The past month has not been overly kind to cryptocurrencies. The prices of the three leaders – bitcoin, ether and ripple – have been battered with declines ranging from 8% for the former to almost 40% for the latter (ether’s losses are somewhere in the middle). In comparison with the typical performance of more standard financial assets – equities, bonds and commodities, etc. – price moves of this magnitude are certainly towards the upper (or lower depending upon your point of view) end of the spectrum.
Nevertheless, while undoubtedly painful for new entrants into the cryptocurrency investing world, these price moves need to put into context. Even after the recent falls, the prices of all three cryptocurrencies are up very strongly year to-date: bitcoin’s has more than doubled, ether’s has gone up 20-fold and ripple’s 30-fold.
Not All Sunshine and Rainbows
This recent price weakness has coincided with some well-documented issues for at least two of the three aforementioned cryptocurrencies. Ether witnessed a spectacular flash crash on June 21 when its price plummeted from $319 to just 10 cents after a large sell order triggered stops and margin calls. In addition, the network has suffered increased congestion following a series of successful ICOs.
Network congestion has also been a negative focal point for bitcoin. Determining how to overcome the limited transaction capacity of bitcoin (presently seven trades per second) has been a long running source of contention between developers and miners.
Developers propose increasing bitcoin’s transactional bandwidth by fixing a transaction malleability bug thereby allowing the creation of two-party smart contracts that can conduct transactions off the blockchain (but with the confidence that the transaction can at any time be broadcast to the network allowing enforceability).
This proposed change (SegWit), would markedly increase the potential transactional bandwidth of bitcoin. But, for the very reason that it allows transactions off the blockchain, it has not been warmly received by miners who are remunerated for validating transactions.
As an alternative, bitcoin miners have proposed increasing the size of each block from the current 1MB. However, this proposal is opposed by many non-miners including the core developers, because of the associated risk that it could concentrate power in the hands of the larger miners due to the increased cost of operating full nodes.
This is viewed as almost heretical given bitcoin’s raison d’etre is its decentralised nature. (In decentralised networks prices much constantly adjust to eradicate any demand/supply imbalances. This is one of the reasons why cryptocurrencies are more volatile than fiat currencies, where central banks can and do conduct smoothing operations).
In light of the surge in interest in bitcoin, and cryptocurrencies more generally (nothing attracts interest like strong price momentum, it is like blood in the water for sharks) a comprise solution is about to be implemented.
SegWit2x software, which introduces SegWit while doubling the block size to 2MB, will be released on July 21. More than 80% of the network hash rate has agreed to run the SegWit2x code, which suggests that the solution to increasing bitcoin’s scalability will be enacted smoothly.
However, it is also possible that the hard fork required to increase the block size leads to a bifurcation of bitcoin into two separate currencies –something that would unquestionably trigger a sharp price correction by undermining the bitcoin brand. (The key date by which a split can be avoided is August 1 when BIP148 activates – this represents the last opportunity for miners to accept Segwit2x and thereby avoid a chain split resulting in the creation of two parallel bitcoins.)
For advocates of cryptocurrencies, these issues are nothing more than growing pains – symptoms arising from their increasing popularity. For the naysayers, who view cryptocurrencies as nothing more than technologically sophisticated Ponzi Schemes, they are the pin pricking a bubble mentality that drove the parabolic price gains witnessed over recent months.
Of the two camps, the former is the more compelling. Cryptocurrencies satisfy many of the prerequisites for money and hence are no more Ponzi schemes than any other fiat currency. This suggests that once these growing pains are overcome (and assuming bitcoin does not split), the price of cryptocurrencies should gravitate towards their fundamental value. But what is this fundamental value if it is not zero?
The Underlying Value
Fundamental valuations are hard enough to estimate for financial assets investors have been trading for centuries and hence are extremely familiar with. For a financial instrument without precedent, such as cryptocurrencies, this is a much trickier proposition. Indeed, there is not even a broadly agreed upon approach for valuing cryptocurrencies, with several methods having been suggested.
In a recent bitcoin article, one outlined our preferred valuation method. The best analogy we can think of for this specification is the famous Drake equation used to estimate the number of extraterrestrial technological civilisations in the Milky Way.
The Drake equation was derived to identify the key elements for contemplating the answer to the question rather than a deliberate attempt to accurately predict the number of civilisations. Nevertheless, it is still possible to use the formula to generate estimates, and the same can be done for cryptocurrencies. The key metric upon which this equation is based is the outstanding stock of fiat money globally. In the case of bitcoin the equation looks like this:
BIT_fv = (S . 1/N . R . C) / B
BIT_fv = Fundamental value of bitcoin
S = Stock of global fiat money
N = Total number of cryptocurrencies
R = Ratio of bitcoin’s market share to average cryptocurrency market share
C = Ratio of cryptocurrencies/fiat money
B = Total supply of Bitcoin
The Long-term Outlook
The number of cryptocurrencies likely to exist in the long-run is considerably lower than the 900+ presently around. One of the key prerequisites for money is that it is widely accepted. This feature generates very strong network effects that stand to cap the number of supra-sovereign cryptocurrencies.
The guesstimate is that globally there will be no more than ten cryptocurrencies in the end – a number that satisfies this network effect while also providing investors with sufficient diversification opportunities. One further assumes that the percentage of money individuals will hold in cryptocurrency form versus fiat money is around 10%.
Finally, one assumes that bitcoin has an equal market share of the cryptocurrency space, down from its current 45% share. Plugging all of these inputs into the equation bitcoin’s fundamental valuation comes out at $29,000.
One may, of course, disagree with one, or all, of the assumptions included in the above equation (the same equation can be applied to any other cryptocurrency). Some may think that there will be many more than ten cryptocurrencies, in the end, others that the equal market share for bitcoin is too low given its strong first-mover advantage and robust brand in this space.
Changing these assumptions will generate different estimates. Nevertheless, it does provide an intellectual framework for thinking about how to value cryptocurrencies, just as the Drake equation provides an intellectual framework for estimating the probability of extra-terrestrial life in our galaxy.