If experts are right, one of bitcoin’s prevailing characteristics could also be its biggest problem – a fixed supply that helps to send prices yo-yoing. They say that cryptocurrencies with flexible supply would help to avoid scaring everyday users away.
Even in bitcoin’s digital universe, the same basic economic rules apply, with price being determined by supply and demand. Bitcoin’s algorithm makes the supply of bitcoins predictable, with a constant stream of bitcoins distributed via block rewards that halve at a preset rate. This leaves demand to fluctuate.
Bitcoin’s bouncy demand
In bitcoin’s case, that demand fluctuates wildly.
“Daily BTC/USD volatility is around 5%, which is about 5–7 times the volatility of a major forex cross,” points out Robert Sams, a cryptocurrency economics consultant with 11 years of experience in hedge funds.
This fluctuation in demand isn’t a good thing, because it has an effect on the price, making it volatile too. Volatility in price makes it hard for bitcoin businesses to grow, because it introduces too much uncertainty, warns Joseph Lee, founder of Singapore-based cryptocurrency trading platform BTC.SX, who added:
“This is damaging for the huge array of businesses who simply want to be involved in the space by accepting bitcoins for their products, whether its food or hardware, but unknowingly end up playing a long speculative bet on the price.”
Sure, they can accept bitcoins and get them converted immediately into fiat by someone like CoinBase or BitPay, so that they never have to touch the cryptocurrency. That doesn’t make them a bitcoin-invested business. Rather, they’re just a business that happens to accept bitcoin.
Making supply elastic
Faced with this problem, which is better: fluctuating demand, or fluctuating supply?
“People do care about price, so stabilising price is more important, and that requires having the supply be adjustable based on price via some metric,” he continued.
What metric could you use to stabilise the price of a cryptocurrency? It’s a tricky question, because you’re effectively talking about a monetary policy. Centralised monetary policies go against everything that Satoshi’s original concept for bitcoin stood for.
Instead, Buterin and others are talking about a decentralised monetary policy, decided by the network. But there are significant challenges to that. The right metric must be picked, and it must be implemented in a way that doesn’t let an attacker grab hold of the reins and set the price of the coin.
How to set a coin’s supply
So, what metric should be used? Buterin lays out a few suggestions in this blog post, and divides the possibilities into two main kinds. The first is exogenous – using metrics outside the network, such as the price of a fiat currency.
The alternative approach is endogenous (using some internal metric to determine the supply). The internal approach is better for a cryptocurrency like bitcoin, believes Buterin, who said:
“It doesn’t introduce implicit dependencies on specific institutions (eg: targeting USD parity would essentially give the Federal Reserve control over bitcoin).”
Sams also prefers that the information comes from inside the network. There are different internal metrics that could be used, ranging from variable mining difficulty through to transaction fees.
There have been proposals before that would make the price of a cryptocurrency elastic. Improved Bitcoin (IBC), the proposal from the Institute of Economic Research at Hitotsubashi University in Tokyo, pegs the price of cryptocurrency to the US dollar, but then uses the reward given to bitcoin miners as a way of adjusting the supply of coins.
The IBC concept has some problems, though, warns Sams. “Their approach isn’t workable for lots of reasons. The main problem with it is that they do not have any mechanism for reducing coin supply, only increasing it in an elastic way,” he said.
Sams prefers to target a constant mining reward, based on the optimal level of network hashing costs. Then, coin supply can be increased or decreased to maintain that rate, using some alternative channel.
“In my paper, that channel is the seigniorage shares,” said Sams, whose theory for stabilising bitcoin price would see two kinds of token.
One token, the coin, would be used for transactions. The other token would be a share in the coin’s seignorage (the profit that an issuer of money can make by creating money). Coins are exchanged for shares – and vice versa – when the supply of coins needs to increase or decrease.
Lovely. That’s all set, then. We’ll just get the core devs to code it into the protocol, shall we? Not so fast, said Sams, who argues that there’s no support for such a fundamental change to the bitcoin technology.
Better to treat bitcoin as a good 1.0 cryptocurrency and start over, he said:
“I don’t believe in the thesis that everything rises and falls on backing a single protocol. There’s no reason to think that the first protocol got everything right.”
Sams, who also consults to Ethereum, argues that a cryptocurrency designed with stability in mind from the outset will bootstrap with some function other than payments to start with.
“They buy the coin not because they want to, but because they have to to do the something else that they really want,” he said.
Buterin goes so far as saying that bitcoin will never move beyond its current phase as a speculative currency, hoarded by those hoping for a ‘to the moon’ ending, because an asset will never be stable without variable supply.
A different approach
Not everyone agrees that we have to change supply to reach a more stable price for a cryptocurrency. BTC.SX’s Lee things that liquidity and size are key.
“As a community, instead of trying to control the price via artificially manipulating the supply, why not collectively work on increasing its demand?” he said.
“Prevailing consensus amongst economists is that liquidity is an important factor in price discovery, and that it will fuel the growth of any market or asset class regardless,” Lee added, citing this World Bank report.
He suggests that startups focus on on-ramping consumers and targeting merchant adoption, and argues that watching venture capital flows into these two sectors is a good indicator of rising demand.
“This will create a feedback loop in which monetary velocity can increase,” he concluded.
If Buterin is right, and flexible supply is the only answer to volatility, then bitcoin will be stuck in a hoard-and-wait cycle forever. If Lee is right, then there’s a future for bitcoin as a cryptocurrency that prioritises transaction over investment.
What do you think? Should people be lobbying for a new, stable coin with flexible supply? Or should the bitcoin community simply try to grow its way out of the problem?
Correction: This article was amended to clarify that, while bitcoin’s algorithm makes the supply of bitcoins predictable, the rate at which they are distributed reduces over time.
Balancing image via Shutterstock