6 min readVolatility has been a common and persistent concern of potential bitcoin investors since the early days when it was first discovering a market price. It is true that bitcoin has been more volatile than most monies, and this is likely the reason for its limited global use as a medium of exchange at present.
We find that bitcoin’s volatility may best be explained visually — take note below of the nine instances when its price has fallen over 40%, in just 13 years of existence.
Of course, long time bitcoin investors have always been rewarded generously for tolerating bitcoin’s wide-ranging price swings. To them, a downside volatility event is an opportunity to accumulate coins, and is to some extent now expected, or at least unsurprising.
Many are choosing to simply wait for bitcoin to move past its youthful phases of adoption, expecting that volatility will decrease as bitcoin markets become more liquid and less speculative over time. Others have found that volatility is not an issue at all, as changes in BTC exchange rates have historically had no effect on how Bitcoin functions, and it is unlikely to do so in the future.
Not everyone is poised with the perspective of a long-term bitcoin owner however. In a world of dollar denominated debt, the exchange rate of BTC rightly matters to potential investors, as well as existing owners who either speculate on bitcoin’s potential as a store of wealth or regularly spend it on goods and services.
So in the spirit of several new designs recently released to address the topic of dollar access within bitcoin markets, this post will briefly explain some of the tools that can help evade bitcoin’s volatility. Through this explanation, we’ll also attempt to briefly touch on the trust and scalability elements associated with each design.
A Packaged Solution To Hedge Volatility in Bitcoin Derivatives Markets
The bitcoin market has matured to enable investors access to more financial infrastructure, including the emergence of Bitcoin banks and derivative exchange markets. With this, clever hedging strategies have enabled users to gain exposure to US dollar stability without having to touch the US banking system.
The use of the bitcoin derivatives market to reduce volatility has been well-documented since 2015, however recently, Galoy’s Stablesats project has packaged a somewhat known hedging strategy into a transactable tool for its clients. The product relies on Galoy, a bank-like entity, to maintain dollar stability by trading inverse perpetual swap contracts with the collateral of voluntary customers. If implemented properly, users are expected to transact this dollar exposure both within the Galoy clientbase and the Bitcoin Beach Lightning wallet created by Galoy.
Using Galoy’s new product to limit the effects of bitcoin’s price volatility exposes an investor to essentially the same categories of risk as others using financial products for the same purpose, but with the added risk that Galoy is properly trading on your behalf. Most critically this includes the counterparty risk of the product’s issuer, however it also extends to the custodian responsible for keeping any collateral as well as the pricing agent providing any exchange rate data. The scalability of these products then generally depends on the depth of the market where they trade, and more specifically, the volume of counter traders that alternatively aim to profit from bitcoin’s price volatility.
Bitcoin-Native Contracts Offer A Highly Technical Option for Price Stability
Another approach similarly employs a financial agreement designed so investors’ can hedge against changes in the bitcoin price, but also frees users from having to depend on a centralised bank-like entity. Rather than a contract being coordinated and enforced by an outside third-party, the contract is created directly between two peers and is then programmatically enforced through the Bitcoin settlement process.
Using native bitcoin transactions does not completely remove counterparty risk from the equation, rather the risks are shifted such that users must trust alternative sources. Specifically, this involves data providers (often called oracles) that publish the BTC/USD exchange rate necessary to accurately settle the agreement, and also the contract itself, which must be properly programmed to deliver the expected results.
We find the scalability of these arrangements are ultimately quite low, even with the emergence of a new proof of concept design. In a scenario of heightened demand, we find the peer-to-peer level coordination necessary to create these contracts would likely limit any highly significant and sustainable adoption levels. While a marketplace that matches potential trading partners would likely enhance its potential to scale, such a coordinating entity would indeed add another degree of counterparty risk.
Stablecoins: The Most Classic Bitcoin Market Tool to Access Dollars
The most common and tenured approach to find stability within bitcoin markets is to purchase an asset designed to remain specifically pegged to the US dollar via custodied reserves. Called stablecoins, these assets operate similarly to physically-backed exchange traded products, where a token is issued, created and redeemed directly with an underlying asset, such as US dollars, or gold.
Contrary to the other methods where an investor’s price exposure is stabilised by trading specific kinds of financial agreements, stablecoins anchor their value to a pool of capital, where each token represents an entitlement claim that is redeemable by its issuer. An example would be USDT, a stablecoin which can be created by depositing US dollars and following certain compliance proceedings (most notably, Know-Your-Customer guidelines) at Tether Inc, we have written about them here. The same then applies when aiming to convert USDT back to US dollars, vice versa.
Here, the potential risks most evidently reside with the issuer of the stablecoins and the custodian of the underlying reserves, however other risks may stem from how such stablecoins are independently stored and transacted. In that sense, investors may also consider the solvency of a certain depository exchange, or the assurances of a certain wallet provider and cryptocurrency platform. Moreover, the scalability of stablecoins has evolved and proven to sufficiently service demand to the tune of over $138 billion in market capitalization for the top projects, as well as $3.95 billion settled daily to their respective host blockchain platforms and $2.05 billion volume traded via spot market BTC pairs.
We find the next phase of evolution for stablecoins may well be the adoption of layered payment rails that enhance the economic capacity of blockchain transactions, such as traditional networks Visa and Paypal, or native networks, like Lightning. We look forward to stablecoins becoming compatible with more scaling technologies in the future, and in the coming weeks will detail a new proposal, Taro, that is designed to do just that atop the Bitcoin network.
There is no Perfect Solution to Finding Stability, Only Trade Offs
Bitcoin may continue to experience significant price volatility, however we also expect it to continue its trend of having a higher Sortino ratio compared to other asset classes, meaning such volatility will be greater when its price is rising as opposed to when it is falling. Additionally, many long-term bitcoin investors may well be correct that these price fluctuations will ease as the market matures, liquidity deepens and speculation levels in general decline. If we continue to see additional populations discover the properties and potential of bitcoin, this is also a likely catalyst for further declines in volatility.
In the meantime however, new and more efficient tools will likely continue to emerge that allow investors to limit their exposure to bitcoin price movements without having to exit bitcoin markets. As it stands today, there are many options for users and speculators alike, each with their own forms of risks and constraints. We close with a chart that aims to sum up these tradeoffs:
