The Exchange

How Bitcoin Could Become a Viable Currency

The Exchange

There's been no end to bitcoin's volatility in 2013.

The decentralized electronic crypto-currency has risen 15 fold relative to the U.S. dollar since the beginning of the year, from $13.30 on December 31 to $205.50 on October 22, its highest price since April.

This extreme momentum is fueled by speculators betting on huge upside in the event bitcoin continues to get adopted by more businesses and over time evolves into an accepted means of exchange. The resulting bullish price behavior has then attracted traders who observe the rise and pile in, expecting the trend to continue. Finally, the upside is exacerbated by illiquidity, or the limited bitcoin supply.

So far in October alone, bitcoin has rallied 46% and had three days with swings of 15% or more. Back in the spring, there was a one-month period in which it traded from $47 up to $266, a 565% gain, and then dropped back down to $50, losing 81%.

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The intrigue surrounding the fledgling currency makes for great copy and the upside volatility has been tremendous for speculators who got in early, as well as some traders, especially those adept at positioning themselves ahead of big moves.

But what does the price instability suggest about bitcoin going forward as a viable currency? And while the price fluctuates so wildly, can it be counted on as a store of value and reliable exchange for goods and services?

Bitcoin volatility vs. established currencies

Comparing the volatility between bitcoin/U.S. dollar (BTC/USD) and other more established currency pairs, it is all the more striking how abnormal these big swings are and why they might be detrimental to the integrity of the currency's acceptance and real usage.

The euro/U.S. dollar (EUR/USD) has traded in a range, year to date, between $1.2747 and $1.3748. This is less than a 10% fluctuation from low to high.

The U.S. dollar/Japanese yen (USD/YEN), while more volatile than EUR/USD, is still much more stable than BTC/USD. Year to date, USD/YEN has ranged from a low of ¥86.61 to a high of ¥103.73, or almost 18%.

Now let's look at a historically volatile currency, the Brazilian real/U.S. dollar (BRL/USD). This pair has traded as high as $0.5102 and as low as $0.4081 this year, a range of greater than 20% but still nowhere near BTC/USD.

Finally, let's take a quick look at the volatility of gold. Gold has been a traditional store of value going back thousands of years. It is distinct from the traditional currencies thus far mentioned in that it is not backed by the full faith and credit of a nation, which makes it more similar in a sense to bitcoin.

Gold has traded as low as $1,233 and as high as $1,674, a 32% range, which is still much lower than bitcoin volatility.

What bitcoin needs now

For one thing, it will take time.

Ed Matts, Senior Strategist at Switzerland-based MarketVisionTV, puts it this way,

To be there in the future, bitcoin will need to be there in the past. It will need a history. We may be seeing the beginning of its history right now but there's no way to be reasonably certain. I don't trade it now, because I don't yet have faith that I will wake up tomorrow and it will be a store of value. In five years, though, if it survives, I will.

So before it is universally accepted, bitcoin will have to survive for a period of time in which it establishes a history.

And if it is going to survive, it will need to settle down.

Volatility must decrease significantly and liquidity will need to increase. Think about it this way - if bitcoin is going to effectively store value, its value must fluctuate much less.

Let's say, for example, a vendor is considering whether to begin accepting bitcoin. She will need to be able feel relatively certain that, when she leaves the storefront in the evening, she will have nearly the same amount of value on balance when she returns the next morning. If she perceives that the value of her cash holdings could be cut by as much as half, based on a website shutting down or an arrest being made, then it will not be worth the risk.

As for liquidity, the structure with which bitcoin was conceived assures that the supply will continue to increase at a decelerating rate for the next 20 years. That's a good thing. In addition, as bitcoins increase in value, there will also be more capitalization. That's good, too.

In the near term, bitcoin's path to sustained viability as a global currency will be marked by peaks and valleys - a manifestation of birthing pains. But if it is to become a broadly accepted and full-fledged currency, then price volatility must decrease significantly.

In the meantime, it's really more of a trading sardine.

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