Cryptocurrency: Investment or Gamble?
Almost every day, I hear the same sentiment expressed: the value of cryptocurrencies is impossible to predict, and therefore they cannot be considered an investment. Just last week, President Donald Trump hinted at this idea in a series of Tweets:
So, is Trump right? Does Bitcoin’s volatility mean that its value is just a roll of the dice, or is there a way to determine (with reasonable certainty) when to buy and sell? Can Metcalfe’s Law or another formula be used to determine when a currency may be over- or under-valued? Can assets that aren’t touched by banks (except decentralized entities like TrustlessBank) have a true value at all?
Metcalfe’s Law: A Brief History
In the 1980s, Robert Metcalfe, the inventor of Ethernet, proposed that the value of a telecommunications network is proportional to the square of the number of nodes (or users), N, in the network. Put another way, the value of a network is proportional to the number of connections between users, assuming that all users are connected to each other; the more people I can contact, the more valuable the system will be to me.
In 2015, Zhang et al. discovered that this same principle applies to Facebook and Tencent (China’s largest social media network) when the number of monthly active users is used as N.
In 2017, Ken Alabi demonstrated that the law also applies to three different cryptocurrencies (Bitcoin, Ethereum, and Dash) fairly well. Just one year later, Wheatley, et al. proposed a modification to the formula for cryptocurrencies, N^(1.69), that fit the data better and accounted for the fact that not every user is connected to or interested in connecting to every other. The researchers estimated that each user is connected to N^(2/3) other users.
What About Bubbles?
Following a series of major crashes in the price of Bitcoin, many in the crypto community lost faith in the ability of Metcalfe’s Law to accurately predict the value of cryptocurrencies. After all, the number of users did not fall as dramatically as the price after Mt. Gox was hacked in 2011, a major Ponzi scheme involving Bitcoin was discovered in 2012, Mt. Gox collapsed in 2013 or South Korea threatened regulation in 2017.
However, Didier Sornette proposed that a market is bound to crash if its value is growing at a super-exponential rate (if its rate of growth is itself growing), unless there is an infinite supply of people to join the market. This idea is widely accepted, but it does not postulate exactly when the market will crash, only that it will eventually. The wise investor will be aware of this condition and, when the price starts tumbling, will sell immediately.
Sornette goes on to argue that the exact timing of each of these crashes was determined by the outside events affecting the market and that any market disruption would have caused similar effects due to this super-exponential growth. Each event was just the straw that broke the camel’s back (before the camel regenerated, only to have its back broken again).
Network Value to Transactions (NVT) Ratio
Popularized by Willy Woo and Chris Burniske, the Network Value to Transactions ratio is another formula that aims to determine when the price of a crypto asset is over- or under-valued.
Note: The original version of the formula used a 28-day moving average in the denominator. Dmitry Kalichkin proposed this revised version so that the ratio would predict a crash before it happens, rather than while it’s happening. This metric also only includes on-chain transactions.
Kalichkin suggests that any NVT over 20 indicates that a coin is overvalued and a correction is likely. However, as with the other models, one cannot use this to determine exactly when a correction will occur. In addition, it can be challenging to find accurate data on daily transaction volume, limiting the practicality of this metric.
Final Words
According to Edward Fricker, co-founder of the lightning wallet TrustlessBank, attempts to determine the objective value of Bitcoin and other cryptocurrencies miss the mark:
“Metcalfe’s Law and NVT have been promoted by analysts who struggled to find some way to determine an objective value [of Bitcoin] that is outside the market price, but in doing so, they failed to see the truth that was right in front of them: the market price is exactly the same as the objective value because Bitcoin is the most liquid asset in the world.”
So, what do you think? Comment below and be sure to follow me for more.
