Bitcoin's Price Largely Supported by Adoption Fundamentals

This is our live model of bitcoin’s equilibrium value.  The equilibrium value is the fair value of bitcoin assuming there is an equally motivated buyer and seller in an efficient market (meaning participants have equal access to information).   

 I describe this as “live” because although prior to 2018 the model was backtested, 2018 data has been updated on a regular basis on this site (here).  The red line is bitcoin’s actual daily price.  The blue line is the theoretical value based on addresses, transactions, new coin issuance (inflation), and other factors.  It is based on peer-reviewed, published work that we originated in 2017 (available here and here).  The reversion to Metcalfe value in late 2018  only served to validate that we have the appropriate model parameters in place.

You don’t need the full formula and all the data to see that Metcalfe’s law is the single greatest explanation of bitcoin’s value over time.  Here is a simple graph of active addresses (squared) vs. bitcoin price.  Pretty convincing that Metcalfe’s law is exactly what it says it is:  the value of a network.  You can learn about Metcalfe’s law here.

Statistics 101

Models are just that – simplifications of the truth.  With models come two kinds of errors: modeling error (the formula itself may be wrong or incomplete) and estimation errors (the output is not perfectly accurate).  Assuming we have a decent model (again, see the addresses relationship above), we have an estimation error in our model of about 20% over a 60-day period.  In other words, fluctuations of +/-20% around the “true” value of bitcoin are normal.  Alternatively, the true value lies within +/-20% of the stated value (68% confidence), or +/-40% of the stated value (95% confidence).

Metcalfe’s law has a property which is its first derivative.  It says that the change in price (P) is twice the growth rate in users (n):  %∆P = 2 × %∆n.  So if user growth is 10% per year, the price would go up about 20% that year.  Of course, there is a margin of error, and so the actual price appreciation might be -20% to +60%, a range we would expect to see 95% of the time.  It may seem like a large range, but it’s far more predictive than a wild guess, a talking head on TV, or short term chart analysis.

Assuming our model is (mostly) right and the value of bitcoin in January 2018 is (about) $3,600, then there is a 95% chance its real value is between $2,160 and $5,040.

Bitcoin’s price not entirely “propped up” by illegal activity

Now let’s assume that University of Sydney researchers are correct, and 25% of bitcoin transactions involve illicit activity.   That does not mean that  25% of the users are involved in illicit activity, because one criminal can undertake many transactions.  Also, a criminal may be on one end of a transaction and an unsuspecting innocent on the other.  Based on a transaction-to-user ratio of 40%, a rough guess would be that 12.5% or fewer users are involved in illicit activity.

Now suppose that all of these bad guy users are caught and stop using bitcoin immediately.  We mention this because some claim that bitcoin’s price is propped up by illegal activity.  That is true, but to now we can quantify it:  about 12.5% of users, on average, engage in illicit conduct with bitcoin.  So if they went away we would have a -12.5% decline in user growth, which equates to a -25% decline in bitcoin price.   

Using the low value of $2,160, and then applying a further 25% price decline, we get $1,620.  This value assumes a) the 97.5th percentile of the valuation estimate and b) all bad guys stop using bitcoin.

You can argue the specifics of the numbers if you like, but changing the assumptions doesn’t change the circumstance.  For bitcoin’s price to fall significantly all three of these things must be true:

• there must be a lot of criminal users;

• all the criminal users get caught and/or stop using bitcoin; and

• Metcalfe’s law grossly overvalues bitcoin.

In other words, to arrive at low values for bitcoin, you have to have increasingly unrealistic and negative assumptions about the user base and Metcalfe’s law. In so doing, the probability of this negative occurrence becomes smaller and smaller. It becomes very difficult to find downward pressure on bitcoin price, even with perfect regulatory enforcement and large, pessimistic ranges for price estimates. 

Add to that the fact that bitcoin is adding users at a rate of about 20% per year.  This implies a 40% upside to price which would also have to be overcome. To us, it looks like there’s a 97% chance that $2,000 is a theoretical threshold bitcoin will not cross, and $1,500 is an impractical, if not impossible, bottom.

Bitcoin’s 2018 Price Decline A Correction from 2017 Price Manipulation

1. Bitcoin’s price was artificially inflated in 2011, 2013, and 2017.  Though the evidence for this claim received some minor press, it was not carried by the mainstream media and within the crypto community it was derided as Fear, Uncertainty, and Distrust.  Having reviewed the math myself I was able to confirm the 2013 and 2017 events using a different mathematical model.  The 2013 high price was a 1-in-13,000 year event.  The 2017 high price was a 1-in-600 year event.  These are not “bubbles” in the traditional sense, though there was some of that as well. 

   2018 was a year when bitcoin’s price was retreating from its artificially inflated value, and returning to its fundamental value (found by applying Metcalfe’s law, below). People were not retreating from bitcoin, however. For nearly the entire year, Bitcoin added users and transaction activity.

   Metcalfe’s law really does explain network pricing, including cryptocurrency networks.  Excluding the periods where bitcoin’s price was manipulated, Metcalfe’s law is perhaps the single greatest factor that explains bitcoin’s price.  I wrote the first peer-reviewed rigorous paper to validate this relationship with bitcoin. Since then I have done it for many other cryptocurrencies, and track their price to value weekly. 

   Further information:

   o   https://www.caneislandcrypto.com/s/AIAR_Vol-7_issue-2_7-2-18_MetCalfesLaw.pdf

   o   https://www.caneislandcrypto.com/s/network-effect.pdf

   o   https://www.caneislandcrypto.com/s/How-to-Use-20.pdf

   Bitcoin’s price behaved exactly as predicted, and I publicly tweeted about its price trajectory on a regular basis since April 2018:

   o   From my presentation to CAIA in Houston March 7th

o   April  14th:  https://twitter.com/nsquaredcrypto/status/985272430976536577

o   April 21st: https://twitter.com/nsquaredcrypto/status/987767545833902080

o   April 25th: https://twitter.com/nsquaredcrypto/status/989124321233776641

o   April 27:  https://twitter.com/nsquaredcrypto/status/989843204936790016

o   May 17: https://twitter.com/nsquaredcrypto/status/997201225820131329

o   May 18: https://twitter.com/nsquaredcrypto/status/997627918175096833

o   June  11: https://twitter.com/nsquaredcrypto/status/1006107308613464066

o   July 6th  CAIA Australia: 

o   July 6th:  https://twitter.com/nsquaredcrypto/status/1015193467910123520

o   July 26th:  https://twitter.com/nsquaredcrypto/status/1022473529386840064

o   July 26th:  https://twitter.com/nsquaredcrypto/status/1022596999693193218

o   Aug 5th:  https://twitter.com/nsquaredcrypto/status/1026176676919689219

o   Aug 27:  https://twitter.com/nsquaredcrypto/status/1034200872450813952

o   Aug 28: https://twitter.com/nsquaredcrypto/status/1034576935119187968

o   From my presentation at DASS October 17th and TMA Houston November 7th:

3. Confirmation bias plays a role.  Confirmation bias, also called myside bias, is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses.  People also tend to interpret ambiguous evidence as supporting their existing position.  Crypto bulls view positive information as a reason to buy or HODL.  They ignore evidence to the contrary, or disparage it as FUD.  Crypto haters view any negative information as proof that bitcoin is worth nothing.  Evidence to the contrary must have been developed by idiots and therefore cannot be correct.  Neither belief system is true, let alone objective.  

A Simple Model for Cryptocurrency Valuation

We use Metcalfe’s law to calculate an estimate of a cryptocurrency’s value.  The methodology we used is based on a paper[1] by Timothy Peterson.

The formula uses three components:

M:  Metcalfe’s number based on number of active accounts.  Increases in n increase value.

A:  a decay factor based on the number of transactions (t).  Higher t means smaller A. Smaller A increases value. 

          b:  inflation caused by the issuance of new coins.  Increases in b decrease value.

 The general formula is:

We also must take into account periods of extreme pricing, such as those resulting from price manipulation[2] or investor bubbles.  Adjusting for these factors, we have developed a valuation model for each of the following cryptocurrencies:

 *Bitcoin's model uses 60-day periods.

Explanatory power is the extent to which Cane Island’s network economic model explains a cryptocurrency’s 30-day price change.  For example, Cane Island’s model explains 98% of Ethereum’s monthly price changes.   Based on these results, as well as the theory behind the model, we believe we have one of the most robust and valuable tools for valuing cryptocurrency ever developed.

Standard error is a degree of accuracy associated with the model.  About 68% of observed prices fell within the range predicted by the model.  For example,  if ZCash’s forecast price is 120, then there is a 68% chance its true price will fall between $80 and $160.

[1] Peterson, Timothy, Metcalfe's Law as a Model for Bitcoin's Value (January 22, 2018). Alternative Investment Analyst Review, Q2 2018, Vol. 7, No. 2, 9-18.. Available at SSRN: https://ssrn.com/abstract=3078248 or http://dx.doi.org/10.2139/ssrn.3078248

[2] Two documented examples are Gandal, Neil and Hamrick, JT and Moore, Tyler and Oberman, Tali, Price Manipulation in the Bitcoin Ecosystem (May 2017). CEPR Discussion Paper No. DP12061. Available at SSRN: https://ssrn.com/abstract=2977479  and Griffin, John M. and Shams, Amin, Is Bitcoin Really Un-Tethered? (June 13, 2018). Available at SSRN: https://ssrn.com/abstract=3195066 or http://dx.doi.org/10.2139/ssrn.3195066

Cryptocurrency vs. "Real" Money

There are two types of money:  commodity money and representative money. 

Commodity money is traditionally found in gold and silver coins.  Gold and silver are suitable for coinage because they do not decay, rot, or rust; were malleable and divisible into smaller parts (such as gold “pieces of eight”); and were rare and not able to be counterfeited.  Gold and silver have been used as money for 2,500 years. 

The risk with commodity money is debasement.  This involves reducing the quantity of gold or silver in a coin without changing its face value.  The Roman Empire substantially devalued its currency by debasement.  By 300 A.D., the once invincible Roman Denarius was no longer accepted as currency by the public.  

The origin of the word “Eurerka!” (Greek:  “I found it!”) is attributed to Archimedes, who, while bathing, discovered a method for determining the purity of gold objects by water displacement.  This method would be used for centuries to ascertain the validity of commodity money.

Representative money is money that does not have intrinsic value itself, but can be exchanged for things that do have intrinsic value.  There are two types of representative money:  fiat money and fiduciary money.

Fiat money is money that has a stated value by decree of a government.  It is legal currency and only has value because the issuing authority says so.  Nearly all money in the world, including coins and banknotes, is fiat money.  The U.S. dollar has been pure fiat money for less than 50 years.

The primary problem with fiat money is the risk of inflation, which is caused by issuing more money.  Since it costs almost nothing to make fiat money, the temptation to use it to pay the public debt is overwhelming. Modern examples include German Marks post-WWI, and Venezuela’s Bolivar today. 

In 1918, a German Reichsmark was worth one gold mark.  Five years later, it would take 1 trillion Reichsmarks to exchange for one gold mark.

In 2005, the Venezuelan Bolivar was worth about 40 U.S. cents.  In early 2018, one Venezeulan Bolivar was worth about 10 cents.  By August 2018, it took almost 2.5 million Bolivars to buy one U.S. dollar.

Fiduciary money has value only because parties engaging in exchange agree on its value.  You have been using fiduciary money for most of your life.  It includes things like frequent flyer points, transit cards and tokens, even grocery coupons.  Cryptocurrency is fiduciary money because the users agree on its value.

A great example of fiduciary money involves a once-popular Italian telephone token−the gettone.

The word gettone (pronounced “jet-TONE-ay”, plural:  gettoni) literally means "token."  The first Italian telephone token was created in 1927.  It was a little disc made of an alloy of copper, nickel and zinc, or bronze.  Production stopped in 1983 when it was replaced with magnetic phone cards.  It is estimated that 600 million such tokens were produced. 

Gettoni were commonly used as and interchangeable with a 50 Lira coin until 1980, when its value (and the cost of a phone call) suddenly doubled to 100 Lira.  The doubling occurred again in 1984, to 200 Lira, again a result of a price increase associated with pay-phone calls.  It remained at that value until 2001, when the Euro was introduced and the gettone suddenly lost its money-like nature in the Italian economy. 

The parallels between the gettone and cryptocurrency are many.  Both serve only limited roles as a literal form of currency, and as fiduciary money both are intrinsically worthless.  It was not necessary to have a gettone to make a phone call; one could use a phone at the home or office to do that.  Likewise, one is not required to use cryptocurrency to make purchases, but can choose to do so for convenience or other reasons.  People carried both gettoni and Lira, in the same way people hold cryptocurrency and sovereign fiat money.  Like cryptocurrency, the cost to counterfeit a gettone, relative to its value as a medium of exchange, was so high it was ridiculous to even consider it.  And, like cryptocurrency, a user could do one of three things:  spend it, exchange it for government currency, or hold it.