Over the past week, Eat Sleep Crypto subscribers received the first four parts of the Cryptocurrency Price Floors series.
Price floors can be used to predict what technical analysis experts call “support.”
In part three of the series, I described how I used price floors to predict Bitcoin’s fall from $5600 to $3170 almost to the dollar.
You can access the full article by signing up. It’s less than $5 a month, and the insights you’ll get will more than pay for themselves.
This is part five, on the price floor created by denomination of goods and services in a currency.
Price Denomination
The denomination of goods and services in a currency provides the sturdiest price floor for a currency.
We haven’t seen this yet in cryptocurrencies on large scale, but it’s starting to happen in Venezuela through sites like Freelance For Coins.
Denomination of goods and services in a currency inevitably follows the adoption of cryptocurrencies as payments in a local, closed-loop economy, or in economies with no imports and exports. Without products priced in other currencies on either end of a supply chain, the relative price of a currency becomes irrelevant.
Native denomination of goods and services has a ripple effect. Through social pressure, this ripple effect might extend outward, but through economic forces it extends downward in a supply chain.
For example, a merchant pricing sandwiches at ₿.001 might see his competitors adopt a similar rate, but a farmer selling chickens at a fixed ₿0.001 enables his whole supply chain downstream to start pricing products in Bitcoin with an absolute reference to their costs.
This relative valuation of goods and services is the principle behind the Big Mac Index, which values goods and services of a country relative to the price of a McDonald’s hamburger in its currency.
In the same way, we can start to value a cryptocurrency with reference to what it buys.
Cryptocurrency Adoption In Venezuela
This hasn’t happened on a large scale yet, but it may be the next step for third world countries using cryptocurrency.
I’ll be discussing the ways this might play out in Venezuela and modeling the Venezuelan economy with Dash and Bitcoin Cash to show the effect this would have on these currencies in the Eat Sleep Crypto newsletter later this month.
In the Dash and BCH articles this month, we will discuss the practical application of this framework as well.
Dash and BCH models will be available exclusively for subscribers of Eat Sleep Crypto.
Sign up for just $5/month to receive articles like this one delivered Monday through Friday every week, and exclusive access to other articles on the site including the full Cryptocurrency Price Floors article where I explain how price floors can be used to predict prices.
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.
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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.
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.
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.
