Price volatility is a way of life in the Bitcoin community. It is not really a big deal for someone involved in the world of Bitcoin to watch prices fluctuate by 20-30 dollars within a timespan of a few hours. On a daily or weekly time-frame, the price could fluctuate even more. Many Bitcoin skeptics use this volatility as “proof” that Bitcoin can never be a viable monetary system fit for the replacement of the gold standard, a government-controlled fiat monetary system, or whatever their desired monetary system happens to be. However, volatility is not an inherent feature of Bitcoin. The value of Bitcoin changes so rapidly due to its lack of wide acceptance, which also is not an inherent feature of the cryptocurrency. Currently, Bitcoin prices are so volatile because — due to its lack of wide acceptance — individual transactions have much more of an impact on Bitcoin’s purchasing power than an individual transaction would have on the purchasing power of the US dollar or Japanese Yen. As more people start to use Bitcoin and more businesses accept it as a legitimate form of payment, however, not only will we see general volatility decrease, but we will see a steady growth in Bitcoin’s purchasing power.
But price volatility isn’t necessarily a net negative for Bitcoin. Volatility in Bitcoin prices offers arbitrage opportunities that can draw investors into the Bitcoin community. From an increase in the number of investors buying and selling bitcoins, there will be an increase in the general awareness of the Bitcoin monetary system as a whole. As more and more investors get into the world of Bitcoin trading, ordinary people looking for alternative media of exchange with which they can preserve their wealth against the destructive monetary policies of the world’s governments will increase in number. In this article, we will look at the arbitrage opportunities in Bitcoin that are made possible by price volatility and discuss how a strong investment ecosystem can grow out of these volatility-induced arbitrage opportunities.
What is Arbitrage and What does it have to do with Bitcoin Volatility?
Arbitrage is the act of taking advantage of price discrepancies in a market. To put it in simple terms, arbitrage is the essence of the age-old investment advice, “buy low, sell high.” For example, Person A has $100 to invest in any area of the economy that s/he chooses, and invests the money into the stock market, more specifically, in Generic Computer Company, Inc., spending all $100 in buying one share of the company. A year later, s/he sells that stock for $200 dollars, producing a profit of $100, getting a 100% return on investment. This person bought low and sold high, such is the act of arbitrage.
We can now see the opportunity in the Bitcoin market. Since prices are so volatile, capable of moving 30-50 dollars in one day, there is a huge reward to be had by buying and selling at the right time. Imagine if you invested $1000 in Bitcoin at $100 per coin, getting 10 bitcoins. How much would those 10 bitcoins be worth right now? Or imagine the profit you would have made if you bought 10 bitcoins at $100 per coin and sold them during the November 2013 price peak. The potential profit margins in Bitcoin investment are monumental, all thanks to the current volatility in prices. This earning potential creates a huge incentive for investors to stake a claim in the Bitcoin market. However, due to the rapidity of Bitcoin’s price fluctuations, many of the investors seeking arbitrage in Bitcoin may be incentivized to partake in day trading, or short selling.
Many critics of the free market look at the short selling of stocks, bonds, commodities, currencies, etc. and view it as an extremely detrimental practice that drives prices down infinitely and destroys the profits of companies and entrepreneurs, thereby destroying jobs and creating economic regression. These same critics were the ones that blamed shorting in the US stock market for the great crash of 1929, which marked the beginning of the Great Depression. These people are sorely mistaken in their beliefs and accusations, however. While shorting does exert a downward pressure on prices, that pressure is not constant. It cannot be constant. Investors cannot short a stock or commodity infinitely until its value reaches zero; at some point, the thing being shorted will end up in the hands of someone who has the intention of holding on to that commodity for an extended period of time. So while shorting may lower the prices in the immediate short-term, bitcoins will necessarily find their way into the hands of someone looking to hold on to them for a long time, which will preserve the long-term value of Bitcoin. Additionally, short selling is not a one-sided activity on the part of the person selling the bitcoins. In order to sell the bitcoins, the person in question must have bought them at some point, which would produce and upward pressure on prices. Thus, the short seller both drives up and lowers the price of Bitcoin during the action of shorting coins. Therefore, the upward and downward pressures that the short seller puts on the price of Bitcoin may counterbalance each other, keeping the price at an “equilibrium,” for the lack of a better word. Bitcoin shorting — combined with the arbitrage potential, which comes from Bitcoin’s price volatility — will bring more investors into the market and will increase the demand for bitcoins, thereby making them more valuable. The long-term increase in the value of Bitcoin is what crypto enthusiasts long to see, as most of us envision a future in which Bitcoin has replaced the existing monetary system of government centralization.
A strong derivatives market is the mark of a highly developed, thriving economy. Derivatives are used as a hedge against volatility and uncertainty, making the derivatives market a source of economic stability. We can see here how derivatives can be incredibly beneficial to Bitcoin.
We have seen above how price volatility can create large incentives for investors to come into the Bitcoin community. However, as the Bitcoin economy develops, more and more users of Bitcoin will be ordinary consumers and entrepreneurs who are not interested in arbitrage, shorting, or any other stock-market-like trading activities. These individuals will use Bitcoin in their daily business as a medium of exchange, a money commodity, not a stock or share to be constantly bought and sold on an exchange. Thus, from the advances that price volatility can potentially bring to Bitcoin, there will arise a demand for the stabilization of Bitcoin’s purchasing power. Once the Bitcoin economy progresses to this state, we will see the emergence of a Bitcoin derivatives market.
Amidst all the arbitrage action and shorting, there will prevail a short-term atmosphere of volatility and rapid price fluctuation. However, as mentioned earlier, the activities that occur because of price volatility will produce a tendency towards long-term stability. How? Simply put, the trading activities that come as a result of Bitcoin’s volatility will drastically increase Bitcoin’s level of general acceptance on the market as a medium of exchange. As we know, the more widely accepted Bitcoin becomes, the more stable its purchasing power will be. With this emergence of price stability, there will be a tendency for the period of provision for contracts to become drawn up on an increasingly longer time-frame. Whereas in the present, Bitcoin trading takes place on exchanges where people buy and sell with rapidity, the future Bitcoin economy will consist mostly of daily consumption transactions and long-term business contracts rather than fast-paced exchange trading. Therefore, the concern over value fluctuations will not be focused on tomorrow or next week, it will be focused on years or decades from the present. This is why a derivatives market will likely emerge in the Bitcoin economy.
A derivative contract is an agreement between two people to trade commodities at their present value at a set date in the future, regardless of the value of the commodity in question on said date. For example, if Mr. Jameson makes an agreement with Miss Jones that he will give her two bitcoins for 20 chickens 10 years from now, then that price will remain in place no matter how much the price of chickens increases or decreases over the years. If the price of chickens goes up, then Jameson has benefited because his price for chickens is locked in at two bitcoins per 20 chickens. If the price goes down, however, then Miss Jones will benefit because she will get a higher market price per 20 chickens because of the derivative agreement between her and Mr. Jameson. These types of derivatives can apply to any commodity that has exchange value. Derivatives are a source of long-term stability and assist in sustaining a developed market economy.
Thus, we can see a sort of evolution take place as the Bitcoin economy progresses. Arbitrage opportunities and shorting draw in serious investors at first, but then the very actions of these investors create an economic ecosystem in which various methods of wealth preservation, such as a derivatives market, can emerge and sustain the viability of Bitcoin’s purchasing power. If the potential of Bitcoin is to be fully realized in the future, we can expect to see the development of the Bitcoin economy at least somewhat follow the basic outline of progression that was drawn up in this article. These financial establishments will arise out of necessity, out of spontaneity and chaos. Such is the nature of the free market. If these value-preserving, financial establishments can be erected, we can expect to see continuous growth and prosperity in the growing Bitcoin economy.