Bitcoin exchange rate volatility definition
Like any other currency, bitcoin's price is driven by monetary supply and demand. Individuals are willing to pay a particular price to exchange an amount of their home currency whether it be US Dollars or or Ukrainian Hryvnia for an amount of bitcoin based on how much value they see in it demand and how many units are in circulation supply.
With respect to supply, the number of bitcoins currently in circulation as well as the total number of bitcoins that will ever be in circulation are both known quantities. Bitcoin monetary supply expands at a predictable rate, and will cap at 21,, bitcoins at or near the year Both attributes are entirely by design, and make understanding the supply side of bitcoin relatively straightforward.
What is far more complex, and infinitely more important to driving bitcoin's long-term pricing stability is its demand. For a currency to be valuable there needs to be significant and stable demand for making purchases denominated in that currency.
Take the US Dollar: When a tourist wants to buy a hamburger, they need to exchange their home currency for US Dollars. When a business wants to build a new factory it needs to buy equipment and pay new workers in US Dollars.
The more demand there is for US Dollars, all else equal, the higher the exchange rate will be. In comparison, bitcoin currently faces relatively low and uncertain demand. Today, of the millions of people holding bitcoins worldwide, only a small fraction are doing so as a means to purchase goods and services. The vast remainder are holding bitcoins purely as a speculative investment with little intention of ever spending.
Thus, the current, volatile price of bitcoin, whatever it may be, is less a representation of the overall health of the bitcoin ecosystem and more a symptom of isolated trading activity.
What will eventually bring significant appreciation and stability to bitcoin will have to be increased adoption of bitcoin by consumers and merchants and growing forward optimism around bitcoin's utility as a secure store of value. As such, the easier it is for someone to pay for a meal at a restaurant or send money to a friend in bitcoin, the more demand for bitcoin will increase.
We are beginning to see signs of such adoption, but may still have a ways to go in reaching a point where bitcoin can sustain a relatively high, stable price over the long-term. Since its inception, bitcoin has become accepted for payment by a wide variety of businesses and nonprofit institutions. Bitcoin-based start-ups and projects have proliferated. For instance, in March , Bank of America filed a patent for a system of executing wire transfers using cryptocurrency such as bitcoin exchanges to mediate between two sovereign currencies.
Bitcoin-to-bitcoin transactions between digital wallets can be performed at a negligible cost relative to transaction amounts. However, unlike traditional currencies, bitcoin does not currently serve as a widely accepted unit of account in and of itself.
Therefore, most users seeking to make payments in bitcoin generally need to purchase it on third-party exchanges using traditional currency. After receiving bitcoin in a transaction, the user has the option of holding it with the expectation of using it in a subsequent transaction. Therefore, the bitcoin payee may be better off exchanging the bitcoin for traditional currency which is more useful as a general unit of account. This phenomenon can be observed in practice since many large retailers, such as Dell, Microsoft, and Expedia, that accept payment in bitcoin never actually receive any bitcoin.
Rather, they utilize third parties who, for a fee, receive bitcoin from the customer and forward dollars to the retailer. The round-trip transaction from traditional currency to bitcoin and back see the diagram below , may entail potentially significant transaction fees and counterparty risk. In turn, these exchange-related frictions could lead to different bitcoin prices across exchanges.
Bitcoins are strictly homogenous: Therefore, any price differences across major bitcoin exchanges should be promptly eliminated by arbitrageurs buying bitcoin where it is less expensive and selling it where it is more expensive, thus enforcing the law of one price. However, the charts below show large differences between the prices of bitcoin-U.
The average difference is positive, indicating that bitcoins bought on BTC-E consistently trade at a discount relative to those bought on either Bitfinex or Bitstamp. This discount averages about 2 percent and has at times been higher than 20 percent.
Large, persistent deviations between pairs of identical assets are unusual in exchanges and, when they have occurred as for so-called Siamese-twin stocks , they typically have not constituted profitable arbitrage opportunities. For bitcoin, an arbitrageur could, in theory, safely profit by buying bitcoin on BTC-E and then selling it or going short by first borrowing bitcoin and then selling it on either Bitstamp or Bitfinex.
Transaction costs come in two forms: As shown in the price difference charts above, however, the bid-ask spread as a percent of BTC-E price in these exchanges is negligible relative to the typical price difference, and thus does not likely impede arbitrage significantly. Other fees, however, represent more substantial barriers. BTC-E, for example, charges a 0. These fees reduce the profits from arbitrage, and may explain the observed price differences.
Bitcoin arbitrage opportunities across exchanges may also pose two risks: In fact, bitcoin prices are volatile; the intraday volatility of the bitcoin price on BTC-E often exceeds the average price difference between it and Bitfinex see chart below.
Therefore, delays in executing trades imply that the price difference can shrink or even revert before an arbitrageur can exploit it.
The most significant delay is in the transfer of U. A trader wishing to execute this trade by transferring dollars to BTC-E faces significant risk of price changes over that period. In order to deposit bitcoin for use on Bitstamp or Bitfinex, three network confirmations are required.
Each confirmation takes ten minutes on average, so the delay between the purchase of bitcoin on BTC-E and its deposit on Bitstamp or Bitfinex is about thirty minutes.
This shorter delay is avoidable by short selling, but shorting is only offered by Bitfinex and entails additional fees. Exchange failure or fraud is another source of risk. Exchange failure is not merely a theoretical possibility in bitcoin markets—it occurs regularly.
A study in reported that eighteen of the forty bitcoin exchanges analyzed—almost half—ultimately failed. Most notable among all bitcoin exchange failures is that of Mt. Counterparty risk could help explain the consistent discount realized on BTC-E.