Cryptocurrency as an asset class is notoriously volatile. For example, since the start of 2017 the standard statistical measure volatility of the price of Bitcoinover that period, the standard deviation, is a whopping 4%. That means on average there is a daily move up or down of 4% or more, roughly once every three days. That equates to an annualized measure of volatility, or the range of outcomes that captures two-thirds of possible price paths, of plus or minus 78%! That’s volatile.
Clearly, that’s a lot of risk to carry. But against that risk, over the same period there has been an average daily return of just over half a percent. Annualised, that’s 555%. That’s enormous.
Dividing the average annualized return by the volatility gives a simple standardized ‘risk-return’ measure — the average change in value for a given quantum of risk. For Bitcoin that is 7% since the beginning of 2017.
Comparing this with risk-return metrics for traditional capital markets, the equivalent numbers for the Standard & Poor’s top 500 equity index are an annualized volatility of 11% and returns of 14%. This gives a risk-return measure of 1.3%, which is about a fifth of the risk-adjusted return of Bitcoin.
Do volatile assets make good investments?
Clearly, cryptocurrency can offer good returns for a given amount of risk. For that reason the asset class might appeal to investors that can reasonably expect to stay invested over a long time period, because they are well placed to ‘look through’ bouts of extreme volatility and so benefit from the possibility of outsized gains over an extended period.
And then there are risk-loving investors, like day-traders, hedge funds and venture capitalists, that actively seek high risk-return investments. They make money by placing big bets on risky investments, and have the specialist skill and expertise to manage those risks.
Even for risk-averse investors, allocating some capital to cryptocurrency will help to lower the overall risk of a broader portfolio of assets through diversification. That’s because cryptocurrency typically does not co-move very closely with other asset classes, so it’s ups and downs will help to offset those of other investments and reduce the overall level of risk, for a given expected return.
That low correlation arises from the fact that the price of cryptocurrency is driven by very different factors to other risky assets.
What drives changes in cryptocurrency prices?
Cryptocurrency prices are volatile because the technology that underpins them is new and the asset class itself is new. The technology develops daily, with continuous refinements to the underlying codes and applications to new use cases. The asset class itself is some hybrid of currency, equity and commodity, along with some unique characteristics, all of its own.
The fact that the technology continues to evolve at lightning speed, along with the challenges associated with valuing an asset that does not lend itself to traditional asset pricing theory, makes it very difficult to put a price on the true, fundamental value of cryptocurrency.
The price discovery process, wherein new information about an asset is captured in its price can be somewhat chaotic, and there is a constant daily diet of shocks and news, all of which have a bearing on the fundamental valuation of the asset class.
There are panics associated with market concentration and the activities of ‘market manipulators’. There are panics due to hacks of exchanges and 51% attacks. There are panics associated with regulatory actions. There are sell-offs due to good news for another given coin. There are sell-offs due to bad news for a given coin. There is bickering between developers and supporters of different projects. There is fraud. And there is good old-fashioned sentiment. It all makes for a rather volatile market.
What is the fundamental value of Bitcoin?
Some commentators claim that Bitcoin has no inherent value at all. Others predict with great confidence that its value will reach $500,000 per coin by the end of this year.
So what ultimately gives cryptocurrency inherent value? For some investors, it is simply a speculative asset. For them, the value lies in the expectation that the price will be higher tomorrow than today.
But many investors buy cryptocurrency because they believe in the technology’s worth as a utility. They believe it offers a replacement to fiat currency and potential solutions to all sorts of real world problems. For those investors, the value of cryptocurrencies rests on people’s willingness to use them as decentralized alternatives to current, centralized, economic and financial systems.
Put simply, the more people who adopt cryptocurrency, whether as money or to utilise the various platforms that they give access to, the greater the benefits of belonging to the network for all users and so the higher the price should be. Valuation is therefore inherently linked to adoption.
Using Bitcoin as an example, the basic use-case for Bitcoin, according to Satoshi Nakamoto’s original vision, is as a form of peer-to-peer electronic cash. What gives cash value? Its usefulness as a ‘store of value’ and a ‘medium of exchange’. What does that mean for Bitcoin? If no one will buy it from you in the future, and no one will accept it as payment, it’s worthless. But if they will, it has value. The more who will, the higher its inherent value.
To give a very extreme example, suppose that everyone on the planet decided overnight that Bitcoin was as acceptable as fiat, and swapped one for the other. That would make the market capitalization of Bitcoin in circulation worth about $100 trillion or so. That’s about 300 hundred times more than the outstanding stock of Bitcoin is currently worth, or over $2 million per Bitcoin. It’s currently trading at around $8,000 per coin.
The case for stable coins
We won’t know the true value, for sure, until the whole cryptocurrency project has run its course and the asset class has become widely adopted — such is the nature of price discovery in crypto.
This leads to something of a paradox: greater adoption increases the value of cryptocurrency, thereby creating volatility. But in turn that volatility undermines the value of cryptocurrency as a currency. As a result, the fundamental value of the currency is in continuous flux as these interdependencies are played out. It seems likely that the price will eventually settle at some equilibrium level, but it will be a bumpy ride until then.
Given the extreme price volatility of cryptocurrency, there is a huge demand for a form of stable crypto-asset. That’s where ‘stable coins’ come in. Some stable coins are backed by fiat currency. Others try to achieve stability by backing with baskets of other assets.
Another promising solution, or even perhaps the most promising, is the fully decentralized dynamic peg soon to be implemented by BitBay ($BAY). This gets around problems of lack of confidence in tethers and scaling issues associated with backed stable coins by directly influencing the liquidity of the coin supply. It’s an entirely novel approach and we at BitBay expect great things from it!