Why Bitcoin’s Volatility is Unique Among Commodities
Published on April 29, 2014 at 11:15 BST
A single bitcoin broke the price of an ounce of gold five months ago. Now, it’s worth less than half that – and, of the two, it’s bitcoin’s price that’s bouncing around the most.
For people trying to evaluate bitcoin’s potential against other commodities, its relative price volatility could be a worry or an opportunity, depending on your appetite for risk. So, how closely can we map bitcoin’s volatility against other commodities?
Not very closely, argues Kirill Gourov, Director of Finance for Blocktech, a new company that creates open-source block chains for industries in need of disruption. He recently wrote a paper that explored whether there was an intrinsic value for bitcoin.
Gourov pointed out that it is difficult to find a direct correlation between bitcoin and other commodities:
“There may be a correlation between commodities and bitcoin because people consider both to be hedges for macro risk, but whereas oil might go up 5-10% because of some legislative issue in Europe, the price of a bitcoin might spike up 25%, then immediately drop by 30% because someone cashed out into the market.”
Copper’s recent price drop looks dramatic, for example, but it represented a 9% decrease in its value. That may be considerable, but it’s hardly in line with some of bitcoin’s more dramatic yo-yoing.
In five or 10 years, when the market is more developed, trends will be more prevalent and will force bitcoin to spike less, Krill suggested. But, today, the market is too easily manipulated.
Physical vs virtual
If bitcoin’s age is one factor that stops it being correlated easily with other commodities, then are there others?
One of the issues separating bitcoin from other commodities is physicality, argues Antony Lewis, who works in business development at itBit.
Most other commodities are used and transformed into something else, which drives certain behaviours, pointed out Lewis, who used to trade interbank foreign exchange at Barclays:
“For example, people buy copper to use in construction, power, and electronics. People buy oil to use to transform into fuel which is burned. Once used, gone.”
Conversely, he says, virtual currencies are bought either as a store of value or as a payment mechanism putting them in a different category to conventional commodities.
Let’s not write bitcoin off as entirely separate from the commodities market, though, said George Samman, Chief Operations Officer at BTC.SX, which offers derivatives services for bitcoin traders.
There are correlations today between bitcoin and at least one other commodity, Samman said, but they’re only obvious if you turn them on their head. They are negative correlations, and we see them particularly between bitcoin and gold. When bitcoin goes up, gold falls, and vice versa, he suggested.
Samman pointed to longer-term pricing for evidence of this effect. For example, when bitcoin rose dramatically at the end of last year, gold can be seen to fall (see chart).
The linear chart shows bitcoin’s price from around the time that it spiked, shortly after the financial crisis in Cyprus last year. However, the digital currency was showing slight gains on gold as far back as 2011, said Samman.
Bitcoin’s price doesn’t seem to cross that of gold because the chart isn’t granular enough, but it did. That crossover happened for a period of hours, and we’re plotting closing prices at two-day intervals here.
Gold’s movement in relation to bitcoin might not seem that pronounced, he said, but don’t be deceived. A $10 move in bitcoin wouldn’t show clearly in a long-term chart because of its significant moves later on; furthermore, gold’s high value makes it difficult to spot smaller price moves.
Gold has been moving back up since the beginning of the year, while bitcoin has been going down, Samman added, which is clearly visible on the graph. Since then, gold has trended downwards, while bitcoin has been “semi-stable” in the mid-$400 range, he said.
Samman admitted, though, that bitcoin has “bounced around” in that $400-$500 window, as would be natural for a young, relatively thinly-traded asset influenced by events such as the suspension of bitcoin trading in China by certain banks, and the perceptions around those events.
The link between bitcoin and gold makes sense. When the market flies from bitcoin, it has to go somewhere, and the argument goes that gold gets some of that action.
If you see negative correlations in this chart, then why do they exist? It’s because Gordon Gecko was only half right. Greed isn’t the only factor driving financial markets: the other is fear.
ItBit’s Lewis calls gold a ‘fear asset’, and said that in time, it will make sense to compare bitcoin against the VIX.
Also known as the ‘fear index’, the VIX is the colloquial name for the Chicago Board Options Exchange Market Volatility Index. It is a weighted blend of 30-day options across the S&P 500 index, enabling people to use it as a broad measure of volatility over the coming month. In short, when markets get wild, the VIX goes up.
In the meantime, Samman is waiting for the time when he can more easily compare bitcoin’s activities in a broader context, outside of commodities. He likes exploring intermarket dynamics, evaluating the performance of different asset classes such as equities, bonds, and commodities, in relation to one another.
What about the longer-term opportunities for bitcoin? While we read the market’s entrails looking for relatively short-term correlations now, will bitcoin and other commodities draw closer over the years?
“Some people believe we are in a commodity supercycle which began around 1990, supercycles generally last 30 years, give or take, if thats the case we are likely to see another up leg in this cycle, and I think it will be caused by inflationary events,” Samman said of long-term cycles in the commodity markets.
In particular, the tendency towards quantitative easing – central banks creating more money – and the spectre of rising interest rates come to bear here. “This all bodes well for bitcoin to spike again as well,” he argued.
Some also point to correlations between the price of bitcoin throughout its young life, and the longer-term price of gold, potentially supporting theories of long-term similarities.
“Whereas oil might go up 5-10% because of some legislative issue in Europe, the price of a bitcoin might spike up 25%”
Scarcity helps drive up the price of a commodity. Food prices rise when a drought chokes off supplies, for example, and bitcoin has its scarcity built in, Samman said, adding.
“The same can be said about bitcoin and its finite amount which is capped by mining algorithms that get harder and harder.”
This scarcity is both a known and unknown quantity in bitcoin. Scarcity has a big impact on price action, which is caused by big disparities in supply and demand. Conventional commodities can be moved by external events that affect demand and supply, such as bad weather (wheat), or growing unrest in Ukraine (oil), for example.
With bitcoin, there is a base level of supply which is relatively known, because it is underpinned by the mining community, which produces them at a predefined rate of 3,600 coins per day.
However, bitcoin’s algorithmically coded scarcity isn’t the only part of the equation; just as with commodity markets, other factors come into play.
With institutional miners producing bitcoins, and with large funds holding significant percentages of the digital currency, it’s hard to predict what that supply will look like in the future, and when people will begin letting more bitcoins out onto the market.
The same is true on the demand side. “Demand is the unknown here. We are hearing of many millions of dollars being lined up to buy bitcoin when the time is right,” pointed out Lewis.
Looking for liquidity
If and when the volume of bitcoin trading increases substantially, we’ll see bitcoin become more liquid. Liquidity dampens volatility, because there is more of an asset moving through the system.
This in turn makes it harder for people to move the market substantially with relatively small trades, or for events to move the market by spooking enough inexperienced investors into knee-jerk reactions.
One thing that will help here is the build-out of more established, reliable exchanges to provide a base level of reliability and choice to the market. The other is the building up of more sophisticated services on those exchanges, such as derivatives trading.
We’re starting to see markets for bitcoin derivatives emerge, such as BTC.SX. More will come, said Gourov, although the market is too immature to support complex trades yet. He explained:
“The market is neither liquid nor mature enough to handle anything like a futures contract. I would imagine the fees would be so high on a contract that you might as well just purchase the underlying bitcoins right now.”
However, he thinks that will change: “There are several companies creating products and platforms to facilitate this as I type.”
Even when its price volatility smoothes out, though, the chances are that bitcoin will remain a distinctly different animal from many other assets, making it hard to see correlations with lots of commodities.
For now, the cryptocurrency is a young, idiosyncratic asset all its own. As the honey badger of money, it tends to be a solitary animal, unaccustomed to moving with a herd.
Graphs image via Shutterstock
Word Analysis Shows How Different Bitcoin and Dogecoin Fans...
MIT Project to Distribute $500,000 in Bitcoin to...