Viewpoint | Bitcoin Volatility Misunderstanding: Volatility does not mean that it cannot be a good means of storing value

Noelle Acheson is a veteran of corporate analytics and a research director at CoinDesk. The opinions expressed in this article are all personal opinions of the author.

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Most of us think that we understand the term "fluctuation."

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We absorb news headlines from the tense political situation around the world; we are wary of explosives; some of us have experienced ups and downs.

“Flucency” refers to dramatic and unpredictable changes that often have a negative meaning. Even in financial markets, we instinctively avoid investments that cause violent wealth.

But in the financial sector, volatility is often misunderstood. Even the most commonly accepted calculation methods are often mistakenly applied.

The desirability of volatility is also confusing. Investors hate it unless it allows them to make money. Traders like it unless it means a high risk premium.

Few of us know where it comes from. Many people think that volatility is the result of low liquidity. This makes sense intuitively: in the case of small transactions, large orders can push up or drive down prices. But empirical research shows that the opposite is true: volatility leads to low liquidity, and through wider spreads, market makers use it to compensate for the additional risk of holding volatility assets in their positions.

(The misunderstanding that volatility is the result of low liquidity also stems from our erroneous conflation of low liquidity with low trading volume – high volume and low liquidity are possible, but this is another problem.)

This confusion also exists in the field of encryption.

The volatility of Bitcoin is often cited as the reason why it can never be a good value storage tool, a reliable payment token or a reliable portfolio hedging tool. Many of us are caught in a trap: As the market matures, volatility will fall. This leads us to believe in use cases that may never be appropriate; it can also lead us to use the wrong cryptographic asset valuation methods, portfolio weights, and derivatives strategies, which can have a significant impact on our bottom line.

Therefore, it is necessary to sort out some assumptions and see why the unique characteristics of Bitcoin can help us understand the fundamentals of the market more broadly.

Uncertainty of change

First, there are different types of market volatility. The academic literature provides a range of variants, each with its own unique formula and limitations. The Jump-diffusion model used to assess the value of an asset implies a beneficial differentiation. As its name implies, "jumping" fluctuations are caused by unexpected events. However, “diffusion” volatility is part of the standard trading model of assets, ie “normal” volatility.

With this, we can begin to see that when we assume that increased liquidity will curb price volatility, we are talking about “jumping” volatility.

However, “diffusion” volatility is a more intrinsic concept.

Standard Deviation Calculations—the most commonly used measure of volatility—includes the destabilizing effects of violent fluctuations by using the square of large deviations (otherwise they may be offset and masked by small deviations). But this exaggerates the impact of outliers, which are often the result of "jumping" fluctuations. As the volume of transactions increases, these fluctuations may decrease, resulting in a misleading downward-sloping volatility curve.

JP Koning proposed another calculation method that uses deviations from the median rather than the mean, which reduces the effect of outliers and shows a more intrinsic measure of volatility. As shown in the table below, this ratio has not decreased significantly over the years.

Now let's see why this is happening. One of these methods is used to evaluate bitcoin.

Basic value

Bitcoin is one of the few "physical assets" on the market today because its value is not derived from another asset.

More importantly, it is a “physical asset” with no obvious income stream. This makes it difficult to value. Even junior analysts can calculate the “fair value” of an asset that can be stripped from the cash flow or a certain return at the end of life. Bitcoin has no cash flow and no "end of life", let alone an identifiable value.

So, what is driving the value of Bitcoin?

Many theories have been proposed, some of which are described in our report "New Basis for Cryptographic Money." As the market develops, some theories may be sought after, while others will be forgotten or replaced.

However, for now, the main driver of Bitcoin's value is popularity: its value is consistent with what the market believes its value. In the absence of fundamentals, investors try to figure out what other investors will think. Keynes compared this to a competition in which "we put our wisdom into predicting the general opinion's expectations for ordinary opinions."

Gold is also in a similar situation because it is also a kind of “physical assets” with no income stream, and market value is mainly driven by market sentiment.

So why is the volatility of gold much lower?

Bitcoin one year volatility

Because of "fundamental uncertainty."

Changing story

In his book The End of Alchemy, Mervyn King explains that under “fundamental uncertainty,” market prices are not determined by fundamentals, but by The description of the fundamentals is determined.

Bitcoin is a new technology, so we don't know its end use. Everyone has their own theory, but like all new technologies, no one can be sure, which makes its narrative change.

On the other hand, gold is neither a new technology nor a technology. It has existed for thousands of years and its narrative is not uncertain. Market sentiment plays an important role in its valuation, and scientists may also discover the innovative use of this metal that affects demand and price. But its "story" has been well established, which makes it less volatile.

For now, the fundamentals of Bitcoin are its story, and the uncertainty of the bitcoin “story” means that its volatility is unlikely to weaken in the short term.

More important role

This is important for the ultimate use case of Bitcoin: Is Bitcoin always too unstable to be used for payment tokens, value storage, etc? This in turn affects its narrative, which affects its valuation and volatility, which in turn affects its end use case. As the industry matures and Bitcoin becomes more stable as an alternative asset class – this cycle of self-sustainment will eventually be broken when uncertainty decreases and its “intrinsic value” becomes easier to quantify. .

But before that, its price will continue to be driven by market sentiment. Market sentiment is easily affected by global developments and changes in market sentiment.

Until then, regardless of the volume of the transaction, market changes will continue to expand in either direction.

Instead of worrying about it, we should accept and even embrace it. More and more mature suppliers are working to improve the acquisition and interpretation of emotional data, which strengthens our analytical tools. Crypto Twitter provides a fascinating platform to measure the mood of the industry. The identification of the impact of narratives and emotions on an asset class will open up new sources of investigation that may spread to other areas of investment.

More importantly, fluctuations may be inconvenient for some people and may be uncomfortable for many people. But this is also an important part of high returns. Perhaps the tools and skills we developed to improve bitcoin valuation techniques will enable us to be more proficient in dealing with the inherent uncertainties of volatility and give us a deeper understanding of the value it provides.

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