Price Volatility Versus Systemic Volatility

Bitcoin’s price swung wildly this week, causing many to conclude Bitcoin is unstable. But this conclusion misses a key nuance: Bitcoin was designed for systemic stability, not for price stability. Indeed, as a system Bitcoin is highly stable even though its price may not be. Bitcoin is the opposite of fiat currencies, which generally exhibit price-stability but are susceptible to periodic bouts of financial system instability. By extension, stablecoins that track fiat currencies, such as Facebook’s new cryptocurrency (Libra), fall into the same category as fiat currencies—they’re designed for price stability, not systemic stability, and are exposed to the same risk of periodic instability of traditional financial systems.

Can a monetary system be both price-stable and systemically-stable? Probably not, and here’s why.

The real world isn’t stable. Unpredictable events happen. Consequently, demand for money is inherently unstable too, influenced by factors such as earthquakes, droughts, hurricanes, technology break-throughs, the sudden discovery of large oil/mineral reserves, tax/tariff/regulatory changes, population trends and even simple seasonality. To cajole price stability within fiat currency systems, central bankers counteract these demand fluctuations by intervening in markets—in an attempt to steer the economy to perform within a target rate of price inflation, a currency peg or interest rates.

But remember—demand for money isn’t stable. Central bankers manufacture the price stability of fiat currencies by interfering with natural market processes. Their actions can eventually lead to systemic instability. But hold that thought.

Bitcoin as a System: Designed for Systemic Stability, Not Price Stability

Bitcoin, by contrast, is a system that prioritizes security over price stability. Bitcoin’s systemic stability stems from the security of its network. This week, as Bitcoin’s price volatility was capturing headlines, I was watching core Bitcoiners get excited about something else entirely—the network’s hash power hit an all-time high, and its “difficulty” also adjusted to an all-time high.

Translation: Bitcoin’s network security hit at an all-time high.

Hash power is defined as the processing power of the Bitcoin network to perform calculations necessary to confirm transactions. The higher the hash power, the more secure Bitcoin becomes—i.e., the more immune it is to attack, simply because (by design) the cost to amass enough hash power to attack the network far exceeds the gain from doing so. Bitcoin is almost certainly the most secure computer system ever created, mostly due to the staggering size of its hash power. The Bitcoin network hit a high of 66.7 quintillion hashes per second (66.7 exahashes/second) on June 22—it’s hard to convey just how powerful that is because it’s not directly comparable to supercomputers, owing to the specialized nature of chips used in the Bitcoin network, but it’s safe to conclude it still dwarfs the world’s top 500 supercomputers, combined. The size of Bitcoin’s hash power is one reason why it has survived every attack thrown at it to date, and its hash power continues to grow. What happens when additional hash power is added to the Bitcoin network? Answer: the network becomes more secure. That’s it. Adding more resources does not—cannot—create more Bitcoin. Why? Because (1) Bitcoin’s supply is fixed by algorithm and (2) the protocol’s “difficulty adjustment” automatically kicks in when more hash power enters the network, to ensure that a new block is added to the blockchain every 10 minutes, on average. 

“Difficulty adjustment is the most reliable technology for making hard money and limiting the stock-to-flow ratio from rising, and it makes Bitcoin fundamentally different from every other money (emphasis added),” wrote Saifedean Ammous wrote in his book, The Bitcoin Standard.

While investing more resources in gold mining causes more supply of gold to come online, that’s not the case with Bitcoin. More computer resources simply create more security, not more supply. 

So, Bitcoin has a virtuous cycle that fiat currencies don’t have. As Bitcoin’s price goes up, more hash power joins the network. As more hash power joins the network, the network’s security hardens. Bitcoin becomes more immune to attack—more systemically stable. (Of course, the reverse is true as well—a vicious cycle could occur whereby Bitcoin becomes less secure as hash power exits the network. But even though the Bitcoin network lost hash power during the “crypto winter” of 2018-19, the loss of hash power negated only the prior four months of hash power growth and didn’t remotely come close to rendering Bitcoin systemically insecure. When hash power leaves the network, the difficulty adjustment adjusts downward until the cycle turns virtuous again. It’s a self-correcting system.)

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