Estimating the Price Impact of Widespread Transactional Usage of Bitcoin

An interesting research paper by Wilko Bolt and Maarten RC van Oordt published in 2016, On the Value of Virtual Currencies. Outlines a framework to evaluate the potential price impact to cryptocurrencies from broader transactional usage. Using Bitcoin as a case study since it was the furthest along this path the authors proposed:

The price that speculators are willing to pay for virtual currency equals the (discounted) expected future exchange rate minus a risk premium for the uncertainty in the future value of the speculative position in virtual currency.

Highlighting the fact a cryptocurrency’s scarcity model has the potential to provide high returns to early investors. If the currency takes off because of the demand from users down the road to obtain the currency for transactional usage.

The author’s continued

The larger the amount necessary for payments using virtual currency, the higher the exchange rate. The more the value of virtual currency is absorbed by payments, the lower the exchange rate risk that has to be absorbed by speculators, and thus the higher the level of the exchange rate of virtual currency it is possible that the exchange rate is especially sensitive to changes in speculators’ beliefs in the early-adoption phase, when few real payments are settled in virtual currency. In other words, the model suggests that the exchange rate becomes less sensitive to the inflow and outflow of speculators as the use of virtual currency by merchants and consumers increases in intensity. To summarize, the impact of speculative behaviour on the exchange rate of virtual currency becomes smaller as virtual currency is used more frequently to make real payments.

Meaning, successful investing in cryptocurrencies requires the ability to properly assess the probability it is widely used in the future. As much of the potential return is front loaded into the beginning of the adoption curve. When its future prospects are least clear and most volatile.

Because

additional speculative demand from the consumer side will increase the discount factor and, therefore, provide upward pressure on the level of the current exchange rate. In particular, we show that the equilibrium exchange rate depends on both a purely speculative component pinning down a “floor” under the exchange rate and a transaction component that affects the exchange rate risk absorbed by speculators. More widespread use of virtual currencies by merchants and consumers lowers the impact of speculative behaviour and therefore stabilizes the exchange rate.

Showing that betting on Bitcoin at least is less risky than many think. Because the HODL phenomenon puts a floor on the price. Since a portion of speculators are willing to hold indefinitely to capture the expected gains from the exchange rate increasing as Bitcoin becomes more widely used transactionally.

The authors conclude

Our analysis illustrates that a steep increase in the exchange rate due to speculative motives is exactly what one can expect at the introduction of a potentially successful virtual currency. Moreover, the current high levels of volatility seem to be a symptom of early development: theoretically, volatility is expected to drop if the adoption by consumers and merchants increases. The future will show how much volatility will drop. The fixed supply of virtual currency may suggest its volatility will reflect that of other commodities than that of traditional currencies whose quantities are managed by central banks. Moreover, the model also shows that, conditional upon survival, deflationary virtual currency prices may be expected during the early-adoption stage.

Meaning the recent gains in Bitcoin and other cryptocurrencies are potentially sustainable. If these coins succeed as investors expect.

In many instances it is possible investor’s expectations have gotten ahead of reality so the price increases will prove unsustainable. But the volatility associated with price movements is not unexpected given the early stages of most cryptocurrency projects.

And

The price action many view as bubbly and unsustainable. Appears to be potentially less susceptible to bursting than many expect because of the long term outlook speculators in these coins possess. That digital currencies will supersede traditional fiat currencies as the prominent medium of exchange in the world.

How this could play out

It is unlikely that all existing currencies are replaced exclusively by Bitcoin. As this would be unprecedented. One worldwide medium of exchange.

Even today. Digital currency enthusiasts who value privacy have begun using Monero, Zcash, Dash over Bitcoin. Because of their specific feature sets adding additional layers of privacy when transacting in these coins versus Bitcoin.

Niche use cases like these always exist. So I would expect multiple digital currencies to exist in whatever end state is arrived at. Versus all of them being subsumed by Bitcoin

Although it could be substantially fewer than exist today as the market evolves.

Existing Fiat Currencies Continue to Digitize

Fiat currencies are increasingly digital as well. With some forward looking Central Banks working towards incorporating blockchain technology into their issuance and management processes.

As these experiments prove successful. Blockchain technology should be incorporated into the issuance and management of all currencies.

Fiat or digital. Because of the advantages it provides.

Once currencies are blockchain based. Transacting between them will be much more seamless than it is currently.

So I would expect digital currencies to take an increasing share of currency holdings/transactions from traditional fiat currency as more users discover their usefulness.

I would not expect traditional fiat currencies to completely disappear. Unless they are unwilling/unable to adapt to more seamless interaction with digital ones.

As there should continue to be many instances where using government issued fiat currencies for transactions makes sense. Especially if competition from the digital realm improves the way they are managed.

Meaning

The most bullish predictions regarding Bitcoin and its cryptocurrency peers should prove wildly optimistic. As it appears traditional issuers of fiat currencies have an appreciation for what is going on. While forward looking ones are beginning experiments to further digitize their currencies.

This does not imply that Bitcoin is in a bubble though. As the current run up in price reflects HODLers views that Bitcoin’s will continue to increase in value as it continues to expand its role in worldwide transfers of value.!