I don’t like technical analysis. It’s imprecise at best, and I prefer to base my investments in sound reasoning.
I can tell you that if it is in a bull market, BTC won’t be there long. It doesn’t take TA or reading tea leaves to figure this out.
The Finger Trap Effect
Bitcoin is in a perpetual bull trap. Actually, it’s more like a finger trap – the further BTC goes, the deeper it gets stuck.
Here’s the cycle:
Price increases attract speculators
Speculators create transactions
Transactions fill blocks
Full blocks cause high fees
High fees alienate speculators, and merchants leave
When speculators sell BTC, its price declines. When merchants leave, BTC’s value declines. A currency’s value comes from its use as a medium of exchange.
Devoid of actual use, BTC trades even lower. Once it goes down, it can’t climb back up through speculative transactions without triggering panicked buys that set off the same cycle.
This continues with BTC in a death spiral and no fundamental value to bring its price up.
It ends once Bitcoin scales. That could be on-chain or off-chain, but right now it doesn’t look like BTC will do either.
Adoption’s Effect on Price
While Bitcoin Core developers actively advocate for less transaction space, other cryptocurrencies’ communities are focused on adoption as currency.
This is the focus cryptocurrency communities should have. Used as a medium of exchange, cryptocurrencies must increase in price – over time, the market demands a higher value for these currencies.
We see this through the equation of exchange. Don’t worry – it’s not complex. I explained it to my grandma over Christmas.
The equation of exchange is the most important equation for cryptocurrency valuation. Eat Sleep Crypto’s public articles on cryptocurrency valuation are a good intro, but we explain the applications of this framework and many others for valuing cryptocurrency in the Eat Sleep Crypto newsletter.
Sign up for just $25/month to receive articles like these Monday through Friday each week, and access to exclusive articles on Eat Sleep Crypto.
You don’t want to be left hanging when BTC inevitably gets surpassed by currencies that work.Sign up for our newsletter where we teach you how to value cryptocurrencies based on fundamentals instead of pure speculation.
For the past several years, the Bitcoin block size has been the biggest controversy in the space. The debate surrounding the issue started around 2013, and in 2015, the Lightning Network was announced as a possible solution.
Despite four years of development on a 6-month project, Lightning employees still haven’t answered the question the Lightning Network was designed to address: how will it scale and remain decentralized?
In this article, we discuss five reasons the Lightning Network can’t scale and remain decentralized.
1. The Lightning Network is too expensive
One of the proposed benefits of the Lightning Network is low fees. It’s not really the case. Lightning transaction fees are low, but only relative to Bitcoin’s. It still requires an on-chain transaction to open one Lightning channel, which is not supposed to be enough to route payments anywhere else in the network. The optimal number of channels per user is around 14.
Bitcoin fees have been hovering around $0.10 for some time now, but even this amount is enough to price out third world users. Venezuelans making a dollar a day can’t afford to open 14 channels just to get paid, let alone the $50, $100, or $1,000 transaction Bitcoin maximalists want to see on-chain.
That the Lightning Network can’t cater to Venezuelans, Zimbabweans, and other marginalized 3rd world users severely limits its target audience. These are the people who need Bitcoin the most, and adoption must begin with the people who need it.
2. Lightning has terrible UX
One of the components to using the Lightning Network as envisioned by the developers is running a Lightning node. Lightning nodes require connection to a Bitcoin node, and additional hardware to make sure they never go offline. Downtime for a Lightning node can mean complete loss of funds.
Short power shortages don’t affect LN channels unless the outage messes up your node and causes irrecoverable channel state data loss!
PLEASE be sure to use an external UPS battery wherever you plug in your node hardware!
Despite Lightning advocates’ insistence that the technology is still in its early years, a technology as clunky as this isn’t even being adopted by tech enthusiasts, let alone the average person in the US, or Venezuela.
3. Lightning has a low ROI
On the demand side, Lighting prices out users by keeping fees high. On the supply side, Lightning is equally impractical. Besides the requirement for nodes to be live 100% of the time lest users lose all their funds, the Lightning Network is impractical for liquidity providers.
Insufficient returns are the greatest antagonist to meaningful investment in the Lightning Network. This may change in the future, but at the cost of decentralization, as a high ROI would attract competitors and eventually spawn large hubs as are already being formed.
4. Lightning’s Network Latency and the Routing Problem
The aforementioned problems are mostly economic obstacles facing the Lightning Network. There are equally damning technical hurdles LN faces.
Network latency refers to the time it takes to send messages across the network. In Bitcoin, this is done through block propagation, with game theoretical incentives to ensure the entire network can quickly come to consensus.
In the Lightning Network, nodes must find a path to send payments before sending. The problem is, every time a payment is sent, the balances of each channel must be updated. Nodes have to always remain aware of the channel balances, learning about updates almost instantaneously. Lightning payments have a high frequency of failure now, and this problem will be even worse at scale (without centralized hubs) due to the volume of payments.
To ensure successful payments, users are incentivized to open channels with nodes which have lots of BTC available to route. This leads to a “hub and spokes” (centralized) network topology.
5. The Lightning Network is easy to censor
Because the Lightning Network naturally tends toward a hub-and-spokes model, it’s very easily disrupted. If a node with large balances were taken down, it would disrupt the network immensely.
Furthermore, if the identities of Lightning Network nodes operators are known they can be easily censored through the same KYC restrictions which are placed on exchanges today.
In Bitcoin, this censorship is impossible because of the incentives of the system, but Lightning has no such incentives to prevent centralization.
Closing Thoughts
Because of its high costs and highly technical UX, Lightning appeals to a small subset of people – skilled developers in first-world countries who already hold BTC.
Without custodians to take on these issues, further adoption is inhibited. With custodians, the Lightning Network becomes a recreation of the existing banking system, entirely defeating the purpose of Bitcoin. This means that the Lightning Network can’t scale and remain decentralized.
Thankfully, there are alternative approaches to scaling that may remain decentralized. Bitcoin Cash and Bitcoin SV have interesting approaches to this problem.
We write about these and other cryptocurrencies, analyzing them using their fundamentals and incorporating the technical viability of their solutions into our projections of their future value.
Sign up for a 5-day free trial of the Eat Sleep Crypto and receive one of our most popular premium articles – Price Floors in Cryptocurrencies in the welcome email.
In How to Value Cryptocurrency: The Equation of Exchange, we walked through the steps to valuing a currency based on its utility. Eat Sleep Crypto tries to be as straightforward as possible, but valuing cryptocurrency based on utility is a paradigm shift from the still-speculative market.
I may have overestimated the article’s clarity, but I passed it to my grandma, who’s very sharp and capable of understanding the subject. This was her actual response:
Nate
I sort of understand your article. But why is another valuation method needed? Isn’t the value what someone will pay? I.e. what the coin will purchase?
Love,
Grandma
Disclaimer: My grandma is more well-versed in politics, economics, and business than most people I’ve ever met. I hope my response is concise enough for all grandmas, but your mileage may vary.
Cryptocurrency Price Factors
Grandma,
You’re thinking of it correctly. The ‘valuation’ is a loose price floor created by demand for goods in that currency.
For example, say Ford wants to buy $1000 worth of parts from China. Chinese manufacturers demand payment in a new currency, the Gold Yuan.
If there is only $500 worth of Gold Yuan in circulation, Ford can’t pay. However, by buying Gold Yuan – assuming there is some outside demand for the currency, Ford raises the price of Gold Yuan until their holdings are valuable enough to pay the manufacturers.
The principle here is that the money supply of an economy must be valuable enough to support purchases in that economy. In the absence of market-makers, volatility may push the price under this price floor temporarily.
Speculators can push the price infinitely high, but as long as commercial transactions exist, there is a loose price floor waiting at the bottom.
Market Demand For Cryptocurrency
I sent the first email. I tend to realize what I left out after sending an email – a terrible habit, not unlike leaving the house without your keys – my other favorite. So I quickly sent the following:
As it relates to cryptocurrencies – online merchants demand them.
Some demand cryptocurrencies on principle, more demand them for privacy, and half the world demands crypto because they don’t have access to traditional finance.
I write about cryptocurrencies which are adopted for the latter two reasons. Eventually they will become the standard.
Thank you for sending the previously linked article, and thanks for asking these questions.
Conclusion
This is a lightly edited version of an actual exchange between my grandma and I. She’s sharp, but anyone understand cryptocurrency when it’s explained in common terms.
Fostering understanding is Eat Sleep Crypto’s mission. We detest the deviations from utility-based investing principles. Speculation delays adoption and doesn’t work. The sooner the market gets on board, the quicker cryptocurrencies will be adopted by the world – particularly by those with no alternatives.
We write about valuing cryptocurrencies using each cryptocurrency’s utility a medium of exchange to mirror Warren Buffett and Benjamin Graham’s style of value investing, and have created several articles on individual cryptocurrencies with this lens.
Though you may not be familiar with the term, you’ve almost certainly been exposed to the ideology.
Bitcoin maximalism is the belief that Bitcoin, and only Bitcoin must succeed in the market. This belief stems from a faulty understanding of the role of social consensus in currency markets, and belief in myths about the origins of money.
A Collective Memory
Through centuries of cultural conditioning, money has been elevated to a special place in the public’s mind. People cannot imagine what money might look like in a free society.
In a free market, money would be a good just like any other – cryptocurrencies included. Demand for goods stems from the value those goods bring to consumers. Money is not unique in this sense.
Good money has distinct qualities, which Bitcoin maximalists like to list. Scarcity, portability, and fungibility are among them. However, Bitcoin maximalists are working from a different paradigm. They don’t recognize the ordinary status of money.
Due to unconscious conditioning and reasoning by analogy, maximalists imagine money has special properties which make it act differently than ‘ordinary goods’. In a sense, Bitcoin maximalism is only a step removed from existing arguments for fiat currency.
Fiat currencies remain popular through the threat of force. In Bitcoin maximalist circles, it’s the threat of ostracization. Insults are not violence, but they’re hardly a competitive strategy.
Benefit of the Doubt
Unlike policymakers of the past century, Bitcoin maximalists are not malicious. Bitcoin maximalism stems from a genuine desire for Bitcoin to succeed, coupled with a faulty understanding of the interactions between technology and economics.
Maximalists believe that money is purely a social construct, that its value is subjective. Bitcoin maximalists are afraid that if Bitcoin fails, there will be no reason for people to agree on any one cryptocurrency. They see Bitcoin’s failure as driven by speculation on other coins, and reason that, because code is adaptable, any currency can copy the properties of any other.
While it’s true that code is adaptable, the network effects of currencies are much more robust than maximalism implies. Among other reasons, these network effects remain because infrastructure is built around them. And infrastructure is an objective reality, not a social construct.
Another reason for Bitcoin maximalists’ fervency is that they believe money must be (or must be made) valuable before its use. This line of reasoning comes from their reasoning by analogy, and uses few examples.
Bitcoin is compared to gold ad nauseam, but there are other non-fiat currencies circulating today which should be considered. Drawing insights from a sample size of one is bad practice.
The currency of choice for drug users, and hungry millenials.
Cigarettes, Food, and Tide laundry detergent are still used as currencies in distinct niches. Bitcoin maximalists tend to ignore these examples and decline to consider what makes them valuable.
Why Are Currencies Valuable?
On a high level, these currencies are accepted because of their near-universal utility in their target markets. For that matter, even gold has utility, supremely in the ability for owners to flaunt their wealth.
The utility of a currency is its usefulness as a medium of exchange. Currencies are affected by supply and demand just like any other good. Assuming stable supply, currencies appreciate with demand. And the best way to create demand for goods is through utility.
As explained in How to Value Cryptocurrency: The Equation of Exchange, utility drives adoption; adoption drives price. The next time cryptocurrencies spike, it will be due to utility. Unfortunately, utility has been masked while most new money to cryptocurrency comes in through Bitcoin.
Bitcoin is the dominant base pair on most exchanges. Because buying other cryptocurrencies typically requires BTC, the BTC price stays up, even without Bitcoin’s utility.
A currency’s utility is in its use as a currency. This is axiomatic. It’s self-evident, implied by the very name crypto-currency.
At Eat Sleep Crypto, we focus on utility rather than speculation. Gambling is fun, but it’s not a sustainable investment strategy.
We’ve been creating models in the Investor Series which tie cryptocurrencies’ utility to real-world use cases. Models are created with comprehensively-sourced data and adjustable assumptions for you to see the effects of individual factors on the value of each cryptocurrency.
The Monero Investor Series article is in its final stages, and you can get a discount on it by subscribing to the Eat Sleep Crypto newsletter for FREE. As a subscriber, you’ll also get access to articles like this one in advance.
If you enjoyed this article, or even if you disagree completely, we’d love to hear your thoughts on Twitter @officialESC and in the comments below.
Cryptocurrency investment has been almost entirely speculative. In 2017, anyone with a half-baked idea could write a whitepaper, create a token contract, and raise $50 million in a week-long ICO.
Besides Joe and Jane Sixpack, participants with larger allocations were BTC early adopters and Silicon Valley veterans who should have known better. Then again, everyone is a genius in a bull market.
It wasn’t until the bear market struck that these investors started second guessing their positions. Fundamentally, investors failed to understand that cryptocurrencies (and tokens) should be valued not as stocks or commodities but as currencies.
The Bitcoin model yields a $50 million dollar per BTC value in 2030 with default assumptions.
Fortunately, it’s not only possible to value cryptocurrencies on a fundamental basis, this type of appraisal delivers more accurate valuations than speculative targets, and fortune awaits those who identify these investment opportunities.
The Equation of Exchange
The equation of exchange is used by economists to model currencies. It has four variables which describe the relationship between purchases made in an economy and the amount of circulating currency. We can use this equation to assign a value to a currency based on its utilty…that is, its fundamental usage as a medium of exchange. This, after all, is what the genesis of cryptocurrency was all about.
The equation is
MV = PQ
M represents the units currency actually circulating in an economy. Hodl’d units don’t count.
V is for velocity. Velocity is the number of transactions an average currency unit will encounter, per year.
P stands for purchases. Its value is the average price of purchases in an economy.
Q is the quantity of these average transactions.
Given any 3 of these variables we can determine the 4th. Now for some application.
In the US, M1 is the term for all dollars circulating in the economy. According to the St. Louis Fed, dollars are used an average of 5.5 to 6 times per year so we’ll use a V of 6.
Suppose that the average purchase in the US is $50 (P=50), and that the yearly quantity of these purchases is 20 (Q=20).
Therefore, PQ is $1000 and through the equation of exchange must be equivalent to MV. (MV = PQ)
So, what we know is:
P = $50
Q = 20
PQ = $1000
MV = $1000
V = 6
Given a velocity of 6, we can solve for the remaining variable M, the monetary base. To do this, we divide both sides by 6.
This leaves us with M = $1000/6 = $166.67.
And voilà, with only three variables, we’ve just calculated the total monetary base of an economy.
This can be solved for any size economy, but the relevance to cryptocurrency is that the equation of exchange can be applied to specific use cases targeted by niche cryptocurrencies. Let’s look at one now.
Example B: WidgetCoin (WGC)
Imagine WidgetCorp sells widgets for an average of $20. Five hundred of them are purchased per year for an annual volume of $10,000.
Q = 500, P = $20
Now suppose as the sole manufacturer of widgets, WidgetCorp decides to create WidgetCoin (WGC) and require payments be made in WGC. WidgetCorp also has a monopoly, (state-sanctioned of course).
Because it’s a closed system, the new currency has its own velocity. Some speculators are reluctant to spend their WidgetCoins, so we’ll estimate a WGC velocity of 4.
Now we can solve for the monetary base required to support purchases, M, i.e. the value of circulating WidgetCoins.
M * 4 = $20 * 500
4M = $10,000
M = $2,500
So we’ve figured out that the total value of circulating WGC is $2,500, but what is one WidgetCoin worth?
We could simply look at the market price, but price won’t tell us what the actual value is. WGC could be fairly valued, overvalued or undervalued, and as investors this is what we want to determine.
We seek the intrinsic value of a WidgetCoin. To calculate that, we need a critical piece of information – the circulating supply of WGC.
There may be a thousand, ten thousand, or millions of WGC but let’s imagine WidgetCorp was conservative in determining token supply. WidgetCorp wanted each widget to cost 100 WGC, and they issued 12,500 coins.
With the known dollar-value of the monetary base, we can factor in the coin supply to calculate the expected market value of each coin.
In this case, $2,500 divided by 12,500 coins is $0.20 per coin.
Now pretend WidgetCorp instead decided to create 1 million coins.
The same $2,500 divided by 1,000,000 coins is $0.0025 per coin – a quarter of a penny.
If WidgetCorp had ICO’d WGC for 20 cents each, they’d have made a killing. Unfortunately, early investors would have seen the value of their WGC fall by 98.75% as the market adjusted.
Wittingly or not, this is what happened in 2017 with ICOs.
It’s also the reason behind Bitcoin volatility. The market price strays from Bitcoin’s intrinsic (i.e. utility) value.
With largely speculative transactions, Bitcoin’s economy has no fundamental drivers of value – no necessary purchases (PQ). Eventually, the market catches on and adjusts the price accordingly.
For a more in-depth exploration of Bitcoin’s intrinsic value, go to Investor Series #1. (At this point, you’re well-equipped enough to skip the first part and go straight to the calculations.)
Implications
The equation of exchange is not only relevant to ICOs, or Bitcoin. The equation of exchange is the single most important equation in the industry, and yet it’s been largely ignored. Eat Sleep Crypto applies it, and you should too.
As the bear market eats weaker currencies, we focus on the value propositions of utilitarian coins in niche markets. Hope is not an investment strategy.
These currencies are the subject of our Investor Series. Our next edition is due this week and will be offered at a discount exclusively to subscribers of Eat Sleep Crypto. We’re covering Monero, one of our favorite coins, and the determined value will shock you.
Keeping with the “utility determines value” theme, free analysis is readily available on Reddit and Facebook, and is worth exactly what it costs. However, if you want to know what we know, it’s going to cost you something.
Right now though, you can get a preview for free.
Sign up for a 5-day free trial of the Eat Sleep Crypto daily newsletter and send us a message to receive a notification when we release Investor Series #3 – Monero.
In Investor Series #1 – Bitcoin, we looked at the possibility of Bitcoin replacing all transactions in the SWIFT network. The article leaves off with a list of factors which have kept Bitcoin from already doing so.
Without second-layer scaling solutions, Bitcoin (BTC) is unable to scale to the thousands of transactions per seconds it would need to effectively replace global settlements. Or at least, this is the argument given by various Bitcoin Core developers. For reasons that have frequently been rebutted, these developers wish to avoid scaling on-chain as described by Satoshi Nakamoto.
Scaling ‘Solutions’
While BTC is pursuing off-chain scaling solutions, it’s far from certain that these will work, let alone on a proper timescale.
The Lightning Network, one proposed solution is just now gaining traction. Although it’s far from ready. Bitcoin developer Gavin Andresen recently described Lightning as “an order of magnitude more complex than Bitcoin.”
Maybe 18 more months. A year or three ago I was ridiculed for predicting it would take until at least 2020 for Lightning to be user-friendly and secure; it is an order of magnitude more complex than Bitcoin.
Despite taking nearly three years to roll out a six-month project, Lightning developers have yet to solve the most critical aspect of Lightning’s operations: routing payments. This is a gross oversight, since Lightning’s ability to route transactions is its scaling mechanism.
The Lightning Network routes Bitcoin payments much like SWIFT does for the existing banking system, relaying payments between nodes to reach a final recipient. But because Lightning has separate consensus mechanisms, it doesn’t need Bitcoin in order to operate – any provably scarce digital asset will do.
Even if Lightning existed in full, functioning form, it would work better using Bitcoin’s competitors: other cryptocurrencies, or even a digital dollar. While Lightning transactions themselves are cheap, users must bear the cost of an on-chain transaction in the currency they’re transacting.
Because all of Bitcoin’s competitors have lower fees, users would be better off using those in the Lightning Network. The only reasons to use Bitcoin are ideological.
Adoption
Adoption is the critical metric by which Bitcoin’s success can be measured. And adoption can only be defined as use in commerce. But because Bitcoin and the Lightning Network appeal very little to those outside narrow circles, adoption is curbed indefinitely. As the chart below shows, Bitcoin’s adoption and price are closely correlated.
This common sense relationship was taken for granted during Bitcoin’s price rise through the Silk Road years, 2011-2014. After the Silk Road was shut down, there was less demand for Bitcoin as a medium of exchange. Nothing comparable replaced Silk Road as an online marketplace requiring cryptocurrency, and coins with better privacy features have since filled the niche for illicit transactions.
Those who had lost sight of Bitcoin’s history as a currency instead began to push a narrative of Bitcoin as a “store of value,” independent of its utility.
Bitcoin Cash
After many years of debate in the community and attempts to fight malicious actors in Bitcoin, a few developers who recognized the ignorance of abandoning Bitcoin’s utility forked the chain to create Bitcoin Cash, which follows the original roadmap for scaling Bitcoin. We’ll be examining the future potential of Bitcoin Cash (BCH) in the next article, Investor Series #2.
If you’d like a notification when we release it, subscribe to our newsletter.
You’ll also receive our weekly analysis of the cryptocurrency industry, delivered every Monday morning.
There has been a lot of talk about Bitcoin this year. Bitcoin saw a meteoric rise from $1,000 at the beginning of 2017 to over $20,000 in December. That’s 20x: 2,000%. The most astonishing part is that it wasn’t unprecedented. Bitcoin does this.
Accusations of ‘bubbles,’ ‘scams,’ and talk of tulips has kept the world outside the crypto space jaded enough to put off investing. Some brave souls have dipped their toes in, but nearly all of the activity has been speculation. Even in crypto circles, the common understanding is that Bitcoin has 1) no intrinsic value and 2) no fundamental basis for valuation. The case I’d like to make is that these two properties are not synonymous.
There is a vacuum in the crypto space: very few people are trying to fundamentally value cryptocurrencies. I want to prove that it’s not only possible to determine the value fundamentally, but rational to do so. Therefore the goal of this model is not to create a specific prediction, but to enable those who would like to justify their investment to do so according to the assumptions they see fit. Reasonable experts may disagree about the assumptions which underlie a valuation model, but that is to be expected. To be clear, this article poses a sound, rational framework for valuing cryptocurrency. This is not intended as financial advice.
Background
This article is the first of several to come in the Investor Series. These include concepts from economics, finance, and a few specific to cryptocurrency. I do my best to provide links to resources about these concepts, but if you are unfamiliar with any of them, please leave a comment and I’ll respond directly and by updating the article itself.
Additionally, it will be helpful to readers to have read some of the thought leaders’ work in this space, specifically Cryptoasset Valuations by Chris Burniske, whose work I’ve found unparalleled in the space. I’m also a big fan of Kyle Samani and Ari Paul.
In addition to this article, I’d also recommend these for context.
Cryptoasset valuation is a new field. When I’ve broached the subject with friends working in traditional finance, they’re a little quizzical.
So, do you just use a DCF? Comparable private transactions? Public multiples of some kind?
Not exactly. Cryptoasset valuation is a new field, and cryptoassets are a new asset class.
However, traditional equations are still at play. We’re not quite at a point where ideas are widespread enough to consider entirely unique valuation formulas for cryptoassets (but Willy Woo’s NVT ratio is a great start). As Chris points out though, a Black Scholes Model for crypto would be a sort of holy grail.
Of these traditional formulas, the most helpful equation in understanding cryptoassets is the Equation of Exchange, traditionally used to value currencies. Until now, currency creation has been the near-exclusive domain of central banks and governments. The difference with Bitcoin is that it’s not centrally created, planned, or controlled. Hence the term: decentralization.
While cryptocurrencies are new types of currencies, we are still able to use traditional metrics and formulas to measure them. One such formula is the Equation of Exchange, which is used to calculate aspects of a currency’s supply and demand.
MV = PQ
In essence, this means that the amount of currency in an economy multiplied by the number of times each unit is spent is equal to the amount of purchases, times the average purchase amount.
We call M the monetary base, or the amount of currency in an economy. M is most often calculated using the other factors which are more directly measurable. In solving for M, we usually break up the equation and move some variables around. Mathematically, the equation used to solve for M looks like M = PQ/V.
We’ll be solving for M in the model in order to estimate the necessary supply of Bitcoin to support a growing number of transactions over time. In solving for M, the monetary base, we’ll start from the right explaining each of these components beforehand.
P stands for the average purchase amount made with the currency.
Q stands for quantity – the quantity of “average” purchases.
V stands for velocity. The velocity of money measures how often a unit of currency is transacted, typically per year or per quarter.
The other equation we’ll be using in this model is a Net Present Value, which has 3 basic premises:
The current price of an asset reflects expected future value.
Future value is based on expected returns.
Returns are proportional to risk.
Valuing Bitcoin
I’d like to restate that the assumptions included in this article are not meant to justify any particular valuation of Bitcoin. They will, hopefully, prompt healthy discussion of the drivers of value in the Bitcoin economy, and serve as a launchpad for future discussions of cryptocurrency’s value.
I took notes from Burniske’s model of the fictional INET protocol and included adjustable assumptions in my own. I think it’s important to justify assumptions wherever possible, and for this reason, the assumptions in my model have links in the comments of each cell, tracing them back to the strongest justifications I could find.
Of course, these assumptions are adjustable for a reason. Please include your own assumptions for any exploratory analysis. To change the assumptions, you’ll want to download or copy the Eat Sleep Crypto Bitcoin Valuation from Google Sheets, and revise that copy, as this one is view-only.
Overview
Models for cryptoassets are different than Discounted Cash Flows. With cryptoassets, there are no cash flows, or dividends; the asset itself appreciates.
This model is broken up into inputs, outputs, graphs, and backend calculations. As shown in the picture above, it is also color coded for traceability.
In the module labeled BTC Supply Inputs, the inputs for rows 2-7 are related to the supply of Bitcoin. I’ve also included a separate supply schedule sheet entitled ‘Bitcoin Supply Table,’ where cells are referenced in row 4.
% Hodl’d is the percentage of BTC held as investments (as opposed to being used for payments). “Hodl” is a widely used term in the crypto space. It’s a misspelling of hold, coming from this legendary post on a Bitcoin forum in 2013. % Hodl Liquidated is the divestment rate for invested coins. Assumptions are informed by data from a 2016 Coinbase survey.
Lost Coins is an estimate of how many bitcoins are inaccessible. The default assumption of 3 million coins is based on a 2018 study by Chainalysis.
The Economic Inputs module (in blue) includes inputs about economic factors , including worldwide GDP growth, and inflation rates. It also includes data about Bitcoin’s addressable market. For this example, we use the SWIFT payments network.
Bitcoin Valuation: Competing Theories
There have been a few theories about Bitcoin’s proper role in the world economy, and many debates even within the cryptocurrency community about this. I imagine the choice of the SWIFT network as a proxy for Bitcoin’s demand will be somewhat contentious, and to address that, I’d like to look at competing theories.
The first was the asset rotation thesis – that some percentage of another asset, namely gold will be displaced by investment in bitcoin.
A quick back of the envelope calculation:
190,000 tons of gold at $1,200 per ounce equals $7.3 trillion of gold total
Replacing 10% of investment in gold, total bitcoin supply equals $730 billion
$730 billion divided by 21 million bitcoin equals $34,700 per BTC
To the asset rotation thesis’s credit, we are starting to see evidence that bitcoin is replacing gold as an investment. However, this disregards Bitcoin’s network effect, and treats BTC as a commodity instead of a currency.
Side note: There has been much debate on Bitcoin’s properties as a medium of exchange versus as a store of value. It’s a topic I really enjoy, and one I can’t wait to post about in the future. For this article though, I’ve tried to stay out of that debate and create the best framework with assumptions most will agree on.
Another compelling argument for Bitcoin in the world economy is its use as a reserve currency. This argument is given by John Pfeffer in his paper An Institutional Investor’s Take on Cryptoassets.
As a cryptocurrency, Bitcoin is best valued with the medium of exchange equation. As a medium of exchange, Bitcoin has several addressable markets. While Bitcoin’s addressable markets are theoretically infinite, “large electronic payments” is sufficiently encompassing for this model. As a proxy for large electronic payments, SWIFT transactions are the most direct.
SWIFT
SWIFT, the Society for Worldwide Interbank Financial Telecommunication is the current system banks use for cross-border payments. Banks send messages back and forth to keep a system of credits. Bitcoin is a significant improvement from SWIFT. SWIFT operates only five days a week, takes days to settle, and users’ funds can be frozen by banks and governments. Bitcoin’s on-chain transactions are uncensorable, and faster than SWIFT settlement times. To replace SWIFT entirely, Bitcoin needs to be cheaper to transact.
SWIFT inputs are found in the Economic Inputs module, and in the SWIFT Payments Data sheet. The data comes directly from the SWIFT website. Predicted figures are based on historic growth of the network.
Also included in the Economic Inputs module is data on GDP growth, and inflation.
Adoption Curve Inputs
“A great technology company should have proprietary technology an order of magnitude better than its nearest substitute.”
The most subjective inputs in this model will be in the Adoption Curve Inputs module. These inputs represent your personal take on the scope of Bitcoin’s impact, and the amount of time that will take. For example, if you believe Bitcoin is a marginally disruptive technology, you may put 10% in for Market Share in cell B19. If you are a Bitcoin maximalist, you’ll likely put 100%, as you believe Bitcoin is an order of magnitude better than the existing payments infrastructure.
To model adoption of Bitcoin over time, I’ve used a logistic S-Curve function. The formula is used in row 19, columns E-Q. The Start of Fast Growth input is for the year you believe Bitcoin will have 10% adoption, which approximates the “tipping point” of adoption. After a tipping point, rapid growth follows. The take over time is the time it takes for adoption to go from 10% to 90%.
The specifics of the Adoption Inputs reflect in the Cumulative Adoption table, which factors into Bitcoin’s Current Utility Value as we’ll see next.
Synthesis
Now it’s time to calculate the intrinsic value of Bitcoin according to the Equation of Exchange. MV = PQ, if you’ll recall from earlier in the article.
These calculations are done in the spreadsheet in rows 18-28, but we’ll do them here in tables for simplicity, starting with values from 2018.
Our goal in using the Equation of Exchange is to solve for M, the value of the Bitcoin monetary base. An important catch here is that we’re solving for the actively used portion of Bitcoin’s supply. Coins held in paper wallets, for example, don’t explicitly affect the price of BTC.
To solve for M, we first want to input P into the equation. P is the average purchase amount of a currency. In this case, where Bitcoin is set to replace SWIFT transactions, we can take the Average Expected Message for 2018.
P = $558,018.69
Rounding that, we get:
M x V = 550,000 x Q
We’ll find Q next. Q stands for quantity – the quantity of average purchases. We also have the expected SWIFT messages per year, calculated in the spreadsheet using SWIFT’s data https://www.swift.com/about-us/swift-fin-traffic-figures. In 2018, Q = 3,485,852,902. We’re also assuming that Bitcoin is only taking a percentage of SWIFT transactions – according to default assumptions, 0.14% for 2018. We apply that to the number of SWIFT messages for a new (rounded) Q of 4,880,000.
Our equation now reads:
M x V = 550,000 x 4,880,000
We’re almost ready to solve for M, but we need V, velocity. To make things easier, we’ll move M to one side by dividing both sides by V.
M = 550,000 x 4,880,000 / V
You’ll recall V is a metric tracked by traditional economists, and published on websites including the St. Louis Fed. Bitcoin has turned a few heads in economist circles, and there are a few websites http://charts.woobull.com/bitcoin-velocity/ like this for Bitcoin metrics as well.
Bitcoin’s velocity fluxuates, but hovers around 5.5. Remember that we’re solving for the circulating and available supply of Bitcoin, so rather than using what Burniske calls hybrid velocity, we want to use transaction velocity. This is the number of times a particular unit of bitcoin is used in a year. To get this, we’ll divide the hybrid velocity of 5.5 by the percentage of bitcoin in circulation. Taking 1 minus our HODL % of 60% in 2018, we get 40%.
5.5 / .4 = 13.75
So our transaction velocity in 2018 is 13.75. Putting that into the equation, we have:
M = 550,000 x 4,880,000 / 13.75
We can now solve for M, the circulating portion of the bitcoin monetary base.
Multiplying and dividing these numbers out, we get:
M = 195,200,000,000
This means that to effectively process 0.14% of 2018 transactions from the SWIFT network, the circulating and available supply of Bitcoin would need to be worth 1.7 trillion dollars. Taking from our spreadsheet the circulating supply of Bitcoin in 2018, 5,362,500, we divide M by it.
195,200,000,000 / 5,362,500 = $36,400
Because of rounding, the model will be off by about 1% from our example, but the point stands. A per-Bitcoin value according to our assumptions would be $36,400.
With this same set of assumptions, the intrinsic value of one bitcoin continues to increase, roughly doubling for the next 8 years until adoption starts to level off in 2026. In 2030, after replacing 90% of SWIFT transactions, Bitcoin would be worth over $50 million per coin.
This is the intrinsic, or Current Utility Value (CUV) of Bitcoin. Currently, Bitcoin is trading around $7000, the market value. The difference between CUV and market value is analogy to the difference between book value and market value of a stock.
As I mentioned earlier, markets price assets according to future expectations. The Discounted Cash Flows method is used to price assets with foreseeable incomes. Bitcoin, however, has no cash flows. Instead, bitcoin itself is the appreciable asset.
Chris Burniske uses the term “Discounted Expected Utility Value”, abbreviated DEUV. We’ll use that. Bear in mind that most people aren’t valuing Bitcoin with any type of framework, so we should expect price discrepancies between DEUV and the market value as well.
To get the Discounted Expected Utility Value, we take a hypothetical End Year for our investment. In this case, we’ll say 2028, which gives us a 10 year holding period. Similar to a DCF model, we’ll also be using a discount rate. Discount rates are the average rate of return between the starting period of an investment horizon and the end period. Because risk is proportional to return, discount rates reflect the riskiness of an asset. Bitcoin is viewed as extraordinarily risky, so we’ll use a very high discount rate. In this case, 100%.
To get the DEUV for Bitcoin 10 years out, we take the Current Utility Value in 2028 and put in the discount rate to a Net Present Value formula.
NPV = 32,000,000 / (1 + 100%) ^ 10
Simplified
32,000,000 / 1024 = 31,250
This tells us that if the market held the same assumptions, Bitcoin would be trading around $31,250 in 2018.
Conclusion
The model accompanying this article was created with adjustable assumptions. However, there are many more factors surrounding the the ongoing development that should be considered. These include regulatory measures, the scaling debate, and the general perception of cryptocurrencies as scams, thanks to a few shady ICOs. Additionally, the lack of utility and intrinsic value of most tokens has left new entrants to crypto markets disenchanted with many 95% losses. Each of these problems have their root in a lack of economic understanding. For this reason, it is the goal of this series to highlight the importance of economic factors in cryptocurrency valuations. These factors are found at:
The development level, where token economics must be taken into consideration by developers;
The macroeconomic level, where macroeconomic trends in the traditional financial world must be accounted for;
And to a lesser extent, the regulatory level, where regulation tends to (at least temporarily) affect the value and use-cases of particular cryptocurrencies. Being that blockchain development tends to outpace regulations and route around them, this is less of a factor than the previous two.
The ways in which these factors affect the prices will be explored for each currency in future posts. As for Bitcoin specifically, we have seen the public perception change and the use-cases for Bitcoin limited. The main issues facing Bitcoin are adoption, the ability to scale, and fading anonymity. The decision by the Bitcoin Core development team led to the blocks frequently becoming full in December 2017. This caused the fee market to become an auction system, where users had to bid for their transactions to be included by miners. At their peak, transaction fees reached an average of $41.
Obviously, Bitcoin is a less suitable medium of exchange with high fees, especially for smaller transactions. This is by design, to create demand for second-layer protocols.
The next article in this series will be published at the beginning of next week. Eat Sleep Crypto Investor Series #2 examines the effects of such protocols on Bitcoin’s price and adoption.
