A study by researchers, Dirk G. Bauer, and Thomas Dimpfli – published November 2020 – analyses the role that price volatility plays in the performance of Bitcoin as a medium of exchange, or a store of value. The debate has raged on for almost as long as the benchmark cryptographic asset has enjoyed the mainstream media spotlight, and since it carries many of the characteristics of both, no one seems to be able to come to a conclusion as to what role Bitcoin plays in human economic activity. This is one of the latest academic papers, on the subject, attempting to define Bitcoin’s economic function.
Compared to incumbent, government backed, fiat currencies and precious metals like gold or silver, digital currencies (though having enjoyed phenomenal growth in the few years since inception) are an infantile asset class. While the biggest digital asset, by market capitalization, Bitcoin – as per Satoshi Nakamoto – is a peer-to-peer cash system (and certainly features currency-like characteristics,) empirical studies have usually – due to price volatility – typically classified it as a store of value. Recognizing that the nature and degree of volatility had an influence on the digital asset’s functionality as both investment asset, and currency, the pair focused on volatility in their analysis.
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Bauer and Dimpfli, in their research paper, titled The Volatility of Bitcoin and its Role as a Medium of Exchange and a Store of Value, perform an in depth analysis of Bitcoin volatility and its impact on the asset’s usability as a currency, portfolio diversifier, or at the very least, a store of value. They pulled data from six different markets, detailing BTC exchange rates against the USD Dollar, Euro, and Japanese Yen, then comparing them to USD/EUR, and USD/YEN forex pairs among other data. They came to some interesting findings.
Bitcoin Market Characteristics
Introduced in October 2008, by Satoshi Nakamoto through a whitepaper, Bitcoin is a completely electronic peer-to-peer cash system that is independent of any central authority. With no intermediaries to verify transactions, the Bitcoin system relies entirely on coded algorithms and a network of nodes to confirm, and add transaction information to a distributed ledger known as a blockchain.
Blockchain technology is the backbone of most digital currencies, which differentiates them from traditional fiat currencies that are issued by a central banking authority. While there is virtually no limit to how much fiat that can be issued by a central bank, Bitcoin’s supply is capped at 21 million coins – there are already about 18.5 million BTC out there. Bitcoin are generated at a steady rate, which degrades by half every four years or so. In order for a Bitcoin to be issued, miners must solve a hash to reconcile a block of transactions to the ledger. The limited, and fixed supply has driven speculative activity around the currency, which – in turn – has led to wild price fluctuations.
This volatility apparently inspired doubt in Bitcoin’s usability as a currency, which is probably why many have taken to storing it, and perhaps why the majority of stored Bitcoin remains untouched. Stable coins exist to mitigate some of the effect of volatility.
Concerning Trading & Regulations
The paper drew data from 5 different digital currency exchanges, Bitfinex, bitFlyer, Bitstamp, little-known BTCBOX, as well as Kraken. Digital Asset trading environments are not unified, and therefore no consolidated tape of market data is available. There are also disparities in minimum tick size – across platforms – in any given sample period. Probably making the data reconciliation effort even more cumbersome, is the fact that each platform charges different fees for (a percentage of total transaction volume within a given period), with some charging different fees across all order types offered on the platform.
Another aspect that could stand to be more uniform, is the global regulation of cryptocurrencies. Some territories have totally banned Bitcoin, and sundry, while other countries (usually the more developed nations) impose few – if any – limits on the use of digital assets. Other territories fall between the two extremes, with some Middle Eastern nations having greenlighted the use of crypto assets, just not on home soil (I know, right?) The subject of taxation is an equally messy one.
While digital assets don’t have some of the security risks attached to fiat currency (muggings, bank robberies, counterfeiting), they share similar risks on the digital end of things. The paper notes that, without a clear cut, and binding regulatory regime, it remains unclear who bears the burden of responsibility and/or accountability in the event of a crypto platform security breach resulting in losses for users. These kinds of security breaches will become more prevalent – apparently – as digital assets become more popular, the volatility of crypto markets, as the paper suggests, may be a consequence of crypto markets pricing this risk in.
Analysis:
Trend In Volatility
Data showed that Bitcoin volatility -though high at the beginning of the sample period (2010-2020) – seemed to drop off toward the end of the sample period. However, the regression was too insignificant to make any real difference.
Correlations
Bauer, and Dimpfli scrutinized how Bitcoin prices, on the 5 digital asset trading platforms, correlated. This was important to understand as price differences on each exchange could vary quite widely. Using the trading pairs with the longest sample period, Bauer, and associate, found that the correlation of BTC returns was 0.95 (higher than the Forex market’s average of 0.43.
The researchers also noted that prices tended to converge towards the end of the sample period (2014-2020,) suggesting the growing maturity of markets. The development of the correlations of Bitcoin prices is, apparently, an important indicator of market efficiency.
Bitcoin Volatility In Times Of Crisis
Another important aspect in the usability of Bitcoin -as any kind of asset, really – is the question of its performance in times of crisis. The study identified two such periods in the digital asset’s, and global economy’s recent history. One related to the Bitcoin market itself, the security breaches. The other is the Covid-19 financial crisis.
Funny thing, Volatility did go up in times of an exchange attack. However, no significant changes were noted for the period of economic crisis. No statistically significant changes. In fact any rise during the period was identified as endemic to current market conditions.
Is Bitcoin Money?
Transacting in Bitcoin currently exposes participants to exchange rate risk. With Bitcoin volatility causing an average price fluctuation rate of 10%-30%, the cost of adopting Bitcoin as a means of value exchange would be too high for retailers, as consumers would – at any given time – find themselves paying more, or less than retail for an item or service. Same goes for services that exchange Bitcoin for equivalent fiat value, at time of transaction.
The only way out of the conundrum, it seems, is for a country to adopt Bitcoin as its official currency, and ban the exchange of the digital currency, for any other currency. Nobody’s doing that any time soon, though. So, if Bitcoin is money, it needs to hit the gym on a few aspects (Goodluck getting the community to agree on how best to do it.)
Is Bitcoin A Store Of Value?
Outright, the paper dismisses Bitcoin as a store of value, on account of its high rate of volatility. However, looking at the bigger picture, Bitcoin’s price development has been positive, overall. In addition to that, the benchmark cryptocurrency’s deflationary design plays in its favor, on the market demand front.
The Verdict?
“Bitcoin is a cryptocurrency but does not work as a currency due to its excess volatility. The high volatility makes it prohibitively costly to use as a medium of exchange and a unit of account” states the paper. Bitcoin, however, can be used as a store of value – despite its volatile nature.
Bitcoin’s deflationary design lends credence to it being a viable store of value over long periods, however it’s rate of volatility hampers its bid to be considered a decent risk diversifying asset. It appears, though it was created as a peer-to-peer cash system, Bitcoin has largely become a store of value with some currency-like properties.
