150396365 Robert Dobie
Applied Economics – Group 6 Report
Bitcoin is the first and most commonly-known cryptocurrency, which has stirred up the
interest of both financial markets and moreover everyday people; who have been enticed
into purchasing it as a consequence of its profitable volatility. Since its first major increase in
value from $13.30 at the beginning of 2013 to $732.39 at the end of 2013, Bitcoin has
continued to grow in financial backing and cult appeal, as individuals who had not traded
before, speculatively backed the emerging cryptocurrency bubble. 1 Bitcoin hit a peak of
$19,343.04 on the 16th December 2017 but has since been floating around a mark just
above half of that, reflecting negative shocks to Bitcoin and the underlying block chain
technology. These include but are not limited to: government actions, such as the 2 Chinese
government’s banning of initial coin offerings (ICO’s); as many of these were seen as Ponzi
schemes, negative press over the energy usage of the bitcoin mining process; 3 which now
uses a similar amount of energy as Bangladesh, as well as the financial security issues with
regards to hacking. Two notable examples of this are, the 4 $534m worth of Bitcoin
alternative NEM which was stolen from the Coincheck exchange in January 2018 and the
$460m stolen from the Mt Gox Exchange which bankrupted the company back in 2014.
Within this report, the main aim will be to effectively demonstrate some of the most
prominent determinants of the currency’s supply and demand and why these; some more
than others, have such an influential impact on the volatility of the price of Bitcoin,
especially in comparison to other currencies and to other trading options, like that of the
S&P 500. Even so, while this report will attempt to be as fully comprehensive as possible it
will still not be able to address and analyse all of the factors with regards to Bitcoin and so
the view laid out must be seen as only a part of the larger picture of Bitcoin, within the
even-larger market of cryptocurrencies and their block chain technology. This will be further
limited by the actual size of the report and so while the points will be analysed this may in
some cases come as a trade-off to description, thus a prior basic understanding of
cryptocurrencies would aide significantly. Nevertheless, within the central part of this report
the reader will gain understanding of the basics of Bitcoin along with the economic overview
of why each factor influences the demand and/or supply, and so consequently why this
leads to daily fluctuations in the Bitcoin spot rate unparalleled in other currencies
worldwide.
So, what is money? There are many different correct and incorrect uses of the term in
every-day life, but simply, from an economist’s perspective, it is separate from income and
wealth and can be generally accepted as payment for goods and services. While Bitcoin isn’t
anywhere near the level of acceptance of other monetary payment types; primarily credit
and debit, it can be used to purchase an ever-growing variety of goods and services. In
addition to this, it must satisfy the three functions of money: medium of exchange, unit of
account and a store of value, which it does achieve although volatility issues do test the last
function. These volatility issues reflect an interesting development in relation to Bitcoin, and
that is its transformation from a low level currency used for actual purchasing exchanges
(and illicit activities) to a majority speculative vehicle.
In consideration of Bitcoin as a fiat money we look at the literal definition, that fiat money is
such that the government has declared it as legal tender, but it is based on faith and the
credit of the economy rather than backed up by a physical commodity (e.g. Gold). This is the
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main problem with Bitcoin as it is not backed up by a physical commodity and yet its original
design explicitly created it out of the realms of effective government and regulatory control.
Even so, fiat money cannot suffer from the issue of scarcity, and so will allow the modern
economic variables of: credit supply, liquidity, interest rates and monetary velocity to
operate effectively. This Bitcoin achieves, as although it has a fixed ceiling of 21 million
bitcoins, each Bitcoin is not only valued at $10,911.55 (01/03/18) but is essentially
indefinitely divisible, at 100 million times.
As it can be seen, Bitcoin does hold up itself as a money under the economic definition, and
does also maintain many attributes of a fiat currency. The one reoccurring issue that causes
deviations from what we would consider the proper functions of money; and especially fiat
money, is the large amount of trades that owe themselves to the speculative bubble. As has
happened throughout banking and financial history: Tulip mania and the South Sea bubble,
markets emerge, which through growth above traditional investment returns, entices retail
investors into
investing which then
culminates in
devastating crashes,
as the bubble bursts.
While this has not
occurred for Bitcoin
as of yet, by looking
at the data it seems
to be following this trend. 5 All this investment activity has led to a straining of Bitcoin’s
functions as an effective currency, as while it increases in value; perceived as a positive by
most, this actually prevents it from operating as a reliable store of value. In addition, Bitcoin
is also inherently deflationary and so would have negative effects on the economy, 6
“deflation in the unit of account leads to unemployment, thanks to the fact that wages
generally don't adjust downward… wages are "sticky", and so deflation in the currency in
which wages are set is costly”.
Bitcoin was the first decentralised cryptocurrency in existence, created in 2008. It uses
encryption techniques to regulate the generation of units of currency and verify the transfer
of funds. Also, unlike the majority of fiat currencies, it operates independently of a central
bank. It’s the currency’s peer-to-peer nature, and supposed ability to be used without a
central authority that initially appealed to consumers and businesses alike.
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The data of all Bitcoin transactions are recorded in a linear, time-stamped series of bundles;
which are individually referred to as blocks, and collectively as a blockchain. Unlike
traditional fiat currency, records of these transactions are publically available, continually
updated and under no central control. Bitcoins are exchanged and created through a process
known as mining, where private individual’s computers solve proof of work algorithms in
order to add transaction information to Bitcoin’s public ledger of past transactions. By doing
so, they verify previous transactions and allow new ones to be completed, in return for the
chance to be rewarded with a pre-determined number of new Bitcoins. This creates an
incentive to verify payments
between users, supporting the
cryptocurrency’s network and
thus maintaining its reliability
and value. However, the
number of bitcoins rewarded
diminishes over time, halving
every time 210,000 blocks are
mined (roughly every 4 years)
and eventually falling to zero.7
As this is the only way new
bitcoins are created, there will
only ever be 21 million
Bitcoins in circulation, and
therefore in the long run it is
considered to have perfectly inelastic supply. This in uncharacteristic of government-backed
fiat currency, where the money supply is technically infinite, and can change according to
the monetary objectives of the central bank that controls it.8 Although, Bitcoins are currently
divisible down to 8 decimals places, and this has the potential to be increased further
through a rule change to the network, helping to create price stability as demand changes
over time. Bitcoin is therefore technically divisible to a near infinite degree, however this
division is dependent on the owners of the currency, rather than a governing body; which is
the case for standard fiat currency.
As previously stated, in order to verify and propagate transactions miners rely on an energyintensive computing process that also has a degree of human involvement. It could
therefore be said that the resources expended through mining gives the currency a degree
of economic value. However, similarly to fiat currency, this value is not intrinsic.
Furthermore, the fact that this value is inconvertible means that Bitcoin can’t be classified
as commodity money, and like fiat money; instead gains its value by consensus and by virtue
of the ability to exchange them for goods and services. Semantic scholar
As the mining process only requires private individuals to function, Bitcoin is subsequently
considered to operate independently of intermediate organisations. This is why the
currency is classified as peer-to-peer, and is thought to have the potential to disrupt
traditional financial systems. Altough, in the same way that fiat currency relies on private
companies to link consumers to the banking system, an extensive ecosystem of 3 rd party
intermediaries still exists for Bitcoin, such as currency exchanges and mining pools.
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However, these de-facto central authorities just create a greater element of risk when using
the currency, rather than making Bitcoin similar to fiat currencies.
In reality, bitcoin still has a degree of governance and is susceptible to variations in the
objectives of economic agents, whose preferences and reason for possessing the currency
will often be at odds, and continue to change over time. A lack of general consensus has
continued to be an issue for not only users of the cryptocurrency, but also the miners
responsible for continuing its supply. The most significant example of such discrepancies in
the vision that individuals have for Bitcoin is that of the creation of Bitcoin Cash, which
ultimately came to fruition on 1st of August 2017. This was the result of individuals
disagreeing with the proposed implementation of the Segregated Witness rule change,
which would have altered the block-size limit in the mining process. People argued that such
a change would favour those who see bitcoin as a vehicle for investment rather than a
transactional currency bitcoin cash,and subsequently wished to ‘fork’ the currency. This
means that the blockchain and hence the currency as a whole splits, with the developers
copying the basic set of rules originally designed for bitcoin, with minor alterations in the
way the blockchain is governed. Bitcoin is therefore completely different to fiat currency in
the sense that the process by which it’s supplied can technically be manipulated and even
replicated by individuals. This has led to the creation of many alternative cryptocurrencies
through Initial coin offerings, which seek to offer improvements on Bitcoin, whilst in fact
serving the same purpose. The creation of these new coins, whilst offering some genuine
innovation in blockchain technology, more often than not simply acts as a way for
developers to easily and quickly gain increasingly large amounts of wealth, supporting the
idea that to many people Bitcoin is seen purely as a digital asset rather than a form of
currency. However, many governments dispute this, and in fact the EU and US treasury
considers Bitcoin to be a virtual currency, which can be defined as "A medium of exchange
that operates like a currency in some environments, but does not have all the attributes of
real currency". Although, virtual currency does not have legal tender status in any
jurisdiction[2], and thus can’t truly be considered a fiat currency. On the other hand,
improvements to blockchain technology can transform the nature of the currency, and
given the correct rule changes (known as Bitcoin Improvement Proposals) it has the
potential to better satisfy the characteristics of traditional currencies. For example,
improvements to it’s transaction times and the associated fees will further it’s use as a
medium of exchange. Furthermore, the more steps that can be taken to exclude the
currency from intermediaries, the less exposed it should be to the inherent risk of having
another organisation being responsible for individuals’ holdings. In turn, this has the
potential to create a greater degree of price stability, as multiple sudden price fluctuations
have been the result of security breaches of Bitcoin exchanges (include source). Such price
stability is essential for the currency to be used effectively as a store of value, and should
also reduce attention from regulatory bodies and short-term investors; who have the
potential to undermine the future success of bitcoin.
This shows that bitcoin’s features aren’t necessarily rigid, and the extent to which it can be
successfully used as a currency has the ability to change over time as a direct response to
the will of its users. This is directly opposed to the system of independent central banking
adopted by most western societies, where the public are only able to make indirect changes
to the money supply through democratically electing politicians who in turn influence the
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objectives of central bankers. However, lack of public involvement actually helps to prevent
the kind of manipulation that can destabilise a currency and have critical implications for
economic performance. The decentralised and apparent democratic nature of bitcoin
therefore creates another barrier to it being adopted as legal tender and thus considered a
fiat currency, as unless it can be regulated and controlled in a way that can allow
governments to successfully implement their own fiscal policy, adoption as legal tender
could be seen as counterproductive.
The demand for Bitcoin is unique compared to other currencies as there are various other
factors contributing to it’s demand other than being a medium of exchange, unit of account
and store of wealth. Some of the determinants of demand such as anonymity, speculative
mania, security levels and sensitivity to good or bad press can help explain its the volatility
of.
Bitcoin conceals the identity of peers in the ledger and so this makes it suitable as a
currency for many goods and services, namely illegal items. This can lead to price volatility
as it means some of the demand is dependant on it’s continuing ability be used in these
markets and if these markets were to shut down or reject Bitcoin, it can be damaging for the
demand. Before October 2013, an estimated 4.5% of the BitCoin economy (by Nicolas
Christin from Carnegie Mellon University) was dedicated to Silk Road, which could only be
accessed through the dark web1. 70% of the market was used to buy & sell illegal goods and
services such as drugs, prostitution, weapons. This made it an appealing medium of
exchange because of the anonymity of its transactions. When Silk Road closed on the 2 nd
October, the price of Bitcoin plummeted from over $140 to below $110, a 21% decrease.
Before this, price was relatively stable, which shows how valued the anonymity advantages
of the currency are. What may be even more surprising is how quickly BitCoin managed to
recover to it’s previous price in the days following. Users looked beyond the closure of Silk
Road and remained optimistic.
Since 2013 and the Silk Road closure, Bitcoin price has soared to what it is now valued at
today which is currently around $9000. Much of its rise in price is pegged to speculation
about its function as a store of wealth. Its supply features can help explain why it is in so
much demand. BitCoin is governed by a design decision that limits its production to a finite
amount, as mentioned before. BitCoin is independent of Government rule unlike other fiat
currencies and so when economies built on fiat currencies show signs of strength or
weakness, people can choose whether to allocate more or less of their assets to Bitcoin. In
this way it seems a lot like gold to some investors because of the similar properties they
share. In 2017 the number of transactions per day fell from 300,000 at the start of the year
to 196,422 by the end of the year2. In contrast to this, the price of Bitcoin at the start of
2017 was just under $1000 and by the end of 2017 price increased by more than 1,300% to
end the year at $14,500. This is significant as it suggests its use as a store of value outweighs
its function as a medium of exchange in the minds of those in the market. Therefore
speculation can be said to be a driving force in its price volatility as oppose to any changes in
its ability as a medium of exchange.
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In the few years following the inception of Bitcoin, the security of the system was seen as air
tight due to it’s complicated algorithmic nature. This fuelled a lot of the demand as physical
currency was easier to steal and the banking collapse wasn’t long before Bitcoin. However
these security assurances have been tested recently. When the security of Bitcoin was
questioned in December 2017 this lead to a panic in pricing with different exchanges valuing
Bitcoin at different prices due to conflicting agendas, mainly between restoring faith in
BitCoin and representing the dumping of the currency by scared investors. The Slovenianbased cryptocurrency platform ‘NiceHash’ told its users that its payment system had been
compromised and that a reported 4,700 Bitcoins (worth about $70m) had been stolen from
a digital wallet. The following day the financial times reported: “In one wild 20 minute
period, the price of Bitcoin soared $2,000 per coin to more than $19,000 only to drop to
$15,000 on the Coinbase trading venue. The frenzied demand left other exchanges
struggling to cope, and the difference in prices quoted on other venues for the same Bitcoin
asset was as much $4,000.” This shows how volatile price can be in response to security
shocks. Even though most would expect prices to drop sharply following this news, the price
fluctuations after the news show the determination of some Bitcoin platforms to maintain
confidence in the currency, even going as far as to bypass honest representations of the
price.
As discussed previously, a significant amount of demand is due to speculation, as the
currency itself has no physical or government tendered value. Because of this, demand has
also become reliant on the news surrounding the cryptocurrency. Typically good news for
Bitcoin injects confidence in the currency and leads to speculation on a wider scale, as
people believe that the price of BitCoin will go up because they assume others have seen
this positive news as well and so that means Bitcoin is secure. This links to the greater fool
theory as people believe their Bitcoin’s will be bought for more, meaning there is an
incentive to buy more and make a greater profit. The opposite can be said for bad news. If
people see bad news, such as a country banning Bitcoin or a Government official
condemning its lack of regulation, they start to question whether it is what a lot of people
say it is, an economic bubble. This induces panic and many would start to dump their
BitCoins on the open market. The Graph below tries to label price fluctuations with the
relevant pieces of news that explain these movements.
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Graph provided by WWW.CCN.com
From first glance we can see how volatile the price of Bitcoin is, but when we look at the
relevant pieces of news; against the graph, we can start to see the pattern of how news
affects price. In the case of Ecuador banning Bitcoin we see that this leads to a huge
downward spike in price, as would be expected. On the other hand, good press for Bitcoin,
such as eBay considering the currency and Dish accepting BitCoin, lead to two huge
sequential gains in price. However, there are some outliers to this, for example when the
Chinese government began censorship of the Bitcoin summit in Beijing, there isn’t any price
movement worth noting. Despite this it can be seen that good and bad news can massively
impact price movements depending on their relevance and scale.
There are many other determinants of demand that may be harder to observe in price
fluctuations but still remain a factor for some who buy and sell Bitcoin. The Cypherpunk
movement that started cryptocurrencies saw it as a way of having financial freedom of
expression and also to combat the current financial system in place, with the ultimate goal
of removing the need for central banks.
As has already been discussed earlier in this report, there are many determinants of Bitcoin
demand, derived primarily from the acceptance of Bitcoin as a Fiat Currency. For example,
its use as a medium of exchange for illicit goods, as a store of value for individuals in nations
with highly unstable currency (e.g Venezuela) (News.au, 2017) or indeed as governments
and companies come to accept Bitcoin as a legitimate payment method.
Since its inception however, Bitcoin price has always been highly volatile, as can be seen in
the graph below. The average volatility since creation is 77% vs the USD (charts.bitcoin,
2018) the volatility reached a peak of 272% in June 2011. The factors of demand
determining price do in part explain the volatility, as for example when South Korea
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announced plans to ban cryptocurrency trading, the price of Bitcoin plunged by 13.5%
overnight (Guardian, 2018).
Price Volatilty of Bitcoin vs USD
300
250
200
150
100
50
0
8.17.10
8.17.11
8.17.12
8.17.13
8.17.14
8.17.15
8.17.16
8.17.17
Data Source: https://charts.bitcoin.com
In contrast to Bitcoin volatility, in this graph, we can see the implied volatility of the
exchange rate between GBP/USD in the last decade, which aside from the credit crash of
2008 has remained fairly consistent at roughly 5-15%.
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From these two graphs, it is easy to see how the use of Bitcoin as a traditional currency is
hindered by its volatility
As I will be explained presently, in the last 12 months the issue of volatility has further
exacerbated the problem of using Bitcoin as genuine tender.
However, while these determinants have played a significant part in explaining Bitcoin price
and its volatility since its inception, the most significant factor over the last 24 months has
been the speculation and expectations of the future potential of Bitcoin and cryptocurrency
as a concept. This speculation has encouraged investors to purchase Bitcoin as a
commodity, with gains derived from an increase in value.
This degrades the functionality of Bitcoin further because currencies should have a steady
price if they are to be a medium of exchange. Put simply, buyers do not want to exchange a
token that could jump sharply in price the next day. Meanwhile sellers do not want to
receive a token that might plunge in price.
The emergence of a bubble effect as more and more companies and individuals believe
their shares of Bitcoin will rise in value is an example of the greater fool theory in practice.
‘Those who subscribe to the greater fool theory will often make questionable investments,
not because they believe that the current price is attractive, but rather because they believe
that they will be able to sell to someone else at an even higher price.’
To highlight this, in the past year, demand has soared for bitcoin, driving the trading price of
one Bitcoin from $997 to the peak of $19,343 an increase of more than 900%. As you can
see in the following graph.
Bitcoin Price vs. USD
25000
20000
15000
10000
5000
0
1.10.09
1.10.10
1.10.11
1.10.12
1.10.13
1.10.14
1.10.15
1.10.16
1.10.17
1.10.18
Data Source: https://charts.bitcoin.com
Those investing in Bitcoin appear to be the main driving force behind its increase in value in
the last 12 months, purely on the shared assurance any investment in Bitcoin is likely to
bring satisfactory returns. This consequently affects the price volatility because it now
means the price is largely determined by the investors sentiment and speculation towards
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Bitcoin, making it more possible that changes in demand could be caused by sources such as
journal articles and changes of circumstance with Bitcoin regulation for example that impact
the combined outlook of the investors.
In conclusion, while this report has highlighted the reasons that Bitcoin can be considered as
Fiat Money, an important factor to take away is that as of yet Bitcoin is only recognised as
legal tender in two nations, Japan and South Korea. This, it’s function as an illicit payments
system and the lack of acceptance as tender for most transactions in day to day life, have
restricted its ability as a medium of exchange. This of course is liable to change in the future,
as more nations may come to accept it as legitimate currency. If this happens then Bitcoin
may well become an internationally utilised currency in the future and it is possible that the
price volatility may stabilise. The potential for stability is encompassed as we have seen in
the supply side of the report, for as the mining process levels out and the total number of
Bitcoins is established it is likely the price may also stabilise given other factors are
consistent.
With respect to the demand for Bitcoin; over the 7 years from its inception to January 2017,
we have established that some of the main determinants of demand were associated with
its similarity to conventional currency and were firstly; The lack of transaction fees as Bitcoin
is transferred peer to peer. Secondly, as a store of wealth, for those who mistrust central
banks or financial institutions. And finally, as a medium of exchange for both criminal
transactions and a currently limited array of legitimate trades.
But since this January demand has boomed for Bitcoin due to the speculation of Bitcoins
potential in the future, with regards to the technology behind it, and seems to be now the
primary determinant of its price. The issue of Greater Fool theory is also prominent as m
This new aspect of demand has threatened to form a ‘Bitcoin bubble’ akin to those of the
housing market in 2007 and the dot-com bubble of 1999. This bubble burst in
Looking into the future of Bitcoin, volatility will likely remain a prominent feature as the
basis of its value is less determined by hard evidence or numerical reasoning.
References:
Harry:
1 Bitcoin
price information- https://www.coindesk.com/price/
2 Chinese
government crackdownhttps://www.forbes.com/sites/sarahsu/2018/01/15/chinas-shutdown-of-bitcoin-minersisnt-just-about-electricity/#286d79b5369b
3 Mining
4
energy usage- https://digiconomist.net/bitcoin-energy-consumption
Bitcoin/cryptocurrency hacks- https://www.siliconrepublic.com/enterprise/coincheckcryptocurrency-bitcoin-nemcoin
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5 Bitcoin
and previous asset bubbleshttps://www.theguardian.com/business/2017/dec/02/bitcoin-bubble-the-warnings-fromhistory
6
Bitcoins deflation problemhttps://www.economist.com/blogs/freeexchange/2014/04/money
7 Bitcoin:
A Peer-to-Peer Electronic Cash System - https://bitcoin.org/bitcoin.pdf
8
Benjamin Franklin And the Birth of a Paper Money Economy https://www.philadelphiafed.org/-/media/publications/economic-education/ben-franklinand-paper-money-economy.pdf
https://www.economist.com/blogs/freeexchange/2017/09/not-so-novel
"Some Bitcoin Backers Are Defecting to Create a Rival Currency"
https://pdfs.semanticscholar.org/c55a/6c95b869938b817ed3fe3ea482bc65a7206b.pd
f
https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?referer=http://scholar.goo
gle.co.uk/&httpsredir=1&article=2349&context=law_and_economics
https://www.enisa.europa.eu/publications/enisa-position-papers-and-opinions/enisaopinion-paper-on-cryptocurrencies-in-the-eu
https://www.fincen.gov/news/news-releases/fincen-issues-guidance-virtualcurrencies-and-regulatory-responsibilities
http://fessud.eu/wp-content/uploads/2013/04/Commodity-Currencies-vs-Fiat-Money-Working-paper-No.44.pdf
1https://www.cylab.cmu.edu/_files/pdfs/tech_reports/CMUCyLab12018.pdf
- Traveling the
Silk Road: A measurement analysis of a large anonymous online marketplace
2https://blockchain.info/charts/n-transactions?timespan=1year
http://uk.businessinsider.com/bitcoin-price-in-2017-review-2017-12
https://www.investopedia.com/articles/investing/052014/why-bitcoins-value-sovolatile.asp
Rob:
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https://www.theguardian.com/technology/2018/feb/02/bitcoin-biggest-bubble-in-historysays-economist-who-predicted-2008-crash
http://www.news.com.au/technology/online/venezuelans-seeing-bitcoin-boom-as-survivalnot-speculation/news-story/b4ee91a802ed265a237699aa2ed4dd44
https://www.theguardian.com/technology/2018/jan/11/bitcoin-drops-value-south-koreatrading-ban-cryptocurrencies-tax-gambling