bitcoin is a store of value
Since its inception in 2008 bitcoin has gradually adopted the properties of a global store of value. This article will look at the key properties that define bitcoin as digital gold including the increasing base level of utility that supports a price floor.
Summary
- bitcoin displays the properties of a store of value and can be likened to digital Gold.
- It’s important to distinguish between the Bitcoin Network and bitcoin, where, the Bitcoin Network is a global public exchange infrastructure and bitcoin is a store of value.
- Utility-driven demand for bitcoin has increased each cycle. This is observed through an increase in the base level of daily active users (DAU) and adjusted on-chain transaction volume.
- Publicly available data can be used to identify some of the economic outputs associated with on-chain transaction volumes.
- Price forecasts based on bitcoin capturing 5%, 10% and 25% of the existing store of value market.
bitcoin is a scarce asset
Due to its limited total issuance and predictable inflation schedules, the case for bitcoin as a store of value should be seriously considered. When coupled with the ease of storage and transferability, bitcoin presents itself as a quasi-gold asset in the digital age.
The bitcoin network is a decentralized and distributed ledger hosted on 9,3k nodes across more than 20 countries[1]. bitcoin, the native currency of the Bitcoin network, is a deflationary digital asset that has a finite supply of 21 million. To the present day, 17,5 million bitcoin have been minted (or mined) and approximately 2.7 million are inaccessible due to lost access keys [Chainalysis, 2018][2]. New bitcoin can only be minted through committing hash-based proof of work computing power, generated through a Central Processing Unit (CPU) or Application Specific Integrated Circuit (ASIC). The rate at which new bitcoin can be minted is controlled by the network’s algorithmic programming, releasing new bitcoin approximately every 10 minutes. The bitcoin for that period are awarded to the entity controlling the computer power, or miner, that successfully solves a mathematical proof. In simplified terms, every 10 minutes a new mathematical proof is solved.
As a finite currency or asset, the number of bitcoin that are rewarded to the miner decreases over time. The number of bitcoin awarded to the miner is known as the block reward and determines the inflation rate. The block reward is cut in half every 210,000 blocks which is roughly four years, periodically reducing the rate of inflation. The first period of block rewards was 50 bitcoin per block in 2009, and in 2014 was halved to 25 Bitcoin per block. The next halving is estimated to be in 2020.
bitcoin’s annual inflation rate began at 25% and has now reduced to 4.17%. The initial inflation rate programmed into the network was intentionally high to incentivize miners to commit their CPU and ASIC power to the network. At this point, it should be noted that the security of the network is correlated to the total computational power allocated to the mining process and therefore the network requires computation power in order to thrive.
Once all bitcoin have been awarded by 2140, miners will continue to compete for blocks in order to win the sum of transaction fees associated with adding a block to the chain.
The transaction fee mechanism is fundamental to the continuation of the network and incentivizes miners to commit computational power to the network in perpetuity, while simultaneously creating a deflationary supply of the digital asset.
The supply controls that are algorithmically engrained into bitcoin’s core code prevent the unpredictable and sporadic inflation associated with the Keynesian economies of today.
As a point of comparison, the FED printed $86Bn worth of dollars over the 12 months up to March’19, equating to a 5.3% increase in supply.
From 2024, the bitcoin inflation rate will drop below 1% and by the year 2140, no new bitcoin will ever be created. As a digital asset with a finite supply, bitcoin has been likened to digital Gold. With this comparison in mind, we will now examine three key properties that an asset must have in order to qualify as a store of value.
3 Properties of a store of value:
- Non-perishable, such that it must be resilient to all external environments.
- Accountable or measurable, to enable a record of its existence and ownership.
- An established base level of demand, so as to guarantee a minimum price.
Examining bitcoin in the context of these three properties, it should be evident that a decentralized digital ledger is both non-perishable and accountable. The following section will, therefore, address the third property, an established base level of demand which serves as price support, due to the fundamental utility derived through its use.
An established base level of demand
Establishing a base level of demand for any asset or good is a key requirement of a SoV. The base level of demand describes the utility that underpins the asset, which is expected to increase over time. Gold is an excellent example, being both a store of value and an efficient conductor of electricity. While there are other conductive materials that can substitute gold, they are less efficient and less resilient to the elements — Copper being one example that is used for its conductive properties. While Copper is cheaper than Gold, its chemical properties mean it loses electrons through the process of corrosion, eroding its conductive utility over time. Gold’s resilience and reliability makes it invaluable for applications with a low-risk tolerance and has seen it used in minute quantities in almost every electrical appliance[1].
The utility of Gold is not the sole driver of its price, however, it guarantees a non-zero price floor. As the price of Gold approaches that of Copper, its superior conductive properties would see it used as a substitute.
The following section will argue that the Bitcoin network, similar to Gold, has an underlying utility that performs its function better than any other good or asset in its class. This base utility provides a price floor for the asset. The price floor subsequently acts as a key requirement for its acceptance as a store of value.
The Bitcoin network has utility as a decentralized public payment infrastructure, accessible by everyone from anywhere in the world at any time.
At this point, it is necessary to make a clear distinction between bitcoin, the digital asset, and the Bitcoin Network, the infrastructure that enables the transfer of bitcoin. While one cannot exist without the other, the two have different purposes and should therefore not be treated the same way. We consider the Bitcoin Network to be a global public exchange infrastructure and bitcoin itself to be a store of value, due to its scarcity and relatively high cost of the transfer.
We can measure the base demand of the Bitcoin Network by observing the total value, or on-chain transaction volume, that is transmitted over the network. The on-chain transaction volume has been likened to the economic output or GDP of the Bitcoin Network and can be seen below;
There have been a number of new base levels set over the past 9 years of bitcoin’s history. The first example was at the end of the 2013 bear market, where daily TX volume found a floor at $35MM in Jul’13. The second base level, “base 2” settled at $65MM per day in May’15, at the end of the 2015 bear market cycle. By July of the same year, the on-chain TX volume surpassed $100MM per day, reaching a new base level at “base 3”.
While this paper makes no comment as to our current stage in the cycle, a preliminary base level from Feb’19 saw daily adjusted transaction volume over $1.3Bn, marking a 550% increase from the $0.2Bn level at “base 4” in Oct’15.
The natural question that follows in this analysis is the composition of the adjusted transaction volumes.
Skeptics of the Bitcoin network reasonably assume that this volume is related to an increase in speculative trading and does not equate to economic activity or real value transfer.
The following section will address the composition of on-chain transaction volume in four parts;
i. The decoupling of speculative trading and on-chain transaction volume.
ii. Peer to Peer Transfers; increasing daily active users on the Bitcoin network.
iii. Growing interest in bitcoin as a SoV observed through investor behavior.
iv. Company case studies; using the Bitcoin network for international payments.
i. Outlining the decoupling of speculative trading and on-chain transaction volume
As with any tradeable asset, the bitcoin price is subjected to long and short positions, leveraged positions, swing trading and exploiting information arbitrage. Traders do indeed speculate on the future value of bitcoin. Speculative trading, however, is not the sole driver of bitcoin’s on-chain transaction activity which can be observed through a comparison against exchange-traded volumes.
The unique system architecture of the Bitcoin Network enables us to distinguish between exchange-traded volume and on-chain activity.
Through observing the decoupling of these two metrics, we can extrapolate that speculative trading is not the sole driver of transactions on the Bitcoin Network.
While we acknowledge that a portion of on-chain activity is related to the settlement of speculative exchange-based trades, the reduction in correlation between these metrics implies on-chain activity takes place independently of speculative, exchange-traded volumes.
The decoupling of on-chain activity and exchange-traded volume can be observed on the graph below:
While there is no disputing that traders speculate on the price of bitcoin, the graph above demonstrates that economic activity on the Bitcoin Network is not entirely driven by exchange-traded volume.
ii. Peer to Peer Transfers; increasing daily active users on the Bitcoin network.
Having demonstrated the decoupling of speculative, exchange-traded volume, and on-chain transaction activity, we proceed with the assumption that a large proportion of daily active users are non-speculative actors. On this basis, we can now observe how the increasing number of daily active users on the Bitcoin Network points towards its rising utility as a public payment infrastructure.
Within any network, the value of the network bears some relation to the users that are connected to it — the aptly named network effect. The network effect is applied in business and economics to describe the increase in value generated through a marginal increase of users of a product or service. Take the telephone network for example. With only one user, a network is extremely limited in its application. Adding a second user to the network doubles its utility. As more users are added, the utility of the network continues to increase.
The proportional relationship between the increase in users and the value of a network was first proposed by Robert Metcalfe in 2013. Metcalfe’s law states that the value of the network is proportional to the square of nodes, or in this case users, that are connected to it.
Metcalfe’s law has been successfully applied in this form to describe the relationship between user growth and certain financial metrics for social media platforms such as Tencent and Facebook.
Given the nature of the Bitcoin Network as a public payment infrastructure, we believe that the value of this system, as with the internet, can be largely attributed to the number of connected or active users.
On the Bitcoin Network, the number of active users is calculated by observing the number of unspent outputs or UTXOs that are active on a given day. It should be noted that this indicator can be used to determine the relative increase or decrease in activity on the network but does not accurately represent the number of individual users, since we cannot say for certain how many UTXOs, or accounts, are attributable to each user.
On the chart below we have smoothed daily active users over a 30-day moving average and overlaid adjusted transaction volumes. The grey horizontal lines denote the base levels previously outlined:
The chart above demonstrates a steady increase in the number of daily active users between April 2013 and May 2019, reaching a peak of close to 1 million in February 2018. The gold circles highlight the level of daily active users at each of the base levels and can also be seen to increase periodically. A correlation of 0.75 between on-chain transaction activity and daily active users over a six-year period supports the argument that growing network volumes are largely related to increased user-driven activity as opposed to purely speculative trading.
iii. Growing interest in bitcoin as a SoV observed through investor behavior
In this section, we will look at the relationship between the market value of bitcoin and the perceived value of bitcoin from the perspective of bitcoin holders. Through this data we will argue that values become increasingly sticky as we reach the later points in a bear market cycle, which in turn signals the typical bitcoin holder is an investor, perceiving current price at a discount to future value, rather than a speculator. To understand this relationship further we will begin by defining two key terms.
Market capitalization describes the total value of the bitcoin network through the relationship between the current exchange-traded price and the total number of bitcoin in circulation. It is calculated through the following formula;
Market capitalization = Circulating Supply * bitcoin market price
Realized value is a measure of the perceived value of all bitcoins to their holders. It is calculated by aggregating the price of each bitcoin at the time it was last moved, sent or received. Realized value can be likened to accounting for a fixed asset at book value, only realizing profit or loss on the sale of that asset rather than periodically marking it at market value. If a bitcoin was acquired at $6k, the realized price of that bitcoin is $6k, irrespective of the market price.
The graph below outlines the relationship between the market capitalization and realized value of bitcoin over the past 5 years:
Observing the graph above, the points where BTC_market capitalization crosses below the BTC_realized value indicates that investors have chosen to hold bitcoin at a loss. A reasonable interpretation of this data suggests that at these points, highlighted green, investor’s place a higher than market value on the bitcoin they have bought, unwilling to sell at market price which is perceived as lower than its value. They perceive these unrealized losses as temporary.
The realized value has exceeded the market capitalization at three distinct points in bitcoin’s price history, with the first two events (prior to Q1’19) preceding the start of the next bull market cycle.
As such, the areas highlighted in green are support levels, or accumulation zones, where buying begins to increase and sellers become exhausted. The most recent of these cases occurred during Q1’19, with the market cap crossing back over the realized value on 6th April, 2019.
Both historical evidence and technical trading analysis, which saw bitcoin close above the 200 day moving average on 2nd April, suggest that this move signifies the start of the next cycle.
Another way to examine the relationship between market capitalization and realized value is through observing the ratio between the two metrics versus the USD spot price of bitcoin. Observing the chart below, periods where bitcoin’s market cap is less than 1.2:1 of the realized value signal accumulation zones, while a ratio above 3.7:1 signals an overvaluation relative to the perceived value.
As outlined previously these accumulation zones are synonymous with lower price volatility and signal an increased volume of bitcoins held on longer time frames.
iv. Company case studies; using the bitcoin network as a payment network.
The adjusted transaction volume taking place on the Bitcoin network has grown, in USD terms, for the past three consecutive years. The largest annual increase in transaction volume took place in 2017, increasing by $879Bn. While 2018 saw significantly less growth, the total economic activity across the network grew marginally to $1.1Trn. The volume walk below is compiled of data independently sourced from a handful of businesses, as well as individuals, that we consider to be extracting economic utility from the bitcoin network. Given the pseudonymous nature of bitcoin addresses, the majority of transaction activity cannot be identified. The below is to give a high-level outline of the value of activity transmitted across the bitcoin network and is not to be considered as conclusive.
One of the best examples of economic output generated through the bitcoin network is Bitpesa, which did approximately $220MM in international transactions in 2017. Bitpesa is a fully regulated FCA company that supports businesses with foreign exchange payments between Europe and Africa. Bitpesa utilizes the bitcoin network to circumvent the costly and often slow process of international settlements. Another prominent user of the bitcoin network for international settlements is Bitpay, who claimed to have facilitated over $1bn of payments in both 2017 and 2018. Similar to Bitpesa, Bitpay is a regulated company that only facilitates legitimate, legal and therefore taxable payments.
While a controversial subject, the darknet remains a significant use case for bitcoin and payments over the Bitcoin network and is a fundamental part of the network volume.
While not conclusive, we believe that the combination of factors detailed above are sufficient to suggest bitcoin is increasingly perceived and therefore becoming, a legitimate store of value. On this premise, we will now estimate the current and forecasted value of bitcoin as a store of value.
Estimating bitcoin price as a store of value
The Store of Value (SoV) model applied is relatively simple. We begin by estimating the value of the existing Store of Value market which we believe bitcoin can access. In order to forecast the bitcoin price in 2024 we then estimate the total bitcoin in circulation of 17M, which is 19.7M minted less a conservative estimate of lost access keys of 2.7M bitcoin [Chainalysis, 2017].
To estimate the SoV market we have applied data taken from a report by Bank of America Merrill Lynch. The categories included in the set are investable gold, investable silver and large denomination bills. In projecting the value of these categories we have assumed gold and silver will keep up with a global growth rate of 3.7% and that cash will be inflated by 2% (IMF estimates 3.3%). Based on these estimates, the total investable SoV market is valued at $3.95T in 2024. The graph below is based on bitcoin taking a 5%, 10% and 25% market share from the investable SoV market by 2024.
The prices on the graph above are representative of a “minimum” value of a single bitcoin resulting from capturing a 5%, 10%, and 25% share of the store of value market by 2024. It is worth noting at this point that bitcoin price can be considered as driven by more than SoV alone, also affected by speculative value and value required to operate effectively as a medium of exchange. The SoV component is one element of the bitcoin price composition. Subsequent analysis will look at three bottom-up models to cross-examine the price forecast of bitcoin; Network Value to Transaction (NVT), Zipf’s Law based on Daily Active Users (DAU) and the marginal cost of production.
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