We know now that Bitcoin moves a lot more like FAANG stocks than Gold. It is not an imperfect hedge or even a reliable store of value. It is not a security because most regulators can’t agree on what a “security” is – except that it is traded like securities (with futures and proposed ETF) and it is not a commodity, because well, you can’t see it.
Its numerous skeptics put its value at zero. My broker puts the value of a stock pledged as margin, when is a small or midcap stock at … zero after a 100% haircut – it doesn’t matter to my broker if its EPS is growing at 50% CAGR. Value is in the eye of the beholder.
To the Romans, early Christians were a nuisance but to its believers – they were witnessing a miracle. Similarly, old finance tends to see Bitcoin as either a useless or dangerous nuisance, while the zealots value it bizarrely between 10k to 100k.
What is noteworthy is an anonymous creator and “immaculate conception” of some trustless token that is not backed by sovereign guarantee but is still secured and scaled by a collaboration of unpaid programmers across borders. A miracle, after all, is something that cannot be replicated.
So what is the fair value of one BTC in USD/Yuan/Rupee?
NOTE: This post is NOT Buy or Sell advise. Cryptocurrencies are very volatile, are subject to legal / regulatory risk and also carry a risk of permanent capital destruction.
Bitcoin went past $3000 as “segregated witness” or Segwit, the latest version of its open source code is days from locking in to the nodes on its blockchain on August 8th, 2017.
Segwit aims to solve Bitcoin’s long standing scaling problem and serves as a positive fundamental trigger to its price. For stock investors, imagine capacity expansion without the capex. True to fashion, the market bought the rumor before the news and pushed the price above the last all time high of $3019 in June.
This move caught many technical analysts by surprise, as Bitcoin – honey badgerlike – continues to shrug off bad news and humiliate market oracles. I think what is most significant is that the long-term underlying bullish trend has been confirmed this week, which means the odds of a major Bitcoin “crash” have plummeted and a $5000 to $10,000 Bitcoin price is now in sight.
Valuation of cryptocurrencies is not an exact science
Fiat currencies draw their value from demand and supply and are not pegged to intrinsic value. Cryptocurrencies are no different from fiat currencies issued by central banks – except with their cap on inflation
Like fiat currencies, the value of cryptocurrencies also derives from network effects, trust and utility
Over time cryptocurrencies may become liquid and divisible assets – more like gold coins or shares than paper or “fiat” money
An amount of $1000 invested in Bitcoin in July 2010 is worth more than $35 million in 2017. This confounding rise has been called an asset bubble. Some have even termed it mania. Analysts at a top investment bank on the other hand have predicted that Bitcoin could almost double from its current price. There is no consensus in expert opinion over the value of cryptocurrencies and this reflects in the price as huge volatility and swings that are uncharacteristic of traditional and efficient financial markets.
In the long run the market is a weighing machine, in the short run a voting machine – Benjamin Graham
Source: The Balance.com
Not Monopoly Money: Cryptocurrencies are based on the sound internal logic of the Blockchain
The blockchain is by nature a de-centralized and distributed network. To create an internal system of incentives between the many nodes in such a de-centralized system, requires a system of trust and reward. The blockchain uses network tokens or coins – which the rest of the world buys and trades as cryptocurrencies on currency exchanges.
Without these tokens the nodes, miners and developers distributed across the blockchain would have little economic incentive to enhance and support (known as proof-of-work and proof-of-stake) a de-centralized network’s functionality. Tokens can therefore be seen as a gamification of open-source software development and serve to enable collaborative maintainance and creation of these blockchain applications. In sum – they serve as a financial incentive – like regular money – only in a different milleu.
Illustration: Cryptocurrencies enable gamification of the blockchain’s economy
Based on the underlying code – this system of token based rewards can be inflationary – like regular currencies – or deflationary like gold. Over time deflationary systems like Bitcoin grow more valuable due to scarcity (only 21 million bitcoins can be “mined” or created) as opposed to inflationary systems like Ethereum that were designed to reward and enable newer and bigger applications over the Ethereum blockchain. “The code is the law” in blockchain economies. There will be no arbitrary quantitative easing or tightening. Due to de-centralization, the schedules of monetary policy have been pre-determined and are hard-coded.
All that is Gold does not Glitter
If Bitcoin is like digital gold, what is its intrinsic value? You can’t use Bitcoins in electronics or in cosmetic teeth, neither does it have industrial applications like diamonds. You can’t see, feel or hoard Bitcoins during economic depressions or times of war. Bitcoin has no intrinsic value like gold.
But unlike stocks, gold (or diamonds) offer no future cash flows to arrive at a present value. Generational gold lies in your bank locker or comes to you through inheritance. Gold is part of human tradition and history, just as cryptocurrencies may be a part of our digital, increasingly cyberpunk future and a reflection of our loss of faith in central institutions. Value can be perceived without being quantified.
Millenials are growing disinterested in precious metals and the stock market, which they see as rigged. Digital cryptocurrencies – with their appeal of privacy and de-centralization – may be more suited to their style. Bitcoin’s recent price has been pumped by demand from Venezuela, China and Japan where “issued” currencies are backed (arguably) by poor monetary policy.
Perhaps value like beauty lies in the eye of the beholder. Or perhaps people are increasingly looking for liquidation value, privacy and trust in their assets and coins rather than putting their trust in the ghost of future dividends and a future with centralization and state interference in property rights.
Cryptocurrencies are a new unit of Trust
All currencies are meant first to be tokens of trust and exchange. Due to its distributed, de-centralized architecture, one of the most promising business applications of the blockchain is a transparent and distributed public ledger that cannot be altered. Think of it as Triple Entry Accounting (Double-entry + Fractal entry). Fractal entry is an encrypted entry of every transaction on every node on the blockchain. Nothing can be tampered with under such an arrangement and no trusted third parties are required.
What this means is that while Central Banks can declare the legal tender of their paper currencies void and make them illegal overnight – they cannot confiscate your Bitcoins or alter your records of property because they are verified on a blockchain node on the internet and stored for eternity. Cryptocurrencies are trustworthy as a store of value because of privacy, de-centralization and their enduring nature.
Fiat currencies are powerful because of network effects (think Petrodollar). Paper currencies are traded on exchanges, accepted by banks, transfered globally over SWIFT and swiped at the end of your plastic cards – so why do we need cryptocurrencies?
With Cryptocurrencies in circulation:
You won’t need the plastic cards – just your smart phone wallet
You won’t need banks and intermediaries – just the hash address of the payment destination to transfer at lightening speed
You won’t need to pay a transaction fee to the bank or card company – just a miniscule “mining” fee to the miners on the blockchain
The middle-men would be gutted out in a global blockchain of trust between direct participants.
How far along are we towards mass adoption? Bitcoin USD and Ethereum USD pairs are already being traded and accepted at several “cryptocurrency” exchanges and crytocurrencies are convertible from fiat currency.
Japan, Austria, Australia and South Korea have taken several steps to facilitate the retail acceptance of Bitcoin and Ethereum at shopping stores and even post-offices. ETFs for investing in cryptocurrencies are being reviewed by the SEC for regulatory approval. Ethereum blockchain has even become a funding platform to raise venture capital funds via ICOs (Initial Coin Offerings) like equity IPOs facilitated by investment banks. Market Making in cryptocurrencies has already kicked off. Hedge Funds are adding Cryptocurrencies as a part of their portfolios. Network effects are coming into play.
Money flow drives relative valuation
Liquidity drives valuations in these times of FANG stocks trading at 200+ PE and Unicorns with no free cash flows. Total M2 money supply in the US is about 13.5 trillion and that is driving up asset bubbles. Cryptocurrencies have cornered only a small share of that amount.
Ethereum is trading at about the same market capitalization of Snapchat and institutional funds are still to enter. It may be a bubble but is it a mania yet? Liquidity gives cryptocurrencies another leg to stand on.
Business utility will drive future value
The value of our our wealth decreases with time due to inflation. Inflation as they say, is taxation through other means. So why not replace bank notes that depreciate in value with a currency that is earnings accretive like stock securities?
Enter platforms like Ethereum that allow business applications be developed on top of their blockchain. Some of these platforms will grow potential new Web 3.0 companies worth billions of dollars that disrupt financial services like payments, clearing houses and insurance. Blockchain architecture also lends itself to government uses like registering of digital assets and collection of taxes. The Chinese government is already researching potential applications of KYC compliance blockchains.
Since there is a theoretical cap on the number of network tokens, the cash flows of each of these business and government applications will accrue to the owners of these tokens – like dividends in a company’s stock. Some day in the future it may be possible to do a discounted cash flow analysis to calculate the value of each unit of cryptocurrency – just like stocks.
This post is a strictly personal view on the durability and valuation of cryptocurrencies and is not trading advice. Cryptocurrencies are a completely new asset class/currency which defy our traditional understanding of valuation and should be looked at as a speculative investment albeit with promising future utility.