The Intrinsic Value of Bitcoin (and other Cryptocurrencies)
By Darin Oliver on ALTCOIN MAGAZINE
Let’s begin with the fact, that we remain a blockchain bull; and, at one time, we were a major cryptocurrency bull. But times change. Markets change. People change and assessments change as you re-evaluate opportunities and markets.
Let’s leave alone the fact that people like Warren Buffet and Charlie Munger hate Bitcoin, and that recently (also) the founder of Ripple guessed that (only) 99 percent of all coins and tokens would eventually be worthless (of course Ripple wasn’t one of them!). Let’s take a look at the issue of cryptocurrency values both from a historical (markets perspective), financial, and practical standpoint.
The Madness of Crowds
Cryptocurrencies are at best a new hybrid asset class and at worst a massive financial illusion. As a former equities and commodities trader, we grew up studying manias. The closest mania to Crypto might be the Tulip mania. I only choose that one, because the value of Bitcoin, which 90% of all coins/tokens are directly correlated to, could easily be worth zero or near zero.
Since early 2000, many financial commentators have noticed how some markets value many high flying technology stocks — with many feeling markets had become broken. The first internet boom was a landmark moment, not only did venture and private equity companies obtain insane values for many portfolio companies, but public shares reached fantastic levels. While that bubble burst, the horse had left the barn and valuations have never been the same.
Let’s put this in perspective with the present crypto-mania (or post-mania).
One of the most idealistic ways to value equity is to think of ownership in the company (or the asset) as a pro-rata stream of future cash flows and then discount those cash flows into the present. The insanity that began around 1998 occurred when equity analysts started estimating completely impossible future earnings for a company, 10, or 20, or even 30 years out in time and then using those discounted cash flows as justification for current prices in the stratosphere. Another method was to estimate future cash flows from the technology, the brand or put a value on the number of users that were currently unknown (by projecting current growth trends). Amazon is an excellent positive example, this company spent over 10 years not earning any money and needing regular share sales to survive, but in the intermediating years, returned billions to investors in equity share price gains — all based on growth but uncertain profitability. Ultimately Amazon monetized its users and brand — and now the value is finally reaching a point where one can justify its share price. But for all the Amazons in the world, there were many, many, and many others that either failed or became walking dead. What about Whatsapp? The jury is unclear, but Facebook also traded its equity, which itself was possibly overvalued to buy WhatsApp shares that were themselves priced to perfection. If Libra works and Whatsapp becomes its primary delivery system, then Whatsapp will surely be worth everything Amazon paid for it. Still, like all technology shares, the value will ultimately be based on the monetization of users. Tesla might be another Amazon — but it hasn’t made a penny for any investors from traditional profits (it’s only made loses). Still, like Amazon, its share prices have made investors billions. In some respects, all of these businesses feel like Ponzi schemes, that have a potential exit (if the company can earn a profit or monetize their core customers)!
This madness is not limited to these companies; thousands of other lesser know companies have similar dynamics at work. And yes, this brings us to Bitcoin.
We would first argue that it’s the madness of our broken financial system that allows for anomalies like Tesla, Amazon (to last a decade without profits) and companies like Whatsapp to be priced at such levels (Whatsapp had essentially no revenue and at best a dubious revenue model at the time of sale). People like Ray Dalio have written about the vast amounts of money chasing returns, and it is hard not to believe this is a factor where investors will give something a lot of time to demonstrate its value, especially in a negative interest rate world.
Is Bitcoin an Asset or a Store of Value?
But a broken financial system aside (which accounts for why Bitcoin probably hasn’t gone to zero, as investors give it time to “monetize” its “protocol” or perceived store of value), a realistic person, looking to find a real reason for Bitcoins market value ($136B on Dec 7, 2019), let alone the other $68B in other coins/tokens, would currently be hard-pressed to justify their value as either an asset or as a store of value at this current juncture.
Bitcoin as an Asset
“An asset is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide a future benefit.”
Whether the likes of Warren Buffet or Charlie Munger like it or not, we think it’s evident that Bitcoin can be called an asset, merely because millions of people expect an unknown future benefit. However, its “value” is another matter.
This said, it’s an asset only because of its user’s perception it’s an asset. It’s not like Gold, Silver, Platinum, Oil, Natural Gas and on and on — all of which have real commercial use cases. If Gold vanished tomorrow, the world would miss Gold. It’s the same for Silver, Copper, Platinum, Palladium and many other commodities. If Bitcoin disappeared tomorrow — only Bitcoin users, exchanges and some black markets would miss it. A superior version of blockchain would replace it immediately, so justifying its value as an asset, is a dubious argument at best. Commodities, currencies backed by governments and equities are all assets classes, but Bitcoin and cryptocurrencies are all dubious assets because they lack any real intrinsic value or substantive use. You can hate a government for debasing its currency; but in most cases, those governments offer debt instruments that pay dividends — and there are a plethora of switching options. Cryptocurrencies provide a glimpse into the future of what might be, but even Bitcoin doesn’t solve the problems of governments that debase their currency — that might come in the future. Still, the answer isn’t likely to be Bitcoin. Maybe another iteration, but not the current version. Remember this statement well, Bitcoin or any other cryptocurrency has no buyer of last resort. By design, there is no central bank for good or bad to save the day when a crisis occurs — and man-made crisis’ always happen. The mechanisms built into Bitcoin to reduce supply take time to realize and are built on assumptions of continuous demand; assumptions that don’t work in the real world. And Bitcoin was never intended to be bastardized with leverage or derivatives; man has done that out of greed.
What about Bitcoin Price and Market Capalitization
The biggest arguments justifying the price/value of Bitcoin are:
First Mover in Cryptocurrency — true, but will it matter?
Cryptocurrency and Bitcoin will revolutionize remittances, giving the unbanked, banking options — hasn’t happened, and there are better alternatives anyway
Cryptocurrency and Bitcoin are private (perfect for black market operations, including evading government sanctions and avoiding currency controls) — it’s all public blockchains and governments are investing money to trace transactions due to hackers use of Bitcoin for illicit transactions. And now there are legitimate new privacy coins gaining traction on black markets slowly replacing Bitcoin as a transactional currency in these markets.
Cryptocurrency will revolutionize eCommerce (and Bitcoin has the most significant use case and scale) — hasn’t happened, and there are better alternatives anyway
Cryptocurrency is a new store of value (and Bitcoin is the clear leader) — hasn’t happened — and its an asset with no alternative use case
Bitcoin has limited supply; demand will far exceed supply (driving prices higher and higher, even to a million dollars per coin) — price/value perception is more important to price than supply and demand
Yes, Bitcoin has first-mover advantages, but its technology, while ingenious in creation is now getting dated. Both the forks of Bitcoin cash (BCH) and Bitcoin SV (BSV) are superior, they offer faster confirmations and far lower transactions costs, and both have institutional scale. And then there are just new blockchains that are faster, cheaper and possibly more secure. These points made, Bitcoin has the largest scale of any cryptocurrency. It is used moderately in eCommerce, you can buy cars, convert it to gift cards and even buy a house using it, but that said, its far from mainstream. It was widely used on the dark web, but that is beginning to change with privacy coins taking market share from Bitcoin. Governments are investing in technology to trace and crackdown on finding end user wallets — those efforts have led to the arrest of many dark web suppliers. And Bitcoin mixers create unnecessary risks. Ethereum also has a market scale and offers real use cases through DAPP development capabilities. But Ethereum’s founder has himself warned users against speculating on the price of Ethereum (another warning investors are not accepting). As for remittances, if all you are doing is using the protocol to move fiat from one country to another, then the relative price of Bitcoin doesn’t matter; it only matters if you use Bitcoin as a store of value (something we discuss later). We use cryptocurrencies to move fiat all the time — we don’t care what the market price is, except that it remains stable for an hour or two. In fact, we stopped using Bitcoin and switched to Bitcoin Cash, since it was far faster, cheaper to transact in and just as liquid (for my modest needs anyway). We will bet that we are not the only users to move away from Bitcoin for this purpose. What we can say is that Bitcoin does have first-mover advantages and this is why it’s the king of the hill, but we can’t measure how much value that brings to its price — or if that value is sustainable in the long-term.
Now is also an excellent time to speak about perceptions. In the cases of Amazon, Whatsapp, and even Tesla, it’s clear that “price” perceptions determined value more than supply and demand. Tesla is a great example, the company regularly issues more stock diluting former holders, yet the price rises nonetheless. One of the favourite strategies of token issuance was the corporate profits buyback theory — which works in equity shares. But here we go again; a cryptocurrency isn’t the same sort of asset as a share of ownership in a profit-making (even potential profit-making) company. The idea is that the company will share part of its profits buying back the tokens, and this will drive the token higher and higher. LEO and Binance coin are two prominent examples. But there is a problem, what is the intrinsic or starting value of the coin itself? This matters, because if you start at a $1 you might drive the value to $100M by the time you purchase the final token (or higher if no one will sell), but what if the starting value is zero? Market clearing value might start at $1 and then go to $0.000000001. These sorts of tokens have no other value than the buyback mechanisms, and this creates real risks to the token holders. The point is that even $100M of buybacks do not guarantee $100M in profits to token holders depending on the starting value of the token, the current price of the token at subsequent buybacks, and future perceptions (which may already overestimate profit buybacks). Nor is there a guarantee that the companies, themselves widely unregulated, will buy back the tokens they promise to redeem. Given there is no disclosure or public audits of the financial statements in these companies, investors are stuck with trusting corporations to make accurate payments. History is replete with examples proving such trust is a bad idea (even in regulated environments). So remember perception drives price, not supply and demand — if the perception is negative, prices will fall.
Interestingly, virtually all other coins and tokens price actions are highly correlated to the price of Bitcoin; so like it or not, the complex is like one asset class with individual coins/tokens having a different beta relative to Bitcoin (in a similar way to small-cap stocks vs big-cap stocks). And sadly, the fate of all tokens /coins currently have rests upon the success or failure of Bitcoin. If Bitcoin loses value then the entire complex will also lose value (except stable coins). These “correlated” coins/tokens are already nearly worthless. But nevertheless, their existence effectively draws buying power away from Bitcoin, which could be used to increase Bitcoin demand. It’s underappreciated, in the community, the negative impact these dead coins/tokens have on the future buying power of current cryptocurrencies adopters who became or have become disillusioned by the complexes potential value, due to their previous adoption of these coins/tokens that now are among either the walking dead or completely worthless. A great deal of these coins/tokens controllers are paying traders to create wash trading to create fake volume, which is euphemistically called market making. But finally, whether or not Bitcoin’s first mover advantage helps bitcoin’s value will be shown over time. For now, no other token/coin has come close.
Bitcoin owners find Bitcoin dominance reassuring, but they shouldn’t. The fact is that there are better, more scalable, cheaper, more private, and potentially more secure tokens out there; it should worry Bitcoin’s true believers that none of these coins are gaining traction or adoption. Increasing Bitcoin dominance is a sign of the sickness of the market complex. The strength of Bitcoin dominance isn’t a positive for Bitcoin; it really suggests strongly that Bitcoin is full of speculation and therefore, vulnerable to real negative catalysts should anything happen to shake people's sense of Bitcoin’s value.
Bitcoin as a Store of Value
The debate over Bitcoin being a store of value will continue well after this article is digested. In the end, everything is relative. But lets first define this concept:
A store of value is an asset that maintains its value without depreciating. Any physical or digital asset can be considered a store of value under the right circumstances or when a base level of demand is believed to exist. Many economies throughout history have used gold, silver, and other precious metals as currencies because of their ability to store value and their relative ease of transport, as well as the ease of forming them into different denominations. Wealth preservation is a key component of a healthy economy, especially in the formation of a currency or monetary unit. Money is relied upon to facilitate exchange and preserve the economic value of an individual or business’s accumulated labor.
One of the most persuasive arguments for Bitcoin’s store of value argument is the limited supply (and an implicit assumption of continuous demand). But shares in companies are also stores of value. And we have shown that increases in share stocks don’t always lead to share prices falling, because it’s possible the company can generate additional economic value offsetting dilution. One other aspect of a store of value is having some base demand or alternative uses cases. All precious metals have “use cases” outside of their functions as monetary instruments. What “use case” does Bitcoin offer? Moreover, the bitcoin protocol cannot generate revenue for users (outside of mining and transaction profits which few users can profit from). The mining component of value might be valuable if Bitcoin functioned as a transactional or eCommerce instrument — but it currently doesn’t in any meaningful way. And due to lack of regulation and its volatility, lots of reputable retailers are concerned about accepting cryptocurrencies. Finally, here is some additional proof that Bitcoin hasn’t functioned as a store of value found in the following chart/data:
A UTXO is an unspent transaction. Here you can see both a warning and a concern. While it’s true that Bitcoin has been (at times) a store of value there are several periods where it hasn’t functioned that way; moreover, this chart doesn’t filter out lost coins (or coins which may never move), which could be skewing the results significantly (some estimates are as high as 20% of all coins are lost). The other issue is the warning. When unspent profits reach a certain critical point, there tends to be a reversion to the mean with UTXOs in profits falling to loss; or, at least, back to equilibrium. This is not the chart of a store of value.
Those who are true believers will never accept these apparent facts, nor will a man who loves his beautiful wife believe she is cheating on him even if a photo shows up with her and another man eating at a restaurant! Some people need irrefutable proof. But the evidence is suggesting that Bitcoin is a speculative instrument at best.
The Value Bitcoin Offers Today
Bitcoin’s value advantages are simple — it has scale, widespread acceptance and is fulfilling the madness of crowds theory; but what price can you put on that? For now its $7000/token! And it could go a lot higher if hype returns, but history suggests hype will not return to Bitcoin the way it did in the past. It’s much more likely another coin will take over the mantel later on. Bitcoin isn’t an asset that can produce cash flow. It’s an open-sourced asset that can never create a return to investors (outside of capital gains). And since it’s core technology isn’t licensed (i.e. it’s free), it can be forked at any time, and an improved version can be offered. These facts differentiate all Bitcoin and cryptocurrencies from commodities (such as precious metals) and equities. And yes, in theory, with no real value other than what we have discussed, Bitcoin could go to zero or near zero. But zero is unlikely since the scale and strength of the underlying faith of the movement (madness of crowds) will kick in at some point and save it from going to zero. We are not saying that zero will happen, but there is nothing to guarantee that Bitcoin will not go to zero — this is just a fact. We will discuss at the end of this article what we think the future prices of Bitcoin might be and why.
Bitcoin and all Cryptocurrencies have Significant Threats to Counter their Value Proposition (Catalyst Anyone?)
In the investor’s world, we all understand that events are triggered by catalysts. Event-driven hedge funds are always looking for these catalysts and attempt to position themselves to profit from them. These event strategies don’t always work and are particularly unsuccessfully against government-backed investments (think Japanese Government Bonds, and Government-backed Chinese Banks holding underperforming debt), but everything about cryptocurrency is anathema to government support — in fact, it’s an entirely anti-government “asset” class. And hence event-driven strategies in a free market are always vulnerable to catalyst risks. Let’s look at those risks in the cryptocurrency space:
Regulation — regulation is cracking down slowly, country by country and AML/KYC rules gradually limit users desire to use cryptocurrencies — it puts a brake on adoption
Privacy Coins (targeted at Bitcoin) — as dark web users understand that governments are monitoring Bitcoin, the use of privacy coins will increase — there is a real use case for privacy coins, and they will retain a real transactional value
Quantum computing — it’s years away, maybe decades, but the cryptographic algorithm built into Bitcoin and other cryptocurrencies are vulnerable to a quantum attack — quantum-resistant coins will need to be developed in the future
Technology and interchangeability — there are already better blockchains that do everything and more than Bitcoin offers, it’s first-generation stuff — it’s arguably already outdated
Too many unregulated exchanges — Bitcoin adoption is not growing — it’s a fact- but new exchanges are still being created — its not a sustainable environment, this will lead to lower transaction costs and reduced profitability. Since exchanges are not regulated it’s only a matter of time before bankruptcy and lost coins happen on a large scale — be very careful about leaving crypto on an exchange — the exchanges will hide their financial condition from participants until the very last minute. In a world where Bitcoin was supposed to provide transparency, these centralized exchanges offer virtually no transparency and limited oversight (when they are regulated) to ensure user funds are protected; there are no probity checks on the owners and almost no financial transparency.
Unregulated Derivative Products (WOMD) — the greatest threat to crypto is the mass adoption, by exchanges seeking new revenue paths through futures and options contracts. Let’s be clear these are not regulated futures contracts. They are modified “contract for difference” (CFD) agreements disguised as futures contracts. They are unregulated weapons of mass destruction (WOMD) that pose the biggest threat to crypto due to the leverage they create in the system.
Government policy against Bitcoin in China — this is a major wild card. Still, they have already been gradually cracking down; if it gets worse, the price impact could be severe given the amount of Bitcoin that could be controlled by the Chinese population.
While regulation, technology, and unregulated exchanges are a severe threat, Bitcoin and other cryptocurrencies futures are the biggest threats to the value of Bitcoin. We believe that the next sell-off will bring panic selling that we have not yet seen in cryptocurrencies; possibly resulting from the failure of a major exchange brought about by losses related to CFD agreements in Bitcoin or another cryptocurrency.
The Unregulated Derivative Threat
To understand this threat, let us look at Bitmex XBT (XBT stands for Bitcoin) contract, one of the better exchanges that offer an insurance fund to protect users from potential market dislocations:
As you can see, there is an open interest of 662,354,549 contracts, with each contract representing $1 USD. At current prices of $7525.15 that equates to 88,018 Bitcoin (662,354,549/$7525.15). That open interest means there are 88,018 shorts in the market. Now let’s look at the insurance fund:
Bitmex has 33,071 Bitcoin to cover open interest (expressed in XBT) of 88,018 contacts: the exchange is leveraged 2.60–1. But the contract is priced in USD, not Bitcoin. So let’s imagine that prices fell instantly by 50% then open interest expressed in XBT would be 176,627 XBT and they would still only have 33,071 Bitcoin (5.34–1). The reason for this is because the collateral is mismatched — Bitcoin (XBT) collateral for a USD contact. As the price of Bitcoin falls, the collateral value also decreases.
A few afterthoughts, there is no audit of the collateral fund, and there are no guarantees that the company will liquidate Bitcoin to satisfy a market dislocation. There is virtually no regulation of Bitmex, including no probity or financial oversight — and this exchange has 10% of all Bitcoin volume. In fact, you don't even need to do much KYC to open an account.
If it were just Bitmex, perhaps it wouldn’t be so severe. But as crypto market volumes have been falling, all the exchanges are rushing to add futures and even options. Although not yet popular, even the Chicago Mercantile Exchange now offers (regulated) futures contracts. Binance added futures this year, Kraken added, and all the others are rushing to add them. What might surprise you is that by adding them to each exchange, they increased global market turnover. But I want to stress these are not real regulated futures contracts they are unregulated gambling contacts — they should be called “contracts for difference” (CFD). Here the exchange guarantees that wagers are automatically stopped out when the player loses more than his equity. The problem here is that the exchanges are on the hook for the shorts (unless they also force liquate them). That means if there is ever a market crash, the exchanges put their business equity at risk. In a traditional exchange, all the exchange members guarantee the total losses of each member-and then usually a central bank stands further behind those exchange members.
We are old enough to remember the 1987 stock market crash. We stood on the floor of the CME on Black Friday. We saw the crash first begin in Asia on SIMEX Nikke 225 futures (which immediately lost 80% in a blink of an eye since there were initially no buyers). Then, in Chicago, it was the options market makers that took the biggest hit when the S&P 500 futures crashed on the open and continued throughout the day. A company called First Options backed by the Continental Bank had to shut its doors — too many traders had sold far out of the money put options that were now in the money. The losses that First Options market makers had generated far exceeded not only First Options equity but likely that of all members! And it wasn’t just First Options. The next day the Federal Reserve Bank of Chicago dumped liquidity into Continental Bank, First Options re-opened and in time recovered after it was sold.
But mark my words today. What we saw happen that day in Chicago will repeat in Crypto. Many academic studies show the futures contracts not only create volatility, but they cause overshoots in equilibrium prices. Every time an exchange offers these products, they are increasing overall leverage in the Bitcoin market; which Bitmex pioneered with leverage. Since not all exchanges provide either transparency on their capital, financial condition or their legal responsibility to make users whole, you can bet they can’t afford a sudden sharp fall.
What will the catalyst be to cause a market dislocation? As leverage increases in the system, the impact of the needed catalyst decreases — it’s an inverse relationship. We can’t predict what event will trigger it, but the next time we start to get some gridding sell-off, we would be aggressively getting short Bitcoin. In 2018, we had only a gradual grind lower, next time it will be much worse — leverage is increasing every month. A run on an exchange could trigger panic, or even rumours of an exchange’s financial condition, or a significant crackdown on regulation.
The Fair Price of Bitcoin
An excellent tool to use can be found here. In this webmasters opinion, Bitcoin has a value of around $400/coin. They cover most of the issues we have outlined above, their analysis doesn’t take into consideration all the risk factors mentioned herein and it tends to be theoretical in nature — it certainly doesn’t take into the madness of crowds argument, which has kept lots of assets at elevated prices for decades.
But we believe that the entire cryptocurrency complex, in its current unregulated form, has been transformed into a massive unregulated casino, with the primary beneficiaries being exchanges, professional market makers and informed insiders. The madness of crowds ideology sucks even the most intelligent people into believing the impossible and ignoring financial common sense. I am not forecasting Bitcoin to zero, because there is some difficulty to define intrinsic value, but its real value today is nowhere near current levels (unless underlying factors change). As hard as it is to believe the world would not change if Bitcoin goes to $1000 or even $500, except there will be many crypto exchanges in bankruptcy and a lot of lost users money on these exchanges that will be unrecoverable. Individual stable coins backed by real assets are another matter, but they are not genuinely decentralized currencies either. Also, privacy coins will probably maintain some value; one day, a privacy coin may even have more value than today’s bitcoin. Many readers who are among the true believers will write this article off as Bitcoin FUD (fear, uncertainty, and doubt), but we suggest you keep an open mind. We are true believers, but we also have a rational eye. Man’s thirst for greed has corrupted Satoshi Nakamoto’s vision. We are happy to buy and sell Bitcoin at any price, but holding it as an asset is a perilous risk, in my opinion. The exchanges should diversify their income streams now; there are too many of them, and collectively they cannot survive any coming crypto deep winter storm.
We still believe in cryptocurrencies. The madness of the crowd will keep many of them in circulation for a long time (even Bitcoin). It’s the current mix and leader board that will be changing. Even if Bitcoin were to die, it would not mean the death of cryptocurrencies. There are some real uses cases for fiat-backed and privacy coins — or maybe even a combination of the two. But we think we will see a massive correction in the pricing of the current pool of cryptocurrency assets like no one is expecting. Bitcoin will surely see $2000+ but likely will trade below $1000 before any recovery in the future. And any crash in Bitcoin will finally kill most of the many token/coins that currently have low or fake volumes. Such a necessary cleaning will lead to new coins taking over the mantel. This will be a period of a purge. At some point, another coin will probably eclipse the value of Bitcoin- as hard as that is to imagine today. Bitcoin going to $1M, it's not going to happen, not even $100,000.
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