The equivalence of hundreds of billions of US dollars seemed to have vanished into thin air, when after a massive rise to over 60 thousand, Bitcoin went into a strong nosedive before stabilising again. How rare are such price moves and what do they tell us about the future of the father of all cryptocurrencies?
This is far from Bitcoin’s first rodeo
While many individuals are aware of the recent massive drop in the value of Bitcoin and other cryptocurrencies and the incident in 2018, it is important to remember that this was ‘not the only rodeo’ that Bitcoin went through in its more than 12-year history. On three occasions, or roughly every four years, the most prominent of cryptocurrencies experienced a peak to trough retreat of 75% or more. Equities have exhibited such a drawdown only once during the entire last century, after the peak of 1929 which coincided with the start of the Great Depression. Of course, equities have also not exhibited the compound annual growth rate of Bitcoins during the last 12 years, or in any 12-year time frame during the last century. As of 14.06.2021, Bitcoin’s current max drawdown stands at roughly 36%.
While the recent decrease is certainly eye-opening in dollar terms, historically speaking, it is not special in percentage terms. The key takeaway is that Bitcoin has not only shown an extremely high return profile, but has done so with very high levels of risk and substantial temporary drawdowns, once again driving home the message “there is no free lunch”. There almost always is a strong relationship between risk and reward. Any investment that has the potential to perform phenomenally is nearly bound to also exhibit frightening levels of risk.
Drawdown charts are pessimistic charts in the sense that they only focus on the downside. They tell you about price declines versus previous peaks and tell the story of the frequency and the magnitude of price corrections. As such, they also answer the question, what would have happened in a worst-case scenario, if an investor bought at the absolute peak and sold at the absolute trough.
Why is Bitcoin so otherworldly volatile?
Bitcoin has a very clear and predefined monetary policy. Supply growth is currently always positive and small and, in the future, will steadily decrease down to zero. The supply side does not really have a strong impact on the volatility of Bitcoin. It is pretty much entirely driven by the demand side of the equation, and since Bitcoin is not linked to any real-world value, the demand side is almost entirely the result of market sentiment. Market sentiment, in turn, is the result of the story that market participants put the most faith behind. It is, therefore, no wonder that statements by important regulators or even tweets by famous individuals, such as Elon Musk, can have massive price implications for Bitcoin and thereby make the cryptocurrency extremely volatile.
The massive levels of volatility exhibited by Bitcoin highlight its failure as a store of value currency.
During 2017, it was the story of “Blockchain might change every facet of how corporations operate. We need to buy crypto right now!” and, as a result, Bitcoin increased by a factor of 20. When the story shifted to “Where are all the promised revolutionary use cases, maybe blockchain isn’t the future”, the price tumbled from around USD 20 thousand down to roughly USD 3.5 thousand. Fast forward in time and the story turned to “Central banks are unhinged. They are printing money in a coronavirus relief effort. We need to shelter with Bitcoin to protect us from inflation”, and massive price appreciation happens again. The very recent worries on China prohibiting cryptocurrencies for payment usage and questions about the environmental impact have swung the perception pendulum back into negative territory. As a result, the price has swung down strongly.
While the sentiment of tomorrow is nigh impossible to predict, it is likely that Bitcoin will react strongly and therefore continue to exhibit levels of volatility that make emerging market equities look tame in comparison.
What does that volatility mean from an asset class perspective?
The massive levels of volatility exhibited by Bitcoin highlight its failure as a store of value currency. Few want to use a method of payment for day-to-day transactions that has value swings as wide as Bitcoin. Price stability is one of the most important cornerstones for a currency and Bitcoin has never been able to achieve it in its more than 12-year history. There is no strong evidence that would point to more price stability in the future.
But, elevated levels of volatility do not necessarily have to be a bad thing when approaching the subject matter from an investment angle. Short term traders tend to be drawn towards instruments with high volatility figures. Long-term investors might be enticed by an asset class that still hasn’t fully entered the investment management mainstream, has a structural setup that is completely different from traditional instruments like stocks and bonds, and which has so far performed rather well, even after adjusting for the massive levels of volatility. Julius Baer CIO Yves Bonzon has highlighted that the high volatility figures in the crypto space can be seen as the price to pay for learning, capturing potential long-term opportunities and more importantly avoiding missing the potential impact on other assets in their portfolio.
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