5 Reasons Behind Bitcoin’s Towering Volatility

Bitcoin has grown from $0 to $110bn behemoth in just 9 years. However, the ride has been anything but smooth. Since 2009, Bitcoin has experienced five major crashes and each time a major rally pushed the price beyond the previous all-time high. This translates to a towering 110% annualized volatility. For context, the annual volatility of equities tends to range between 20% — 30%. Meaning, Bitcoin is five times the risk of the riskiest asset class of most portfolios.

While Bitcoin’s volatility has so far been dominated by speculative demand, real demand is slowly forming. This means that the volatility of Bitcoin will be undergoing an evolution in which it will organically decrease across time. Understanding the maturation of these drivers is essential to determine what is the appropriate weight of crypto assets within a portfolio. In this note, five sources are identified:

• Bitcoin’s fixed supply
• Speculative demand from investors
• Real demand from users
• Demand erosion from competing cryptocurrencies
• Portfolio flows

The Consequences of Fixed Supply

The terminal supply of Bitcoin is known. Now and always. In economics, this is called a perfectly inelastic supply (see the right chart of the panel below). This feature makes prices very responsive to small changes in demand. We can see in the panel below that the same increase in demand results in a substantially higher price movement. This means higher price volatility.

Therefore, Bitcoin’s fixed supply is one of the structural reasons underlying its volatility, small shifts in demand cause large price movements.

It’s All About Demand

Drawing on the conclusion above, we can probably agree that the primary driver behind Bitcoin’s price is demand. Therefore, understanding what triggers its movements is key to forming a long-term view of the asset.

Speculation

Fickle, unpredictable, and greedy is the nature of speculation. At the moment, speculation is the primary driver behind Bitcoin’s price volatility. We think this driver will continue to dominate in the short to medium term.

The reason why this driver has the aforementioned characteristics is simple. First, speculation is entirely forward-looking. The only thing investors care about is tomorrow’s price. Today is entirely irrelevant. Secondly, since speculation is forward-looking, any new piece of information will shift speculative demand. Why? Because with new information comes a better understanding of the potential outcomes of the future. Therefore, price must adjust to reflect this new reality. Finally, investors only allocate capital if they think forward-looking returns are higher.

This effect explains why new news has such a strong impact on price. For instance, the SEC has been postponing and rejecting the creation of a Bitcoin ETF. For context, this is the difference between trillions of dollars having access to Bitcoin or not. The binary nature of this outcome is what causes expectations, and therefore price, to shift so violently. Another example is when Bitcoin Cash was added to Coinbase. The price of the cryptocurrency jumped from $3,200 to $8,500 (and precipitously dropped shortly after) upon being listed in their exchange. Erratic and hard to predict. This is the nature of the speculative beast.

It is worth noting that the combination of speculation and fixed supply is the primary ingredient for 110% volatility. If you are interested in learning more about the volatility and other risk metrics of crypto assets visit our market dashboard.

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Real demand

Real demand drivers are what gives any object value over time. Simply put, if more than two people want an object and it is scarce, then its value must be greater than zero. Understanding this driver cannot be overstated, for it is the single most important driver of any asset class. Take the case the of real estate investing. Current supply is largely fixed and production is fairly well known. Therefore, the only reason you would buy an apartment is if you believed real demand for living in the neighborhood will grow. Since it’s the only way real prices (i.e. price after inflation) can move upwards.

It is commonly said that Bitcoin does not have real demand drivers. We disagree. They are small but rapidly growing. Unique addresses have been growing steadily over the past four years, while the number of transactions going through the Bitcoin network has been increasing. It’s worth highlighting that despite the 66% price drop of 2018, network transactions have not slowed. As of August 2018, the number of Bitcoin network transactions are already at 80% of last year’s volume. Though difficult to pinpoint, we think the demand is coming from transactions between crypto exchanges, few retailers, and from countries whose currency is in distress. Venezuela is a great example of the latter and Turkey could easily follow suit.

Over the foreseeable horizon, we think there are clear signs of the formation and strengthening of real demand drivers. Nowhere is this more evident than by looking at the number of ICOs and the amount of capital raised. 2017 was a record-breaking year with 525 projects raising a combined total of $6.5bn. Despite the selloff of 2018, that record has already been beaten with 334 projects raising a total of $8.2bn. The vast majority of these fundraises have used Bitcoin as one of the preferred cryptocurrencies for raising capital. Furthermore, Bitcoin trading pairs markets (e.g. DASH/BTC vs DASH/USD) are the largest sources of liquidity for the smaller cap crypto assets. This positions Bitcoin as the base currency for the rapidly expanding crypto economy since transactions and fundraising activities use primarily Bitcoin.

Furthermore, some of the largest players in finance and banking have started entering the space. The most notable example is the recent entrance of the Intercontinental Exchange (ICE), one of the most important entities behind the finance infrastructure and the owner of the New York Stock Exchange. ICE partnered with Starbucks, Microsoft and BCG to enable consumers and institutions to buy, sell, store cryptocurrencies. This is an important step towards building the much needed missing pieces of the financial infrastructure for Bitcoin transactions and investing.

A few important examples of missing infrastructure are: 1) the lack of registered broker-dealers which trade crypto (so far no major crypto exchanges has registered nor been recognized by the SEC), and 2) the lack of reputable crypto asset custodianship solutions which are integrated into the blockchain infrastructure.

But the story doesn’t end there, there are numerous projects being built on top of Bitcoin’s protocol that attempt to tackle many of its scalability problems. The most notable example is the Lightning network. This advancement enables real-time Bitcoin transaction settlements. When you combine these technological advancements with the construction of a financial infrastructure, you get the recipe for take-off. We think this process will be relatively slow, taking 12–24 months to finalize (infrastructure takes time to build). After this period, speed of adoption should rapidly accelerate as mainstream actors gain easy access to use the cryptocurrency.

Substitutability and demand erosion

Bitcoin is not the only cryptocurrency in the crypto economy. In fact, many of its competitors are copies (i.e. forks) of the Bitcoin code (e.g. Bitcoin Cash). This begs the question, can Bitcoin’s demand be eroded by these forks? We think it’s unlikely.

The reason is that you can replicate Bitcoin’s code but you cannot instantly replicate the community. This defensive moat created by the network effect cannot be underestimated. This is because buyers want to be where the sellers are and vice versa. Building such a community takes time and cannot be simply created overnight or with a fork. For example, Bitcoin was hard-forked more than 15 times over the last year. Not a single one of these copies have been able to be anywhere close to dethroning the king of cryptocurrencies. Bitcoin still remains at the center of the crypto economy. Furthermore, the numerous improvements in the pipeline to enhance Bitcoin’s capabilities (e.g. the lightning network) will make it even more difficult to dislodge the king of cryptocurrencies. This is why we think it is unlikely that any Bitcoin copies will erode in a meaningful manner the demand drivers behind the cryptocurrency.

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The Asset Allocator Perspective

However, there is another final demand driver we think is important to be aware of. The shifts in crypto asset demand due to investor portfolio positioning. Let’s unravel this.

Generally, investors will hold a diversified mix of assets within their portfolio. For instance, the classic long-term investor will typically allocate 60% to equities and the remaining 40% to bonds. The optimal mix between these two assets will ebb and flow with market conditions. The shift of investors moving between optimal weights will directly impact the prices of the underlying assets. For example, when asset owners position their portfolio to a higher weight in equities due to high macroeconomic growth, they will be selling bonds. This creates downward pressure on bond prices and provides tailwinds towards an equity rally.

Crypto assets are no different. The assets of family offices, endowments, and high net worth individuals across the world adds up to roughly $5.3tn. Let’s assume these investors decide to allocate 2% of their portfolio to Bitcoin. It would imply a $114bn aggregate demand for investment purposes. Given Bitcoin’s current market cap of $124bn, any shifts to that demand would necessarily translate into meaningful shifts to Bitcoin’s price. However, at least to the best of our knowledge, there are currently no structural asset allocations dedicated solely to Bitcoin. Therefore, we do not think this driver will play a large role in the short term. That being said, as the crypto financial landscape matures, we expect this to be an increasingly important driver behind Bitcoin’s short-term volatility.

Putting it all together

Long story short, Bitcoin’s 110% volatility is due to the ebbs and flows of speculative demand in the presence of fixed supply. The lack of real demand drivers leads to a very large range of potential outcomes. Which is part of the reason why Bitcoin’s price is highly sensitive to almost any kind of news. Only the formation of structural demand drivers will reduce the range of outcomes, and thereby the overall volatility of the cryptocurrency.

Given the weak real demand drivers behind Bitcoin’s performance, we think a cautious approach is warranted. Because, even though the overall story points towards growth, there are numerous risks to the materialization of this outcome (e.g. regulation). Therefore, positioning sizing for the portfolio should integrate these risks. Our research suggests that a 1% to 3% portfolio weight is appropriate given the current risk/return properties of Bitcoin.

In the context of high volatility, building up a position is best achieved across time. The high speculative content combined with the 110% annualized volatility implies that returns are highly sensitive to entry points. Therefore, a simple strategy such as buying a fixed amount each month (i.e. dollar cost averaging) will go a long way in reducing market timing risk and achieve smoother and more consistent returns.

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Previous publications:

The DigiCor Thesis — The Argument to Invest in Crypto

Guess What? Bitcoin Isn’t Decentralized

The Battle of Consensus — Sometimes You Just Have to Fork it Out

How About a Sprinkle of Crypto in your Portfolio?

Originally published at blog.digicor.io on September 7, 2018.