Sunday, November 18, 2012

How bitcoin illustrates the idea of a liquidity premium

On November 15 @ 5:37 PM, Wordpress.com tweeted that it would be accepting bitcoin as payment. Over the next twenty-four hours, the price of bitcoin steadily rose on Mt. Gox, the major bitcoin exchange. See chart below.


This is a great illustration of the idea of a liquidity premium.

All assets carry a liquidity premium. This premium will be smaller or larger depending on an asset's ability to be easily bought and sold, or its liquidity. The idea of liquidity is straight from Carl Menger, who figured things out back in 1872 (pdf). Keynes also knew this, read Chapter 17 of the General Theory. (This is one of those great examples of Austrians and Keynesians agreeing). Other words for liquidity include saleability and marketability. In short, the more marketable an asset, the larger its liquidity premium, which in turn means a higher price. Illiquid assets have small premiums and lower prices.

In announcing the acceptance of bitcoin, Wordpress has added yet another avenue for the use of bitcoin. And Wordpress is not just any old site. According to Alexa, Wordpress.com is the world's 22nd in terms of traffic. Bitcoin is now more liquid, and as a result, its liquidity premium has increased by about 75 cents.

Why is liquidity worth something? The future is uncertain. Knowing that an asset you own can be readily sold should the need arise provides you with a degree of comfort. Thus liquidity shields you from the displeasure of uncertainty, and since highly liquid assets do more shielding than illiquid ones, you'll have to pay a larger premium for that benefit.

  So with the Wordpress announcement, bitcoin has become a slightly better hedge against uncertainty.  What happens if other large venues start accepting bitcoin? Bitcoin up.

5 comments:

  1. A challenger to MTGox would be a better example of liquidity premium. WP marks the beginning of mainstream acceptance-- i.e. speculation.

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  2. Steve is right on. The more merchants the more liquid and the better for everyone using Bitcoin. Given the counter-party risk in the banking system and ZIRP environment it makes an incredible amount of sense to begin using Bitcoin.

    We started accepting bitcoins as payment for rental of several airplanes or private charters. By doing so we have eliminated counter-party risk (no potential bank failures for us!), reduced payment processing fees from credit cards by about $150 per $5,000 of revenue which makes our pricing much more competitive and benefited from a 'stronger/harder currency'. For example, Bitcoin revenues are accounted on a monthly basis and there have been about $7,325.43 of rental payments but the current value of the bitcoins is $9,148.92 due to the rising price over the past several months. Merchants should really consider accepting bitcoins because they can make and keep more money.

    Sure beats having the $$$ sit in a bank account not earning any interest having gotten there from a credit card where the tax audit trail is a lot easier to follow. Hey, revenues are down because its a recession, didn't you know?

    ReplyDelete
    Replies
    1. Interesting details, thanks for that.

      I'm actually surprised that you keep your balances in BTC, I thought any business accepting BTC tried to get it into USD as quick as possible.

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  3. bitcoins are an awesome way to make investment !

    ReplyDelete