Bitcoin dominance denotes the percentage market share Bitcoin has among all cryptocurrencies.
The metric made sense at its inception, though there was little need for other cryptocurrencies in 2013. It was assumed that Bitcoin would scale to handle all possible transactions.
Now, Bitcoin dominance is used to compare Bitcoin (BTC) to every other cryptocurrency – without regard to the fact that BTC is no longer a currency, nor does it aim to be one.
After Bitcoin was co-opted by globalists and the Bitcoin community split into two, the BTC branch started promoting Bitcoin as ‘digital gold,’ while the other side of the community became Bitcoin Cash (BCH) and promotes Bitcoin as cash.
Apples-to-oranges comparisons
Because BTC is no longer a currency, it seems ill-fitting to compare it with actual cryptocurrencies like Bitcoin Cash, Dash, and Monero.
Apples-to-apples comparisons would use TAMs to compare cryptoassets with the same niches.
Actual BTC dominance
By this standard, BTC’s dominance is nearly 100%; no other cryptocurrency is as slow and expensive to use as BTC.
Through a host of cognitive biases, BTC maximalists have actually convinced themselves these are desirable properties for Bitcoin, since they are also features of gold.
We’re speaking somewhat tongue-in-cheek, but BTC is actually the only cryptoasset pursuing “store of value” uses for a Total Addressable Market.
Other TAMs
As we mentioned above, cryptocurrencies have a separate niche from ‘digital gold’. Cryptocurrencies like Bitcoin Cash, Dash, and Monero address the ‘medium of exchange’ market.
There are also many niches for blockchain applications to disintermediate. Many ICOs issued tokens designated specifically for this second niche.
Platform tokens
Through the 2017 ICO wave, speculators learned that separate currencies are unnecessary for specific niches. Most use cases of a blockchain can use the blockchain’s native asset, or a stablecoin built on it.
The blockchains underlying applications are generally called platforms; we call their native assets platform tokens.
Ethereum and ETH are one such example.
Platforms fit a large niche with several sub-niches, each with a corresponding TAM. In making comparisons, it would make sense to compare the supply of these platform tokens to each other, rather than to BTC, or to cryptocurrencies like BCH.
Conclusion
BTC used to be fast, cheap, and reliable – it used to work like Bitcoin Cash.
Now when BTC fees increase, people use other cryptocurrencies. The only context in which it makes sense to compare BTC to Bitcoin Cash (BCH) or Ethereum (ETH) is in the amount of money flowing into the ecosystem through each asset.
A new metric or series of metrics is required to measure dominance between cryptoassets.
For now, we’re specifying the TAM of each currency in our Investor Series articles and models. If there’s demand for it, we’ll create charts to classify cryptocurrencies according to target markets.
Let us know in the comments what you’d like to see in future articles, or in follow up to this one.
The question is compelling because it’s real. It’s easy to balance two, but a blockchain with all three is still theoretical.
Bitcoin Forks
Bitcoin has been forked innumerable times, but the Bitcoin community has only forked twice – creating three separate chains.
Each of these chains correspond to a position in the “blockchain trilemma.”
BTC
The fork of Bitcoin known as BTC chose security and decentralization.
By limiting the amount of transactions which could fit in a block, BTC ensures that miners will never get so large that they can be coerced by malicious actors.
BCH
Bitcoin Cash (BCH) forked over BTC’s decision to keep the blocks small, and transactions limited, because small blocks cause high fees, and high fees limit the potential user base – rendering Bitcoin (BTC) useless as cash.
The (short-term) sacrifice BCH made was security, and to some extent decentralization, but the community’s support of the coin is exercised through the market; if decentralization were to falter, the market would punish holders of BCH and therefore miners and developers.
Regarding the trilemma, BCH chooses decentralization and scalability.
BSV
That leaves one position for the third and final fork. Bitcoin Satoshi [sic] Vision (BSV) chooses scalability and security.
Conveniently, BSV supporters deny that the trilemma even exists. Nevertheless, it’s quite clear to everyone outside their cult why they’ve chosen this. It has to do with the political ideologies of those involved.
Solutions to the Trilemma
Between those forks which acknowledge the blockchain trilemma, third-party solutions to it have been suggested.
BTC’s solution is the Lightning Network, supposedly trustless and decentralized, but not so in practice. Without a trusted oracle to keep nodes aware of the state of the network, formation of centralized hubs is inevitable.
Pending its success in a testnet environment, Avalanche is one solution for Bitcoin Cash. Avalanche is similar to the theoretical Lightning Network in that it would shore up BCH’s weaknesses dictated by the trilemma.
We’ve linked the latest example, which just so happened to be yesterday – we Googled the recurrent problem and that came up.
Conclusion
This problem is not unique to Bitcoin forks. Every blockchain is trying to solve the blockchain trilemma – even BSV; the problem still exists.
This framework is helpful for contextualizing Bitcoin forks thus far, and may be helpful in predicting future Bitcoin forks.
While there are only three possible answers, according to the structure of the question posed by Gabriel Cardona, in practice, blockchains may include some level of each.
The extreme positions resulting from “pick two” are merely illustrative.
It’s possible that in the future, should the market call for further forks, that splits will be along these lines – for example, an emphasis on scalability over decentralization, or in varying degrees of all three.
Bitcoin forks have caused a financial bloodbath and vicious animosity between community factions, so we hope there are no further forks, but (thankfully) that’s not up to us – the market determines whether a fork is prudent or not.
“Bitcoin is digital gold” is a popular trope among Bitcoin (BTC) maximalists due to its scarcity and [former] use in payments.
Bitcoin had obvious advantages over gold, Bitcoin Core developers destroyed these after ousting Satoshi Nakamoto’s handpicked successor and those who supported his vision.
Bitcoin’s unique value proposition was as a permissionless payment network with a native asset.
Digital dollars require a Visa, Paypal, or SWIFT to move through; cryptocurrencies are native to their networks.
Bitcoin scaling and high fees
Contrary to Satoshi Nakamoto’s advice, Bitcoin Core developers artificially limited the amount of transactions Bitcoin could process.
This created a bidding war for block space, driving fees up to ten, fifty, even hundreds of dollars per transaction in some cases.
Apologists like Safidean Ammous argue that this is how Bitcoin is supposed to work; some developers are even campaigning for less space for transactions each block.
A new analogy
Maximalists’ reasoning that difficult, costly transactions are desirable because they mimic gold is clearly absurd – a dogmatic fixation with reasoning by analogy instead of from first principles.
Yet, the analogy conveys a potent message: Like gold, Bitcoin is scarce and durable, and therefore valuable.
Analogies can be useful in teaching, but all analogies break down in some detail. “Digital gold” misses Bitcoin’s unique nature as a payment network AND its native asset.
If we are to continue introducing newcomers to cryptocurrency by analogies, a new analogy is in order – and one that highlights cryptocurrencies’ unique utility.
“Digital Platinum”
Gold is not an especially useful metal.
Most of its “use” is as a speculative instrument, or else as a display of wealth – a feature not replicable by Bitcoin.
Among precious metals, copper is arguably the most useful, but it’s not scarce. Platinum lies somewhere in between.
Digital platinum makes for a better analogy, especially for Bitcoin Cash, which follows Satoshi’s outline for scaling that affords it utility.
True to the analogy, platinum is even used in its own mining, found in the catalytic converters of the heavy machines which harvest the ore.
Conclusion
No analogy is perfect; taken to extremes, this one would fall apart as well.
For the purpose of informing the next wave of cryptocurrency users, though, “digital platinum” should do.
Hopefully we won’t need to write another article in five years clarifying the intent of this one.
This article is based on a Twitter conversation with Adrian X and Tao Jones, two of my favorite Bitcoiners.
I am consistently impressed with their creativity, open-mindedness, and articulation of arguments; they are worth following.
Transaction Volume and Decentralization
Each of Bitcoin’s three major forks can be summarized by their ideological preference for these two characteristics: transaction volume, and decentralization.
All of Bitcoin’s forks agree that censorship resistance is desirable. However, Bitcoin, Bitcoin Cash, and Bitcoin Satoshi Vision have different ideas of how to achieve it.
Bitcoin started as a way to make payments which couldn’t be censored. We call this quality ‘censorship resistance.’
Censorship resistance is achieved through Bitcoin’s incentives, which encourage a level of decentralization.
Bitcoin (BTC)
The fork of Bitcoin which kept the BTC ticker is mostly focused on decentralization.
BTC achieves decentralization at the base layer, but the community has become so fixated on decentralization, it’s forgotten the original goal.
Rather than peer-to-peer electronic cash, BTC is becoming a settlement layer – too expensive to use in daily transactions.
While the main chain is still ‘decentralized,’ using BTC for payments will soon require the trusted third parties Satoshi sought to eliminate.
The BTC community’s fetishizing of decentralization keeps forcing it further and further from its original purpose as a permissionless medium of exchange.
Bitcoin Satoshi Vision (BSV)
Bitcoin’s latest incarnation, Bitcoin SV aims for censorship resistance of everything.
BSV doesn’t limit censorship resistance to just transactions. It wants to include all types of data – photos, videos, documents – the whole internet on BSV.
This is entirely possible, but at the cost of significant levels of decentralization.
Bitcoin SV advocates frequently and aggressively assert that BSV can scale.
Of course it can – as can Facebook Coin, JP Morgan, and Hashgraph.
They all sacrifice decentralization.
Decentralization
Decentralization is necessary to offset systemic risk.
Unfortunately, in the hostile environment of the modern world, incentives within the protocol are not enough deter bad actors from outside it. Because all BSV miners will be known at scale, they could be forced to censor transactions.
Bitcoin Cash (BCH)
BSV sacrifices decentralization for censorship resistance of increased transaction volume.
BTC sacrifices its utility altogether.
BCH strives for sufficient levels of each in order to maximize its utility as a medium of exchange.
Decentralization exists on a spectrum; transaction throughput is high enough when all demand for payments is filled.
BCH is not perfect – it suffers from the same governance problems as the other forks.
But it’s the only fork of Bitcoin which has its priorities straight.
For different reasons, BTC and BSV miss the forest for the trees.
BCH is solving for Bitcoin’s intended use, as a medium of exchange.
Valuing Cryptocurrencies
BTC and BSV advocates also rationalize that their use cases will give their coin value.
These are topics for another post, but utility as a data store doesn’t make BSV very valuable, and Metcalfe’s Law is mostly relevant to BTC because it’s a pyramid scheme.
This is not a unilateral endorsement of BCH; each of these three currencies could succeed in their own way.
However, BTC and BSV don’t create futures worth supporting.
I’m with you, any of them could succeed but BTC is just a cosmetic upgrade of the status quo and BSV far too easily lends itself to an Orwellian dystopia.
A case can be for the success of other coins, but the cryptocurrency that dominates the market in the future will be the one which is used as a medium of exchange.
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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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.
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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.”
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.
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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.
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.
