Monthly Archives: July 2017

Bitcoin (OTCQX:GBTC) (Pending:COIN) (OTCPK:BITCF) (OTCPK:BTSC) and other cryptocurrencies have skyrocketed in value recently:

And I see a lot of misconceptions. Since cryptocurrencies are very hyped up currently, most people investing in these things are not very sophisticated. So where to start? Valuing a currency is difficult. I will start by laying out the different types of asset classes and how I think about valuing them. A currency has several characteristics:

Now as far as cryptocurrency is concerned, the same rules apply. I am going to assume the reader knows the technical side of bitcoin, and I will only focus on the economic aspects.

So how do we value a cryptocurrency? This seems problematic since a large amount of speculators have poured in a ton of money with the only purpose of selling their coins later for a profit. Which would basically make this a pyramid scheme if no legitimate buyers come in with the goal of actually using cryptocurrencies for transactions.

First let's define what value means. We ran into a little problem right away here since the first bullet point of this article already states that currency has no intrinsic value. I would say something has value if it helps filling our needs and wants. Generally this is expressed in monetary terms. Obviously there are things that have intangible value like friendship, etc. So let's just focus on assets that are actually transacted on a market for money. I can see three different types of asset classes:

The most common way to value a currency is in terms of another currency. So the Japanese Yen would be valued in terms of USD or EUR for example. A more convoluted way would be to look at total goods and services being transacted in that currency or value it in terms of bags of rice or grain. But if you use bags of rice to measure a currency, then those bags of rice would actually turn into a currency as well. Obviously there is a grey area between the currency asset class and the commodity asset class. How to proceed?

The main difference between a currency vs. the other two asset classes is that the supply demand dynamic is very different. For example, if I go on vacation to Mexico and need to buy pesos, I don't look at what the fair value is. I just look at the general exchange rate and try to buy as close to that as possible. This is the same for cryptocurrencies. This is very different than when I buy a house or a barrel of oil. There is a certain price cap at which I would never be a buyer with those asset classes. This is not really the case for currencies (with some extreme exceptions of course). It makes no difference to me if bitcoin is at $20, $200 or $2,000 if I want to exchange it for a bag of weed on one of the dark web marketplaces.

So in order to value a currency, we have to look at what fundamental factors other than speculation cause the supply and demand to be in equilibrium. And how much money from other currencies needs to flow in to get supply and demand in equilibrium determines its fair value relative to those other currencies. This is very important to keep in mind. Since we don't need to know what drives supply and demand to value a house or a barrel of oil. We just need to figure out how much rent it could produce or what the marginal cost is and at what price these two assets can be reasonably used. If oil goes to $1,500 per barrel (with other asset values staying constant), I would not buy it to fill my gas tank, and would probably switch to an electric car. And I would not speculate on it since demand will likely fall of a cliff if oil gets this expensive, cratering the price. And I would probably start buying canned food since the survival of civilization depends on low oil prices.

Or as Warren Buffett likes to say: Mr. Market is there to serve you not to guide you when valuing those assets. But with currencies you want to know if people buy it to use it (in that case, it has value) or just buy it to speculate (in that case, it would look more like a pyramid scheme).

Due to the lack of sensitivity for price paid for another currency and the large % of speculative money compared to money that flows in only to buy goods using bitcoin, the total market cap is very unreliable to see how many people use bitcoin for transactions. Why is that? Allow me to give an extreme and unlikely hypothetical scenario to get this point across.

Let's say that in a given day there is one person using bitcoin for practical reasons who wants to make a number of transactions with a total value of $1 million. So he goes to CoinDesk to exchange a total amount of $1 million. Let's also assume that all the miners have been hoarding their bitcoins and there are only ten bitcoins whose owner is willing to sell. And let's also say that there are no other buyers or sellers in this day.

And they are sold all in one chunk to make it easy.

Another very other important assumption in this hypothetical scenario, no price is high enough to create more sellers (let's assume willing sellers are all on vacation at the time). So no matter how high the bitcoin value goes, the number of bitcoins available stay at 10 in this day. So now this $1 million is fighting for 10 bitcoins. And in order to fill the order, the price would have to shoot up to $100,000 per bitcoin.

So now the market cap is $100,000 * 16.5 million bitcoins, right? That would be a market cap of $1.65 trillion. But there was only an inflow of $1 million, which is a fraction of $1.65 trillion. So obviously there is a problem here. If those other speculators would wake up the next day, there would need to be an inflow of $1.65 trillion if they wanted to actually cash in.

Or you might say they simply use bitcoin to make transactions and cash in that way. But there is one little problem with that which I will explain below.

Consider bitcoin's main value currently. Since it is not that widely used (especially by B2B companies), it is very volatile and salaries and suppliers are generally not paid in bitcoin, and merchants need to sell their bitcoin after making a transaction. So usually the time between when a buyer buys bitcoin and when the merchant sells it to pay his bills and wages is pretty short. The main way it is used (other than speculating) is that most hold their bitcoins for a short amount of time to make transactions that are difficult or not possible with regular currency. This is very important to keep in mind.

Let's consider another hypothetical scenario to show why this matters. In this world, bitcoin is not used for speculating at all. This is basically another extreme since now all bitcoins would be available to buy for the above user who wants to buy $1 million worth of goods with bitcoin. The hype has passed. And coins are only used for making transactions (mostly on dark web marketplaces).

The average holding period is one week given the limited number of vendors willing to accept them. So there is exactly one week between a person buying coins to make a transaction and the merchant who accepts this transaction selling them again for fiat currency.

Now there are 21 million coins in existence. And nobody hoards them to speculate. All the holders are immediately willing to sell them for any price (economics is easy with all those assumptions!).

To make this easier, let's say that there was a break and this is the first week bitcoin is being used again (this is unrealistic but makes it more intuitive to understand). So no sellers from the previous week.

In week one, $10 million flows into the bitcoin economy and every bitcoin holder sells their coins. Bitcoin value would edge up until it reaches about $0.50 per coin. And the total market cap of bitcoin would now only be ~$10 million. Very different from the above $1.65 trillion.

How would price discovery work? Let's say that they are bought each hour in fixed chunks of $10 million divided by 168 (number of hours in one week), or blocks of $60,000 per hour. So the first transaction would be $60,000 bidding against 21 million coins, and since no seller is anchored at any price, they will be sold for a very low price.

This process will be messy at first. If they are sold for a lower price than $0.50, there will be shortage later on. And there would be a need for arbitrage. So the price might be only $0.15 at day 4, but on day 7, the price might be $15 if the last blocks of fiat currency bid against a much smaller amount of bitcoins. It would take some time for the market to learn that weekly volume is about $10 million. So arbitrageurs might hold coins at any time to smoothen out demand. So possibly the fair value in this case would be a bit higher than $0.50 since at any time a % of coins are taken out of circulation by traders.

So why is length of holding period important? Well, the amount of coins available would slowly decrease while the market is discovering demand. In the second week, there would be $10 million of coins gradually being sold by merchants, and they would again be bought by buyers of goods (assuming that every week $10 million of goods are being transacted).

But if merchants would hold on for two weeks, then the market cap of bitcoin would double. Since there are no sellers for two weeks now. So $20 million would bid at 21 million coins, and market value of one bitcoin would stabilize at around $1 when the merchants' coins flood back in.

So what can we conclude from this? If on average bitcoins would take longer and longer to be sold back for fiat currency, it's value would go up. Even if total transaction volume stays the same. This would only happen if bitcoin would be very widely accepted. And there is a bit of a problem with that. Bitcoin and other cryptocurrencies are very useful to use in markets that sell illegal goods or services or for hackers to get their ransom from locking up computers. The illegal drug market has exploded in size. In 2013, the Silk Road was estimated to generate about $100 million in sales annually. There are now several marketplaces that have replaced Silk Road that are each larger in size. The main advantage here is that due to the ease of leaving good and bad reviews, it is much easier to buy quality drugs. A lot of vendors even offer customer service!

But for completely legal markets, bitcoin or other cryptocurrencies seem very impractical. I would need to pay more transaction costs (both for buying coins and making the transaction), there is more volatility, and if I lose my password, there is no central authority to get a new password! This last point is especially annoying since this has happened twice to me in the past 10 years. If I used bitcoin, I would have lost several thousand USD. It is very telling that in Venezuela and Zimbabwe they now use USD instead of cryptocurrency. Bitcoin caught on very, very quickly on dark web marketplaces, yet there seems to be little interest in it in countries with hyperinflated currencies. Even if they are used in countries like Venezuela, they are not used for transactions due to the high transaction costs currently. But are used instead to evade capital controls.

That said, there does seem to be a use for remittances, underage gambling, and illegal drugs. If we assume that governments won't successfully crack down on this, this could be a large market.

And, of course, there are a lot of people arguing that fiat currencies inflate over time. And that deflation is the main selling point of cryptocurrencies. But here is a problem since if there is large deflation, it encourages speculation, and if there is a lot of speculation, the currency will be very volatile. This will discourage people to use it (or hold it for long if they use it).

And with regular currencies, you can buy investments to protect against inflation, so this should really not be an issue. For example, the S&P 500 generated 7% annual returns after inflation in the past 100 years. So, yes, you would have lost a lot of money if you held US dollars in your bank account, but you would be rich if you had put it in stocks instead. This is not yet an option for cryptocurrencies.

The current market cap of bitcoin is about $44 billion. And the current market cap of all the cryptocurrencies is close to a $100 billion. Now, I know for a fact that those other cryptocurrencies are rarely used for actually transacting goods and services since most vendors do not accept them. And most people who buy cryptocurrency don't seem to use it. They buy it to speculate. Since bitcoin has a clear network effect advantage here, I will focus on that.

What is total addressable market (TAM) of bitcoin? The illegal drug market is about $400 billion a year and the total online gambling market is about $40 billion a year. And the total remittance market is about $500 billion. So a TAM of $940 billion. But it is obviously not realistic they take 100% market share. For one, it would be very easy to detect $400 billion in illegal drugs going through the postal system. And financial institutions are not just going to sit on their ass and let some Internet currency take away their billion-dollar businesses. But let's say Bitcoin capture 50% market share here. Or about $470 billion.

Now, here is why I bored you with the above hypothetical examples. The fair value of bitcoin will not be $470 billion. Because holding period is going to be very important here. Often people do not hold bitcoin for a long time; they will use it as a transmission mechanism. For example, for remittance, they buy $500 worth of bitcoin, and then send it to their relatives who then exchange it for an equivalent of $500 in their local currency. So holding period is often short. Same with gambling, the gambling platform would likely convert it to fiat currency right away after the deposit due to its volatility. But let's be generous here and say the average holding period is a month. That would imply the TAM of bitcoin would be about $470 billion/12 months = $39 billion.

If the holding period is only a day, fair value would only be $1.3 billion.

This would imply that cryptocurrencies are in bubble territory. The only way there is significant upside is if cryptocurrencies replace fiat currency in a significant way. But as we have seen with Venezuela and Zimbabwe, even if there is hyperinflation in a country, its inhabitants can always use another more stable fiat currency. Which is easier.

Bitcoin's value depends on it being decentralized. A way to destabilize bitcoin would be to do a 51% attack. This would mean that you need more than the total amount of mining rigs (mostly ASIC chips) that currently mine bitcoin. Generally bitcoin fanatics don't think this will happen. But this will change the moment bitcoin would get seriously big. For example, if 20% of the US economy is dependent on bitcoin, Russia might be willing to shell out $10-15 billion to destabilize it. Which is a small amount given that Russia is a $1 trillion + economy.

What would it cost to do a 51% attack currently? The Hashrate is about 6 million TH/s currently. Hashrate means total amount of computing power each second that is mining bitcoin currently. A 14 TH/s mining rig costs $3,000. So hardware would cost about $1.2 billion (assuming no bulk discount). Now there is real estate, electricity and labor costs as well. So let's be very conservative and double that to $2.4 billion. That is pocket change for countries like China or Russia to destabilize a foreign government. Russia's annual government revenue is $200 billion. So this number would have to grow by 20-30x before it would become prohibitively expensive to destabilize it.

There is kind of a problem here if transaction volume does not reach a critical mass before most of the bitcoins are mined out. When current mining rigs expire and transaction volume is not significantly higher, there will probably be a drop-off in the number of mining rigs and this will increase the risk of a 51% attack. Or miners will have to raise transaction costs, which will discourage people to use bitcoin. Currently transaction costs are quite high.

Based on the above, I would stay far away from bitcoin and other cryptocurrencies. There are simply too many obstacles, and it seems the current valuation is too high. I would probably enter if bitcoin was valued below $50 a coin. Which might happen soon given that most coins are hoarded currently. And all those speculators might get impatient and want to sell. And if that happens and there is no significant legitimate demand for non-investment purposes, the price could easily get below $50 again.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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How To Value Bitcoin - Seeking Alpha