Speculative buying can drive cryptocurrency prices down. This is contrary to the usual laws of economics. Blockchain technology limits how quickly transactions can be settled. This constraint creates competition for priority between different users. The more speculative activity there is, the longer it takes to make a payment. But the future value of cryptocurrency depends on its usefulness as a means of payment. Speculation therefore affects price formation through a channel that does not exist for other asset classes. This can explain the high price volatility of cryptocurrencies, and is consistent with the low adoption rate so far.
During 2017, there was a surge in cryptocurrency speculation. The price of bitcoin rose from around $1,000 in January 2017, to a peak of almost $20,000 in December. This trading led to congestion in the system. The resulting delays caused problems. In January 2018, Microsoft had to temporarily stop accepting bitcoin on its online store. Dark web users have switched away from bitcoin to alternative cryptocurrencies, partly due to long settlement times. And, in January 2018, a major Bitcoin conference stopped accepting bitcoin payments for its tickets. This problem is not limited to Bitcoin: a popular online trading game called Cryptokitties led to congestion on the Ethereum platform in December 2017.
Congestion occurs because the blockchain – a list of all transactions that have settled – has limited capacity. For example, Bitcoin allows for a maximum of only around 7 transactions per second. This makes it a more limited payments system than, say, Visa or Mastercard, which each handle thousands per second.
The chart below shows a close association between trading activity and demand for space. Cryptocurrency users can bid for blockchain space by paying a fee to miners. The speculative surge in 2017 coincided with an increase in the fees paid for bitcoin payments. On Christmas Eve 2017, the average fee paid was equivalent to $162. You would not have used this to buy a cup of coffee!
Limited blockchain space means different users of the cryptocurrency have to compete for priority. If more people are trying to acquire cryptocurrency for speculative purposes, then it is more difficult for others to use it as a means of payment.
What does this mean for the price of cryptocurrency? Cryptocurrency has no fundamental value. If you hold a coin that nobody else will ever accept for payment then, ultimately, it is worthless. People speculate on cryptocurrency because they expect it to be adopted as a means of payment, or because they expect to sell it to someone who believes adoption will occur. But the act of speculation makes it harder for adoption to happen. All else equal, an increase in the number of speculators drives the price down, even if they are buying. This is contrary to the usual laws of economics! Normally, we would expect more buy-side trading to increase the price of an asset. My accompanying paper presents a model to formally demonstrate this result.
Bitcoin daily exchange volume (LHS) and mean fee per transaction in US dollars (RHS), 3 December 2011 – 30 September 2019. Data are from blockchain.info and are plotted in log-scale, daily over a 30-day backward-looking moving average.
Blockchain congestion may explain why cryptocurrencies have such high price volatility. Typically, the price on an exchange is set by a market maker or liquidity provider. She bases the price on her beliefs about how well cryptocurrency works as a means of payment. An investment in cryptocurrency is like a fairly-priced lottery. When there is less blockchain capacity, or more speculative activity, the cryptocurrency becomes a worse form of payment. The odds of the lottery get longer, so cryptocurrency becomes a riskier investment.
There are other potential explanations for high volatility, such as the fixed supply of coins, instability in the platform, or market manipulation. I do not reject any of these other explanations, but none of them are specific to blockchain technology. My research suggests cryptocurrencies are different from other assets, and high volatility may be an inherent feature.
Why do cryptocurrencies have limited capacity?
Constrained settlement capacity is a characteristic of any truly decentralised cryptocurrency. By design, a cryptocurrency does not rely on any single authority to maintain the list of payments that have occurred. Instead, there is a large number of agents around the world, called nodes, who maintain individual copies of this list. If at least half of the nodes agree on the state of this list, then this can be considered the definitive version of the blockchain. Thus, a technological limiting factor is the speed at which nodes can communicate with one another. If blocks are too big, or arrive too quickly, then nodes may disagree with one another. This would undermine the ability of the cryptocurrency to reliably record transactions, rendering it less useful as money.
A smaller block size also reduces the cost of becoming a miner. This can encourage participation, and help to make the network more secure. Proposals have been made to adjust Bitcoin’s core code and increase blockchain capacity, but it is difficult to achieve the required consensus among the developer community.
Fear of a block planet
My results provide a reason why cryptocurrencies have not yet been widely adopted as a means of payment. If speculators believe that adoption will happen in future, they buy cryptocurrency. This takes up blockchain space and hampers usage. Therefore, adoption is slower than we might otherwise expect. But, over the long-term, trading profits may dry up, as the value of the platform becomes apparent. At this point, speculative activity falls, and the cryptocurrency can be used as a means of payment. This suggests two possible phases of development:
- An initial hype phase: Little adoption and lots of speculative activity. Prices are volatile. Blockchain space is mostly taken up by speculative trading.
- A subsequent adoption phase: The cryptocurrency begins to be adopted widely as a payments instrument. Prices stabilise at a high level. Blockchain space is mostly taken up by payments usage.
So far, we have seen the hype phase, with feverish speculation out of all proportion to the actual use of cryptocurrency as a monetary instrument. Some commentators claim the lack of adoption is evidence of a bubble. But I argue it may actually be consistent with rational speculation on a potential future monetary instrument. A future adoption phase is therefore possible. Roy Amara’s law states that the impact of technological innovations are often overestimated in the short-term, and underestimated in the long-term. For blockchain technology, overestimation today pushes that long-term horizon further out into the future.
Nothing to lose but your chains
Congestion could be improved by reducing demand for blockchain space. Traders use blockchain space to move their coins off the exchange and into their own wallets. They may need to do this if they wish to spend the coins on real goods and services, or move coins between different exchanges. The landscape for cryptocurrency trading is highly fragmented with many exchanges: consolidation would decrease the demand for blockchain space and improve the efficiency of the payments system.
Cash-settled derivatives markets allow for true off-chain speculation. These let agents bet on future movements in cryptocurrency prices, without needing to trade the underlying coin and take up blockchain space. Currently, cash-settled Bitcoin futures markets can be traded on the CME, but the total value of contracts traded remains small relative to the size of the Bitcoin spot market. Other proposed solutions, such as the Lightning Network may allow for more payments to be settled. My results relate to decentralised cryptocurrencies, and not to other asset classes, because of two distinctive features. First, limited blockchain capacity means that there is competition between speculative and transactional uses of the asset. Second, the value of the asset is determined by the extent to which it is used as a means of payment, rather than by fundamental cash flows. Until speculation can be moved entirely off-chain, these effects will persist, and cryptocurrency prices will remain volatile.
Peter Zimmerman works in the Bank’s Global Analysis Division.
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