Many analysts, investors, and pundits (cough, cough Jamie Dimon) have recently been quite vocal in declaring that Bitcoin or cryptocurrencies are a bubble. They come to this conclusion by the looking at the rate at which the price of Bitcoin has increased over the past year and declaring that it is unsustainable. Many of the justifications for why the increase in price is unsustainable are based on the analysis and the governing assumptions that are used to analyze traditional assets. Traditional assets include stocks, bonds, and real-estate. They assume that because this is a reasonable methodology for assessing the value of most assets and assume that it would naturally hold true and also apply to Bitcoin. To understand if this is an appropriate extension of these traditional analysis techniques, we must first understand more about traditional financial analysis and see if the assumptions underlying it are applicable to Bitcoin.

Traditional Analysis

There are typically two schools of thought when it comes to analyzing traditional asset values. Specifically, fundamental analysis and technical analysis. Fundamental analysis, or value investing, is what Warren Buffet prescribes to and focuses on finding stocks whose underlying value is higher than what is reflected by the current market price. Fundamental analysis relies on two things, the price of the asset, and the underlying value. The price of the asset is relatively straight forward, but there are many different metrics for trying to understand the underlying value. Examples of numbers which are used to try and measure the underlying value include earnings, assets, equity, and growth. These metrics are then combined with some measure of price to get metrics of value such as P/E, P/B, Debt-Equity, or PEG ratios. Unfortunately, none of the metrics used to ascertain underlying value apply to Bitcoin, blockchains, or even money. So, where does that leave us. If fundamental analysis can’t really work how about technical analysis.

Basic Technical Analysis

Technical analysis depends on the idea that markets are efficient and have always accurately priced an asset at any given point in time, but that pricing of assets follow patterns. Technical analysis uses different names or indicators to describe different chart patterns such as resistance/support, channels, Fibonacci retracement, or MACD. These indicators don’t distinguish between different asset classes such as stocks, bonds, or commodities, but rather prescribe to the idea that the price patterns will appear regardless of the underlying asset. This is likely a fair assessment for things like stocks, bonds, and commodities whose value is tied to real world business processes whose change is dependent on the physical business growth or decline.

As far as I can tell, this is where the underlying fallacy of asserting that Bitcoin is a bubble originates. Traditional asset investors fall back on the heuristic understanding of patterns, and the fact the patterns will repeat themselves, to argue that Bitcoin is in a bubble. Below is a chart of the Bitcoin price as well as MS, NFLX, and PYPL overtime. The fact that Bitcoin is raising at a non-linear rate, seemingly exponential, is what critics point to as evidence of the Bitcoin bubble. This is it, this is their argument. So, why do I think that Bitcoin isn’t governed by the same rules as other assets?

Metcalfe’s Law and Network effects

Bob Metcalfe, the inventor of the Ethernet and professor of innovation at The University of Texas, coined a rule to assess the value of networking computers which is known as Metcalfe’s law. Metcalfe’s law states that the value of a telecommunications network is proportional to the square of the number of connected users of the system (n2). This is shown in the diagram below. If you talk to Dr. Metcalfe, he will freely admit that he originally created the graph as a marketing device to sell Ethernet cards. But it is also interesting to note this crossover point. This shows there is some non-negligible cost that has to be invested before the network is of a sufficient size to be a net economic benefit. So how does Metcalfe’s law apply to Bitcoin? To money generally?

The Value of Money

Before we talk about Bitcoin’s value specifically, I would like to discuss why money has value. When most people are presented with the question “why does a dollar have value?” most will respond with something that has to do with it being backed by the government. This in it of itself is a logically flawed argument, in that the government itself does not have a good or service for which everyone could possibly redeem their dollars. The US dollar used to be backed by gold, but FDR ended that in 1933.

Executive Order Confiscating Everyone’s Gold

The follow-up response typically has to do with the fact that the government has the power to tax, which may be true, but the taxes are collected in dollars. So, the power to tax is the power to back dollar with more dollars, not with some other good or service. Therefore, the dollar is worthless paper backed by more worthless paper and does not have intrinsic value in it of itself. So how does our economic system work? The dollar has value because individuals are willing to exchange it for goods and services.

That’s it, the dollar has value because so many people mutually agree it has value. If at some point in the future, a large number of individuals decide that the dollar doesn’t have value, or has less value, and are less willing to accept it as a method of settlement it would lose value. When confidence is lost in a state issued paper currency, for whatever reason, the feedback cycle in the collective loss of confidence typically manifests in rapid inflation and eventually loss of all value. The average life of a fiat currency is only 27 years, and major economies including China, Russia, Germany, Brazil, Argentina, and Turkey have experienced it in the last century. Therefore, we have established that currencies have value because people or willing to accept them as settlement and when that willingness changes, value changes.

The natural follow-up question is what factors might affect a person’s willingness to accept a dollar, or any other fiat currency as settlement. Historical cases highlight the main causes of confidence loss which are changes in money supply, and changes in economic output. Changes in the money supply can shake confidence in fiat currencies because an increase in total supply leads to a decrease in unit value. The underlying cause of the increase in the money supply can be due to irresponsible monetary policy of the central bank (Venezuela 2017), irresponsible behavior of commercial banks (US Banks 2009), or some combination thereof. Changes in economic output are typically due to a natural disaster (Haiti 2010) or war (Germany 1914, 1939). Therefore, if there was a financial system that wasn’t dependent upon any single country or region’s output, and wasn’t subject to the whimsical monetary policy of politicians and central banks, the main causes of historical losses of confidence in money would no longer exist.

The Value of Bitcoin

I propose that the value of Bitcoin does not follow the typical rules used to analyze traditional assets, but rather is a network and therefore is governed by a rule similar to Metcalfe’s law. The modification of Metcalfe’s law is as follows.

Blockchain’s value law: The value of a blockchain is proportional to the square of the number of individuals that are willing to accept the digital asset as settlement.

There are many factors that may affect an individual’s willingness to accept a digital token as a method of settlement. These include the awareness, monetary policy, scarcity, security, confidence in technology, adoption, transaction cost, and perception of future value. There are potentially many other factors, but the underlying causes do not actually matter, but rather the aggregate willingness of individuals to accept the asset for settlement. A Bitcoin has value for exactly the same reason that the dollar has value. People are willing to trade it for goods and services.

Is there any proof that the Bitcoin follows the proposed value law? If we are to take the number of transactions on the network as an indication of the size of the user base and plot the square root of price and the number of transactions, the correlation is stunning.

The Rate of Adoption

The next question is what is the rate of adoption of Bitcoin. I believe there are two factors that influence the rate. The first is the acceptance of the idea of Bitcoin as a mechanism for financial settlement. The second, is the barrier of entry for the average person to cryptocurrencies. Presently, the awareness and willingness to accept the idea of cryptocurrencies seems to be spreading quickly. The biggest barrier that I see is the fact that cryptocurrencies are hard to use securely and technically challenging for the average person. At Grid+ we are attempting to address this by building a system that will provide the average person state-of-the-art turn-key security solutions that make cryptocurrencies as easy to use as PayPal. Once the systems are in place which lower the friction to individuals participating in Bitcoin to be similar with incumbent technologies, we will see viral rates of adoption.

Disclosures

I am the cofounder of Grid+ which is creating the world’s first blockchain based electrical utility. I own Bitcoin, all of this is only my opinion and is not investment advice.

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