since its origination.

As a store of value, the Chinese citizen can let the bitcoins sit on the ledger until the PBOC reveals its latest plot.

Don't assume that interbank clearing mechanisms that use blockchain technology will not have to have the government in a node to monitor or permit transactions using government insured financial institutions.

Satoshi Nakamoto has 1 million Bitcoins now worth about $20 billion.

No one knows who he/she/they is. And they still haven’t spent a single coin.

Future Iron Man/Batman? Or future Lex Luthor?

The relevant literature indicates that a high risk premium is paid out to assets that have highly negative returns that are correlated with other assets. Most simply put in the sp500 drops 25% over the next week does the asset outperform or underperform. Selling out of the money puts earned lots of money over the life of Bitcoin.

Therefore I see the big question as: does Bitcoin appreciate or depreciate in this scenario?

Strong arguments can be made for both sides but claiming Bitcoin is a store of value implies that it has negative correlation. (ie insurance in a disaster scenario) I would like evidence that is true before I buy the insurance.

Imagine you hold a currency which, over the next period will either double or halve in value. The expected return of such a Bitcoin is in fact (0.5 x .5) + (0.5 x 2) = 1.25.

Well, it is if you assume equal probabilities. Also if you assume that the pattern of price movements is such that the percentages by which the value moves up or down are the same. Why assume that?

In general, volatility increases value if the asset is negatively correlated with other widely held assets, because that reduces portfolio risk. Does bitcoin move that way? Volatility is also valuable in assets, options most notably, that have one-way payoffs, but I don't think that describes bitcoin.

Your envelope example is quite strange, as such a skewed distribution of returns isn't really the same thing as "volatility" in general. "Ah, look at the spread! Yes the skew is heavy to the right tail but so what?" is not persuasive in the 'volatility can be a perk,' line of argument.

"The expected return of such a Bitcoin is in fact (0.5 x .5) + (0.5 x 2) = 1.25."

Wow.. beginners mistake. You aren't calculating "return" but value relative (gross return). The geometric formula is appropriate: (1+0.5)*(1+1)=1 (0% return)

see also: https://en.wikipedia.org/wiki/Rate_of_return#Rate_of_return

oeps: (1*0,5)+(1*2)=1

I dunno about this line of reasoning. It seems to me that if I couldn't predict the value of the dollars in my pocket tomorrow to within a factor of four, they wouldn't be very useful for buying things.

Expected returns are nice, but when I'm hungry I want to buy a hamburger. I don't want to come up just short half the time.

Put another way: why couldn't we just buy things with penny stocks instead of bitcoin? The certificates are prettier, and half of those Chilean gold mining stocks are switching to Bitcoin, anyway!

Bitcoin seems to illustrate that some of the metaphors economists use to explain things aren't fully thought through.

It's mostly true that money is a shared delusion. But applying the same reasoning to Bitcoin seems... delusional.

At some point when this is all over, people might want to drill down and think harder about the attributes that make a commodity useful as a currency. I suspect that after the blossoming of Ethereum, Dogecoin, etc, it will suddenly become obvious that a stable and limited supply of the commodity must be accompanied by a lack of near substitutes.

The 'bitcoin is useless as a currency' argument is trite and pointless. It probably is pretty useless as a currency (outside of illegal uses), so far it has been a spectacular store of value.

msgkings,

Tulips were once a spectacular store of value.

Again with the damn tulips. Tulips can be grown whereas bitcoin has a fixed supply. Tulips never had a chance, whereas bitcoin does have a chance at widespread adoption.

A currency is a store of value if its buying power is stable. Bitcoin is a terrible store of value.

No, bitcoin is not a viable currency at all. There are other stores of value that are not currency, like real estate or gold. Bitcoin may end up being a new one.

No, I'm saying that "speculative investment" and "store of value" are opposites. You store something because you want to get it back in the same condition as when you stored it.

Regardless of whether bitcoin is useful as a currency, it is terrible at being worth the same amount that it was worth yesterday.

Almost nothing is worth the same amount as it was yesterday, so nothing is a store of value? What qualifies in your estimation?

In Cowen's example of Bitcoin either doubling of halving, isn't it the positive expected return of 25% that is attractive, not the volatility? Wouldn't an investment with a guaranteed return of 25% in 1 year (or for that matter 15%) be more attractive?

Correct.

https://en.m.wikipedia.org/wiki/Sharpe_ratio

If i recall, Victor Niederhoffer says market movements are closer to being arithmetically symmetrical than log, and therefore the the two-envelopes problem is not relevant to markets.

Seems a bit like the old probability paradox puzzle of the price one would pay to play a fair coin toss game where the winnings are doubled each flip until you lose.

We might also ask what the time horizon for that 25% expected total return ( assuming the calculation give was correct) is not all that impressive if we're talking about having to hold it for an infinite period of time.

Finally, what's the value of bit coin if some of the major currencies more to block chain?

More relevant than volatility itself is a) is volatility forecastable, and b) how cheap is asset to trade?

If forecastable and cheap can choose your own volatility by scaling investment size and rebalancing.

I don’t know the answers here though.

At some point the tails of that return distribution will be not be equal. When a "stock" or "currency" is small maybe 2x and 1/2x are equally probable. But not when it becomes large. The size will draw competition and there will be reversion to the mean. Is is more likely that Apple becomes 10x as big or 1/10 as big in 10 yrs?

I posted comments on bitcoin, entitled "The Future of Bitcoin", here: http://trotskyschildren.blogspot.com/2017/12/the-future-of-bitcoin.html

Well, the expected return is 1.25, but in the long run, over multiple periods, the risk of going to zero is crazy high.

Look up "Kelly Criterion" and risk of ruin. Betting more than 25% of total equity on "double or half" returns profile will nearly certainly end in misery.

This is a common way to think about trading strategies in the pro trading world.

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