Crypto Thoughts: Volatility and Value

The last few weeks seems to have produced a torrent of comment, almost all negative, about crypto currencies, and particularly Bitcoin. Two sets of complaints tend to feature: first, that Bitcoin, and by extension cryptos entirely, are based on 'nothing'; and second, that volatility of crypto prices make them a particularly unsafe environment for investment.

Let's look at the second charge first: that major cryptos are simply unacceptably volatile, particularly when contrasted with the other major non-yielding non-financial asset: gold.

I track both gold and the more popular cryptos on a daily basis, using OANDA, and it's on that data that I base the following. What follows is based on the daily values recorded vs the dollar since the beginning of 2020.

1. Starting point. Standard deviation of daily percentage movements against dollar: Gold 1.1%, Bitcoin 3.9%, Ethereum 6.7%; Litecoin 5.2%. Conclusion: gold is plainly far less volatile than cryptos.

2. But, of course, cryptos have performed far better than gold. The average daily movements are this: Gold +0.1%, Bitcoin +0.6%, Ethereum +1%, and Litecoin +0.5%.

3. One can therefore construct a sort of 'Sharpe Ratio', dividing the average daily movement by the standard deviation of that movement. And it shows: Gold 0.07; Bitcoin 0.16; Ethereum 0.15; Litecoin 0.09. Conclusion: you are getting disproportionately paid for the volatility you endure by holding Bitcoin and Ethereum, compared to Gold.

4. But one can, and perhaps should, complain that the only sort of volatility we should be interested in is downside volatility - those gaps down in price which seem so much more spectacular, more dangerous, in cryptos than in gold. To measure this, I measure the 'downside deviation' by stipulating an level of acceptable return below which I start to count 'volatility'; and then exclude all daily movements higher than that. In this case, being of a generous frame of mind, I took the average daily price movement of gold (ie, 0.1%) as the Minimal Acceptable Return (MAR) - anything below that I took as feedstock for calculating the downside deviation of these assets.

The downside deviations came out like this: Gold 0.7%, Bitcoin 2.4%, Ethereum 3.8% and Litecoin 3.3%. This result is even less favourable to the cryptos compared to gold, than using standard deviations. But finally, I used these downside deviations to recalculate the 'sort of Sharpe Ratio' (ie, average daily movement / downside deviation). The results are these: Gold 0.11; Bitcoin 0.26; Ethereum 0.27, and Litecoin 0.15. In these calculations, of course, the higher the result, the more you are being paid for the downside volatility you expose yourself to.

The conclusion is, I think, absolutely clear: the downsides volatilities for Bitcoin and Ethereum are better justified by their underlying trend performance than is the downside volatility for Gold. This may also be true for Litecoin, but the case is less clear-cut than for Bitcoin and Ethereum.

The second objection to cryptos is that their value is based on 'nothing'.

This charge is most often levelled against Bitcoin. Now, I'm not a particular fan of Bitcoin itself (the fact that there will/can only be 21 million Bitcoins ever mined/issued makes it look like a classic 'bankers ramp', not a currency). However, the wider charge that cryptos are based on 'nothing' is no longer true. I first realized this through thinking about Blockstack. The entire point of the Blockstack environment is to allow you to reclaim ownership of your online data, and thus allow you to duck out of at least some portion of the Attention Economy. Participation in the Attention Economy does, of course, have value, as Google, Amazon etc fully realize. If so, then it's reasonable to believe that Blockstack tokens will eventually be backed by that value - indeed, it will discover what your personal value to the Attention Economy is. Believing, then, that the Blockstack crypto (Stacks) is based on 'nothing' is the exact equivalent to believing that Google's remarkable suite of available apps are actually 'free'. Ie, it's a fundamental misunderstanding of commercial reality, leaving you baffled as to why Google et al make money.

I cite Blockstack because the case is so clear. But from there it is a very short step to appreciating that cryptos such as Ethereum, Litecoin, Ripple etc are also ultimately backed by the value captured in their use (eg, smart contracts, funds transfer etc).

To the extent that these cryptos eventually or ever piggyback on Bitcoin (as Blockstack does), then Bitcoin also gains a backing of value by proxy. Maybe Bitcoin started out based on 'nothing', but as the universe of obviously backed cryptos expands, perhaps it discovers value.