Bitcoin Box

A magazine dedicated to all things Bitcoin


The Calm After The Storm

author: Vitalik Buterin
published: 2011-07-05 22:08:00 UTC

After the recent upheavals that have shaken the Bitcoin economy, both technical and financial, the main question that is on people's minds now is: what now? The majority of the new entrants to Bitcoin have seen the price go from $9 to $30 to $11, and is now floating around between $14 and $17. There have been no new upheavals and very little news in general since MtGox went back up and prices have stabilized at their current levels. The general mood is one of a surreal boredom: at the beginning of June, the two most common sentiments were that Bitcoin was going to take over the world over the summer and that Bitcoin would crash into nothingness. However, the result is one exactly in the middle, and this extreme excitement has nowhere to go. The Bitcoin marketplace forums filled up with gambling games and pyramid schemes to the point that a specialized subforum had to be created for the express purpose. Bitcoin as a short term get-rich-quick scheme, although it is almost certainly not dead, seems to be dormant, but Bitcoin as a community is very much alive.

First, let us look at some data, in a style similar to my previous analysis here.

Google Trends data is also worth examining. The conclusions we can draw from this are:

  1. The correlation between google search volume and the price of bitcoin, that I talked about in my previous analyses, still holds.
  2. The news volume for Bitcoin has dropped to near zero, however the forum activity not suffer a similar drop, and in fact, disregarding the June 20 peak, which was caused by the technical situation at MtGox, it dropped relatively slightly. The Bitcoin users gained in June have stayed with Bitcoin, which further validates the theory that Bitcoin prices are dominated not by large institutional speculators but by geunine public interest in Bitcoin not only as a speculative investment, but also as a currency.
  3. Search volume in Bitcoin is very strongly correlated with the number of new Bitcoin forum users, and this correlation has continued unchanged during the early June boom, where most media coverage was positive, and the latter half of June, with much news coverage from print magazines switching to a more negative tone. The more negative nature of the news does not seem to be having much of an effect on adoption. All in all, this suggests the idea that, from a short term point of view, "any publicity is good publicity".

Secondly, it is important to look at the Bitcoin price. The trading volume has decreased from the massive values seen in mid-June, with the all-time high of 220,000 BTC traded in one day, but it has decreased only to about 30,000 BTC per day, far higher than previous periods of stability. The market depth has also roughly doubled from what one was accustomed to see before the crash, confirming the significance of this observation. The amount of BTC traded should not depend on the number of Bitcoin traders in existence, since the same 6 million BTC are in circulation no matter how many people they are split between, so the increase in volume, in fact, logically points to one conclusion: that the number of bitcoins in circulation has increased by a factor of at least two. The number of bitcoins in existence has only increased by a small amount in this period, so this implies that the June upheaval has caused a number of people to cash out, dealing a substantial blow to the strength of the early adopter aristocracy.

The psychological impact of the situation is worth analyzing. During the April-June deflationary period many held on to their coins since they could be worth ten times as much in a month. This was a common sentiment, but it is worth examining it in detail. If someone had a bitcoin worth $6 and did not spend it for this reason, then that implies that they saw that bitcoin as having an expected future value far above $6. But if this is the case, then why would that person not put a significant portion of their life savings into Bitcoin as well?

The answer is, in fact, twofold. First, there is the psychology of risk - the desire to avoid losses is much stronger than the desire to acquire gains, and putting more money into BTC increases the possibility that money will be lost, while taking existing BTC out increases the possibility that money will be "lost" because the trader will have missed out on a price jump. Secondly, there is the difficulty of converting conventional currency into Bitcoin - in the three days that the process takes, the entire situation could reverse itself. However, this risk is asymmetrical - while it takes three days to convert conventional currency into BTC, converting BTC into conventional currency is virtually instant - it's only getting the money out that takes three days, and during this time the money is secure against sudden BTC price changes.

In the current more level economy, the desire to hold on to one's coins is weaker, and, therefore, the desire to cash out is stronger. But there is no desire to cash out to avoid a sudden decline in prices; the desire to cash out stems from a need to realize one's gains. Here, however, there are two categories of people: first of all, there are the early investors, who see the ceiling of $17 as a good time to cash out into USD and realize a profit of over 2000% from the pre-April rates. However, there is a second group: a large number of Bitcoin users are very new, and bought in at values above $10, or even above $18, so taking out bitcoins now would in fact constitute conceding a loss. This instance of the sunk cost fallacy is important: even though it should not matter at what price the bitcoins were bought, the emotional satisfaction of having secured a 2000% profit drives some to cash out, while the pain of admitting a 40% loss forces some to stay in. The people not interested in cashing out USD and are either interested in sticking out for the long haul or in spending BTC to buy products and services. However, buying a product that can be found just as easily for USD is arguably psychologically equivalent to buying USD, so this category of people can be reached by the possibility of buying goods and services available for BTC only (eg. the original Bitcoin pride T-shirt). The prevalence of Bitcoin forum gambling - a service not available for conventional currency - can be presented as evidence of this theory. To take advantage of this, it would make sense for Bitcoin stores to focus not on competing with existing online and physical businesses, but in delivering unique products - establishing brands that can only be bought with BTC. The allure of Bitcoin, as I argued previously here, is in the informal and the personal.

The relatively level Bitcoin market has two positive results: first, stability negates the relative safety of cashing out versus buying in, so it pushes the price up through reduced supply and increased demand, and, secondly, the perceived value of Bitcoins is now less in their short-term speculative potential and more in their use value, ie. the products that can be bought for them. However, there is the negative result that early investors are more likely to feel that it is time to cash out. We may see a battle between the upward force and the downward force for some time.

For as long as the relative stability remains, the stabilization of Bitcoin prices represents the economy's best chance to develop and grow: it is possible that bitcoin-based stores, of which there are now quite a few, will see increased demand for their products. Bitcoin jobs are, unfortunately, hard to find, so the main way most people have of using Bitcoin long term is by buying BTC for conventional currency in large quantities and then using it a bit at a time to buy products and services. This is the only way that Bitcoin will grow in the direction of being a competitor to Paypal and the like. For this to work, however, Bitcoin must also function as a stable source of value, and it finally has the chance to do so. If Bitcoin's price remains stable, and if consumers are willing to spend more and producers are willing to create goods that give Bitcoin unique value, we may finally see it succeeding in the way it was originally intended to - as a medium of exchange.

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