Valuing Bitcoin and Ether based on Censorship Resistant Record-Keeping
The higher the transaction fees, the higher the holding period. The higher the holding period, the higher the price of Bitcoin or Ethereum.
- The price of a currency is determined by its circulating volume and velocity.
- The lower the velocity (higher the holding period) the higher the price.
- The more people see Ethereum or Bitcoin as offering censorship resistant data-storage (i.e. demand for blockspace), the higher the transaction fees, thus the lower the velocity (higher the holding period) and the higher the price of Ether/Bitcoin.
I’ve previously written about valuation methods for Bitcoin and Ether here and here. This post focuses on valuing Bitcoin and Ether based on the demand for blockspace on each chain. It’s inspired by Vitalik’s post that includes discussion of the concept of velocity (how quickly money changes hands).
The demand for censorship resistant record-keeping (i.e. blockspace)
💡Bitcoin and Ethereum blockchains provide forms of censorship-resistant record-keeping.
It seems reasonable that there should be some value to a record-keeping system that is censorship resistant and cannot easily be corrupted by either individuals, private companies or nation states.
Bitcoin and Ethereum provide such a record. Bitcoin does this with a Proof of Work algorithm (with computing power providing censorship resistance), while Ethereum will soon provide this via Proof of Stake (with ownership and staking of Ether tokens providing censorship resistance). There are pros and cons of each that I won’t get into here.
Concretely, a demand for censorship-resistance is a demand for being able to “write” to the Bitcoin or Ethereum blockchain. Blocks on the blockchain have a finite amount of storage space. Demand for blockspace is balanced — via transaction fees — with the finite supply of blockspace. If demand for blockspace goes up, then transaction fees generally go up.
The cost of transaction fees
💡Transaction fees respond to the demand for censorship-resistant record-keeping because the rate at which data can be written to the Bitcoin or Ethereum blockchains is roughly fixed.
It’s not exactly true, but one can think of the amount of data that can be written to a blockchain (per unit time) as roughly fixed. So, the fees to record this data fluctuate according to demand. One can think of a few sources of demand for writing data to the blockchain:
- Speculation on the price of Bitcoin or Ether. This is particularly pronounced in bull markets and less pronounced in bear markets.
- Changes in demand for owning Bitcoin (or Ether) as a store of value. (Sure, some people don’t believe in Bitcoin as a store of value, but some people do, which creates a demand).
- Demand for censorship-resistant record-keeping.
The focus of this piece is on the third driver as a valuation basis for Bitcoin and Ether.
The relationship between transaction fees and average holding time for Bitcoin and Ether
💡All else being equal, if transaction fees are higher and there is a demand for censorship-resistant record-keeping, then people will tend to hold more Bitcoin or Ether in their wallets for longer.
Transaction fees on Bitcoin must be paid in Bitcoin. Transaction fees on Ethereum must be paid in Ether.
Use of a blockchain requires two transactions — one transaction to acquire Bitcoin or Ether to pay fees, and another transaction (or transactions) to write data to the blockchain and actually pay the fees. To save transaction costs, one can buy and hold extra Bitcoin and Ether and then spend it when needed. For larger and larger transaction fees, it becomes favourable to buy and hold more Bitcoin (or Ether) to have on-hand to pay for transactions. [Side note: it’s true that — on the flip side — the more volatile the currency, the less people will tend to hold that currency to pay for future transactions.]
If there were minimal transaction fees for Bitcoin or Ether, there would be no need to hold Bitcoin or Ether in order to write data to the Bitcoin or Ethereum blockchain*. One would just buy Bitcoin or Ether immediately when needed — the average holding period necessary to access censorship-resistant record-keeping would approach zero. [Note that “transaction fees” here should be interpreted broadly as both the on-chain fees, plus exchange fees to buy Bitcoin, say with US dollars.]
This is exactly what people using Ethereum (or other similar blockchains) do. They keep a small amount of Ether in their wallet to pay for transactions. The higher the transaction fees, the more this small amount becomes. Ethereum users now hold a few hundred dollars worth of Ether in their wallets, whereas previously they might have held tens, and before that, ones.
*Note: Bitcoin is more focused on supporting a pure currency rather than offering data storage like Ethereum. “Writing data” really just means “transferring Bitcoin from one account to another” in the case of Bitcoin.
Relating Bitcoin and Ether holding-periods to Bitcoin and Ether Prices
💡The higher the transaction fees, the higher the holding period. The higher the holding period, the higher the price of Bitcoin or Ethereum.
By definition, there is the following equation relating demand for a currency and price:
Number of tokens outstanding x Price of tokens in USD = Daily volume of token transactions in USD x Average holding time of the token.
If you want to understand this a bit better you can read more discussion by Vitalik here. Now, digging into each term — focused, for ease — on Bitcoin**:
- The number of tokens of Bitcoin outstanding is capped at 23 million.
- The daily volume of token transactions is very roughly constant because of the fixed blocksize.
- The average holding time (setting aside speculation and changes in demand for holding Bitcoin as a store of value) should increase with transaction prices as discussed above.
According to the equation above, upward pressure on holding time — while holding tokens outstanding and daily volume constant — results in upward pressure on Bitcoin price.
**The supply of Ether is not capped but is defined programmatically. Supply of Ether may well start to decrease because, since Ethereum Improvement Proposal (EIP) 1559, the majority of transaction fees paid in Ether are now burned. Separately, the daily volume of transactions on Ethereum will likely increase with technical improvements like sharding, which would further increase price in the above equation. The question is whether the product of number of transactions and transaction fees will increase. Empirically, this has been the case historically and transaction fees on Ethereum have outpaced the rise in transaction volume. I expect it’s a reasonable assumption that transaction fees will increase further if Ethereum (and Bitcoin) are continued to be perceived as the most secure forms of censorship-resistant record-keeping. Said differently, the question is whether demand for blockspace will continue to outpace supply.
Caveats and Concluding Remarks
Underneath speculative behaviour, I see a competition between blockchains based on their ability to provide censorship-resistant record-keeping.
- As a pure currency and offering a focused Proof-of-Work approach, Bitcoin is the leader. It has the highest market cap of any cryptocurrency.
- As a broader data-storage offering and a focused Proof-of-Stake approach Ethereum is the leader. It has the largest token market cap and highest daily transaction fees of all blockchains.
Obviously a large (if not majority) portion of crypto transactions are speculative and this clouds out the signal of what value there might be in a core censorship-resistant record-keeping use case. Perhaps this censorship-resistant value is most clear in down-markets when speculation is lower. I see three cases emerging:
- The value of censorship-resistant record-keeping is small (e.g. smaller than the market cap of crypto today). I think this is unlikely because it seems useful to have different mechanisms of preserving data.
- The value of censorship-resistant record keeping is much larger than crypto market cap today and that value is captured by Ethereum and Bitcoin.
- The value of censorship-resistant record keeping is much larger than crypto market cap today but that value is captured by blockchains (or other mechanisms) that don’t yet exist today.