Bitcoin Volatility Solution

Bitcoin ($BCOIN) is a thing.  A lot of techies love it and have embraced it.  If you haven’t heard of it, I understand.  Many people scoff at the idea of Bitcoin.  How can it be worth anything, no government backs it?

The bitcoin logo

The bitcoin logo (Photo credit: Wikipedia)

In many circles, it’s simply an underground currency used for illegal things.  The Silk Road affair won’t do anything to help Bitcoin’s reputation as a store of value for renegades.

Governments have an economic incentive in bringing Bitcoin down because it threatens them.  One of the hallmarks of a good government is to provide a stable medium of exchange.

To understand why Bitcoin is worth anything gets to the root of why anything is worth anything.  It’s because groups of people trust it, believe it has a store of value and use it as a medium of exchange.

Why is Gold ($GLD) worth anything?  Why is the US Dollar ($USDX) worth anything?  There is supply, demand and faith.

Over the weekend, I watched two videos, read some blogs and thought a lot about Bitcoin.  Fred Wilson posted this one, and it explains a lot about the Bitcoin system.

But the Pando Daily interview with fellow Illini Marc Andreesen was enlightening as well. He sees a future for Bitcoin, though he hasn’t made an investment yet.

Bitcoin is based on math, and the principles of Coase Theorem.  That’s why it could work.  Coase Theorem may be the most powerful economic theory ever published.  It finds it’s way into all successful endeavors in some way.

That’s where I started thinking. What would I invest in?

Coinbase exists.  Coinbase solves the exchange problem.  It’s not any different than a currency exchange business.  That is an essential building block of the Bitcoin ecosystem.  Currency exchanges can proliferate once there is enough of a market.

In my opinion, the thing that is holding Bitcoin back from greater adoption today is volatility.  Bitcoin isn’t stable.  It jumps up and down in value. Check out this chart of Bitcoin vs the US Dollar.  I added the Nasdaq 100 ($QQQ), no paragon of stability, to the chart so you could compare volatility.  It’s the red line, Bitcoin/USD is the candle chart.

All the volatility makes merchants and users of Bitcoin nervous. If I decided to accept Bitcoin to try and expand my customer base, I’d run to Coinbase and turn it into a more stable government currency as soon as I could.

That doesn’t lead itself to a marketplace.  Bitcoin feels more like Zamibian currency.  If you believe Andreesen, Zamibia is a perfect place for Bitcoin to grab a toehold.

Problems beget opportunities and this is no different.

If Bitcoin had a functioning futures market, it could establish itself as a world currency.  Futures markets take volatility away, and provide clarity.   Here is a historical price chart of onions vs corn.

Guess which one has a deep, functioning, transparent futures market?

In the days before futures markets in items like US Treasuries, the cash dealers ripped off the buyers and sellers in the market. The spread on US Bonds was close to a full half point ($500).  Post introduction of a US Treasury futures market, the spread contracted to 1 tick ($31.25).  Futures made US treasuries less volatile, and saved the US government trillions because cash auctions were more efficient.

Problems beget opportunities.

The US banks, like JP Morgan($JPM), Goldman ($GS) et al can’t start a market in Bitcoin Futures.  They would get too much heat from federal regulators.  In my experience, banks are not innovative leaders in things like this, but followers.  Once the market is big enough and there is money to be made, they will jump in.  Until the tipping point is reached, they ignore, or try to protect market share.

A regulated futures exchange like the CME ($CME) or ICE ($ICE) would also stay away from Bitcoin.  It’s too hot, and with the Silk Road things would bring them under more scrutiny than they would want.

What would I look to invest in?

If a group of deep pocketed private traders created a futures contract for Bitcoin and traded it, I’d think really hard about investing.  They would have to set up a bid/ask market, four contract months, and a clearing  mechanism.  Out of all of this, the clearing mechanism would be the hardest to set up.

The risk/reward on the deal is huge.  Once futures exchanges get networks set up and become the place to trade a contract, it’s almost impossible to steal it.  Owning the Bitcoin futures contract once it becomes a mainstream currency would be massively profitable.

Speculators that would come into the market would buy and sell creating liquidity.   That liquidity would attract more volume, limiting volatility.  Once it got going, different permutations of currency contracts along with options would make Bitcoin more stable.

That’s when the banks would jump into the market.

It would take ten to twenty years to pan out, unless a worldwide financial panic happened where all governments were printing currency like it was going out of style and didn’t pay attention to supply/demand issues.

But no reputable government would do that would they?

 

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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