Guide to Crypto-Currencies Part 7 – Solutions to Volatility


One of the things that makes a currency usable as a currency is price stability. There are, of course, fluctuations over time between free-floating currencies such as the US dollar and the euro, but these are rarely very dramatic, at least not in the short term. Between receiving payment for goods or services and banking that payment, the value stays roughly the same, and this is a good thing.

This isn’t the case with bitcoin, and this could be a big problem in terms of its eventual acceptance as a mainstream currency. Imagine you bought a cup of coffee using bitcoin, and by the time your transaction cleared – which can take longer than ten minutes – the value of bitcoins went down by a quarter. This would most likely wipe out the vendor’s profit, unless they were willing to re-quote with live prices once the transaction clears – which would be a very strange way to do business indeed.

The Problem of Volatility

Having a volatile currency means that businesses can’t plan or budget effectively, and the chaos that this could cause would be too much of a risk for most, even if sometimes they came out ahead. Nobody knows how much stuff a bitcoin will be able to buy in a day, a week, or a month – there are no fundamentals to speak of.

Another problem caused by the volatility is that of a deflationary bias – with more and more people wanting access to a limited number of bitcoins, their value will be pushed upwards and things therefore become cheaper for those that have bitcoins. Deflation is bad news in virtually any business or economic environment, because it encourages cash hoarding rather than spending, but it’s virtually hard-wired into the bitcoin DNA.

If the recent price crash turns out to be a blip, and bitcoins rise in value to $2,000 each, who will want to use them as a currency when they could just hang on to them as they rise in value? At this point, it ceases to be a currency and becomes what many people have suggested that it already is – a virtual commodity, or as Matthew O’Brien of the Atlantic described it, a tech stock.

A Central Bank for Bitcoins?

The obvious solution, albeit one that may defeat the purpose of bitcoins for many users, is for there to be a central bank for bitcoins. This would allow for the creation of more bitcoins to satisfy the increase in demand, keeping prices on an even keel. However, it’s unlikely to happen, at least not with bitcoin. The way bitcoin is structured, nobody owns it, so it would be impossible for anyone to set up a central bank and change the protocol accordingly.

Failing that, bitcoin use will be necessarily restricted to niches where the volatility doesn’t cause that much of a problem. For example, online gambling is all about taking risks for fun, so the added variable of the bitcoin value doesn’t make that much odds. International money transfers are already subject to exchange rate risk, not to mention hefty commissions, so bitcoins can be used here too. In short, most of the ways in which bitcoin is currently used are situations in which the fluctuations in value aren’t causing major issues, and bitcoins will continue to be used this way in future.

While it might be impossible to set up a bitcoin central bank, there is nothing to stop a rival cryptocurrency from employing this model and providing a stable, regulated digital currency. So while bitcoin has first-mover advantage, it may not be agile enough to position itself as a mainstream currency alternative, particularly when more manageable alternatives appear.

Other articles in this series

Guide to Crypto-Currencies Part 1 – Introduction
Guide to Crypto-Currencies Part 2 – The Bitcoin Bubble
Guide to Crypto-Currencies Part 3 – How Bitcoins Work
Guide to Crypto-Currencies Part 4 – Bitcoin Mining
Guide to Crypto-Currencies Part 5 – Transactions
Guide to Crypto-Currencies Part 6 – The Problem(s) With Bitcoin
Guide to Crypto-Currencies Part 8 – Security Issues
Guide to Crypto-Currencies Part 9 – Bitcoin Alternatives
Guide to Crypto-Currencies Part 10 – The Future of Money?