Bitcoin – The Challenge of Valuation

Kurt Smock

11/25/2019

Abstract

This is a working paper compiled to discuss the strengths, weaknesses, and risks associated with various proposed valuation models of Bitcoin and to present opportunities for future research and modeling. Bitcoin is said to be an unprecedented technological advancement. However, upon inspection, it provides no actual innovation except to the extent that it has combined well-understood technologies into a form that creates a unique value proposition for block producers (miners) and users. The asset referred to as Bitcoin is an amalgamation of concepts, technologies, and institutions all coupled into an integrated and inseparable composite. All the properties that compose Bitcoin are essentially reduced into a singular product that has established a new asset class not previously available. What Bitcoin lacks in innovation it makes up for in originality, being the first asset that is made up of infrastructure, labor, and capital inclusively but without transparent, direct or centralized ownership of supporting assets. Because of this ambiguous nature, the challenge of valuation is compounded. There are many theories on how to value Bitcoin and its native token, which will be addressed individually. Most popularly proposed models come with critical weaknesses that negate the model’s ability to be effective. This leads to the conclusion that hybrid models should be built that include all the facets relevant to the value of Bitcoin. This, however, is also not without its challenges, but this discussion is designed to provide deliverable objectives that can be utilized in future models.

What is a Bitcoin

The question of what Bitcoin is can be a daunting subject to understand. Many explanations have been offered that range from technical, to practical, to analogous. But, from these many attempts the definition of what Bitcoin is can be surmised as follows, Bitcoin is a decentralized ledger technology (DLT) designed to create a decentralized ecosystem that allows the exchange of an inimitable token, native to the ledger. What that means is that Bitcoin refers to both a ledger of transactions, also referred to as a blockchain, as well as the cryptographic network-native token that is assigned a quantifiable unit value and can be transmitted and transacted within the ledger through the transmission of private keys from one party to another. These cryptographic entities (private keys) are designed to behave like a currency that a marketplace of participants can theoretically transact with. Qualities that are considered necessary to qualify as money include medium of exchange, unit of account, portable, fungible, divisible, and durable. Bitcoin tokens have all these qualities.

To mitigate the confusion, it has been suggested that there be a delineation syntactically to express which aspect the author refers to. The consensus seems to have been established to treat Bitcoin as a homonym, wherein Bitcoin (capitalized) refers to the network and bitcoin (lowercase) refers to the currency. [1] We will adopt this methodology in this document. There has also been debate around the correct ticker symbol for bitcoin. The ticker BTC has been widely adopted as the accepted ticker symbol. However, this is inconsistent with accepted standards of currency notation. This is because whether bitcoin is ultimately categorized as a currency or a commodity, ISO 3166 and ISO 4217 provide guidance for currency designators. ISO3166 indicates that a national currency will never be assigned an “X” as the leading character of a ticker symbol. ISO 4217 indicates that supranational currencies and commodities that behave as money should be designated with a beginning character of “X” in their designator code. Examples of the implementation of this standard include gold (XAU) and silver (XAG). Thus, the appropriate designator code for bitcoin is XBT as it is consistent with ISO standards. [2] In this paper, XBT and bitcoin will be used to describe the token, native to the network.

Bitcoin’s DLT was the first to solve what technologists refer to as the “double-spend problem.” The double-spend problem is characterized by the nature of stored data. Data that is created or stored within a digital framework is inherently easy to replicate. It is generally possible to create a duplicate of any data stored digitally. Because of this, a digital artifact can be created and subsequently duplicated infinitely. Thus, digital items lack scarcity and consequently value. Supply can satisfy nearly infinite demand at nearly zero marginal cost.

What Bitcoin’s DLT accomplishes is cryptographic certainty that the bitcoin sent in a transaction is (a) possessed by the sender and (b) has not been previously spent. It does this by accounting for each transaction in a series of immutable journal entries called “blocks” that can be cryptographically proven to have occurred. These transactions create an account of ownership for the Bitcoin tokens. The owner of a Bitcoin token has the right to transact it on the network, which transfers ownership of that token from sender to receiver. The cryptographic proof is created through a process called hashing which requires a specialized, high throughput processor to solve a math problem that can be verified by all participants. The processors responsible for solving these math problems are referred to as miners. Miners compete to solve the problem. The first miner to solve the current math problem is assigned the task of batching transactions and broadcasting them to the network. The hashing process is a very expensive, energy-intensive task that requires economic inputs and the expenditure of real economic resources, representing a real-world cost to the owner of the miner who solves the block, batches the transaction, and broadcasts the update to the ledger. When these new blocks of transactions are broadcast, all participants on the network can validate the truth of the miner’s solution. Upon sufficient validation, a consensus is reached that the miner indeed solved the problem and the block produced by that miner is added to the end of the chain by all participants (nodes).

The integrity of the system is guaranteed by proof. There is no trust among the peers, only in the system.  When a new block is broadcast to the system, every system is also working to solve the same problem. They can use the broadcast to reverse engineer the solution and verify that the solution is correct. If the solution is correct, then all of the nodes on the network agree that the broadcaster has rights to the next block in the chain and will add the batch of transactions included with the solution on to the chain to be the most recent block.

The described framework will satisfy the requisite definitional requirements to properly frame this discussion. There is an immense amount of complexity beyond this definition and accompanying explanation, which can be disregarded for the purpose of valuation. The most critical concept that must be clearly understood and delineated when attempting to devise a valuation model for Bitcoin is that Bitcoin is more than one thing. It is an infrastructure-based network and can be valued on the basis of its economic inputs, outputs, and value creation. The token native to the ledger can be valued on the basis of its monetary and/or commodity properties. Beyond the Bitcoin network itself, there is also the infrastructure of the larger cryptocurrency industry. This industry has largely been built on the marketable value of Bitcoin. Much like how the auto manufacturing industry relies heavily on a network of part producers and dealer networks, Bitcoin has created value chains that run through the industry built around it. This industry makes up real economic mass that also relates directly to the value of bitcoin as it is through this infrastructure that the public has gained access to this network. These asynchronous components are the source material from which the valuation of Bitcoin must be derived.

The Economy of the Mining Ecosystem

The Bitcoin blockchain is a network that accounts for participants’ transactions. It is updated and maintained by a decentralized asset pool (miners) that all contribute economic input to guarantee the integrity of the system. These assets are directly responsible for value creation in the Bitcoin network. Basic analysis of the miner’s economic choice dictates that if there is a less than an equal exchange of value, miners would cease participating in the economic activity of Bitcoin. A greater than an equal exchange of value will attract new entrants and incentivize incumbents to expand their infrastructure. Embedded in this idea there is are multiple equilibriums at work in the mining ecosystem that create a game-theoretical economic structure. Miners are compensated for their work in two ways. These compensation mechanisms create supply and demand architectures that are designed to create fairness, decentralization and inherent self-balancing.

One equilibrium involves the supply and demand of hashing power, which is a term used to describe the force applied to solve for blocks. This hash rate provides the inimitable security of the network. That is to say, it is a primary contributor to the prevention of double-spending. One attribute of the code which governs the network is that the difficulty of mining is reevaluated every 1600 blocks (b). This evaluation targets an average block production time of 10 minutes per block (t). Because of this feature, the difficulty adjustment rate can be determined to be approximately once every 11-12 days [ bt  / minutes in a day = difficulty adjustment interval]. [3] The first way a miner is compensated is through a reward received for each block successfully created. When a miner successfully creates a new block that is added to the blockchain, the miner simultaneously creates newly minted XBT, which it gets to keep. Block rewards are discussed more in-depth later.

The second equilibrium involves the supply and demand for transactions. The second way miners are compensated is through a fee they are able to charge for the inclusion of a transaction in a block. In this aspect of participant interaction, users have a measure of control and an economic choice to consider when transacting on the network. They can choose to designate a fee they are willing to pay. They can prioritize speed or cost. All transactions users wish to engage in are submitted to a memory pool (mempool) where they await acceptance as valid and completed transactions through inclusion in new blocks as blocks are produced. Block size is limited to one megabyte (1MB). So, there is a competition between transactors to have their transactions included in the limited space each block provides. In periods where the demand for transactions is high, the miners can prioritize transactions that have an allowance for a higher fee. In periods of low demand, the miners must accept the fees they are offered. It is important to note that the miners can include or omit any transactions they choose from the mempool. In any event, transaction fees for included transactions are paid to the miners.

These supply-demand forces affect the network in various ways. If the payoff of mining is less than the cost to mine, some miners will be forced to stop due to sustained net losses. This will, in turn, reduce the speed of block production, which will, in turn, cause a difficulty adjustment down. This reduction in difficulty to mine blocks reduces the cost of mining blocks as less work is required to create each block. This increases the profitability of block-creation. This could attract more miners to the network.  If so, the likely result of a subsequent increase in participation is that hashing will increase, and the difficulty will be adjusted upwards when the increased hashing reduces the block production below 10 minutes.

The converse of this idea is true as well. If certain miners have a competitive advantage over other miners, they can leverage this advantage to create a barrier to entry for smaller entities. As of now, mining is conducted through the use of Application-Specific Integrated Circuits (ASICs). As the name implies ASICs are built specifically for the purpose of mining bitcoin blocks. These are highly sophisticated chips that are expensive to purchase and have no other useful function. If the price of XBT can be sufficiently maintained such that incumbents remain profitable, the incumbents can create a barrier to entry for new potential entrants via utilization of economies of scale, keeping the hash rate at a level that prevents new entrants from being able to compete profitably with incumbents. If the incumbents own the majority of the hash power, they create the majority of the blocks. The block production capabilities of new entrants will be challenged by the dominance of incumbents, preventing them from being able to mine profitably. This can allow for consolidation and increase centralization.

This creates a risk to the integrity of the network itself. If there is a consolidated, small group of miners responsible for the majority of the hash power, they can form a cabal that is capable of monopolization of the market. To the extent this occurs, miners may engage in any sort of illegal market activity, such as price-fixing, market cornering, and so on. Bitcoin is designed to operate outside of the jurisdictional power of any governmental entity. Because of its success in this regard, it is unlikely that these activities would be preventable or even readily detectable. One consideration that must be taken in a valuation model is, to what extent has such things occurred already and what is the likelihood of them happening in the future. The design intent is that the network should be decentralized. It is through the decentralization of mining and consensus that trust in the system can be secured by individual participants. It is these three variables, proof of work hashing, decentralization and consensus that the trustworthiness of the system and thus the value of the bitcoin network is predicated on.

Valuation of the Network

We can understand through historical observation, that there is a segment of the global market that has determined Bitcoin to be trustworthy to some degree and that the integrity of the system can be relied on to prevent double-spending. It is self-evident, however, that any value XBT intrinsically possesses exists because of a transference of value conveyed to it by the integrity of the network. Further, as discussed there is a cost associated with the network. The costs are the sum of economic inputs and expenditures required to produce hashing power. Should the value of the network be lower than its costs to operate, it could cease to function because the continual inputs required for the propagation of new blocks are economically unsustainable. Though this is not strictly true due to the difficulty adjustment feature, it is always fundamentally true on some level. At a minimum, it could have devastating effects on its value, even if it does possess the capability to continue to operate.

GDP

Many refer to Bitcoin as a payment system. Looking at companies, like Visa and Paypal, people believe they can find some corollary that can produce a multiple that Bitcoin can be related to. However, payment systems are operators within an economic system that compete with one another to facilitate the transactions of customers who all mutually participate in the larger economy. To be more precise, all payment processors utilize the same central bank-issued currency and transacting via their services is just one of many available options for the execution of transactions.

Bitcoin, however, is a generally closed system. Miners are given a block reward denominated in XBT and are also paid transaction fees in XBT. There are no other available options for participants to execute transactions outside of miners. Also, XBT is also the unit of account that is exported from this production system and is the only available unit of account available to participants. However, though it is a closed system in this way, all inputs to the system are required to be imported from external sources. That is to say, the Bitcoin has no natural resources except its native token, XBT, which is incapable of being utilized to capture the needed resources for value creation. Within the boundaries of the network, Bitcoin requires consumption and investment. It imports and exports economic mass. Thus, Bitcoin can be described as an economy with a GDP. GDP is a valuation metric of economies. Thus, it is an appropriate model to apply to Bitcoin. In the interest of identifying a comparable, Bitcoin would be likened to an island economy with limited natural resources. GDP, according to the expenditure method, is calculated as (C + I + G + (X – M)). The expenditure method is the only reasonable GDP method that can be applied to Bitcoin using available data. Additionally, because there is no governmental body that exists in the Bitcoin economy to contribute to investment or spending, this formula can be reduced to: (C + I + (X – M)).

In Bitcoin, the economic resources that are imported are denominated in currencies external to the network. Though this can be any currency, the U.S. Dollar can be a proxy for an external currency. Major inputs include plant, property, equipment, labor, and electric utilities. To maintain the inputs of Bitcoin, the outputs of Bitcoin must be equal or greater than its inputs. Because the Bitcoin economy is entirely dependent on inputs that can only be acquired via USD denomination, the relational value of XBTUSD must be sufficient such that the output XBT can be exchanged for the input USD at a rate that will sustain continued inputs. The concept of break-even level applies here, though it is possibly more relevant in consideration of a comparable that utilizes discounted cash flows as a metric for valuation. As it pertains to a GDP analog, the break-even rate is comparable to the balance of trade because inputs that are required to run the network are denominated in USD.

Net Exports

The break-even level of the network can be defined. At a given point in time with a fixed hash rate required to mine a block, break-even level can be defined as (Total Fixed Costs / XBTUSD price).  This implies that the value of the infrastructure, the DLT, and the real-world assets that support it require a determinable exchange rate in order to continue to function at its current capacity. The assets drive the network. Thus, a fundamental value to the network must be ascribed in relation to the acquisition and disposition of those assets in the execution of work to run the network. In relation to the GDP analog, this relates to (X – M). If the USD cost to mine each XBT equals Total Fixed Costs of operation, the value of X – M = 0. As the relative price of XBTUSD increases, Bitcoin has a positive balance of trade to the extent that XBT holders convert those holdings to USD.

The degree of assumption required to perform this assessment is extreme. Total Fixed Costs are unknowable. There is no reporting structure that allows external users to accurately account for the assets or liabilities assumed by network operators. Costs can vary drastically depending on the jurisdiction. In order to apply a model such as this, further research must be done to acquire reliable information on miners’ total costs. Much like emerging national economies, the Bitcoin economy can finance its activities through outside investment, denominated in other currencies. Financing of mining operations can defer the expenditure of current costs, increase profitability, and reduce the present value of inputs. Subsidization is another aspect of input that merits further research. Ultimately, if an accurate Total Fixed Cost is established, a break-even value of XBT can be determined and historical analysis can be performed.

Consumption, Business Investment, and Network Value to Transaction Value Ratio

Continuing the GDP analog, consumption is another challenge. One popular model for the valuation of Bitcoin has been Network Value to Transaction Value Ratio (NVT). The NVT is calculated by assuming the value of the network is equal to its market capitalization. Transaction Value is the USD value of the transactions that take place on the blockchain. NVT is calculated on a daily basis by taking the closing XBTUSD price and dividing it by the transactional volume measured in XBTUSD for the past 24 hours. Though this model has historically demonstrated a correlation to the price relationship of XBTUSD, this is anything but groundbreaking and certainly not a mechanism for the valuation of the network. The logic behind it is extraordinarily basic. Increased transactional traffic presents no inherent informational value as it relates to the value.

In monetary terms, which are discussed later, velocity is the frequency that a currency unit is exchanged for a good or service within a time unit. There is no evidence that these transactions that occur on the blockchain are in exchange for goods and services or even are an exchange between two independent parties. An individual can have multiple XBT addresses. If an individual possessed a sufficient quantity of XBT, they could send it throughout the network in such a way that they would register many transactions with high transactional value in relative USD terms, but both the sender and receiver are the same individual. This would be the equivalent of labeling the transfer of money from a checking to a savings account as productive economic activity.

Further, it is well understood that one of the most predominant use cases of XBT is speculation. If indeed speculation is an aspect of transactional throughput, the analogy of wash trading would also apply as a potential threat to this evaluation thesis. Bitcoin’s ledger provides an account for all Bitcoin transactions. However, it does not provide the nature of the transaction. Just that an exchange of XBT has occurred. Market capitalization is also a poor metric of value as it does not account for liquidity. If one bitcoin sold for $1 million as the final trade before the close of the day, for the next 24 hours NVT could be calculated under the assumption of up to a $21 trillion market capitalization. Any valuation model that is predicated on fair value like NVT and does not factor in volume and liquidity will be sorely insufficient.

The general logic of NVT is sound, but lacks any correlation the network’s value, only its relative USD price. Additionally, it doesn’t offer any novelty that couldn’t be deduced by simple observation. The supply of XBT is limited to 21 million total XBT. If the demand for transactions increases and the available supply is limited, the price is likely to increase. Additionally, when considering that the issuers of transactions must pay a fee to send their XBT, their purchase power is diluted by the fee that is charged. This reduces the incentive of participants to transact unless there is a discount of the goods and services received or there is an increase in its relative purchasing power, due to an increase in price. Also, as a speculative asset, when the price is going up, new money is attracted to the asset.

In the GDP context, this model assumes that transactions can be a reasonable proxy for the consumption and business investment components of the GDP equation. Consumption is defined as the amount consumers, as economic participants, spend on goods and services. Business Investment is the expenditures businesses make to create value as economic participants. This is exactly, what the NVT is attempting to measure. However, the resources available to understand to what extent blockchain transactions are the actual exchange of goods and services between consenting parties. The assumption made by NVT is far too expansive to act as anything but a lagging indicator of past value. What’s worse is if there is an upgrade to XBT that allows for higher transactional throughput (greater than 1mb blocks every 10 minutes), historical NVT metrics will be rendered useless. Thus, NVT is insufficient to describe anything except exactly what it implies, how the market cap relates to transactional value at a moment in time. It has no predictive or intrinsic valuation capacity.

Again, the problem that presents itself, similar to the unknowns surrounding the mining inputs, is that there is an utter lack of transparency regarding the extent to which real economic value is being transmitted between parties on the Bitcoin blockchain. Transactions are not inherently evidence of economic activity. The risk vector of fraudulent representation within the blockchain transactional value is extreme. This is because the parties who have the greatest incentive to engage in this behavior are the ones who own the network infrastructure, the miners. Miners choose what transactions to include in blocks. If the block they issue is empty, they are able to put their own transactions into the list of transactions that are included in the block and create the appearance of full blocks. This is not to assert this as fact. The practicality of it may be lacking from a game-theoretical perspective, but its potentiality is irrefutable.

One final note would be that any consumer who holds XBT is going to find it a challenge to use it in the acquisition of goods or services. An exchange of goods and services for XBT is challenging because products are not priced in XBT. In the event they are, the XBT is transacted in the exchange and the receiver converts that XBT to an alternative, more price-stable currency, thus removing it from the XBT economy. This would be the equivalent of an export of the Bitcoin network, wherein the native currency was used in exchange and the receiver exited the economy with the proceeds. Similar to how an international business may transact in local currency and then convert that currency to the currency of their home nation and/or engage in hedging activities to offset the risk of value loss.

Bitcoin’s Inflation and Supply Cap

One aspect that makes GDP an interesting proxy for network value is its relationship to inflation. Bitcoin has the ability to maintain a nominal GDP that is reasonably consistent with its real GDP. The supply of XBT is fixed at 21 million units. The supply is inflated through the block reward paid to the miners. This block reward started at 50 XBT per block and is cut in half roughly every four years. The current block reward is 12.5 and will be cut to 6.25 in 2020. Bitcoin’s inflation rate is predictably scheduled on a descending scale. It is anticipated to be reduced to zero by approximately 2140. A threat to Bitcoin’s value is that it has to maintain its intrinsic value in terms of its exchange rates since it has to import all inputs through the exchange of XBT for another currency. However, this should be attainable as central bank-issued currencies are continually diluted and XBT’s supply remains fixed. The relationship of Bitcoin to central bank currencies should translate to a steady increase in the value of Bitcoin as central bank currencies inflate at a rate greater than XBT.

In summary, the Bitcoin network’s value would be best if treated as an economy with a GDP. Bitcoin is most similar to an economy in that it has independent economic actors, game theory, independent economic choices available to each participant, and economic inputs and outputs similar to a linear economy. Imports can be quantified as value that is brought into the network and exports can be quantified as value that exits the network. Consumption and business investment would relate to transactions between parties within the economy for goods and services. To value Bitcoin on this basis, further research is required to ascertain the net of imports and exports as well as accurately determine consumption and investments. The unfortunate truth is that though assumptions can be made in this regard the assumptions must be very broad because the information to build accurate models is not readily available. This adds inordinate risk to the valuation model that challenges its reliability.

The Value of XBT

The true value of Bitcoin is purely dependent on the value of XBT, but the value of XBT is completely independent of the value of Bitcoin. Bitcoin must change in value to reflect the relative XBT value because it must export XBT to another currency to pay for its inputs. If the value of XBT decreases, this will correlate to reduced available inputs for Bitcoin, resulting in a necessary reduction in costs to operate the Bitcoin network. As discussed, these adjustments are built-in to the system. However, XBT can vary drastically from the value of Bitcoin. If the price of XBT drastically exceeds the value of Bitcoin, this expands the profit margin of miners. It is often asserted that XBT cannot drop below the miner’s cost without severely negative impacts on the network and the token price. However, due to the difficulty adjustment feature and the potentiality of availability of credit extended for operations, this is not necessarily true.

This allows for price discovery of XBT, also referred to as bitcoin, to happen within a free market, supply/demand-driven system. Speculation in the Bitcoin economy cannot be understated. Bitcoin represents the first asset of its kind, possessing all the attributes of money but without the physical mass associated with forms of money that preceded it. You can theoretically fit an unlimited amount of purchasing power on a USB thumb drive. Its capacity to represent and price value is as strong as any comparable, but also currently comes along with outsized risks relative to any comparable due to its volatility and other uncertainties covered later.

Reflexivity and Asset Bubbles

Some of the factors that drive the value of bitcoin in relative USD terms include demand factors such as the adoption curve and a variety of supply constraints related to the circulating supply and the cap on total supply. However, of all the driving factors that affect the short-run price of bitcoin Reflexivity is most poignant. The Theory of Reflexivity, [4] introduced by George Soros, is highly controversial because it flies in the face of the efficient market hypothesis. However, his assertions are increasingly aligned with findings in the field of behavioral economics.

The theory is based on the concepts of the cognitive function, the reality that economic participants use information from the world to discern reality, and the behavioral function, the reality that the behavior of economic participants can have a collective impact on circumstances and thus the cognitive function. The cognitive function has directional causation from world to mind, but the participating function has an inverse impact, from mind to world. Though both variables deprive each other of an independent variable (because they are dependent on each other) posing an obstacle to empirically testing them, we know this assertion to be self-evident. People learn what they know from external reference points, but the act of thinking (applying cognitive reasoning abilities) allows people to develop an alternative conclusion. Acting on this impetus can impact the circumstances they are observing. This creates positive and negative feedback loops that are self-reinforcing. A participant may act such that it shifts the way other individuals view the world, which changes the way those participants behave. This feedback loop continues to expand in a way that causes reality to move away from equilibrium.

This is particularly true of asset bubbles, a phenomenon often strongly associated with bitcoin. Reflexivity would describe a bitcoin bubble by explaining that a group of thinking participants observed the world and saw an alternative way of creating an economy. This thinking was translated into action that changed the nature of reality, the creation of Bitcoin. Observing participants saw these changes and it caused them to think about the world differently. This caused them to alter their behavior, behaving in ways they may not have otherwise. Others saw this behavior and it changed their thinking and behavior. Thus, a positive, self-reinforcing feedback loop was created. This loop expanded, as more participants bought into the bitcoin marketplace, and bitcoin price increased. This continued until participants began to realize just how far from equilibrium the price was. When a price has expanded from equilibrium as far as the force of volume applied to the mass of price expansion will allow a negative self-correcting loop is created, a crash in price. These positive and negative, self-reinforcing and self-correcting loops have been present throughout all of bitcoin’s price history. This theoretical framework is critical to understanding the price of bitcoin. The asset has gone through multiple booms and busts. Through each of these cycles bitcoin’s price has been resilient, consistently reaching new all-time highs on a relative basis. From the perspective of reflexivity, it can be inferred that bitcoin has a positively sloped equilibrium when plotted over time.

Bitcoin as a Currency

There is disagreement about what exactly bitcoin is or is supposed to be. Most of the debate surrounds two schools of thought. One school believes bitcoin should behave like a currency; that it is meant to be used as a means of exchange. Others see bitcoin as a finite asset that can preserve purchasing power due to its limited supply, allowing it to be a store of value. This has led to divisions among developers that have resulted in what is referred to as “forks” of the network. A fork is simply a change in code that nodes in a network can apply and those divergent nodes establish consensus and can continue to add blocks to a separate chain from the point of the fork going forward. The two forks of the chain are independent of each other. It has been proposed that this has a dilutive effect on the value of bitcoin. This is an area of further research that can be explored.

It is self-evident, however, that a fork creates a new entrant that will be in competition with Bitcoin. However, it doesn’t automatically make that new entrant a competitive threat. Anything posited in this regard is purely speculation and doesn’t warrant attempts at quantification. This is because, to date, there is little evidence that bitcoin is used for anything of any real economic mass or total value. There is no more a mutually competitive market between Bitcoin and its fork than between Uganda and Venezuela. With that said, it must be noted that, if being valued as a currency, bitcoin is highly vulnerable to the threat of new entrants and substitute goods. It is very rare that the first iteration of any technology is the one that is ultimately adopted for use. Additionally, Bitcoin is at an inherent disadvantage because it is very hard to gain consensus on changes to the code and it is very easy for a would-be competitor to fork the code since it is open source. In an environment where use and adoption are what the economic participants and developers aspire to, Bitcoin is severely impaired. At this point, there seems to be no merit to this threat for two reasons. First, bitcoin has a higher value than any other comparable currency available in the world, putting the challenge to would-be competitors to demonstrate their value in the market. Secondly, the truth is, no one actually uses bitcoin or cryptocurrency of any kind to merit valuations that are being implied by current market capitalizations in the crypto market. If the true value is predicated on use, the entire cryptocurrency market is in dire trouble.

The basic equation of exchange is MV = PQ. If bitcoin is to be valued as a currency, this is the best mechanism that has been developed for understanding currency valuation. This formula implies a price (P) of [MV/Q]. M refers to the total units available in the circulating supply, V refers to velocity, and Q refers to the total value of real transactional expenditures.  There are two challenges to the valuation of bitcoin on this basis: velocity and expenditures.

As stated earlier, it is not possible to accurately determine the validity, function or purpose of transactions on the Bitcoin blockchain. All the blockchain allows us to know is that a transaction has occurred. To accept all transactions in calculations of bitcoin’s value is fundamentally flawed and will absolutely produce false conclusions. Also, utilizing only blockchain transaction data ignores transactions that occur within custodial frameworks. For example, Coinbase or Abra users can easily and quickly send bitcoin to each other and it will never show up on the blockchain. The balance will be transferred from one customer to the other within the custody provider’s internal database. Thus, to include raw data from the blockchain leads to erroneous transactional inputs and the ambiguity of transactions within custodial databases ignores pertinent transactional inputs. The conclusion is that Q can’t be known. This means that the framework for assumptions must be rigorously critiqued and tested for them to have any validity. 

The same can be applied to velocity. The total circulating supply of bitcoin stands at approximately 18 million XBT. Four million XBT is assumed to be lost or inaccessible. The amount of bitcoin held on crypto exchanges is somewhere between 7% and 16% (depending on the source and time of analysis) of the circulating supply. Even with these facts, this number is difficult to analyze. Again, assumptions need to be made to quantify these valuation fundamentals. The question stands unanswered of how to quantify that true total circulating supply, and what the true transactional value is being transmitted on the network for goods and services is. Further research must be done to evaluate how to quantify these metrics appropriately to incorporate in well-established valuation models.

Bitcoin as a Commodity

Evaluating bitcoin as a commodity is simplest to quantify. Essentially, the Bitcoin economy is a single asset economy. Nothing is transacted in the economy except bitcoin. As previously described, bitcoin has been touted as “sound money” or store of value. These arguments often refer to bitcoin’s properties of scarcity, censorship resistance, and seizure resistance. Arguments against this thesis assert that nothing supports or “backs” the value of bitcoin. Gold, in the tradition of sound money, is said to be supported by its utility value as well its scarcity and store of value properties. Bitcoin may be backed by something more directly related to its capacity to store of value than the utility value that gold has, the Bitcoin network. As previously stated, the Bitcoin network has real costs and those costs are invested into the network to provide security and proof of ledger validity. The native token, bitcoin is also the product of this work, or economic energy, that is invested into the system. Thus, bitcoin acts most like a commodity in this regard, because it requires an investment of economic energy to exist. The result of this work is the bitcoin that exists within the Bitcoin economy. The network itself infers value to bitcoin by virtue of the economic resources sacrificed so that bitcoin can exist and be transacted, much like the production of any commodity is the result of economic energy expended into a system to create a supply of the commodity.

Commodity markets are inherently economic engines that balance supply with demand. The available supply is referred to as stock. The production level is referred to as flow. The stock to flow ratio is a metric for the valuation of commodities and has quickly become a popular valuation method for bitcoin. The idea is that bitcoin possesses investment utility rather than actual economic utility. Though there will be those who disagree and believe that cryptocurrency exists to be used and not held, observable reality dictates that the present centralized systems work for most people most of the time. To upstage the current incumbents of currency, such as the USD, there would have to be a competitive system that would appeal to a broad base of users to the extent it would become the dominant consumer preference. Essentially, the value exchange of using bitcoin would have to exceed the value that comes from using the traditional money system. Thus far bitcoin has proven incapable to garner this appeal.

Bitcoin does, however, have a high stock to flow ratio. The current stock to flow ratio is 27. This will continue to increase as each halving reduces the inflation rate of bitcoin, ultimately resolving where a ratio cannot be known as there will be no more flow and stock will equal supply cap. Because bitcoin has a theoretically infinite life the stock should remain constant throughout time. However, we know this not to be the case because of the custody risks.  Just like 4 million XBT has been lost, it must be understood that the stock may be reduced in the future due to custody failures. The stock to flow ratio of gold is now commonly compared to bitcoin and used as evidence of gold as a comparable. Unfortunately, there are not many well-supported explanations for why a high stock to flow would necessitate the implication of a high value. The broader cryptocurrency market indicates that it may not. There are thousands of worthless cryptocurrency projects that have no value and very high stock to flow ratios.

In the commodities market, the prices can be thought of as the discounted sum of a future payoff. This would be in alignment with the concept that investment utility is the sole utility that bitcoin provides its users. If there is a net benefit (positive convenience yield) to holding the asset inventory, a holder is incentivized to continue to hold on to it. Being that the supply of bitcoin is predictable and fixed the questions regarding the positive net benefit to holding bitcoin are all found on the demand side. If bitcoin does not have a productive or economic utility in the way a currency does, then it is solely reliant on the extent to which it can store and preserve value.

Risks

Any valuation model that is decided upon for making investment decisions must also include an offset for the risks as they present themselves to the integrity of the model. Risks to models principally center on imperfect information as previously discussed. Bitcoin is often touted for its trustworthiness and transparent ledger. However, since it is a decentralized network and the actors within the network are somewhere between pseudo-anonymous and totally anonymous. It can be difficult to know how to interpret data. In the example earlier, it was discussed how transactional data is insufficient to determine velocity or trade information. There are no reporting mechanisms or regulation that allows external users to obtain relevant data for decision making. As a result, the risk to any model presented is inherently flawed by this absence of access to data integral to the model’s efficacy.

Additional risks include:

  • Unidentified bugs in the code that could jeopardize network integrity.
  • A hack of the consensus algorithm that could jeopardize network integrity.
  • Centralization of mining risk – Risk of Cabal
  • Regulatory risks – Jurisdictional restriction on use or ownership
  • Custody risks – Lost or stolen coins
  • Innovation risks – Risk of substitute goods
  • Risks of manipulation of available data and other ambiguity

One risks that warrant further research and rigorous discussion include the risks presented by other currencies used to purchase bitcoin such as Tether. The parties that control the flow of Tether find themselves in a unique position to acquire bitcoin at zero marginal cost through Tether issuances. The extent to which any of these risks are realized is, to some extent or another, unknown. Finally, it is important to understand that the ownership of bitcoin entitles you to no assets related to the network. Your sole right is to send and receive bitcoin on the network to the extent which you have the private keys in your possession. In the event of system failure, there will be no recompense to investors.

Conclusions

We have merely scratched the surface of the topic of quantifiable valuation models. However, there have been several deliverables that have made this a productive discussion. More research is warranted into the infrastructure built around Bitcoin. The infrastructure, it’s integrity, decentralization, and consensus are the backbone of the value of Bitcoin. Without a Bitcoin network that is healthy and stable, there can’t be value transferred to bitcoin token. Also, additional data should be researched on how filters can be quantified and established to determine the validity and relevance of data points that can be used to estimate the Bitcoin economy’s GDP and bitcoin’s equation of exchange. Most importantly, research needs to be conducted to discover the actual use of bitcoin and how that relates to the internal Bitcoin economy. The bitcoin token is best described as the commodity that the Bitcoin economy produces. More work should be done to discover the relationship of the convenience yield and bitcoin. The problem with all current models is inaccurate or insufficient data to support the conclusion of the model.

Bitcoin’s price history can be most accurately described by reflexivity, its illiquid market size, along with its limited total supply. Bitcoin has an appeal for a certain demographic of the population that values financial autonomy, sound money concepts, technological advances in finance, and investment utility. The risks associated with this asset is high due to a large number of unknown variables and a long list of things that can go wrong within the Bitcoin economy. Any successful valuation will be composed of strongly supported source data and an adequate rationale for its validity. Any accurate valuation will be composite of: the Bitcoin network, which should be treated as an economy for which GDP is being determined, the native token with comparables that include both currencies and commodities, and the model also must attempt to quantify the risks associated with placing economic resources within the network.

References

[1] 1. What is the difference between BitCoin, Bitcoin, and bitcoin. “What Is the Difference between BitCoin, Bitcoin, and Bitcoin?” Bitcoin Stack Exchange, September 2, 2011. https://bitcoin.stackexchange.com/questions/462/what-is-the-difference-between-bitcoin-bitcoin-and-bitcoin.

‌[2] Wikipedia Contributors. “ISO 4217.” Wikipedia. Wikimedia Foundation, November 21, 2019. https://en.wikipedia.org/wiki/ISO_4217.

‌[3] Morris, David Z. “Difficulty Adjustment Is Why Bitcoin Will Never Die.” BREAKERMAG, November 26, 2018. https://breakermag.com/difficulty-adjustment-is-why-bitcoin-will-never-die/.

[‌4] Soros, George. The Alchemy of Finance. Hoboken: Wiley, 2003.

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