The Value Of Virtual Currencies – Analyzing The Exchange Rate

Wilko Bolt

De Nederlandsche Bank (Dutch Central Bank)

Maarten R.C. van Oordt

Government of Canada – Bank of Canada

April 20, 2016

Abstract:

This paper develops an economic framework to analyze the exchange rate of virtual currency. Three components are important. First, the actual use of virtual currency to make payments. Second, the decision of forward-looking investors to buy virtual currency (thereby effectively regulating its supply). Third, the elements that jointly drive future consumer adoption and merchant acceptance of virtual currency. The model predicts that, as virtual currency becomes more established, the exchange rate becomes less sensitive to the impact of shocks to speculators’ beliefs. This undermines the notion that excessive exchange rate volatility will prohibit widespread usage of virtual currency.

The Value Of Virtual Currencies – Analyzing The Exchange Rate – Introduction

This quote from the former Federal Reserve chairman could hardly be more accurate in describing the aim of the present study, in which we attempt to answer the broad question of what drives the value of virtual currencies. Virtual currencies such as bitcoin represent both the emergence of a new form of currency and a new payment technology to purchase goods and services. These currencies may move outside the scope of the current financial institutions. That is, their supply is not necessarily controlled by central banks and they allow distant payments to be made directly between consumers and merchants without the use of any financial intermediaries. The key innovation is the implementation of cryptographic identification techniques into a “distributed ledger”, i.e., a digital record that allows to track and validate all payments made. This allows virtual currencies to be used in a decentralized payment system while avoiding the possibility of “double spending”.

Bitcoin is the most well-known virtual currency.1 For primers on the economics behind bitcoin; see, e.g., Dwyer (2015) and B¨ohme et al. (2015). Bitcoin was launched in 2009 and attracted attention from the financial press, economists, central banks and governments. This attention was fueled by the sudden “explosion” and volatility in the exchange rate of bitcoin by the end of 2013. During the month of November 2013, the U.S. dollar exchange rate for one unit of bitcoin increased more than fivefold, and its value, which had begun trading at less than five dollar cents in 2010, exceeded $1,100. During 2014, however, bitcoin lost ground again fast, settling at around $250 per bitcoin in March 2015. While the supply of bitcoin units over time is mathematically specified with an upper limit of 21 million units, its current supply amounts to approximately 14 million units (in March 2015). Bitcoin’s usage is still limited but rising: from around 20,000 daily transactions on average in 2012, to over 50,000 daily transactions in 2013, and reaching 100,000 daily transactions in March 2014. All in all, compared to volume and value of other existing currencies, bitcoin is still a relatively small monetary phenomenon, but it has been growing.

This paper develops an economic framework that analyzes the exchange rate of a virtual currency in its early stage and its main drivers. Some unique properties of virtual currencies – at least in their current early adopters stage – play a role in our model. First, virtual currency prices of products and services are perfectly flexible with respect to changes in the exchange rate, since merchants tend to instantly adjust price quotes in virtual currency to the latest available exchange rate. In the model, this property is key in providing a direct link between the exchange rate and virtual currency demand. Second, the choice for making payments with virtual currency is simultaneously also a choice for an alternative transaction technology, since these payments are settled and processed through a peer-to-peer payment network associated with that virtual currency. Network economies affecting payment choice play an important role in determining the ultimate demand for virtual currency. Third, the growth of the supply of virtual currency is to a large extent predetermined. In line with this latter property, future demand for virtual currency to execute payments is one of the main sources of uncertainty in our model.

Virtual currencies

Our framework combines an investor’s portfolio model with a payment network model, while adding a flavor of monetary economics. In our framework, three components are important for the exchange rate: First, the actual use of virtual currency to execute real payments. Second, the decision of forward-looking investors to buy virtual currency (thereby effectively regulating its supply). Third, the elements that jointly drive future consumer adoption and merchant acceptance of virtual currency. These latter elements determine the expected long-term growth in virtual currency usage. We show that the equilibrium exchange rate depends both on a “purely speculative” component, that depends on the hypothetical price speculators would offer if not a single real transaction is settled using virtual currency, and a transaction component, that depends on the actual amount necessary to facilitate real payments.

Virtual currencies

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