Blog : 6 Reasons To Go Long on Bitcoin Volatility

by Ed Zwirn on November 10th, 2014

Satoshi Nakamoto and his collaborators originated Bitcoin and changed the financial landscape by demonstrating that it was at least technologically feasible to create currency without a central bank, and that there would actually be demand for such a currency.

Part of the original concept was Nakamoto's belief that his currency would be inflation/deflation free, because of the controls and pre-announcement of total supply. But the volatile trading history of the Bitcoin has produced sharp "deflation" (as the Bitcoin market price rose past $1,200 last year) through to the inflationary trend which has set in since then (with the current quote at $376).

As pointed out in a December 2013 installment of this investment blog, this volatility has at once made Bitcoin of interest to investors but perhaps less suitable as a currency due to its ups and downs. At the same time, there is no denying that the runup of 2013 (as do all runups) drew large numbers of "miners" and speculative traders into the fray, boosting Bitcoin's profile among end users and increasing the number of individuals with a stake in the success of the system

Many Bitcoin aficionados correctly point out that the crypto-currency is in its infancy, and that the wide price fluctuations it has seen are part of the growing pains to be expected when consumers and investors check out something novel for the first time. Assuming actual Bitcoin use doesn't fall off through attrition and in fact continues to gain wider acceptance, the argument goes, this volatility should taper off.

Countering this view is a research paper posted this week by Mitsuru Iwamura, Yukinobu Kitamura, Tsutomu Matsumoto and Kenji Saito of Tokyo's Hitosubashi University. According to these authors, the Bitcoin will tend to be volatile going forward due to flaws in Nakamoto's original design. And they propose ways to fix these flaws and create an "improved Bitcoin (IBC)."

Concentrating on the problem for starters, this paper, which BTW contains the best explanation of the practice and theory behind Bitcoin "mining" I've encountered so far, lays out a six-point explanation for why Bitcoin as it is presently put together will always be more volatile than either gold or the "fiat" currency it purports to displace.

1) In one sense, the Bitcoin is self-correcting. As long as the market quotation exceeds mining costs, you can expect to see more Bitcoins created (or is it dug up?). Eventually this new supply should bring the price down to an equilibrium, and new currency supply would dry up. Good news, or Bitcoin price rises, would bring currency creation back up again. The problem happens, according to the authors, when bad news arrives.

2) Assuming that bad news arrives while Bitcoin supply/demand is in a hypothetical state of equilibrium. A hit to the price would make the miners' return negative, bringing on in the best-case scenario a gradual migration away from Bitcoin mining.

3) But this "pastoral reality" doesn't apply to current Bitcoin fundamentals, the researchers demonstrate. Far from the spare-time decentralized mining of the early days, many entrepreneurs have entered into the Bitcoin mining competition equipped with super powerful computers with designated IC chips. "The current situation resembles a heavy equipment industry in which it is easy to enter but is difficult to exit because of large sunk costs," they write.

4) Under this environment, a substantial, but not a deadly, drop in Bitcoin price would incentivize miners to keep mining because it would be cheaper in the short run to run at a moderate loss than it would be to fold up shop

5) Miners can also migrate to other mines, in effect optimizing chance of return by lessening costs, an opportunity that remains open to them at least until miners' computing equipment reaches the end of its useful life.

6) But a possible Bitcoin demise can play out more suddenly. The many miners who materialized during the boom one year ago probably have similar parameters and broadly equivalent computational power. If the Bitcoin price drops sharply below the average variable cost, "all miners would exit from mining." Assuming this price reduction, "the Bitcoin system as a whole may collapse or the Bitcoin users become limited to a very small number of inner circle members with which Bitcoin is exchanged at a very small scale."

But the study's conclusions are a far cry from knocking the basic Bitcoin crypto-currency concept. They just see the need to tweak the workings of the Bitcoin system.

"We hope that [Bitcoin originator] Satoshi Nakamoto's important contribution can nullify his misunderstandings," they write. "There remains much room for improvement."

Coming up: How to Overcome Bitcoin Instability: Improved Bitcoin (IBC)