Part II. The Parabolic Supertrend in Bitcoin— FCV and the Bitcoin Trifecta

More nuts and bolts on valuing Bitcoin

In my previous post on this topic, I described what I felt to be a useful imagery to have in mind when examining Parabolic Trav’s supertrend chart, which looks like this figure.

Figure 1: The Bitcoin Supertrend (courtesy: Parabolic Trav)

If you haven’t read it, a quick summary of that previous article is that I proposed the imagery of bacterial growth. The three phases of bacterial growth, repeatedly sequenced together, mimics the Bitcoin supertrend. There is a lag phase, during which the bacteria are acclimatizing to the conditions in a Petri dish; an exponential phase, where the bacteria are growing through rapid, exponential multiplication, and phase of stagnation, where the bacteria exhaust the resources in the Petri dish and cannot grow any further. Left in that state, the fourth phase of retardation would then ensue. However, if more resources are provided, say by way of a larger Petri dish, the process continues anew. The parallel to the Bitcoin supertrend are easy to imagine.

Since that view may sit as somewhat too deterministic, in this post, I want to provide some of the nuts and bolts, and explore some other features of the Bitcoin ecosystem that Parabolic Trav and I have been exploring.

A recap on liquidity preference

Let’s begin with some basics. Broadly speaking, our demand elasticity for money, which is to say how sensitive our demand for holding money is to the prevailing opportunity cost of holding money, is called our liquidity preference.

The opportunity cost of holding money is, of course, determined by the real rate of interest that we have access to for a given quantity of our money. Usually this is the risk-free rate of interest, such as the Federal Funds Rate in the US. As the opportunity cost of holding money increases, our liquidity preference contracts, and so does our desire to carry money.

Now, it is, of course, rather insular to think that our liquidity preference is some easily describable static concept with close correspondence to the risk-free rate. This is because, as consumers, we have access to a vast range of interest-bearing assets, differing in their risk-return profiles. As we move our money around from one asset to another, the risk premium, our risk-preferences, our time-preferences, our ability to minimize tax-burdens, and a host of other aspects, all interact to determine our liquidity preference.

What is important here, however, is just that our short-run elasticity of demand for liquidity is pretty low. We tend not to be in a position to adjust our liquidity preferences rapidly in the short run, based on all the various factors that affect the opportunity cost of money. Expenditure patterns, commitments and essential needs serve to lock us into a narrow range of liquidity preference. In the longer-term, however, we tend to have a much more elastic response for liquidity. Expenditure patterns can be adjusted and the costs incurred in undertaking such adjustments can be defrayed over a longer span of time.

FCV

Bitcoin does not alter the logic of liquidity preference; however, it does fundamentally and emphatically interpose itself upon this calculus by erecting itself as an alternate money in the making. What that concretely means is bitcoin reduces liquidity preference in fiat currencies by directly affecting the overall rate of return on ‘money’, and that this is a subtly different effect than arises from the return possible on bitcoin as a commodity asset.

That these really are two separate aspects of the phenomenon becomes clearer when we consider the two aspects of what determines the rate at which we might convert fiat money into bitcoin, or what Parabolic Trav and I have previously called the Fiat Conversion Velocity:

1. When we see bitcoin as money, the Fiat Conversion Velocity (FCV-BM) is modulated by a relative rate, which is to say, a consumer’s liquidity preference is split across two, admittedly intersecting, economies — the incumbent economy and a smaller incipient cryptoeconomy. This relative rate is simply expressed as:

q=(Liquidity Preference in bitcoin)/(Liquidity Preference in fiat).

Note that the equation for q suggests that FCV-BM would be especially sensitive to the risk-adjusted relative rates of return. This suggests an income effect, generated purely from substitutions of consumption away from the cash-based traditional economy to the bitcoin-based cryptoeconomy, and vice versa.

2. When we see bitcoin as an asset, a liquidity preference for bitcoin alone becomes largely a meaningless concept. Expenditures are undertaken exclusively in fiat currency. The Fiat Conversion Velocity (FCV-BA) in this case is relevant directly, insofar as it is a precondition to buying the asset itself.

r=(Value retention in bitcoin)/(Value retention in fiat).

This equation, by contrast, suggests a pure wealth effect from bitcoin, with no reference to consumption substitutions across underlying economies.