The Ambiguous Case of Bitcoin’s Price

Does it matter how much one bitcoin is currently worth? Usually, opinions regarding this question diverge. This article presents the existing arguments and concludes that – as often is the case – the two positions are, in fact, not describing the same circumstances. Only when these are clear, there is the possibility of comparability.

In short, the two positions are the following.

1) (Current) Price is not important – application of the underlying technology is brilliant that it solves fundamental problems. High prices (and returns) will follow.

2) (Current) Price is important – serves as an indicator of bitcoin’s market penetration. Its strong price volatility is not a good sign.

The argument presented in this article is not a complicated one, however it attaches importance to the role time plays in the emergence of complexity in systems. If a system is complex – such as the markets, intricate feedback loops impeding a clear view on it cannot be ruled out. This means that whenever one analyses such a system, one must not only aim to understand the current state of affairs or status quo, but also how the system has developed over time.

It is crucial to be aware of the implications of complexity, such as nonlinear dynamics, that will certainly exacerbate the analysis.

Nonlinear dynamics is not a difficult concept. Assume one builds a house of ten metres, with a window every metre. If you jump out the first window, the impact of the landing will be negligible for a healthy human. Jumping out of the second may test your joints, tendons, muscles etc. already. A leap out of the third window might be indeed problematic to your overall health as the impact of the fall might negatively affect larger parts of the body. The impact from a fall out of the top floor will be lethal, showcasing the results of the different impacts from various heights. While jumping ten times out of the first window is unproblematic (linear), a single leap out of the tenth-floor window will have lethal impact (nonlinear).

Applied to the case study in question, we must examine to what bitcoin’s price corresponds. In May 2019, a year prior to the next halving, where bitcoin miners, who validate transactions made in bitcoin (something everybody can do), will be rewarded half of what they receive now for successful validations, prices went up. Tech-savvy investors, who understand the underlying technology and the fact that bitcoin has a fixed monetary policy, where first-movers who anticipated the move as this has happened several times before – in reflection of previous halvings. “The Bitcoin block mining reward halves every 210,000 blocks [of validated transaction data], the coin reward will decrease from 12.5 to 6.25 coins”. These blocks of data give the blockchain concept its name.

However, only those who were aware of bitcoin’s mechanisms for artificial scarcity acted first. It is not audacious to assume that speculators reflexively contributed to the price surge in order to benefit from and possibly unknowingly contributing to the momentum. Therefore, saying that all those individuals had the same information available and that they based their decisions on these is possible but not likely.

This was one of the few isolated events in bitcoin’s history that may be used to showcase different narratives for price developments. Another such event was a speech by China’s president Xi Jinping who briefly mentioned blockchain technology as regards plans to introduce a digital version of the Yuan. Xi announced, “[We must] clarify the main direction, increase investment, focus on a number of key core technologies, and accelerate the development of blockchain technology and industrial innovation”. Following this statement, bitcoin’s price surged immediately from US$7500 to US$9890, a 32 percent growth, before settling at around US$9000.

Hence, it appears, a security’s price is not an equilibrium emerging from the agreement of its buyers and sellers, as the ‘Efficient Market Hypothesis’ claims. It is rather the reciprocal interplay of buyers and sellers as determined by their available information and the combination of their available funds and risk appetite. Every investor knows that, primo, the fact that information is available does not imply that an investor is aware of it, secundo, an investor trusts the correctness of the information, and tertio, an investor will act on it, simply because they might not have the liquidity. It is perfectly rational to entre a trade in anticipation of a five percent profit while knowing that a week prior the profit would have been eight percent. Payday can make the difference.

Availability of accurate information – returning to the central theme – is purely random. A security’s price is determined by all factors affecting the security’s reality. Hence claiming that buyers and sellers agree on a price because they say all available information is already priced in is an inaccurate idea from the 20th century. How does one price the quality of information, i.e. if the information is correct?

We might have seen several information-feedback loops and may perceive many more in the future. Attempting to argue their impact on prices is already “priced in” is nonsense. Only if all existing money was in one investment object, we could see the impact of new information. The only exception to this rule are critical junctures that change a system’s entire status quo. And even these paradigm shifts could make a price appear stable, even though the reasons for why a price is where it is may be absolutely new ones.

The randomness of the reasons of prices is not be underestimated. This brings us back to the beginning. The current price of one bitcoin isolated from its developments cannot tell us much. However, its volatility, which is the degree of variation of a trading price series over time, shows us that it currently a lot of information is being processed. This enables economists to rethink their theories of efficient markets and will contribute to a better understanding of future market behaviour.

Author: Patrick Lehner