A first take at measuring Bitcoin Volatility

Bitcoin has seen incredible attention from commentators and the general public following spectacular price moves over the previous 12 months. In almost any discussion regarding Bitcoin as viable currency, attention inevitably turns towards its undeniably high volatility. This volatility, in contrast to more widely traded currency pairs, is often provided as evidence that Bitcoin is not and cannot be a currency. Such claims are often unsubstantiated and require closer inspection and data. Our preliminary analysis using major USD Bitcoin exchanges, shows a slight but statistically significant decline in volatility since USD trading began.

Bitcoin Volatility

Classic monetary theory tells us that there are three main uses for money: a medium of exchange, a store of value and a unit of account. While all of these different uses require different attributes of the media used as money, a stable value is essential for the normal functioning of an economy. Indeed as the recent price fall has reminded investors, asset prices rise and fall and hence with high volatility it might not serve as a good store of wealth and even worse as a currency.

The price discovery of Bitcoin has been an interesting journey. There is always wide speculation as to why the Bitcoin price is moving in either direction. News and media hype still probably play a large role but there is some evidence that the volatility is slowly subsiding albeit from a relatively high starting point.

In our analysis we use used data from Bitstamp, MtGox and BTC-e. We analyzed daily price data using a GARCH(1,1) model. We then took the average of the volatility estimates. There are other classes of models that we are looking at to capture the underlying data better. In our next post we will look at the distribution of returns and look at what this means for what model of volatility should be used.

On average Bitcoin is ten times more volatile than the S&P 500 or 15 times more volatile than the EUR:USD corridor. The S&P 500 has a daily volatility of approximately 0.5% and the EUR:USD corridor has a daily volatility of approximately 0.35%. Bitcoin’s daily volatility on average is 5%. Currencies typically have much more stable values to fulfill their purposes demanded by their users. Even the most volatile currency pair ZAR:JPY has a daily volatility of close to 1%.

Bitcoin is however unlike normal fiat currencies. Its inner workings, while transparent, are not well understood and it does not have sophisticated markets to determine its price. It is therefore unsurprising that the road to price discovery is rocky and bumpy. There is plenty instances of asymmetric information as large holders can be owners of Bitcoin businesses and have inside knowledge of the latest regulatory news and other market sensitive information. There are limited routes for people who are willing to short the market to gain exposure limiting the channels of information transmission. Although we remain skeptical about the ability of futures markets to resolve the issue of volatility, Bitcoin may benefit from some of these channels being opened and might lead to a stabilizing effect.

Despite the high volatility of Bitcoin, there are also prolonged periods of lulls in volatility. There are many possible interpretations to such a distribution but it seems like the most conclusive evidence that the price of Bitcoin is informed by new news stories breaking. If all the participants in the market were well informed about the current state of Bitcoin and its course in the near future, the price would not react as much to new news stories. However, large spikes in volatility indicate that the market is reevaluating the price to a large degree on the announcement of new news. The recent price fall on the announcement of new regulation in China is a prime example.

Trend in Volatility

A simple linear probability model shows a decline in the expected volatility of any given day over the past four years from around 9% to approximately 4.5% today. As seen from the chart above, a linear model cannot capture the structure of the data very well but does provide a first look at the trends in volatility that we are observing. As the volatility of the currency remains high we expect many merchants that accept Bitcoin to rapidly convert it back into fiat currencies to avoid the currency risk. Regulators and investors are right to pay close attention to the volatility of Bitcoin and we look forward to continuing our analysis and giving clear measures of the Bitcoin economy.

Postscript: Below are the measures of Volatility across the different exchanges across the different time series: Opening price, High price, Low price and Closing price

Complete Data All Exchanges


Why Bitcoin does not have a market cap

Many tweets and RSS feeds arrive on my monitor every day claiming that the Bitcoin market cap has broken through another big milestone or more recently that the Bitcoin market cap has collapsed. Bitcoin does not really have a market cap, the same way that gold or currencies do not have market caps. Naming the total value of Bitcoins in this way removes people from what Bitcoin was fundamentally designed to be and what it functions as today.

Market capitalisation is defined in Investopedia as

The total dollar market value of all of a company’s outstanding shares. Market capitalization is calculated by multiplying a company’s shares outstanding by the current market price of one share. The investment community uses this figure to determine a company’s size, as opposed to sales or total asset figures.

It is tempting to take the second sentence to mean we should multiply the total number of Bitcoins circulation by the price of an individual Bitcoin and call it the market cap. The similarity between Bitcoin and shares are that they are both scarce. However , shares are not the only scarce items that investors hold, they also hold bonds, commodities and other investment instruments.

Bitcoin was originally intended to be a decentralised payment network where the unit of account was Bitcoin. Perhaps in its original intentions it was not even meant to interact with government issued currencies. Bitcoin, as the unit of account has certain attributes that also made it a currency. In particular, there is divisibility, limited fungibility and well defined property rights which make it theoretically a good store of value. Although, it was not perhaps in the original intentions of the protocol, developers are now creating new protocols that build on top of Bitcoin to provide more complex financial products and alternative use cases. In this way, the Bitcoin blockchain where the unit of account, a Bitcoin, becomes the most fundamental unit of account but there are more platforms and new units built on top. Perhaps eventually transacting on the chain will become a privalege or used for specific services while other transactions will take off the chain in a trusted environment. This resembles our existing financial system in which M1 represents the notes, coins and current accounts. In the United Kingdom, M4 contains: sterling notes and coin; sterling deposits, including certificates of deposit; commercial paper, bonds, FRNs and other instruments of up to and including five years’ original maturity issued by UK MFIs;claims on UK Money Financial Institutions arising from repos (from December 1995);estimated holdings of sterling bank bills and 35% of the sterling inter-MFI difference.

Suffice it to say that the monetary value of broad base money measure M1 captures an estimate of how much basic money that can be used as a store of value and a means of exchange is floating around the economy. Higher orders of money measures capture more complex layers of financial products. While these products have not been built upon Bitcoin, they are under development and we will update our measure of the money supply accordingly. For now we refer to the total dollar value of Bitcoin as M1: The narrow money stock.

Meet the Bitcoin Exchanges

Bitcoin exchanges are the focal point of the commercial landscape. They provide an entry point for adopters and liquidity for speculators to adjust their positions. There are several main exchanges into Bitcoin and the landscape changes often. In the currency’s short history we have had different market structures and behaviours as the currency vies for maturity. Many speculators are familiar with operational issues and failures but despite innovation, the entry and exit into Bitcoin remains a challenge.

In 2010, when there were little transactions being done on the Bitcoin network, Mt. Gox, an exchange that had facilitated trade between previous virtual currencies, offered the first BTC/USD exchange platform. It retained a large market share until it began to lose its monopoly in November 2011. The chart below shows the rise of its two rival exchanges Btc-e and Bitstamp. The market share is calculated using the daily average volume of Bitcoins traded on the exchanges.

Market Share

Market shares have clearly been in flux and so too have the price differentials between the exchanges. Bitcoin has been shown to disobey one of the cardinal rules of economics, the law of one price. When the same product is bought and sold in several markets, the prices in all markets should converge due to arbitrage opportunities. From May 2013 until October 2013, Bitstamp made considerable gains against its competition moving from accounting for less than 20% of the market to over 50% at times during September 2013. During this time, a price differential also opened up rising to a high of about 15% in September 2013. These trends had a common cause, a legal battle which resulted in Mt. Gox suspending all transfers to the USA. On May 15th 2013 , the US Secret Service and Department of Homeland Security seized $5 million in relation to Mt. Gox’s activities. They seized funds from three US bank accounts. Two of which were in the name of Mt. Gox’s US subsidiary and a personal account of the CEO of Mt. Gox. The redemption suspensions have meant that the price on the Japanese Bitcoin exchange trades at a premium to Bitstamp.

In May 2013, Coinlab filed a $75 million lawsuit against Mt. Gox for failure to uphold an agreement signed in 2012. The agreement gave Coinlab exclusive rights to handle Mt. Gox’s North American clients. According to the lawsuit, Mt. Gox never turned over the necessary materials required to facilitate the transition, such as access to client account information. Mt. Gox claims that Coinlab did not fulfill the necessary regulatory requirements. The litigation is on-going. Partially in reaction to the case there is set to be a large proliferation of new exchanges launched in the third quarter of 2013.

Price differentials are interesting and profitable for arbitrageurs but remain challenging and perplexing for users and new adopters. Here at Coinometrics, we seek to bring some clarity in understanding this crucial market and are developing statistics to keep track of new developments. In my next post, I will explore the differences in the exchanges and look through the ways in which obtaining bitcoins on the different exchanges is not a homogenous good and hint at possible explanations for price differentials.

Price Differential