How I guesstimated the value of Bitcoin in 2014…

I had almost forgotten about this until Eric Lonergan said something nice about it — an email to my clients back in 2014, just trying to work out what the correct “price” of Bitcoins might be. I didn’t regard this as investment advice even at the time and certainly don’t now that it’s three years out of date!

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Good afternoon … for various reasons, some of which have to do with forthcoming “thought leader” research (I know!) I have been thinking about the Bitcoin “virtual currency” recently. So I had an incentive to clarify some thoughts, and I’ve even got a toy model to get some intuition about where the long term “value” of a Bitcoin (actually, the long term BTC/USD exchange rate, see below) ought to be. Read on … (or delete immediately if you’ve never heard of and/or don’t want to).

* It definitely _is_ a currency rather than an asset or commodity, and all the reasons for thinking otherwise seem to me to be more or less totally refutable.

The only reason for thinking Bitcoin not to be a currency is that considered as a currency (ie, a unit of account, a store of value) it isn’t very good at what it does. The value, both in terms of the exchange rate against proper currencies, and the purchasing power of 1 BTC, goes up and down a lot. This is true. But on the other hand, it doesn’t seem to me that Bitcoin is more volatile than, say, the Zimbabwean dollar, and the Z$ is definitely a currency. Even the Weimar Mark was a currency, and people did use it for payments, often at ludicrous inconvenience. And Bitcoin’s volatility is at least two-sided — most volatile currencies are only volatile because they’re debasing so fast. So I don’t think it can be ruled as something other than a currency just because it doesn’t currently do the job of a currency as well as the US dollar.

* The criminal uses of Bitcoin are essential to the value, whether or not they’re a majority of Bitcoin transactions.

In the right circumstances, a Zimbabwean dollar can be really useful — specifically, if you’ve got a tax demand from Robert Mugabe on your desk and a ZANU police officer at your door, Zimbabwean dollars are what you are wanting. The “chartalist” theory of money actually makes this the defining characteristic of fiat money systems — the reason why they are regarded as having value, the way in which the convenient fiction of money gets off the ground, is that there is a guaranteed use for government-backed fiat money, which is that you can pay your taxes with it. And by insisting that you can’t pay your taxes in anything else, governments create a guaranteed demand for the otherwise worthless pieces of paper (electronic credits, etc) which they create, which is why people are prepared to swap valuable goods and services for them.

The closest thing that Bitcoin has to a guaranteed use is that you can buy drugs with it. I am not sure how I am going to phrase this when and if I write a research note, but it’s a fact; the price in Bitcoin varies a lot, but even now the old Silk Road website has gone, there are lots of places on the Internet where it is really easy to buy drugs if you have some Bitcoins, but not if you don’t. This is because of the (not total, but pretty total) anonymity of Bitcoins. So, if the tax use for Z$ is a value that Z$ has as a way of getting a government official to go away from your door, the illicit use of Bitcoins is a value that they have in reducing the likelihood of a different kind of government official coming to your door in the first place. This means that there’s a captive user-base for Bitcoins (people who want to buy drugs over the internet), just as there’s a captive user base for all forms of fiat money (the government that backs it), and the existence of the captive user base means that they’ve got exchange value in legitimate uses, because everyone knows that there is a core group who will exchange valuable goods for Bitcoins.

* It’s a currency which has very unusual but actually quite simple exchange rate economics.

There are two obvious things about Bitcoin from an FX point of view. First, Purchasing Power Parity holds very strongly for the BTC/USD exchange rate. As the BTC “price” (ie, the exchange rate) fluctuates, the BTC-quoted prices of goods and services (by which I mean illegal drugs) fluctuate to keep the implied USD price relatively constant. This practice also seems to be followed by the comparatively small number of legitimate retailers who, usually as a gimmick, quote prices in Bitcoin.

The other thing is more or less the corollary. The BTC/USD exchange rate is entirely determined by portfolio capital flows. Because of this, it’s not worth doing any kind of fundamental analysis to try and guesstimate a “fair value” in the near term. A significant proportion of the Bitcoin money supply is hoarded and/or held for investment purposes. It is quite easy to short Bitcoin (ie, it’s not difficult to borrow them). So it is all about near-term sentiment and newsflow.

* It is not by any means a particularly good payments system

The way Bitcoin works, it can take up to ten minutes for the distributed “ledger” to be updated and for a transaction to be final. I don’t see how any kind of securities exchange, or any other wholesale payments system even approaching modern standards could ever be operated on the basis of Bitcoin payments on their own. If you wanted to give immediacy and operate a Bitcoin to seriously rival Mastercard or Visa, then it would have to be done on the same basis; one where what you’re actually sending are not units of the currency itself, but units of claims on the books of the central counterparty. As it is, Bitcoin transaction fees for retail payments are about 1% plus the seignorage built into the “mining” system, which is basically a protocol whereby free Bitcoins are given to anyone who volunteers their computer to run a server updating the ledger. This seignorage is about 10% of the Bitcoin money supply per year at present, so the total cost of Bitcoin payments is about the same as normal retail payments, for less immediacy and a lot of hassle. If you were ever to build in even token anti-money-laundering systems (which you would have to if the Bitcoin economy were ever to have a normal financial system), it would be a lot higher.

* But, as I said, a really lousy currency is still a currency.

So I don’t see Bitcoin taking over anything any time soon, and I am certainly not volunteering to have any of my compensation paid in it. But … it does have some viability as a currency, because it’s got one captive market — in the criminal sector, I can see how the disadvantages of Bitcoin as a general payment mechanism would be outweighted by the very significant disadvantages of using a credit card to buy illegal products online.

* So, order of magnitude “fundamental long term” Bitcoin exchange rate?

If we accept that it’s a currency rather than the equivalent of rare stamps or other pure speculative counters, then it needs to obey the quantity theory equation of money — MV = PT (the real money supply multiplied by its velocity equals the price level multiplied by the transaction volume). And because Purchasing Power Parity holds so tightly for BTCUSD, we are OK in saying that in this equation, we should take T as the US dollar volume of transactions that could reasonably be carried out in Bitcoin, and P as the Bitcoin value of a dollar (ie, 1/the dollar value of a Bitcoin, which is what we’re interested in). M is the Bitcoin money supply, which in the long term we know will be 21 million Bitcoins (this is written into the mathematics of the system), and V is the velocity of base money, which is surprisingly constant at 10x for a variety of normal people’s currencies.

So, rearranging the equation to solve for P, the “ long term fundamental” value of a Bitcoin is [The long term value of transactions that will be carried out in Bitcoin] / 210million. So what should we plug into the top of the equation?

I’m not saying that this is a well-thought-out number, but the UN estimate for the global illicit drugs market is USD120bn, and if you divide 120bn by 201m, you get $571, versus the most recent quoted price Bitcoin price of $634. So … order of magnitude correct? Obviously, if Bitcoin takes off, people will use it for more things than illegal drugs, just like people use Zimbabwean dollars for more things than taxes. On the other hand, speculators must surely incorporate a nonzero probability that the actual long term value of T is zip-zero. But I went into this project thinking that $600 for a magic number was obviously silly, and I took the first fundamental model I could think of, put in back-of-the envelope numbers and … now I don’t think it’s necessarily 100% silly. I still think it’s quite strange, but the market has its own kind of internal consistency.

Anyway, have a good weekend. As they say, don’t take any wooden nickels!

Senior Research Advisor, Frontline Analysts

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