Bank of Canada has recently published a working paper that develops an economic framework to analyse the factors affecting virtual currency exchange rate and predicts that with its widespread acceptance, the exchange rate will become less sensitive to the impact of shocks to speculators’ beliefs.

The paper “On the Value of Virtual Currencies” has been authored by Wilko Bolt, Economics and Research Division, De Nederlandsche Bank, and Maarten R.C. van Oordt, Financial Stability Department Bank of Canada.

It outlines three components that are important for the exchange rate:

• The current use of virtual currency to make actual payments
   
• The decision of forward-looking investors to buy virtual currency (thereby effectively regulating its supply)
   
• 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 will become less sensitive to the impact of shocks to speculators’ beliefs and their inflow into and outflow from the virtual currency market. This prediction undermines the notion that the current high volatility of the exchange rates of virtual currencies will prohibit their widespread usage in the long run”, the paper reads.

In particular, the paper shows that the equilibrium exchange rate depends on both – a purely speculative component pinning down a “floor” under the exchange rate and a transaction component that affects the exchange rate risk absorbed by speculators. With more widespread use of virtual currencies by merchants and consumers, the impact of speculative behavior is lowered which stabilizes the exchange rate.

According to the paper, the current high levels of volatility in virtual currency exchange rate seem to be a symptom of early development, adding that in theory, volatility is expected to drop with the increase in adoption by consumers and merchants. It also expects deflationary virtual currency prices during the early-adoption stage (conditional upon survival).

In addition, it said that the fixed supply of virtual currency may suggest its volatility will reflect that of other commodities rather than that of traditional currencies. Speaking of various competing cryptocurrencies, the paper says that the scenario raises a further issue of whether only a few virtual currencies will ultimately dominate a global market, adding:

“Our framework 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”.