Bitcoin — Volatility, Hashpower and Network Effects
Bitcoin skeptics are quick to point out the historical volatility associated with its price. As with any emerging and disruptive technology, extreme fluctuations in value should not be a surprise as its use case and value proposition evolve over time. That is not to say that Bitcoin is not volatile but it is important to put it into perspective on both a historical and relative basis.
Over time, Bitcoin’s annualized volatility has declined in tandem with a maturing network, user adoption growth and expansion of infrastructure supporting the ecosystem. Buying Bitcoin today is easier than it ever has been, with popular apps including Square’s Cashapp, Swan, River Financial and PayPal making it possible for anyone to start buying in just a few minutes. The global democratization in how to acquire Bitcoin has been a strong driver for increased adoption, network security and declining volatility as asset ownership diversifies over time. Parker Lewis at Unchained Capital has defined this idea in what he calls “adoption waves”.
“As a billion people adopt bitcoin, new adoption will represent orders of magnitude for any foreseeable future period which will continue to drive significant volatility; however, with each new adoption wave, the value of bitcoin will also reset higher because of higher base demand. Bitcoin volatility will only decline as the holder base reaches maturity and as the rate of new adoption stabilizes.”
The Bitcoin network serves as a digitally native store of value and savings mechanism for individuals around the world. Today, many people around the world are subject to hyperinflation, totalitarian governments and currency manipulation. For them, Bitcoin serves as a way to opt out of these oppressive regimes and build long term generational wealth without having to worry about the debasement of their hard earned savings. Those who choose to adopt and adhere to the protocol’s monetary rules are accepting volatility in the interim in return for these advantages.
Attractive Monetary Properties
The graph above showcases Bitcoin’s unique monetary characteristics, notably its issuance schedule and deflationary properties. There will only ever be 21M Bitcoins to be produced with the final one expected to be found around the year 2140. New Bitcoins are introduced into the monetary system roughly ever 10 minutes in what are known as “blocks”. If more miners are dedicating their computational resources to the network, blocks typically tend to be found quicker and therefore the network will increase its difficulty to revert back to the mean and vice versa. The protocol will automatically adjust in difficulty every ~2 weeks to ensure that the issuance schedule remains on target. You can see this biweekly fluctuation depicted in the picture above represented by the light blue line.
Due to its deflationary design, one of the most important aspects of the Bitcoin protocol is referred to as the “halving”. The halving is an event that occurs every 210,000 blocks (roughly every 4 years) in which the block reward is cut in half. In May of this year, Bitcoin underwent its third halving, bringing the current block reward to 6.25 BTC. Many proponents of Bitcoin point to this event as a significant driver of value for the network as new supply issuance will continue to slow as forecasted demand increases. Modern monetary systems of today’s world tend to act in the opposite, with central banks printing vast sums of money in order to manipulate their currency to mitigate short term volatility. This behavior tends to sacrifice long term stability, often resulting in credit fueled asset bubbles over time.
Another way to think about calculating the intrinsic value of Bitcoin is measuring the amount of energy and computing power allocated to running and securing the network. Based on the graph below, one can argue that Bitcoin’s valuation was overvalued during the 2017/2018 period, with the current price now catching up to the increase in hash rate. Vast improvements in computer hardware have also been a driver of increased hash rate, with specialized computers built solely to mine Bitcoin known as ASICs now at the forefront of the industry.
Network Effects
Due to its tamper resistant and decentralized model, the Bitcoin network possesses extremely strong settlement assurance. Those who choose to transact on the Bitcoin network can be confident that all prior transactions are verifiably true, increasing confidence for future payment security, authenticity and settlement. These properties can be attractive to many, particularly those outlined earlier who may be facing rampant debasement of their currency due to malicious activity from central banks and government authority. As each day passes by, more and more people are opting into the Bitcoin network, benefiting from improved monetary characteristics that protect and reward their time and effort.
This network effect — a phenomenon used in economics in which the value a user derives from a good or service is positively dependent on the number of users who also opt in — is extremely symbiotic amongst participants in the Bitcoin monetary system. As user adoption scales and more businesses are created to serve the growing economy, independent actors are incentivized financially to secure the network, creating a positive feedback loop reflected in the underlying price of the asset.
Looking Ahead
Bitcoin is still extremely young as an asset class. With only a 12-year track record, we still do not know the true disruption this technology will have on our world going forward. As infrastructure matures and further improvements are made to enhance the protocol itself, more participants will opt into the network, creating a positive feedback loop resulting in lower volatility as the price appreciates.
Our current monetary system is inherently fragile due to currency manipulation aimed at muting short term volatility — often resulting in over-leveraged asset bubbles fueled by cheap credit.
Reprogramming our psychological roots in order to abandon the current system — one based off endless government printed fiat — and embrace a world built on a Bitcoin standard will be one of the hardest yet important developments humanity will face over the next decade.
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