Price fluctuations in the Bitcoin spot rate on the Bitcoin exchanges is driven by many factors. Volatility is measured in traditional markets by the Volatility Index, also known as the CBOE Volatility Index (VIX). Volatility in Bitcoin does not yet have a generally accepted index since cryptocurrency as an asset class is still in its nascent stages, but we do know that Bitcoin is capable of volatility in the form of 10x changes in price versus the U.S. dollar, in a relatively short period of time. Here are just a few of the many factors behind Bitcoin's volatility:
1. Rate of adoption is hampered by bad press: News events that scare Bitcoin users include geopolitical events and statements by governments that Bitcoin is likely to be regulated. Bitcoin's early adopters included several mal actors, producing headline news stories that produced fear in investors. Headline-making Bitcoin news includes the bankruptcy of Mt. Gox in early 2014, and the high-profile use of Bitcoin in drug transactions via Silk Road that ended with the FBI shutdown of the marketplace in October 2013. Both these incidents and the public panic that ensured drove the value of Bitcoins versus fiat currencies down rapidly. However, Bitcoin-friendly investors viewed those events as evidence that the market was maturing, driving the value of Bitcoins versus the dollar markedly back up in the short period immediately following the news events.
2. Bitcoin's perceived value fluctuates: One reason why Bitcoin may fluctuate against fiat currencies is the perceived store of value versus the fiat currency. Bitcoin has properties that make it similar to gold. It is governed by a design decision by the developers of the core technology to limit its production to a fixed amount, 21 million BTC. Since that differs markedly from fiat currency, which is managed by governments who want to maintain low inflation, high employment, and satisfactory growth through investment in capital resources, as economies built with fiat currencies show signs of strength or weakness, investors may allocate more or less of their assets into Bitcoin.
3. Too much variance in perceptions of Bitcoin's store of value and method of value: Bitcoin volatility is also driven in large part by varying perceptions of the intrinsic value of the cryptocurrency as a store of value and method of value transfer. A store of value is the function by which an asset can be useful in the future with some predictability. A store of value can be saved and exchanged for some good or service in the future. A method of value transfer is any object or concept used to transmit property in the form of assets from one party to another. Bitcoin’s volatility at the present makes it a somewhat unclear store of value, but it promises nearly frictionless value transfer. Since these two drivers of the current spot price of Bitcoin vary against the dollar and other fiat currencies, we see that Bitcoin's value can swing based on news events much as we observe with fiat currencies.
4. Little option value to large holders of the currency: Bitcoin volatility is also to an extent driven by holders of large proportions of the total outstanding float of the currency. For Bitcoin investors with current holdings above around $10M, it is not clear how they would liquidate a position that large into a fiat position without severely moving the market. Since Bitcoin’s volume resembles a small cap stock, the currency has not hit the mass market adoption rates that would be necessary to provide option value to large holders of the currency.
5. News about security breaches make investors react: Bitcoin can also become volatile when the Bitcoin community exposes security vulnerabilities in an effort to produce massive open source responses in the form of security fixes. This approach to security is paradoxically one that produces great outcomes, with many valuable open source software initiatives to its credit, including Linux. Bitcoin developers must reveal security concerns to the public in order to produce robust solutions. The recent OpenSSL vulnerabilities attacked by the Heartbleed bug and reported by Neel Mehta of Google’s security team on April 1, 2014, seem to have had some downward effect on the value of Bitcoin in the ensuing month, with a decrease in value of approximately 10% for the month of April versus the US Dollar. Bitcoin and open source software development are built upon the same fundamental premise that a copy of the source code is free for users to examine and modify at will. This concept makes it the responsibility of the community to voice concerns about the software design, and when the community does so, the value of Bitcoin reflects the level of confidence in the protocol design as a whole. It is only natural then that the value would fluctuate with news events about security breaches.
6. Bitcoin and foreign direct investment in countries with high inflation. Bitcoin’s use case as a currency for the developing countries that are currently experiencing high inflation is valuable when considering the volatility of Bitcoin in these economies versus the volatility of Bitcoin in US$. Bitcoin is much more volatile versus the USD than the high inflation Argentine peso versus the US$. That being said, the near frictionless transfer of Bitcoins across borders makes it a potentially highly attractive borrowing instrument for Argentineans, as the high inflation rate for peso denominated loans potentially justifies taking on some intermediate currency volatility risk in a Bitcoin denominated loan funded outside Argentina. Similarly, funders outside Argentina can earn a higher return under this scheme than they can using debt instruments denominated in their home currency, potentially offsetting some of the risk of exposure to the high inflation Argentine market.
7. Mt Gox: Bitcoin’s recent high profile losses at Mt Gox are another driver of volatility. It is worth noting that these losses and the ensuing news about the losses had a double effect on volatility. They reduced the overall float of Bitcoin by approximately 5%, producing a potential lift on the value of the remaining Bitcoin due to increased scarcity. However, overriding this lift was negative effect of the news cycle that followed. Notably, other Bitcoin gateways looked to the massive failure at Mt Gox as a positive for the long term prospects of Bitcoin, further complicating the already complex story behind the currency’s volatility. As early adopting firms are eliminated from the market due to poor management and dysfunctional processes, later entrants learn from their errors and build stronger processes into their own operations, strengthening the infrastructure of the currency overall.
8. Tax treatment of Bitcoin also affects the volatility. Recent announcements by the IRS stating that the currency is actually an asset for tax purposes had mixed effects on volatility. On the upside, any statement recognizing the currency has a positive effect on the market valuation of the currency. Conversely, on the downside, the decision by the IRS to call it property had two negative effects. The first was the added complexity for users who want to pay with it. Under the new tax law, users would have to record the market value of the currency at the time of every transaction, no matter how small. This can understandably slow adoption as it seems to be too much trouble for what it is worth for many users. Secondly, the decision to call the currency a form of property for tax purposes may be a signal to some market participants that the IRS is preparing to enforce stronger regulations later. Very strong regulation of the currency could cause the adoption rate of the currency to slow to the point where it is not able to achieve the mass adoption that is critical for its overall utility in society. Recent moves by the IRS are not clear as to their signaling motives and therefore have mixed signals to the market for Bitcoin.
The Bottom Line
Bitcoin presents a variety of opportunities that did not exist prior to its development. Yet, it has failed as yet to convert investors concerned about its potential rate of adoption as an alternative currency. Recent acknowledgement by the IRS that Bitcoin is an asset for tax purposes has clarified the situation for investors, and the promise of frictionless value transfer suggests innovative use cases in foreign direct investment. In the near term, much of the volatility will be driven by investor perception of the ability of gateways to safeguard individual holdings and provide for a reliable store of value as adoption increases.