The Washington Post's wonk blog posted this interesting bit by Neil Irwin: Bitcoin Needs A Central Banker. The article is tongue-in-cheek. It immediately drew sarcastic retorts from a few in the libertarian-leaning bitcoin community.
However, it is fair to address the topic of volatility. Several US Senators remarked upon it indirectly in the hearings (Day 1, Day 2). New bitcoin users often raise the issue as well.
There are some simple, high level, underlying economic and development
realities that influence bitcoin's price volatility.
Supply and demand. This is obvious. Let's move on.
Bitcoin is small. Although the market cap exceeds $6 billion -- over 12 million bitcoins at price $500 -- the amount of bitcoins available for trading on markets is a fraction of that. A large purchase might run up the price; a large sale will drop the price. Bitcoin behaves like a penny stock. Penny stocks are also volatile, for the same reason. Volatility is inherent in any system where traders may make million-dollar trades, yet the underlying commodity or stock's market liquidity is small in comparison.
Bitcoin is young. It took a decade or more to convert Eurozone nations to a common currency, including everything from banking software to cash registers to the cash in citizens' wallets. That was with the force of nation-state laws, and the economic weight of trillions of euros, behind the effort.
Bitcoin had none of these advantages in its infancy stage. It is truly a grassroots effort, with enthusiasts and early stage companies filling this role. Building a currency involves many layers of financial tools and services, on top of the currency. It is important to set bitcoin expectations properly. Building a currency from scratch like this is a unique endeavor.
It will take many months before common financial tools such as futures, options, shorting become widely available. These tools will decrease bitcoin volatility, by adding information to the market. It will take months for Point of Sale software to be updated to support bitcoin, and deployed into the field. Needed PoS development holds back wide scale deployment in brick-and-mortar stores around the world. Smartphone apps only fill a small portion of the PoS needs.
Folks are working as fast as they can to develop these tools. This requires both technical and legal developments, to deploy legally in the US and other jurisdictions. It takes many years to build a currency from scratch like this.
Setting the goalposts. In the meantime, perspective and proper expectations are important. What is a reasonable timeframe to bootstrap a global currency from scratch? No one knows, and perhaps we are now watching the answer unfold before our eyes, as bitcoin grows.
Like a startup company, bitcoin is a startup currency. Bitcoin is high risk, volatile, and may fail. Or like many famous startups, bitcoin may succeed beyond our wildest dreams. Bitcoin's price behaves like a very early stage tech company. In my view, predictions of success or failure are premature, at such an early stage.
Question answered. What, then, is the "solution" to volatility? Economic growth of the global bitcoin economy, and time. Bitcoin is simply the base layer in an entire ecosystem of services. Bitcoin itself, as wonderful an invention it may be, is not an end, but a beginning. As adoption increases, the number of market players financially able to move the market decreases.
Once additional financial tools and services are layered on top of bitcoin, once bitcoin grows beyond its tiny size today, reduced volatility is quite likely, indeed. Bitcoin is an odd mix of currency, commodity, payment network and computer service. Time and field experience best inform the development of financial stability tools.
Updated to add: Volatility is also just another engineering problem to be solved. Volatility can be ignored by the merchant, if you price in USD and use a service like BitPay. Volatility is less a factor if you transfer USD -> bitcoin -> bitcoin -> EUR in a matter of seconds, as a means of rapid cross-border settlement.