Cryptocurrency Valuation: Opinion vs Evidence
While perhaps intended as an alternative payment system with no government involvement, it has become a combination of a bubble, a Ponzi scheme and an environmental disaster… The volatility of bitcoin renders it a poor means of payment and a crazy way to store value.
– Augustin Carstens, General Manager of the BIS
You can’t value bitcoin because it’s not a value-producing asset… It’s rat poison squared.
– Warren Buffett, CEO Berkshire Hathaway
These statements come from industry experts, but they remain opinions. And while there is no dearth of opinions in the cryptocurrency space, thoughtful analysis is few and far between.
Much of investors’ understanding of fundamental value of assets has been derived from analysing traditional, product-based businesses in the physical world. Savvy investors such as Warren Buffet look at these businesses as cash-producing assets and apply traditional valuation models, one of the most popular models being DCF (discounted cash flow). Cryptonetworks are not traditional businesses, and the tokens that fuel them should be valued using a different set of metrics (e.g., Network Value / Transactions). Market analysts, researchers and venture capitalists have only started to develop these metrics and are yet to find equivalents of balance sheets and cashflows as they apply to cryptonetworks and tokens.
This article presents a brief summary of rigorous academic and consulting research on the key characteristics and valuation of cryptocurencies.
Bitcoin is Not Gold, Stock, Commodity, or Currency
It has been suggested that bitcoin poses an ideological challenge to conventional forms of money, as it is “commodity money without gold, fiat money without a state, and credit money without debt.”
Indeed, there has been a rapid growth in bitcoin’s market capitalisation, coupled with limited usage as a means of payment. This poses the question of bitcoin’s use case – is it an investment asset, a store of value like gold, or a currency? On the one hand, decentralised mining and lack of government backing is reminiscent of essential features of gold. On the other hand, bitcoin’s use case as a medium of exchange implies that it is a currency. The quantity theory of money would suggest that as supply of a currency (a representation of value) increases, price should decrease.
These ideas, however, are not borne out by empirical evidence. As anyone following cryptocurrency prices movements would have observed, since 2009 bitcoin prices and returns have increased regardless of increasing supply, which is at odds with the quantity theory of money. In addition, bitcoin appears to be unrelated to gold, exchange rates or stock markets, both on a daily and weekly basis, showing distinctively different return, volatility and correlation characteristics compared to other assets. In parenthesis, this is good news for investors, as cryptocurrencies can be used to diversify portfolio risk. Gold and exchange rates, in contrast, exhibit a relatively strong relationship. As exchange rates are correlated with all other asset classes with the exception of bitcoin, bitcoin appears to be different from a traditional currency.
Bitcoin is a Unique Asset Class
Chris Burniske (ARK Invest) and Adam White (Coinbase) evaluate whether bitcoin is a distinct asset class and come to the conclusion that it passes the test of investability, while differing substantially from other assets in terms of its politico-economic profile, price independence, and risk-reward characteristics. The expectation is that with continuous open-source development, bitcoin will differentiate itself even further from other asset classes.
Perhaps the most sophisticated formal model of bitcoin’s value, drawing on ideas from platform economics and network externalities, is presented a the recent study by two ICL professors, Emiliano Pagnotta and Andrea Buraschi. On the demand side, users (consumers) value censorship resistance of transactions and the ability to engage in trustless exchanges. On the supply side, miners (those who provide resources) need to be incentivised as well, because the bitcoin network is decentralised. In the end, bitcoin serves simultaneously two functions, and has a “unity” property, so to estimate the value of bitcoin one needs to consider the interaction between users and miners.
One of the main conclusions from the study – which everyone engaged in the cryptocurrency space should be paying attention to – is that bitcoin is “the first member of a class of assets, decentralised network assets (DNAs), that share the unity property in decentralised networks”. In other words, bitcoin – and many other cryptocurrencies – represent a new, digital asset class, which is impossible to value unless one understands the economics of multi-sided technology platforms.
Bitcoin is Also a Technology Platform
Cryptocurrencies are technologies entailing a true innovation potential, according to a study by Wang and Vergne, who claim that innovation, and not media buzz, is associated with increases in cryptocurrency returns. The researchers measured innovation potential using eight indicators from CoinGecko data. The conclusion is that it is more useful to think of cryptocurrencies as technology platforms, rather than currencies, commodities, or speculative assets.
An analysis of Bitcoin, Ethereum, and Dash networks by Ken Alabi shows that their value can be approximated by Metcalfe’s law, which identifies the value of the network as proportional to the square number of its nodes (i.e., connected users). Melcalfe’s law has been widely used to value peer-to-peer networks such as Facebook. Network effects (aka demand-side economies of scale) matter, as they create strong competitive moats and in many instances lead to winner-take-all (or most) markets. Alabi modelled the value of the network based on the price of the digital currency in use on the network, and the number of users by the number of unique addresses each day that engage in transactions on the network. Incidentally, value bubbles show up where repeated extreme increases in value are not accompanied by a concomitant increase in the number of users.
As technology platforms, cryptocurrencies are also subject to the strong cross-side network effects of users and developers: the more users of a particular cryptocurrency there are, the more developers will chose to work on improving the technology, and the more valuable the network will become. Burinske and White make the point that cryptocurrencies, unlike bonds and equities, may submit to a “winner takes most” dynamic. Those cryptocurrencies that grow user numbers, while simultaneously nurturing developer engagement, can reach impressive market capitalisations. The current popularity and market capitalisation of Ethereum, with allegedly 200,000 developers and over 90 ICO projects (of the top 100 ICOs) being built on the network, is a reflection of these cross-side effects. Rigorous work that values cryptocurrencies while taking into account cross-side effects is yet to gain momentum.
The bottom line is that, from an investor’s point of view, bitcoin (as well as other cryptocurrencies such as ethereum, litecoin and monero), belongs to a new asset class – decentralised network assets – with unity being its distinguishing property. As to be expected, and given inordinate technological complexity and market uncertainty associated with any transformative innovations, cryptocurrencies remain, for now, an immature asset class. But this will change.
If one is looking at the Bitcoin blockchain more broadly, as an entirely new technology stack, then an understanding of platform economics, the winner-take-all (or most) dynamic, and network effects would seem critical. Regulators, investors, wealth managers and traders would be well advised to confront empirical evidence and rigorous models to make informed choices. The alternative is to base decisions on opinion, hearsay, speculation, and outdated frameworks unfit for the decentralised digital economy.