In significant chance that these governments will try


            In recent years,
cryptocurrencies have risen well over any expectations of most economists and
the people in the cryptocurrency community with the prices exploding up to
about $18,837.49 as of December 18, 2017. In addition, the Bitcoin prices are
nearly 20 times more than approximately $899, the price of Bitcoin during the
beginning of the year (January 2, 2016). Many economists are now predicting
that Bitcoin prices will still escalate from the surging demand. In December of
2017, Bitcoin analyst Ronnie Moas, stated to CNBC that the cryptocurrency in the
future could be worth $300,000 to $400,000 and Chamath Palihapitiya, the
founder of the venture capital firm Social Capital and the co-owner of the
Golden State Warriors, claimed that Bitcoin will reach the $1 million mark in
20 years. Yet with all the buzz and excitement surrounding Bitcoin, 96% of private-sector
economists believe that the rising price of Bitcoin is most likely the result
of an unsustainable bubble caused by artificial speculation.


            The very tool that
Bitcoin used to boost its price up, might also be the downfall of Bitcoin.
Futures contracts allows Bitcoin investors to actually bet if Bitcoin prices
will fall or rise, which was previously impossible to do. In addition, since
futures contracts are getting their values deriving from an underlying variable
asset, investors can bet on the movement of underlying assets without actually
owning any assets of Bitcoin. As a result of Bitcoin prices soaring, the
governments of several different countries have begun to watch Bitcoin. There
is also a significant chance that these governments will try and regulate
Bitcoin. In total, 11 countries have banned Bitcoins starting with Thailand in
July of 2013 and then China in December of 2013. Next, in February of 2014,
Russia bans the cryptocurrency and Vietnam, Bolivia, Ecuador, Kyrgyzstan, Bangladesh,
Taiwan, Columbia, and Nigeria. Almost every country included in this list has
stated that it has the intent to start its own currency. However, the main
problem resides in the platforms which processes the transactions because the
technology currently is not enough to meet the high demand for the large amount
of transactions going through in the blockchains and thus, is not scalable. In
comparison, traditional payment processors such as Visa can process at its peak
up to 47,000 transactions per second, while Bitcoin’s theoretical maximum
capacity is in the range of 3.3 to 7 transactions per second.

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In the following sections below, the paper
will first, define what cryptocurrency is and a brief background history of
Bitcoin specifically. Next, the paper will explain the mechanics of Bitcoin and
its blockchain technology, compare it to other transaction-processing actions
services such as Visa, and then define the causes of the Bitcoin stability
problem. Then, the paper will compare and contrast cryptocurrencies and
state-backed currencies, specifically gold and the U.S. dollar, to find the
weaknesses cryptocurrencies has compared to fiat currencies. From there, the
paper will compare artificial speculation and the variations of the perceived value
of Bitcoin with the Bitcoin stability problem and state how they each are
connected with each other and find the causes of the price volatility of
Bitcoin. Furthermore, the paper will explore the causes of the extremely fast
rising prices of Bitcoin and also explore different solutions to the Bitcoin
volatility problem by evaluating different methods of stabilization through automating
the process of adjusting the quantity of coins, extending the size limit of one
blockchain to better accommodate the large amount of transactions, and lastly,
to find different ways of gauging demand reliably by creating a concept of a
Bitcoin index similar to the CBOE Volatility Index (VIX) and stopping or
slowing down artificial speculation.


Finally, the paper will outline Bitcoin an d
other cryptocurrencies’ role in the future global economy and the immense potential
cryptocurrencies have. Moreover, the paper will also explain the effects of how
Bitcoin and other cryptocurrencies will affect central banks and industries.


Although not known by many people,
cryptocurrency was actually the side product of an invention by Satoshi
Nakamoto, the creator of Bitcoin, the biggest and first cryptocurrency to be
created. However, Nakamoto never really intended to create a currency, instead,
his goal was to create a “peer-to-peer electronic cash system”. It is a
misconception that cryptocurrencies are the same as digital or virtual
currencies. Virtual currencies are actually a type of digital currencies, which
means that all virtual currencies are digital currencies, however, digital
currencies are not a type of virtual currencies. Cryptocurrencies such as
Bitcoin are another type of digital currency, but they are actually in a
different category than virtual currencies.



Digital vs.
Virtual Currencies and How Bitcoins Fit:


Digital currencies are currencies that are
stored and transferred electronically. Therefore, any money or currency that
are based in 1’s and 0’s is, by definition, digital currencies. Based on
offshore tax havens, early digital currencies were hated by most people and
also gave the industry a bad image. On the other hand, virtual currencies have
also existed far longer than cryptocurrencies such as Bitcoins and were
primarily used for online entertainment purposes. By definition, “virtual”, is
something that is not based in reality. Thus, virtual currencies are not
intended for expenditure on real assets. Most virtual currencies are
centralized as the control of the money are in the developers of the virtual
world or platform. Visualizing what virtual currency is actually easy. In-game
currencies inside video games are a good example. Other digital currencies,
however, can be redeemed for physical goods and services. Bitcoins and other
cryptocurrencies were originally thought as “internet money”, but with recent
developments, it is actually possible to spend Bitcoins at a physical business
in person. This makes cryptocurrencies more “real” as the ability to spend it a
physical business makes it a little more similar to fiat currencies. Another very
major difference between digital currencies and cryptocurrencies is that most
cryptocurrencies are decentralized which means that no central power has arbitrary
control over the money supply.


            The most important
aspect about Bitcoin is mining. Bitcoin mining is the process by which Bitcoin
transactions are verified and added to the blockchain, a public ledger, and is
also means through which new Bitcoins are created and released. Anyone with a
computer and sufficient hardware is able to mine for Bitcoins. The mining
process involves compiling recent transactions into blocks and attempting to
solve a computationally difficult mathematical “puzzle”. The person who solves
the “puzzle” the fastest is able to place the next block in the blockchain and receive
rewards. The rewards are both transaction fees which are correlated with the
transactions compiled in the block and a newly released Bitcoin.


            The amount of new
Bitcoins released after mining each block is called a block reward. The block
reward is halved every 210,000 blocks mined.


the Various Causes of the Bitcoin’s Price Volatility:



Stability is essential in every currency,
especially Bitcoin. As prices fluctuate, people will shy away from using
Bitcoins in transactions. The unpredictability of Bitcoins affects other money
services such as remittance, currency conversions, and the use of ATMs. In
order for businesses to utilize cryptocurrencies, specifically Bitcoins, they
have to limit their risks by charging exorbitant fees. For instance, Bitcoin
ATMs can charge up to 15% to convert to fiat currency. However, this defeats
the original purpose of the creation of cryptocurrencies as the
cryptocurrencies were meant to provide a cheaper and more flexible alternative
to other payment methods. Overall, the Bitcoin has no current advantage over
government-issued currency except that Bitcoins provide more secure
transactions as well as making transactions anonymous. One of the largest
factors which contribute to making Bitcoin volatile is speculation because of
the uncertainty of demand. In order to stabilize cryptocurrencies such as
Bitcoin, it is essential to have an effective as well as efficient method to
gauge demand. However, a major hurdle for this is the existence of speculators
creating artificial demand.


With the high amount of speculation, the
price for the cryptocurrency will not reflect its actual usage and demand and
then becomes a “bubble” on verge of bursting. As a result, not many people want
to risk investing their money into bitcoin. To visualize and analyze the
instability of Bitcoin, we can use the equation of exchange in monetary
economics below.1




M is defined as the quantity of money, V is the rate at which the money is
spent, P is the price of everything
bought, and Q is defined as the
amount bought.  In bitcoin, the quantity
of bitcoins is fixed at 21,000,000 bitcoins which means that value for M is fixed. This leaves the variables V, P,
and Q to fluctuate.2
In modern economies, prices take a long duration of time to adjust to pressure such
as inflation or deflation. Therefore, if the value of V or M were to drop, it
can be seen from the above equation that the value of Q would also have drop until the value of P is caught up.3
The result of this is recession as well as unemployment. However, people still
price goods in dollars instead of bitcoins when transacting with bitcoins. This
is due to bitcoin’s tendency to fluctuate which means that the easiest way for
the seller is to price the goods they are selling in terms of dollars, and then
at the point of sale, convert the value of dollars into bitcoins. Overall, it
can be seen that bitcoin’s P value is
very flexible in comparison with the U.S. dollar. In addition, the Q value is never hit and therefore,
there are no recessions or unemployment in the bitcoin economy.


If the value of M of bitcoins are fixed and since the value of P and Q fluctuate, The
rate at which the money is spent (V) must
also be unstable. Essentially, the demand for bitcoins is highly unstable. The
usual solution to this is to make M move
the opposite of V. If MV does not move as much, the pressure
on the prices would be lower and Q would
not suffer a drop either.


addition, the fluctuation of bitcoin’s perceived value is also a factor of the
bitcoin’s price volatility. Bitcoin’s perceived value actually fluctuates
against fiat currencies. Bitcoin is very similar to gold in terms of properties.
It is governed by the limit designed by its core developers to limits its
production to 21 million bitcoins. Since this differs from fiat currencies,
which are controlled by governments who want to maintain high employment rates,
low inflation, and satisfactory growth through capital investments, investors
may want to allocate more or less of their resources into bitcoin.




Bitcoin and Gold:


and gold are commodities with many similarities because it does not have a
liability attached by definition, like security. However, unlike gold, bitcoin’s
liquidity might be in the future, its downfall. In addition, bitcoin’s lack of liquidity
is a large contributor to its price volatility. The real difference between the
two commodities is that gold has $8.3 trillion of gold above ground worth of
liquidity, while bitcoin, even when it was at $11,000, the market cap was only
$168 billion dollars. To stabilize bitcoin, it is essential to look back at how
gold was able to overcome problems since gold had a fixed capped supply just
like bitcoins and other cryptocurrencies. Before the explosive economic growth
in the West, the commodity standard were actual metal coins. Thus, the global
money supply was actually less fixed in the long term and without
well-integrated international markets, the prices of money did not fluctuate or
vary as much during normal circumstances. Moreover, “natural” inflation and
deflation occurred. After the New World silver and gold was discovered and imported,
prices in Europe jumped to more than double. This came to be known as the Price
revolution and since it took place over such a long period of time that the
annual inflation rate stayed low compared to modern standards in the range of
1% to 1.5%. Overall, the rigidness of the supply of precious metal did not
become a concern.


some time, the Industrial revolution began and soon after that, the banking
revolution followed, creating immense advancements in the economy, trading, and
banking. Fractional reserve banking was later able to overcome gold’s nominal
supply. Moreover, by using loans and credit to build a larger stock of
banknotes and deposits on top of a smaller, fixed supply of gold and was able
to stabilize the nominal spending even with the widespread variations of demand
for money. In the future, it is likely that innovations such as this will
overcome the same problem bitcoin and other cryptocurrencies are facing.
However the technical hurdles that these cryptocurrencies face in the modern
world cannot be solved by looking at the history of gold alone.




Internal Stabilization:


back on the equation of exchange, MV=PQ, it
is possible to stabilize bitcoin by the value of M (quantity of money) adjusting automatically to compensate for the
changes in V (rate at which money was
bought). As all transactions that happen are recorded on the blockchain, the
program will know the value of V. If
the rewards for mining bitcoins were to be varied in order to compensate for the
rate at which money is spent, rather than targeting a fixed path, it could
stabilize the value of MV more
efficiently and accurately than any other central bank that have existed. However,
this is not the only issue that would have to be solved in order to make
bitcoin more stable as it would require more than one solution to work in
tandem to stabilize bitcoin’s price fluctuations.


the money supply were to be adjusted, it would matter who gets the new money.
Normally, the changes required would go through the banking sector and are
distributed to those who value them the most via loans. If this is not the case
and for example, is distributed to the miners, the currency will not become
more stable. Cryptocurrency is actually the first currency that can be adjusted
without a banking sector. Unfortunately, because of this, it presents to us a
paradox. The macroeconomic benefits of a banking sector will only matter in conjunction
with the microeconomic function of banks (distribution of liquidity by making
loans). Moreover, loan making is something that cannot be controlled by a
computer as it is essential to check to make sure that the borrower can repay
the loan. This process is something that requires irreducible human judgement.
On the other hand, if there is no way around the need for a banking sector, a
very important technical hurdle that cryptocurrencies must overcome will be
regulations and a political fight.





1 “How
‘Bitbanks’ Could Solve Bitcoin’s Volatility Problem.” CoinDesk. December
29, 2014. Accessed December 21, 2017.


Investopedia. “Equation Of Exchange.” Investopedia. May 17, 2007.
Accessed December 21, 2017.