As most everyone already knows by now, some currencies are more volatile than others. The volatility comes from out-of-balance market actions. That is, during some precisely defined window of time, there are more people wanting to sell than there are potential buyers, and vice versa. Sometimes these imbalances are exaggerated, which then manifests as rapid decline or appreciation of exchange rates of said currency.
This has happened to many a currency in the near history. The Icelandic Krona was rapidly devalued during the 2008 banking crisis. The German Mark faced continuous daily drop of value for a prolonged period in the 1930s. There are numerous examples, but not all devaluation events are equal. Some are more equal than others: In Iceland, the devaluation was caused by a rapid lack of confidence in the banking sector, but in Germany, devaluation was a direct cause of the government trying to print more money to be able to fund its expenses.
The Bitcoin, a fledgling cryptocurrency, has also experienced instances of devaluation. What catches the eye is the fact that usually these devaluations have happened rapidly, in very narrow time frames. The USD:BTC exchange rate peak in June 2011 was followed by a rapid drop of value, presumably because of people wanting to take advantage of the recent price rise. Shortly after that came the hacking of the exchange Mt.Gox, which triggered the long downward slope of BTC. Recently, in 13th of February 2012, the Bitcoin payment processor Paxum told about their withdrawal from processing Bitcoins – which affected some of the major exchanges. When the news of this caught the ears of some people holding Bitcoins, it triggered a massive sale of BTC, which drove the exchange rate down very quickly.
What’s common to all the historical cases of devaluation is a lack of confidence. This was evident in Iceland, also in Germany, and now we can see it in the digital world. What’s interesting is that in the other cases, the blame was laid on some central player in the machinery behind the economy: in Iceland, banks were blamed. In Germany, the government was blamed. But when looking at the devaluation bouts in BTC, we have to ask: who is there to blame in a decentralized currency?
Technically speaking, the Bitcoin system works much better than any previous value transfer system in human history. In light of this, it’s baffling that there’s such huge volatility in the Bitcoin exchange rate.
The volatility of BTC is an amalgamation of many factors. First, it’s a new currency and concept, hence it carries higher risk than “established” ways of organizing a market. Second, the Bitcoin economy is small enough to exhibit large fluctuations even though these would be the result of a handful of players. Third, there’s a certain amount of mysticism surrounding Bitcoin. If only a handful of people fully understand its underpinnings, this is not going to suddenly change.
Although, speaking of mysticism, it’s a mystery how currencies like the Euro and the USD achieve their appreciation. If the majority of population would notice how feeble have the attempts been to keep these money systems going, they probably wouldn’t have so much confidence in these currencies. If the wise economists behind these systems would truly understand what they’re doing, then the global economy would be safe from harm, right?
It is evident that the most important factor behind volatility in the Bitcoin economy (and any other economy, for that matter) is the fact that humans, as actors in the economy, do not make rational decisions. Most markets are dominated by strong emotions. Either bullishness about future success, or fear. Especially in the Bitcoin economy, fear has a constant presence in everyone’s mind who has invested in BTC. What if the Mt.Gox gets hacked again? Does the BTC exchange rate recover from that? What if the rate plummets to zero, what do I do then? End up with a bunch of totally useless, valueless bits on my wallet?
The answer is arguably quite easy. The rational actor would decide to sit on the pile of BTC instead of trying to sell as quickly as possible and risk ending up in the cheap end of the slope depicting the buy-sell disequilibrium.
Let’s make a mental exercise about such a disruptive moment in a volatile market. When the bad news reaches everybody, the most rational act would be to wait a bit. An hour, a day, a week. Just don’t look at the exchange rate curves! It’ll make you lose your night’s sleep. If everyone would actually follow this behavioral pattern, we would only see a small dip in the value – where the panickers already sold, but nobody followed them. There would be no avalanche.
If anybody still remembers Beenz or Flooz, these “internet currencies” disappeared with the dotcom bust. Those unfortunate souls who held value in these currencies had to cope with the fact that once the corresponding company went bust, their credits turned worthless – instantly. This is the most likely outcome with any centralized currency system, and it holds true even for governments, as the German example from 1930s testifies.
If there’s nothing fundamentally wrong in a simple system like Bitcoin, then one would assume that if the temporary disequilibrium, given enough time, fades away, then the exchange rate will recover to previous levels. If Bitcoin has even one single important function that people use, then its utility will not disappear overnight. And, arguably, Bitcoin has several things going for it, which have been endlessly discussed in the media and forums. Somebody might argue that the time is not yet ripe for such a disruptive technology like Bitcoin, but this fact hasn’t been able to derail the Bitcoin project. Not in the past, and probably not in the near future either. Not until something better, a Bitcoin 2.0, with two killer features, appears in the scene.
As long as the governments, legislators, banks and other powers-that-be cannot figure out any truly effective ways of crippling the Bitcoin economy, the expected outcome of any bout of devaluation (except a protocol flaw) is just a rebounding of value or even exceeding the previous rate. This calculation is greatly simplified by the fact that the Bitcoin system itself is simple and elegant: the issuance of new money is algorithmically controlled, forgery is next to impossible, fees are either low or non-existent and last but least, all transactions can happen directly between parties with no need for intermediaries.
For now, all we can do is wait and see how governments are faring in their attempts to ban cryptocurrencies or distributed file sharing systems. So far they have only been able to tackle single web sites like Pirate Bay. Needless to say, this is not enough to snub a sprawling, decentralized movement.