The BBC is having a really hard time keeping up with its headlines. For the past two days, they’ve had to continually the title of their “Bitcoin breaks through the $1X,000 mark” piece, because Bitcoin has broken through the $13,000, $14,000, $15,0000, $16,000 and (now) $17,000 marks. To the point where we probably can stop talking about ‘marks’. But all the attention gives me a chance to talk about Bitcoin’s hyperdeflation, which is becoming a thing. And its potential disruption by the futures market.
I’m sure you’re all familiar by now with variations of the following tweet:
Having lived through a hyperinflation, this looks and feels like a hyperinflation.
And that’s actually a narrative that I hear coming from Bitcoiners: “This isn’t a story about Bitcoin – this is a story about the US dollar”.
The implied US dollar inflation
If you’re to buy into that, here are the Bitcoin implied annual inflation rates of the US dollar:
The last few hours of Bitcoin prices have rendered Microsoft Excel speechless (although those are mostly exchange-related glitches – the $17,000 mark was the last true ‘breakthrough’ at the time of writing).
But going back to the US dollar’s apparent hyperinflation – obviously, that is nonsensical. If the US dollar really was hyperinflating at those levels:
- ALL prices would be going up; and
- (more realistically) no one would be using it.
That is, we would collectively have said (some time ago):
“The US dollar is no longer money – we will no longer use or accept it as a medium of exchange – let’s use the Chinese yuan, or gold, or petrol coupons, instead.”
But we haven’t done that. In fact, real world US inflation is quite low. And the price that’s really ‘inflating’ is Bitcoin.
And if we are going to insist on calling Bitcoin a ‘currency’, then we should also acknowledge that it’s a currency in hyperdeflation.
Hyperdeflation v Hyperinflation
If currency hyperinflation is a loss of value at a rate of more than 50% per month for two consecutive months (that’s the official-ish academic definition), then perhaps currency hyperdeflation should be a gain in value of more than 50% per month in two consecutive months.
When I look at the price charts, Bitcoin’s latest episode of hyperdeflation began in September 2017. And we’re four months in.
But in both cases, the ‘moneyness’ of the currency is lost:
- During hyperinflation, people stop accepting the hyperinflating currency as a medium of exchange because it keeps losing value (and at an accelerating rate).
- During hyperdeflation, people won’t use the hyperdeflating currency as a medium of exchange because it keeps gaining value (and at an accelerating rate).
That is, to use the famous Bitcoin pizza example:
- During hyperinflation, the pizzeria would not allow you to pay for your pizza in the hyperinflating currency; and
- During hyperdeflation, you would rather forgo the pizza than exchange your Bitcoin for it.
So how does this “hyperdeflation” happen?
Suggestion: if hyperinflation is caused by too much of a currency floating around, then is hyperdeflation a shortage?
We know that there are an incredibly finite number of Bitcoins in the world. And that the code is releasing them ever more slowly onto the market. At the same time, the market for Bitcoin is growing:
But I think that this is more important:
Because of early adoption and the ‘cultish’ nature of Bitcoin, there is a very high level of wealth concentration. That is: a massive amount of the ‘available’ bitcoins are held by a small number of addresses. Which means that their decision to sell or not sell their bitcoins has a massive influence on the supply of bitcoins for sale.
And they probably didn’t accumulate their bitcoins by selling them all the time. Those massive holdings look like long-term holds to me.
What do the trading charts say?
Now bear with me while I get a bit technical. One of the questions that I’ve been asking for a really long time is “Why is the Bitcoin price going up while the trading volume is going down?”
Until the end of last year, there was a massive amount of Bitcoin trade taking place in China. Here is the breakdown of trades by exchange for the last two years:
Okcoin, BTCChina and Huobi are all Chinese exchanges. And here is a price graph from Okcoin:
Do you notice how the trading volumes drop off toward the end of 2016? That seems to have happened on all the Chinese exchanges. After which, the price began to spiral.
Which is weird.
Here is the exchange situation since:
Bitfinex is suddenly the largest exchange. And this is their price/volume chart:
Now Bitfinex has had some volume increase – but it is nothing compared to the volume drop-off that took place. Those Chinese exchanges have essentially disappeared from the Bitcoin trading scene.
A Hyperdeflation Spiral
So here is a narrative for you:
- In 2016, there was a sudden surge of interest in Bitcoin – mainly in China. Where almost all of the world’s Bitcoin mining takes place.
- The Chinese are very active traders, and they bought and sold Bitcoin a lot.
- This trading activity caught people’s attention – up to then, Bitcoin was a bit of a ‘niche’ market, despite already having had its first bubble.
- The trading activity also caught the attention of the Chinese authorities, who moved to slow the Bitcoin-trades by essentially blocking Chinese banks from transacting with the exchanges.
- So the trading volume dropped substantially – because the ‘market-makers’ for all those small Bitcoin trades could no longer access the exchanges.
- This left the Bitcoin market with:
- Lots of interest on the buy side; and
- Long-term Bitcoin investors on the sell-side.
- When you have more buyers than sellers in the market, buyers bid up the price.
- So the Bitcoin price started to rise.
- At this point, I might mention that people started to write about Tether and Bitcoin margin trading and all the market manipulation shenanigans that were happening in these unregulated waters. Me included. Let me strongly self-promote that Tether post again.
- But Tether and the margin-trading did nothing to solve the supply-side of the Bitcoin market – those just amplified the demand. And if it happened the way that people think it did, then there’s a version of money creation on the other side of this hyperdeflation (which seems quite apt).
- This now becomes a bit of a spiral:
- The people holding Bitcoin see the price going up, so they hold off on selling them – and even buy more.
- This further decreases the number of available Bitcoins for sale.
- This increases the price.
- This attracts media attention, and more buy-side attention.
- The people that just bought Bitcoin at the higher price see the price continuing to go up, so they hold off on selling them – and even buy more).
- This further decreases the number of available Bitcoins for sale.
- This increases the price.
- This attracts more media attention, and even more buy-side attention.
- Repeat.
I mean – you can also call this a pricing bubble (I have before). But this one has some peculiarities:
- Pricing bubbles normally have some kind of leverage or credit involved – and there does not seem to be too much of that here (at least, not overtly).
- There is an almost religious fanaticism when it comes to Bitcoin. And movements filled with zealous fanatics seem to have their own kind of momentum.
But is the game about to change?
We’re days away from the launch of Bitcoin futures contracts by the Chicago exchanges CME Group and CBOE Global Markets.
I’m not sure if these will be successful. Although my bet is if there was no market for them, then there would not be such a push for them.
But the game-changing part: if successful, the futures contracts will allow Bitcoin trading to de-link from the underlying Bitcoin supply. Even if only partially.
And if the Bitcoin price is being driven by a shortage of Bitcoin – then what will a sudden influx of Bitcoin futures do to it?
I’m just going to end on that cliffhanger.
Because I don’t have an answer. I guess we’ll find out fairly soon.
And until then, I imagine that we’ll be hitting more marks. And BBC will frantically be updating its Bitcoin articles.
Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha. Also, check out the RA podcast on iTunes: The Story of Money.
Comments
Somebody December 10, 2017 at 22:57
A lot of large wallets are exchange wallets. They stash all their bitcoins into one or few wallets and credit their users separately on their platform.
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