Category: Investor Series

Investor Series #5 – Binance Coin

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History

Binance was founded in 2017 by Changpeng Zhao. A newcomer to the Bitcoin space, the Binance exchange quickly became popular for its customer focus, and later for its native token, BNB.

Binance has also been working on a second exchange – one that is decentralized. The Binance “DEX” which will go live on or around April 23rd, 2019.

As of April 20, 2019, not much is known about the Binance DEX. In this article, we include as much information as possible in our analysis.

Updates to this article and accompanying model will follow.

BNB Token

BNB is an ERC20 token hosted on the Ethereum blockchain. Holding BNB in a Binance account gives users a 25%+ discount on trading fees when paid with BNB.

The Binance exchange also has BNB base pairs, as will the Binance DEX.

BNB is not used as a medium of exchange (MoE) for goods per se; it’s used as an MoE for other currencies.

Therefore, we can use the equation of exchange to value Binance Coin.

Valuation Principles

The popular narrative about BNB is that it resembles an equity and should be valued according to traditional formulas – a DCF model or similar. Adherents to the theory point to BNB’s correlation with Binance’s revenues, which are based on trading volume. The venture capital firm Multicoin Capital based their investment thesis on this heuristic.

Using Binance’s revenues as a proxy for BNB’s price assumes perfect value capture by the BNB token. The Binance team understands value capture, but based on observations, they are far from perfect at it.

More to-the-point, since Binance Coin is a currency whose variables can be identified and modeled, it makes more sense to value BNB as a currency, not as an equity, or a “store of value.”

For this reason, our analysis focuses on these factors: the circulating supply of BNB, and the variables in the equation of exchange, MV = PQ, which expresses the equivalence between the supply and demand of a currency.

Equation of Exchange Variables

In this article, we’ll abbreviate circulating supply to S.

In the equation of exchange, M represents the value of the circulating monetary base – all BNB in circulation.

V represents the velocity of those BNB. Velocity is the average number of times each unit is exchanged.

On the other side of the equation, P stands for purchases – the average value of a purchase made with BNB. Purchases with other currencies are of goods and services. Purchases using BNB are of other cryptocurrencies.

And Q is the quantity of purchases.

We model the future of each variable with adjustable assumptions in the Investor Series BNB model.

Supply and Demand

Fundamentally, currencies are subject to the same factors as any goods – supply and demand.

There are two sides to the equation of exchange; each side corresponds to supply and demand.

MV represents the supply side of the equation, while PQ represents demand.

Supply

Binance issued 200 million BNB as ERC20 tokens. Of these, 48 million are frozen, pending release according to Binance’s vesting schedule for employees’ tokens (found on page 9 of the BNB whitepaper). Over 11.6 million BNB have been burned by Binance in quarterly “coin burns”.

Due in part to Binance’s engineering the BNB supply, many of Binance’s supporters believe that Binance Coin is a “store of value.” It’s an somewhat irrational conclusion which becomes a self-fulfilling prophecy.

Most of BNB’s perpetual increases can be attributed to trading volume, with which it’s highly correlated.

The perception of BNB as a “store of value” disorients investors unfamiliar with currency valuation, especially since BNB is more frequently affected by changes in supply than other currencies.

Factors which primarily increase supply

Vesting of employees’ tokens

Tokens given as part of employees’ compensation are governed by a vesting schedule, found in the Binance Coin whitepaper.

Each year, 16 million BNB becomes available for employees.

Based on chain analysis and price history, we believe employees’ BNB vests in July each year. Employees appear to have sold their BNB within months of receiving it.

The BNB model includes an adjustable assumption for the percentage of employees’ BNB which enters the circulating supply the same quarter.

Factors which primarily decrease supply

Binance’s quarterly BNB burns

In a direct effort to reduce the total supply, Binance burns 20% of their profits in BNB every quarter.

Binance’s 7th quarterly burn included 829,888 BNB – around $15,600,000 USD at the time. Burns will continue until the total number of BNB tokens reaches 100 million.

Staking requirements for Binance Chain

The Binance Chain which supports the DEX uses a Delegated Proof of Stake (DPoS) consensus algorithm to keep the network safe from malicious actors.

As a result, the Binance DEX looks almost identical to BitShares (BTS). Difference are mostly superficial; the Binance DEX uses BNB instead of BTS, and its blocks are every second instead of every 1.5.

BNB holders elect block producers – one vote per BNB. Block producers can either campaign to receive votes from existing BNB holders, or buy BNB and vote for themselves.

Since it’s cheaper to buy votes than BNB, block producers will do this instead of hoarding BNB. This leaves circulating supply unaffected.

Under a pure Proof-of-Stake system, Binance DEX would require a significant percentage of total BNB, which could decrease the circulating supply. Some DPoS-based blockchains require stake as well; we’ll find out this week what the staking requirements for Binance Chain are.

If the Binance Chain requires a fixed BNB stake per validator, the circulating supply may be reduced by stake amount * number of validators.

Binance Launchpad

Binance Launchpad is an ICO platform that accepts BNB for ICO tokens.

BitTorrent accepted BNB for the first round of their ICO. BNB raised through ICOs stays out of circulation as long as BitTorrent’s treasury chooses to hold it.

BNB locked up for the DEX

BNB locked up via transactions on the Binance DEX is the most interesting way BNB supply is reduced; it’s also unexplored.

The Binance DEX doesn’t exchange other blockchain assets. Buying one BTC/BNB pair on the Binance DEX is actually a purchase of a BTC’s worth of BNB tokens.

When the BTC/BNB pair is purchased on Binance’s centralized exchange, BNB goes to one party, BTC to the other.

Both coins remain in circulation.

On the Binance DEX, it is just BNB being exchanged, except one party holds some number BNB in place of another asset.

This takes a disproportionate amount of BNB out of circulation, while increasing the demand for BNB on the other side of a trade.

The net effect of this is yet to be seen, but if the Binance DEX were to fully displace Binance’s centralized exchange, it would move the speculative value from other cryptocurrencies to the BNB token.

Unfortunately for BNB holders, the Binance DEX is quite limited in scope – requiring a Ledger to sign on.

We will reevaluate this possibility once the Binance DEX gains traction.

Factors which increase demand

Trading volume

BNB can be used to pay Binance trading fees at a discount. Increased trading volume on Binance brings more demand for BNB.

BNB is somewhat correlated with overall crypto trading volume, but not entirely. There are no major uses for BNB outside of holding a balance to pay for fees.

The Binance DEX, Launchpad, and future Binance endeavors may change this.

Factors which decrease demand

Regulatory crackdown

Regulatory action against Binance make BNB less valuable to the extent it restricted Binance’s users or operations.

Because Binance a) moves quickly and b) operates in several supportive jurisdictions, it is unlikely regulators will catch up to the company.

KYC is one of Binance’s concerns, however, and this may take a toll on their user base. It may also have inspired their DEX.

BNB Investor Series model

Now that we’ve reviewed factors which affect BNB’s value, we’ll construct the model.

First, the supply inputs.

The Binance exchange’s current wallet contains just over 91 million BNB.

Since there are no real off-chain uses for BNB, this is the circulating supply. 48 million BNB are frozen; 11.6 million are burned.

The rest are trading on other exchanges, or held by large investors and Binance employees.

Each quarter, we factor in employees’ tokens which enter circulating supply after vesting, and the number of tokens burned.

Based on chain analysis, employees’ tokens appear to vest in Q3 each year, and there are roughly 1.5 million tokens burned each quarter.

Trading volume inputs

Click here to open the model

Exchange fees

Aside from speculation, demand for BNB comes from trading fees on the Binance exchange.

We assume all trading fees are paid in BNB at 0.075% of trade value.

There are two sides to each trade, and each is paying fees, so we multiply the fee rate by 2 and apply it to volume.

Growth rate

Binance is already one of the largest exchanges, so its growth would come from cryptocurrency price increases rather than competitors’ volume.

Assuming increased trading volume is driven by cryptocurrency price increases, all else being equal, the default assumption of 50% quarterly growth reflect a $75,000 BTC price at the end of 2020.

Velocity

Velocity is the number of times each unit is transacted in a given time frame, on average.

We imagine Binance users refill BNB balances every two weeks, on average, which would give us a quarterly velocity of 6.5.

This assumption is adjustable also.

Monetary Base

Link to the model

To solve for the value of circulating coins, we rearrange the equation of exchange to isolate M:

M = PQ/V

In our example, where each BNB circulates 6.5 times per quarter, the required value of circulating BNB is 20.7 million.

Divided by the circulating supply of 89,500,000 gives us a per BNB fair value of around $0.35 in Q2 2019.

Conclusion

Unless we drastically overestimated circulating supply and/or velocity, this analysis suggests BNB is 70x overvalued for its use case – paying Binance fees.

This does not necessarily mean BNB’s price will fall.

Although cryptocurrencies trend toward their fair value, BNB is very popular with speculators. With no way to short, price discovery is difficult.

BNB has consistently traded above its fair value for most of its existence. Due to its noncorrelation with other cryptocurrencies, speculators treat BNB as a hedge. This drives demand up on exchanges while locking up supply.

It makes perfect sense that BNB would be uncorrelated while trading at 70x its value – it’s barely tied to fundamental drivers of value.

Tulips are also uncorrelated.

Future of BNB

An informed bet on BNB is a bet on the Binance team or community to create more uses for the token.

The Binance DEX could give BNB fundamental value if it locks up enough either as stake on Binance Chain or as collateral for pegged-assets.

A second round of ICO mania centered around Binance Launchpad could also bring fundamental value to BNB.

At Eat Sleep Crypto, we prefer cryptocurrencies with fundamental support from real use-cases.

These currencies have less downside and often more upside from less speculation. Maximizing upside potential while minimizing downside risk is key.

We’ll be talking about this concept in the coming week at Eat Sleep Crypto – look out for more email updates on BNB as we hear more information about Binance Chain and the Binance DEX.

Investor Series #4 – Bitcoin SV

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Bitcoin Satoshi Vision is a fork of Bitcoin Cash. Like Bitcoin Cash, BSV intends to scale on-chain with large blocks.

The difference between Bitcoin Cash and BSV is ideological. Where the BCH community is distrustful of government, BSV is not.

The leads to a different scaling approach. Since BSV proponents are not worried about government surveillance, the Bitcoin SV chain has no need for decentralization. It can be hosted by as few or as many miners as will compete to build the chain.

The name ‘Satoshi Vision’ is partly indicative of this approach as Satoshi said Bitcoin would eventually be hosted in large data centers.

Fee Market Solutions

Cryptocurrencies are intended to be means of payment. Bitcoin SV recognizes this, but BSV’s scaling approach is different than other cryptocurrencies.

Bitcoin SV is increasing block size to allow a true free market between miners and users via miners’ fees. Instead of payment transactions, BSV will charge fees for storing data at first.

Because centralization is no threat per Bitcoin’s incentives and BSV’s love of transparency, only miners which are able to store large volumes of data will remain on the network.

To promote this data storage fee market, the Bitcoin SV community developers are creating applications that use the SV blockchain as a data storage layer.

Immutable data storage is not in high demand, and currently prohibitively expensive on BSV for traditional storage. Timestamping data to create an immutable record is a valuable application of blockchain, but there’s not enough demand to make it worthwhile.

However, use as a traditional server is a good fit for a centralized blockchain like Bitcoin SV.

Storage on BSV

SV fans are calling this data storage layer Metanet and have started to build on it.

Bitcoin SV is technically capable of being the data storage layer of the internet. The question is can BSV compete with traditional storage providers?

Short of illegal applications which the BSV community is opposed to, there are few use-cases for this immutable storage at fees of 1 satoshi per byte.

However, at a lower fee per byte of data, Bitcoin SV might be able to undercut competitors.

As an example, we’ll use Google Cloud’s price per GB of storage and compare it to BSV miners’ costs. If BSV can undercut Google at any price point, it will slowly steal market share while accruing economies of scale. Economies of scale would afford miners lower costs and enable continual undercutting of competitors with large overhead costs.

Before modeling BSV’s price under these circumstances, we must see if it’s economical for BSV to provide this service.

Bitcoin SV vs. Google

The use case we’re examining is the most basic that Bitcoin SV can provide – cold storage of data.

A quick note: this means infrequent or no retreival of data. Thanks to public block explorers with limited API calls, this is about what we have.

The price of data retrieval is a different issue, but we assume a specialized node could provide the service more cheaply than large data centers like Google or Amazon.

Coldline storage with Google Cloud costs $0.007 per GB with a minimum of three months. To determine whether BSV miners could compete with this, we can approximate the costs incurred by the network.

Most BSV miners are profitable at present, and the cost of including a transaction into a block is negligible, so we assume the only additional costs are storage space in the form of HDD disks.

The cost per GB of storage is $0.016 and halving every 18 months or so according to Moore’s Law. A user deciding between Google Cloud and BSV at-cost would see the Bitcoin SV chain is cheaper than Google at their 3-month minimum.

But we can’t compare the costs of just one miner – since storage is redundant, the cost to the network is at least the cost of required hard drives for each miner.

We’ve included an adjustable assumption for the number of miners in the model which you can follow along with.

At scale it would be quite costly and likely unprofitable for smaller miners which would keep this number down. Consensus seems to be that about three miners would maintain the network.

This would be sufficient for the decentralization required by redundant data storage, or transparent cash transactions.

The cost of storage would also increase as more miners entered the network if they tried to pass these costs on, which limits the viability of the network for storage in the first place.

Assuming three miners providing data storage at or close to cost, the price of data storage on BSV would be a one time fee of 4.8 cents per GB.

A user comparing prices with Google would see a breakeven at 7 months.

Global Data Storage

The internet is growing at 70 TB per second.

We’re using gigabytes (GB) as a common denominator – 70 TB is 70,000 GB.

10% of that would allow everyone on Earth to upload a few photos to Facebook per day and create some short videos to upload as well.

In the model, we also include an assumption that this user-generated content suitable for immutable storage doubles in size every year.

With our default assumptions, the cost of storing all this data would be $10.6 billion in 2019, and around $135 billion in 2030.

All of this would be paid in BSV.

Using the circulating supply of BSV and the equation of exchange, we can calculate what each BSV would be worth in this system.

Simplified, the equation of exchange shows that the circulating supply of a currency is worth what that currency is used to purchase, divided by the velocity of that currency – the average number of times each unit circulates.

In the model, we estimate the circulating amount of BSV based on bitcoin issued, the number of lost coins and an adjustable ‘hodl’ percentage.

We estimate velocity at 12 to simulate users refilling their balances once per month.

Combining all of our factors into the equation of exchange yields a value of $84 for 2019, and $869 in 2030 with our default assumptions.

At the time of writing, the price is $83.18 – this is purely coincidental, as our assumptions are simulating massive amounts of on-chain storage when in reality there is very little.

Feel free to make a copy of the model and change these assumptions.

BSV as a medium of exchange

If you do adjust the assumptions of the model, you’ll find that that no matter what constraints you include, BSV simply isn’t that valuable as a medium of exchange for just data storage.

However, if the Bitcoin SV blockchain actually became the data storage layer of the internet, it would likely be used for other things.

First on that list would likely be payments for data retrieval i.e. internet service – this would add some value to BSV.

It’s the BSV community’s hope that as the currency native to the internet, BSV would be adopted for all payments.

It’s possible, but because BSV is highly traceable and lacks anonymity, it’s not a given. Some private citizens care about their privacy, but more than this, governments and politicians value the ability to transact anonymously.

The dystopian median between governments’ conflicting interest in surveillance and politicians’ desire for anonymity of transactions would be a mandate that private citizens use BSV for payments while governments and politicians use some other anonymous currency like Monero (XMR).

Short of a government mandate, though, it seems unlikely BSV will be adopted for all payments, but not impossible.

With the way the BSV community is ingratiating themselves to governments by proactively designing legally compliant applications, a bet on BSV is a bet on government endorsement. It’s not necessarily a misplaced bet, but seems likely to lead to dystopian outcomes.

BSV proponents imagine citizens keeping politicians accountable using this system. This seems unlikely – surveillance doesn’t tend to work two ways. Beyond that, this could also legitimize redistribution schemes and create mob rule.

In conclusion, if miners lower the satoshi per byte fee, BSV can become the data storage layer of the internet. It could also be adopted for payments in the future, but not a future we’d support.

Investor Series #1 Addendum

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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.”

Andresen’s suggestion, “18 more months” is also an indirect jab at Lightning Network developers, and Lightning Labs CEO Elizabeth Stark.

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.

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Investor Series #1 – Bitcoin

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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.

John Pfeffer’s Institutional Investor’s Take on Cryptoassets

Friedrich Hayek – The Denationalization of Money

Lou Kerner, Chris Burniske, Ari Paul – Cryptocurrency Conference Call

Valuing Cryptoassets

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.”

― Peter Thiel, Zero to One: Notes on Start Ups, or How to Build the Future

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.