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How 'Bitbanks' Could Solve Bitcoin's Volatility Problem

(@thrica) | Published on December 28, 2014 at 15:54 BST

Cameron Harwick is a PhD student in economics at George Mason University in Fairfax, Virginia. He conducts research into monetary theory and institutions. 

In this article, Harwick examines bitcoins issue with volatility and how bitcoin banks could offer a solution.

Volatility

Everywhere in the modern world, money is plagued with political problems. Bitcoin’s success, with no help – and, indeed, much opposition – from political authorities around the world, shows just how valuable it is to avoid these problems.

Nevertheless, as important an innovation as cryptocurrency is, it comes with its own unique problems. Bitcoin in particular has been notoriously unstable in value, making its success all the more remarkable. Since its inception, its exchange rate against the US dollar has frequently jumped or crashed over 20%, and sometimes nearly as much as 50%, in the course of a single day (see the chart below).

Bitcoin price chart

By contrast, the US dollar/euro exchange rate has never changed more than 2.5% in one day over the same period. As successful as bitcoin has become, imagine how much more successful it could be with a more stable value.

A crash course in monetarism

To diagnose what's behind bitcoin’s stability problem, we’ll use the most important equation in monetary economics, the equation of exchange: MV=PQ.

This means the quantity of money (M) times the rate at which it’s spent (V for velocity) equals the price of everything bought (P) times the amount of it bought (Q for quantity).

This simple equation is true by definition of any monetary system at all times, so it’s a good tool to figure out what happens when one of these variables changes.

In bitcoin, M is on a predetermined path, converging to 21m bitcoins. So in terms of the other variables, it’s basically fixed. That leaves V, P, and Q to fluctuate.

In modern economies, prices take a long time to adjust to systematic pressure, ie: inflation or deflation. So if V or M suddenly drop, the equation tells us that Q has to drop until P catches up. Unemployment and recession is the result.

Fortunately, people still tend to think in terms of dollars rather than bitcoins as a unit of account, even when transacting in bitcoins.

Because the value fluctuates so much, the easiest thing for a seller to do is to price a good in dollars, and figure out at the point of sale how many bitcoins it’s worth. You see the same thing in countries with hyperinflation. During Argentina’s crises, for example, you could pay in pesos, but prices were all in dollars.

What this means is that bitcoin’s P is very flexible compared to the dollar’s. Q doesn’t take the hit, so you don’t get recessions and unemployment in the bitcoin economy. But since this flexibility depends on the dollar as its relatively stable unit of account, we’ll have to figure out how to smooth out bitcoin’s value if we want it to be a self-sustaining currency.

Unstable demand

If bitcoin’s M is basically fixed, its P bounces around and its Q is relatively stable, the equation of exchange tells us V must be bouncing around too. In other words, the demand for bitcoins is highly unstable.

This is no surprise: when people don’t expect your currency to be stable, it’s profitable to speculate against it, which makes it even less stable. For this reason, we can’t expect stability to level out as demand grows.

On the other hand, when you can credibly commit to a stable value, speculation actually reinforces that stability. Great Britain enjoyed this sort of speculation during most of its time on the gold standard. Bitcoin’s problem is not only that its price is unstable, but that there’s no way to convince people that it will be stable.

The usual advice is to make sure that M moves in the opposite direction of V. If the left side of the equation (MV) doesn’t move too much, there’s not too much pressure on prices, and we don’t have to suffer a drop in Q.

This is why central banks try to expand the money supply during recessions, and to contract it during booms. And with a credibly stable P, speculation reinforces that stability.

There are, in fact, two possibilities open to cryptocurrencies to stabilize MV: the traditional way, through a banking system, or by automatic adjustment of the money supply.

Starting with the first:

Bitcoin and banking

Bitcoin is actually very similar to another successful currency whose supply was basically fixed in the short run: gold. So the logical question is, why wasn’t gold as volatile as bitcoin is now?

During the feudal era, money wasn’t that important. V was low and stable, so the rigid supply of gold and silver wasn’t too problematic. Once the Industrial Revolution came around and economic growth started exploding, though, we might have expected violent monetary paroxysms like we see in bitcoin, except on a Europe-wide scale.

As it turns out, the transition was pretty smooth, at least with regard to money. Fortunately – and perhaps necessarily – the industrial revolution was contemporaneous with a banking revolution.

Once people started using banknotes and checks instead of gold coins, this gave banks the ability to expand M beyond the relatively fixed supply of gold. And where these banks were least hobbled by regulation (for example, in Scotland), making loans on a fractional-reserve basis actually tended to keep MV fairly stable.

Similarly, we might expect to see banks arise on the bitcoin platform, issuing banknotes ('bitnotes'?) and making loans, and ultimately stabilizing the value. Unfortunately, banking with bitcoin faces a few hurdles that banking with gold didn’t.

Technical and regulatory hurdles

First of all, there’s a technical hurdle. If we want the money supply to be flexible, a bitnote can’t be a bitcoin, even if they exchange one for one. And since it takes more effort to implement a new payment system than to just accept (physical) notes instead of coins, 'bitbanks' will face an uphill battle getting people to accept and transact in their currencies.

Since this is a technical problem, we can expect smart people to overcome it. More difficult is the legal hurdle. Banks are centralized, so by using bitnotes, you lose a lot of the benefits that made cryptocurrency attractive in the first place.

It also gives hostile governments a bigger target. It’s too costly for the Securities and Exchange Commission (SEC) to prosecute each user of bitcoin, but it’s easy enough to shut down organizations as they get too large.

So, in the current legal climate, where governments are more than willing to take such actions to protect their own currency monopolies, banking is probably a dead-end path to stability for bitcoin.

Internal stabilization

What if, then, we could play to the strengths of cryptocurrency and have M adjust automatically to compensate for changes in V? This is actually a strong possibility. Remember that V is the rate at which a unit of currency is spent. Since all transactions happen on the blockchain, the protocol knows V.

If the reward to mining were to vary in order to compensate changes in V, rather than targeting a fixed supply path, it could stabilize MV more precisely than any central bank in history.

Quite a few proposals have circulated based on this idea. Unfortunately, the quantity problem isn’t the only one to be solved. Most importantly, when you adjust the money supply, it matters who gets the new money.

Ordinarily, these changes enter through the banking sector, where they’re distributed to those who value them most via loans. If this doesn’t happen – say, if the increase is distributed to miners instead – the currency isn’t actually any more stable.

Cryptocurrency is, in fact, the first currency with a supply that can be adjusted without a banking sector. This fact presents us with an unfortunate paradox: the macroeconomic benefits of a banking sector (stable MV) only matter in conjunction with the microeconomic function of banks (distribution of liquidity by making loans).

Loanmaking is not something that can be automated by a computer. As the recent financial crisis demonstrates, bad things happen when you don’t (or can’t) check to make sure the borrower is in a good position to repay the loan and this is something that requires irreducible human judgment.

Economist Ricardo Cavalcanti put the problem starkly:

“Although anonymity preserves money, it rules out all forms of credit.”

If there’s really no way around the need for a banking sector in the bitcoin economy, the most important future hurdle for cryptocurrencies will be the political fight.

On the one hand, a cryptocurrency banking system governed by the SEC would hardly be an improvement over the current banking system. On the other hand, without a banking system at all, bitcoin remains vulnerable to destabilizing speculation, and can’t expect to gain a foothold as an independent unit-of-account currency.

Without these institutions, cryptocurrencies will no doubt continue to innovate on a technical level, but will not be able to supplant today’s legally privileged currencies.

This article is a summary of the author's working paper: Crypto-Currency and the Problem of Intermediation.

Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.

Volatility image via Shutterstock

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