2.0

Why Bitcoin is Volatile aka I Told You So.

In Uncategorized on December 1, 2013 at 4:52 pm

Bitcoin is based on the idea that money gets its intrinsic value from its scarcity, which is a misconception since money gets its intrinsic value from the volume of transactions involving goods and services that use it. The only reason the dollar has an intrinsic value as a currency is because almost every nation use it to buy and sell energy, food, weapons, etc. If large nations like China decide to stop using the dollar then the dollar will crash regardless of how scarce it is. That does not mean that people won’t make a great deal of money from speculation around this dumb idea.

Selling people on the misconceived notion that Bitcoin has real value because of its scarcity seems to have worked so far, but when people wake up and ask what they can buy with their Bitcoins and find the answer to be very limited they’ll likely lose interest in holding on to those Bitcoins. It doesn’t matter how scarce those Bitcoins are: if they’re not widely accepted in trade, after the speculative bubble bursts, they won’t have much value.

The built-in scarcity makes it so that speculative action can lead to huge swings in currency value, i.e. massive instability over time. If supply always caught up to demand then speculation would be a rational process more or less based on real-world transaction volume as opposed to swinging between “OMG  I gotta get some Bitcoins while there are some available at some astronomical price” and “OMG Bitcoin adoption is slowing down and I gotta get rid of mine before I incur losses.”

In order to be less exposed to speculative bubbles, the intrinsic value of a currency must be decoupled from its supply/demand (in other words, supply must catch up to demand, and oversupply only happens if people stop using the currency, i.e. when you have a drop in volume of real world transactions) and the value must be based on the volume of real-world transactions.

We invented Fire. Next, we have to control it.

Update:

China bans its banks from transacting in Bitcoin thus causing an initial 20% drop in the price of Bitcoin. Here is an interesting passage from the Bloomberg article that reflects many of the opinions I expressed above just a few days before the events in China unfolded.

http://www.bloomberg.com/news/2013-12-05/china-s-pboc-bans-financial-companies-from-bitcoin-transactions.html

The People’s Bank of China said financial institutions and payment companies can’t give pricing in Bitcoin, buy and sell the virtual currency or insure Bitcoin-linked products, according to a statement on the central bank’s website.

PBOC, China Banking Regulatory Commission and other regulators have held discussions about drafting rules for trading platforms that facilitate the buying and selling of the virtual money, two people with direct knowledge of the matter said. They were not authorized to speak because the information is not public.

“We’re happy to see the government start regulating the Bitcoin exchanges,” Chief Executive Officer Bobby Lee of BTC China, the largest Bitcoin exchange in the country, said in a phone interview before the PBOC announcement. Regulations would be for “the good of the consumer,” he said. BTC is seeking recognition of the currency so it can be used to buy goods and services instead of being used for speculation, he said.

Update:

This post got plenty of traffic thanks to Hacker News, and in there, someone mentioned that, a few years back, Satoshi Nakimoto, the illusive inventor of Bitcoin, had mentioned my work on P2P Social Currency as being something that can ride atop the Bitcoin protocol. I have my doubts.

http://archive.is/5CbYM

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