The first time that I heard about BTC was back in March 2017. I began to study this new technology and I was stunned by the inefficiencies and the lack of information that there was at that time. The best place to get some relevant information was the bitcointalk forum. It took me a while to understand what BTC and Blockchain technology were. After having read the Satoshi white paper I said to myself: “this is true financial freedom, cryptocurrency is the way to go if you want to live free from stupid political decisions or country specific policies.” Upon graduating, I started trading BTC on July 2017. I found many short-comings in the market and began to wonder why is that. For instance, why there are exchanges with very different BTC prices? This isn’t something that you find on conventional fiat money. Also, why is BTC so painfully volatile? What are the dynamics behind this behavior? Well, let’s find out.
First, we must understand why fiat money is more stable. Fiat money works -more or less- like this: a country’s central bank prints the money. The major banks of the country, borrow that money from the central bank with an interest rate set by the central bank. Subsequently, these banks lend the money to the rest of the world, namely companies or individuals. In order to make a profit, they lend the money at a bigger interest rate than the one that they borrowed it. The central bank is the only entity that controls the money supply and increases it or decreases it according to the current economic situation or country’s policy. As everyone in the country is obliged to use this currency to make purchases and given the fact that the only supplier of that “piece of paper” is one single entity, it has the power to control the price of the currency in respect with other currencies. It is the central bank’s job, to stabilize the price of their currency in respect with other currencies which are being used by other countries. This is why fiat money is considered stable in most cases. Of course, as the latest examples of Venezuela and Turkey have shown, this is not always the case.
Now let’s see how a cryptocurrency like Bitcoin works. Bitcoin is a digital-only currency that can be produced by every individual in the world, just by running a computer program (this process is called mining). It’s being governed by a proof of work consensus algorithm in order to prevent malicious users from corrupting it. Think about this consensus algorithm like our conventional financial laws. In order to prevent inflation, there is a maximum number of bitcoins that will ever be produced (21 million). Every 10 minutes a “miner” that finds a solution in a difficult mathematical problem, gets rewarded with newly created bitcoins (or fractions of them). If more people are trying to solve the problem, the problem gets more difficult to be solved. The reverse is also true. As there is no law in any country compelling us to use bitcoin in our everyday life, no one is obliged to use it. This means that people will use bitcoin only if they want to.
As a result, we have a currency that can be produced by everyone and can be used by anyone, but no one forces anyone to use it. This creates different dynamics than in the case of fiat money. Every fiat currency starts with a huge network effect which is being created by force. Every person in the country demands the currency but the supply is filled only from one place, the central bank. This is not true with cryptocurrency like bitcoin. In the beginning no one will use it, there will be huge supply but low demand. Thus, the price will be very low, with a wide spread between buyers and sellers because there is no interest acquiring it. When more people are willing to use it, the demand will increase but the supply will always have a limit, because the reward that people get when mining it, is fixed. If the new users are satisfied by this new currency, more and more people will start accepting it and use it, resulting to increased prices and more users. If for any reason something bad happened to the bitcoin network, some users will start selling it, being afraid that less people will start using it. This will decrease prices and people will not use it anymore. But as every year that Bitcoin network stays alive, it sends a message to the world, that the network is strong despite any bad news or difficulties. This way, Bitcoin network builds among its loyal users, attracting new ones and thus, creating a virtual floor to the price. This process is time consuming and volatile in nature.
Another dynamic that exists in the cryptocurrency universe is that most cryptocurrencies are global and not country based. This is not the case for fiat money. All the fiat currencies are country based and can be used only in the specific country. You cannot buy 1 kilo of tomatoes in Germany using USD. Also, every country has different standards of living related to the wealth that it produces. For example, in Bulgaria you can live with 500 euros per month, but in Germany you need at least 2000 euros to follow the same life style. One more thing that we need to consider is that every country has its own restrictions in respect to money transmitting abroad. All of these factors, can create a country specific price anomaly. Let’s see an example: in order to obtain a cryptocurrency you need either to mine it or buy it in exchange of a fiat currency. If you live in China and you have only a domestic bank account, you can send abroad only 100,000 RMB per year. What if you want to buy 200,000 RMB worth of Bitcoin? You can do that only by finding a seller that lives in China. But as the same restriction applies to every Chinese citizen, the demand will be much greater than the supply. This means that Bitcoin prices will be much greater in China than in the rest of the world. There are more than 195 countries in the world, with many different laws in respect with money transmitting. A change of a law in one country can create a supply-demand discrepancy at any time.
Also let’s not forget that, even if cryptocurrency market is a global market, it is relatively new and small in respect with the Forex markets which have powerful entities that support them (governments). Let’s take Bitcoin for example, which is the biggest cryptocurrency in market capitalization. Right now it stands at 120 billion dollars market cap, with a daily trading volume of max 2 billion. This is just a tiny fraction of what a fiat currency like USD has in market capitalization and daily trading volume. If for example, a big hedge fund wants to buy 100 million worth of bitcoins (which is a normal number for a hedge fund), imagine the impact that will have in the bitcoin prices, just because one entity wants to buy this amount of bitcoins. It will create a huge spike in the bitcoin price, which will increase the volatility of the asset. The same amount in the EUR/USD market will have no impact to the price, because the EUR/USD market is extremely bigger than the BTC/USD .
These are some of the reasons why a cryptocurrency like Bitcoin is so volatile and has so many different prices.
Does this new currency system provide extra opportunities than the fiat system? What a person can do in order to profit from that system?
In a fiat currency system, the power of printing and controlling the currency is centralized and run by one entity. As a result, the average person cannot play an important role. There are only 2 things that one can do in order to be part of the system and profit from it:
Trade a chosen currency pair and try to predict where the price will go in order to profit from a price appreciation/depreciation.
- Try to profit from a carry trade. Carry trade is a trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. This way the person that makes this kind of trade can make a profit just by holding the high interest rate currency and collect the difference (spread) of the interest rates.
As the cryptocurrency system is decentralized, no one has a complete power over it. This means that the average person can play an important role. Here are a few things that one can do in order to be part of the system and profit from it:
Choose a currency pair to trade and try to predict where the price will go in order to profit from a price appreciation/depreciation.
Mine a cryptocurrency (become a central bank). This way the cryptocurrency network becomes more stable.
Market making. This way the person provides liquidity to the market and creates price stability. This is now possible because there is no entity that has any privileged place in the system. Every participant is equal to the other.
Arbitraging country-specific price discrepancies. The person can profit from the price differences of a cryptocurrency, because of a country-specific restrictions (like in the China example above). Buy a cryptocurrency from a person in a country that doesn’t have any restrictions or sell cryptocurrencies to a person of a country with restrictions. This is now possible because a cryptocurrency is a global system with no borders. This type of activity creates price stability.
In conclusion, the cryptocurrency system creates promising incentives in order to attract many participants. These new ”jobs” that this system creates, are getting filled by curious people who want to get involved, explore new ideas and become successful through the process. While trying to create a robust system that works, these people are getting payed in order to try harder to strengthen it. In the fiat currency system, these jobs are not within reach to the average person.
These incentives are just the basic ones in the cryptocurrency universe. Because of these, I believe that a cryptocurrency system can be more robust and secure than the fiat counterpart. This new system needs time to mature and become comparable with a fiat one. Only time will tell if this system will succeed at creating a more free world.