How to Fight Volatility in Cryptocurrency

By October 14, 2014Bitcoin Business
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How to Fight Volatility in Cryptocurrency

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How to Fight Volatility in Cryptocurrency

You’ve probably heard it many times if you frequently spread the good word about crypto. “Isn’t Bitcoin volatile? What if the price crashes?” By now, many POS systems offer free fiat conversion, alleviating some concern, but until the volatility of cryptocurrencies is addressed, most people will be unwilling to hold any. We need to find a way to fight the volatility that is inherent in Bitcoin.

This doesn’t necessarily mean Bitcoin has to change; many people prefer to use a deflationary currency, especially those who like to save. Despite the skepticism of many altcoin critics, a currency can be better suited for some applications than others. Financial privacy, for example, is great for political activists, but more problematic when it comes to political campaign finance. We need a stable cryptocurrency designed for use in commerce; unless you’re living paycheck to paycheck, this would be held as only a fraction of your wealth, the rest reserved as other coins like bitcoins.

Backing Cryptocurrency

Some of these methods require a little trust. Using smart contracts on blockchain 2.0 platforms, developers can now build cryptocurrencies backed by items of “real” value. The trusted third party promises to redeem cryptocoins for those items at an ongoing fixed rate; assets like .bit domain names would be simple to do this with, while backing with things like commodities, real estate or other property requires interaction with third parties like the traditional legal system.

Rather than fluctuating wildly with the free market, the values of of these cryptocoins are proportional to that of their underlying assets. You just have to pick the right one: commodities like oil which fluctuate in value throughout the year would not make for a stable currency. GENERcoin is working on a cryptocurrency backed by biofuel pellets–10,000 BTUs of energy-worth per coin. Its value would be related to the value of that much electricity, minus the cost of the energy generation process.

People will surely think of more stable assets in the future. For now, the dollar may still be one of the most stable options. Interestingly enough, cryptocurrencies can be backed by dollars, too, an idea proposed by Realcoin (soon to be called Tether). They will keep a publicly-auditable reserve of USD not less than the value of all Realcoins in existence, which the company will exchange for one another at any time.

This is particularly useful for FOREX traders, who previously had to rely on centralized currency exchanges in order to speculate on currency exchange markets; even if the dollar is destined to crash, there’s profit to be made in shorting it, which will be cheaper and more efficient as smart contracts on the blockchain. Realcoin effectively allows you to do that by mimicking the value of a dollar.

Conversely, when Bitcoin experiences periodic sell-offs, you can exit and re-enter the market without any direct interaction with the traditional banking system. Realcoin could also be used transactionally in times of extreme Bitcoin volatility. In the long term, though, Realcoin will go down in value as surely as Bitcoin will go up, and when the dollar inevitably collapses, we’re going to need a new form of stable currency that doesn’t rely on state control.

Basket Case

Before returning to the question of how to automate the authorities in our lives, it’s worth talking a little bit about the idea of basket coins. Essentially, basket coins are the same as value-backed cryptocurrencies, except that they are backed by more than one item. They can be traded as normal on the blockchain via a 2.0 platform; choosing the right combination of items to represent a basket coin can give it interesting properties.

The basic reason critics are skeptical of altcoins is that they fear the dilution of the cryptocurrency market: altcoins currently get most of their capital from previous Bitcoiners, not by converting new people to crypto. This is the unfortunate result of technology advancing faster than mainstream culture, and our common drive to be first at everything. As convenient as it is for branding reasons, however, a new flagship cryptocurrency must emerge.

The only good way to test the dilution theory–and more importantly, avoid the consequences if it’s correct–is a basket currency consisting of all the major cryptocurrencies, tied together via smart contracts on a 2.0 platform. A smart entity known as a DApp would have addresses for all of these, where it holds enough coins to reimburse those wanting to exchange for their basket coins. A basket coin would be worth a number of each cryptocurrency proportional to its total market share, and inversely proportional to its total number of coins–basically, the (weighted) average of every significant cryptocurrency on the market.

This is great for those who want to invest in crypto with less speculation, especially once we include things like equity in decentralized autonomous corporations. However, if cryptocurrency as a whole fluctuates for whatever reason, adoption for use in commerce will still suffer. What we’d need in that case is a coin backed by a perfect, continuously-adjusted combination of deflationary and inflationary cryptocurrencies that evens out to 0% inflation in total.

Even with general cryptocurrency baskets, the DApps will have to operate on fractional basket reserves to a small extent, investing with some of the funds saved for basket coin holders in order to recoup costs like data storage and trade fees. Programming DApps to intentionally invest in less profitable coins to maintain 0% inflation will force them to run on even flimsier fractional reserves, which could lead to the equivalent of a bank run if the conditions were just wrong.

In Math We Trust

All of these complications arise because we cannot find just one currency that can maintain stability without inflation. Without some manipulation of the Bitcoin supply, market forces will always cause it to fluctuate wildly in value. History has shown that humans cannot be trusted to manipulate a money supply responsibly, but maybe using the principles of decentralization and the blockchain, we can engineer a smart currency capable of regulating itself autonomously.

The primary means by which we can do this is by adjusting the mining difficulty or reward. Dollars dilute in value because they can be arbitrarily printed; if a currency is diminishing in value, a logical solution would be to reduce the number of coins generated with each block mined. Conversely, increasing the reward could help limit an unstable surge in value, helping to reduce the momentum and reach of price swings.

A major limitation comes to mind: what if the block reward hits 0, and the coins are still inflating in value? This scheme might work better in a proof-of-stake system, where control of the money supply is relative to how many coins one has on reserve. If the reward hits 0, those minting coins will have to rely on transaction fees, which twice-incentivizes hoarding by giving coins to those who stockpile them while taxing those who conduct transactions.

Like any currency, insufficient market demand could render such a system unstable. If enough people want to sell, the price will have to fall. It might be ideal to program the currency to maintain slight deflation, to make for a safer alternative investment to other cryptocurrencies.

No matter what, it will always be a better alternative to fiat in the bank. The executive power governing the currency would be a non-profit decentralized autonomous organization, and the blockchain will never need to raise money for anything from public education to wars abroad. Programmed correctly, it will simply do its job, quite unlike the central banks we have to deal with today.



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