Pricing signals and deflationary economics

Just a quick thought about deflationary economics, pricing signals, and BitCoin stock markets.

If you own an asset (let’s say shares in a publicly traded company, for the sake of simplicity) and its price goes down, there could be several reasons – perhaps the company isn’t doing so well, or the overall market (or market segment) is moving downwards, or the currency of the country that the company is in is moving relative to your currency. Typically you can figure out the reason though, and make some assumptions about what to do about it (i.e. sell, hold, or double down).

There’s an issue with recognizing these kinds of signals in an extremely deflationary environment though, and it might have implications for some new markets that trade shares in companies that are denominated in BitCoins.

There are currently nearly 12 million BTC in existence, and the total that will ever be created is capped at 21 million. Looking at existing markets, the total value of available shares is likely well over 1 million BTC already (although only a fraction of those shares trade on any given day). It would be easy for the total value to exceed the total number of BTC that are actually available, particularly if we include futures contracts on those shares. All it would take is for one of the existing companies that are traded on those markets to have a successful quarter, and for their share price to rise rapidly.

The problem is that the available BitCoins that can be used to make purchases is limited (but highly, highly subdivisible). So if the volume of trade increases, the available BTC to make those trades becomes more limited over time. This generally will drive prices down (and conversely the value of a single BTC up). This doesn’t matter too much when it comes to buying, say, a book online. The vendor would simply price the item in BTC based on a conversion into their own currency, so the value of the item in fiat currency remains the same.

The problem arises with assets that are denominated in BTC, but which are held for lengthy periods of time. Let’s say you buy one share in company BTCco for one BTC, when a single BTC is valued at $100 USD. If the value of a BTC goes up to $200 BTC, all things being equal the share will go down in value to 0.5 BTC. If you’d just left your BitCoins sitting in your wallet though, you’d still have one BTC.

To make things worse, it makes it extremely hard to tell why the price of a given asset is going down. Is it due to deflation, or is it due to a problem in the underlying asset? The signal gets completely confused.

This didn’t matter so much when these markets were tiny hobby websites, but some of them now have significant trading volume. Whenever I see orders for tens of thousands of dollars worth of BTC-denominated assets fly by, I wonder if the people making those trades understand the underlying risk.