The Bank of Canada has joined the list of bank-related institutions to commission research papers regarding the use of digital currencies, particularly Bitcoin. Its two authors came up with an economic framework to analyze their exchange rates.

Blockchain as a challenge for central banks

The Bank of England had earlier released a research paper that studied the macroeconomic consequences of issuing central bank digital currency (CBDC). The 2015 paper by the Bank for International Settlements noted that the emergence of distributed ledger technology could present a hypothetical challenge to central banks by reducing their functions and, in an extreme case, may obviate their need as a central body entirely for certain functions.

The paper, written by Wilko Bolt of De Nederlandsche Bank, The Netherlands and Bank of Canada’s Maarten R.C. van Oordt, suggests that the exchange rates of various virtual currencies may diverge widely depending on adoption, transactional demand, the quantity and growth rate of monetary units, speculative demand and network stability (survival probabilities).

The value of virtual currencies

However, the research for the Bank of Canada seems compact in its focus. In the paper titled On the Value of Virtual Currencies, its model predicts that the exchange rate of virtual currency will become less sensitive to the impact of shocks to speculators’ beliefs as it becomes more established.

The prediction undermines the notion that excessive exchange rate volatility will prohibit the widespread use of virtual currency particularly as speculative motives are widely believed to be an important factor for the value of virtual currencies.

More use cases are needed

The authors say 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. Their widespread use by merchants and consumers lowers the impact of speculative behaviour and therefore stabilizes the exchange rate.

This will be based on three main determinants - the current use of virtual currency to make real payments; the decision of forward-looking investors to buy virtual currency which reduces its supply; and the elements that jointly drive future consumer adoption and merchant acceptance of virtual currency which determine expected long-term growth in usage.

They add:

“Moreover, the current high levels of volatility seem to be a symptom of early development: theoretically, volatility is expected to drop if the adoption by consumers and merchants increases. The future will show how much volatility will drop.”

A drop in Bitcoin volatility means the risk associated with holding the digital currency will be reduced as the more volatile an asset gets, the more people will want to limit their exposure to it either by simply not holding it or by hedging.

Volatility of Bitcoin

According to btcvol.info which tracks the volatility of Bitcoin and other commodities’ prices in US dollars, the 30-day BTC/USD volatility rate (ended August 30) currently stands at 2.17%. Compared to its 16.11% rate in June 2011 and 14.59% in April 2013 and 7.81% in January 2015, it is not misleading to state that the digital currency is in its best form of volatility - a measure of how much the price of a financial asset varies over time.

The 30-day ETH/USD volatility rate (ended August 30) stands at 5.73% while Gold/USD is at 0.67%.

Some of the identified limitations to the research are the unknown actual number of payments in virtual currency for goods and services, the lack of reliable time series for users and acceptance statistics to study the behavioural aspects of using virtual currencies, and the competition among virtual currencies which raises a further issue of whether only a few virtual currencies will ultimately dominate a global market.