The CEO of Mastercard this week referred to cryptocurrencies as “Junk.” Jamie Dimon has threatened to fire JP Morgan staff for trading it (despite developing its own version in the background since 2013). These statements come from industry experts, but they remain opinions. The problem is, everyone has an opinion.
The way of valuing Cryptocurrency is completely different to what has been done before and is being done by the “so-called” experts. Value of assets is derived from analysing traditional, product or service businesses. These companies are seen as cash-producing assets and apply traditional valuation models, one of the most popular models being DCF (discounted cash flow).
What’s important for crypto is network value, transactions (amount and cost) and the complicated technology that sits behind it. Market analysts, researchers and venture capitalists have only started to develop these metrics and are yet to find equivalents of balance sheets and cashflows.
Bitcoin is something we’ve never seen before
The threat is that bitcoin poses an ideological challenge to conventional forms of money, described as “commodity money without gold, fiat money without a state, and credit money without debt.”
The reason why Bitcoin particularly has caused such a stir is because no one definition can be agreed on to summarise what it inherently is. Is it an investment asset, a store of value like gold or a usable currency? The fact it is decentralised and is free from government control makes it reminiscent of the essential features of gold. Yet, bitcoin’s use to buy anything online in digital form and is evolving to being used in the real world assumes that it is a currency.
If you analyse cryptocurrency prices movements since 2010 bitcoin prices and returns have increased regardless of increasing supply, which is at odds with the quantity theory of money. The theory dictates that as supply increases, the value decreases. The movements in prices are separate to the numerous stock markets globally, the US dollar and any other measurable asset volatility. This is a blessing in disguise as no “normal” or “standard” influences can affect cryptocurrency which makes is bulletproof in a way. If gold, oil or currency depreciates this can easily affect each other and start to influence politic and monetary policy. Exchange rates affect other exchange rates and yes, Bitcoin does seem to be pegged to Altcoins, but this will decline as more detail on each token emerges. In essence, the fact that something with so much volatility can’t be touched by anything other than the volume and price action of its own traders.
Whilst being substantially different from other assets in terms of its political-economic profile, price independence and risk profile. The expectation is that with continuous open-source development, bitcoin separate itself from other asset classes. Bitcoin serves simultaneously two functions and has a “unity” property. One of the key conclusions is that bitcoin is “the first member of a class of assets, decentralised network assets (DNAs), that share the unity property in decentralised networks”. Summarized in normal terms, 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 a technology pioneer
A recent study by Wang and Vergne, claimed that innovation, and not hype, is the catalyst 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 showed 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). We covered this exact topic is a lot more detail here. 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 engages 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.
The theory can be applied more widely for users and developers. As technology platforms, cryptocurrencies are also subject to the strong cross-side network effects: the more users of a particular cryptocurrency there are, the more developers will be drawn engage with the technology therefore and the more value the network accrue.
Those cryptocurrencies that grow user numbers, while simultaneously nurturing developer engagement, can reach impressive market caps. The current popularity and market cap 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.
Looking at it 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 USP. It embryonic, naïve and underdeveloped but this won’t stay the same and the last 1-2 years have proved it.
To set the record straight, before the hype, hearsay and irrational subjective conclusions is made its key to look under the bonnet and see the potential and good behind the technology Bitcoin has and the positive sentiment its due to bring to society.