The team @intuitecon has been working through a detailed valuation of the cryptocurrency market since publishing our last piece on the subject here. Here are some preliminary thoughts on why we are not selling (yet).
Since publishing this post in early March the value of Ether and Bitcoin jumped 1000% and 100% respectivly.
Some are calling this a bubble. Others are calling it inevitable. Without a framework for valuing the crypto market investors are getting cought up with the price action. Rising prices lead to more inflows which in turn lead to even higher prices. Its a classic case of what George Soros calles “reflexivity”. Trust in crypto becomes a self fulfilling prophacy. We would conclude that this is a bubble; except that the same logic applies to fiat currency. A dollar is just a piece of paper, or increasingly, just a sting of ones and zeros just like crypto. This means we have to think about value differently.
Ultimatly, money has value because we believe it has value. This is what we concluded in early March when we made our initial investment. However, given the rapid run up in price it seems only prudent that we think a bit more deeply about how far this can go.
We focus on market cap because the price of crypto doesn’t mean anything in and of itself. Bitcoin is not “more expensive” than Ether just because a BTC trades at a higher price than a ETH. The reason is that the number of coins generated is entirely arbitrary. What matters is the market capitalization; which is the product of price and coins in circulation. For this reason we have been doing a fair bit of benchmarking to other assets as we discuss shortly.
Assets with cash flows can be valued by discounting future cash flows (ex. Stocks and bonds). Assets without cash flows can still generally valued by replacement cost or cost to produce (ex. Commmodities). Money is different. There are no cash flows and the cost to produce is near zero. This reality makes valuing crypto (or money more generally) very complex. Crypto is even harder than traditional money because it has no country!
We have no economy of Cryptoville to analyze as we would for dollars and Euros. Traditional analysis of exchange rates rely on comparisons of economic growth, debt sustainability, capital flows, and other metrics specific to a country. This approach doesn’t work for crypto because crypto is global. This is a big reason why the price can jump so fast and not necessarily be indicative of a bubble. People are simply choosing to sell fiat in exchange for crypto. The size of crypto is too small to have a negative impact on the value of fiat, but the reverse is clearly not true.
That sums up our thoughts on how not to value crypto. Now we turn to some methods for valuing this market that actually make sense.
There are at least three ways one can try to value the crypto market.
1) As a global currency
2) As a risky financial asset
3) As a technology service
1) Global Currency
Crypto is growing rapidly as a global currency because it offers several benefits that traditional fiat currencies do not including faster transactions, anonymity (in some cases), and independence from a central authority. Anyone with an internet connection can participate. People all over the world can already buy goods and services using Bitcoin. Other crypto like Ether, Litecoin, and Ripple can be easily traded for Bitcoin. This makes crypto a global currency.
Price of crypto is growing because it has a positive rate of acceptance. Everyone already knows about dollars and Euros. No one out there is discovering fiat currency for the first time (accept maybe some aboriginal people with only coconuts for assets). However, every day people are being exposed to crypto as an alternative. This positive “exposure rate” is half of why the price is climbing.
The other half is what we call the “recognition rate”. Over time, the percent of those exposed to crypto will grow to recognize crypto as a legitimate currency. Again, this is largely not true for fiat currencies. We accept fiat without thinking about, although this has certainly not always been the case. What was true for fiat currencies following WWII and dropping the gold standard is true today for crypto. At first people were skeptical, but over time concerns fade. Acceptance grows as more businesses and people use it around the world. We expect that Amazon will likely accept Bitcoin within the next year (why not). At that point it’s pretty much game over for anyone that thinks crypto will never be a global currency.
Multiply the exposure rate by the recognition rate to arrive at the acceptance rate. The result is an increase in demand for crypto at the expense of fiat currencies.
Exposure Rate x Recognition Rate = Acceptance Rate
The increase in crypto exposure is evident from the Google Trends above. The recognition rate is harder to measure empirically, but is most certainly on the rise. Governments, such as Japan, are accepting Bitcoin as a currency. Businesses are making it easier to buy goods and services with Bitcoin. As time passes more people will realize their having their dollars stored on a computer at the Federal Reserve is not altogether different from having their Bitcoin stored in a crypto wallet or on an exchange like GDAX. The first fiat currencies went through the same acceptance period, but now we don’t even think about it. Our guess is that 50 years from now the same will be said for some select few of existing cryptocurrencies today.
How much larger could crypto currencies rise in value? If we consider them as substitutes for fiat currency then they are still pretty small. The total value of all fiat currency in the world is about $90 Trillion. This puts all the crypto currency at less than 0.1% of this value (depending on the day).
There is no compelling reason why crypto can’t become a major global currency. The driving factor is what individuals demand. If individuals find crypto to be a more convenient store of value and appreciate the anonymity and independence than they will sell their fiat currencies in exchange for crypto. This will drive down the value of fiat as it drives up the value of crypto in terms of purchasing power. The actions of any one government or individual will have little effect as the phenomenon is global.
The key question to ask when considering crypto value as a currency is whether this change is inevitable. Will people 20 years from now say, “well of course I prefer to have money that I can transfer internationally for free, that settles immediately without bank intermediaries, and in a form that no party (including a government) can unilaterally track or print”. Even if crypto in some form is enevitable, this doesn’t tell us which crypto will dominate. Not all crypto is anonymous and there are technological and governance issues that may prevent crypto from growing to 10 or 100 times it’s current size. However, whatever limitations exist with existing crypto will undoubtedly be addressed in subsequent generations of the technology. In contrast, the rate of fiat money innovation is essentially zero.
2) Risky Financial Asset
Cryptocurrencies currently amount to about 0.03% of global financial assets ($80 Billion Crypto / [$80 trillion in stocks + $200 trillion in bonds and loans]). This may sound small, but keep in mind that only a fraction of the world wealth is controlled by those who have accepted cryptocurrency as a legitimate investment. Suppose that only 1 in 100 people with financial assets recognize crypto. Assuming these people have an equal share of the worlds financial assets that means crypto currenctly makes up an average of 3% of their portfolio. For such a risky asset this may be a lot. However, the acceptance rate for cryptocurrency is still positive so that percent may fall (or prices rise) over time.
The value of cryptocurrency to an investment portfolio is obvious now, but it wasn’t when we first got into this space. What we recognized is that some cryptocurrencies have “positive skew”. We discuss this in detail here: In short, while crypto certainly has the potential to lose most (if not all) of its value in a short period, it also has the potential to multiply in value many times over. One is tempted to compare it to a casino where the edge is in your favor. Betting the farm would be moronic, but a small but may be prudent for the right investor.
This perceived positive edge is helping to drive inflows. However, the higher the price gets the lower the edge. There is a point where the edge becomes negative and what once had positive skew becomes a slippery slide to quick losses.
Valuing crypto as a risky financial asset means thinking about how much investors are willing to hold relative to their overall portfolio. Gold is an instructive benchmark for comparison. All the Gold ETFs in the world add up to about $40 Billion in total value. This puts crypto at twice the value of gold used in liquid private investment portfolios. That sounds like a lot!
If crypto doesn’t turn out to be much use as a currency than it seems hard to justify prices growing much higher than they are today. The reason if that as a percent of global financial assets they are also ready pretty big. There is a limit to how much of a non-cash generating asset global investors are willing to hold.
The key question to ask when considering crypto value as a risky financial asset is how big the market can get relative to other financial assets. A common rule of thumb in portfolio asset allocation is to put no more than 5% of ones portfolio into commodities. This provides an inflation hedge. There are many commodities that fit into this basket such as oil futures, agricultural goods, precious metals, and land. They all provide some benefit via diversification, but they have to share a rather small (around 5%) share of the pie. Investors will still generally prefer cash generating assets like stock and bonds. This puts a cap on the potential market cap of crypto. If crypto never really catches on as a major global currency than it’s probably close to the maximum size that it can sustainable grow.
3) Technology Service
Since the creation of Bitcoin, many major governments, banks, and startups have shifted their focus from the currency to the technology. Blockchain and the general ledger have the potential to revolutionize many industries.
Interest in Ethereum blockchain technology has exploded in recent months. This is even from the millions in initial coin offerings (ICOs) built on their technology and price of Ether which is up over 1500% YTD. Other potential uses are too numerous to list but Ethereum’s creator has mentioned insurance as being the practical application of the smart contract technology.
The trouble with valuing crypto as a technology is that the technology is free! Bitcoin code is open source. New technologies, such as the Ethereum contract language, are built upon this initial innovation and therefore easy to replicate. This makes it difficult to justify even current valuations solely in terms of the value of the technology. Ultimatly, the value of a new technology cannot exceed the cost savings from substituting existing technology. Even if cost savings for insurance companies, derivative contracts, and other potential uses are significant, these same companies always have the option to build their own.
Some of the hype in crypto tech has gotten bubbly…especially the ICOs. Initial Coin Offerings (ICOs) are nothing more than giveaways. Ethereum smart contracts have been used to generate more than $500 Million in venture capital, but owners of coins can expect nothing in return. The name suggests some relation to initial public offerings but ICO ≠ IPO. Buyers have no equity stakE. #Storj Is a highly publicized example. Investors hoping to get more than speculative price appreciation are doomed to suffer the safe fate as kickstarter investors. You have been warned.
The key question to ask when thinking about crypto value as a technology is how much people and companies will pay for it. The answer here is clearly not much. If any crypto coin becoming exceedingly valuable because of “burn” demand as a means of using technology than there will be pressure to build ones own smart contracts. It’s hard to sell something that’s free.
Of these three valuation methods we feel the first two are the most useful. Ultimately, the value of crypto will be determined by its acceptance as a currency. Like all forms of money, this process takes time, but it is moving in a positive direction, so it seems likely valuations can grow. However, looking at crypto as a risky asset is also instructive. Investors will only be willing to hold so much of their portfolio in such a risky asset that doesn’t have any cash flows, even if valuations are up 1000% YTD.
In short, as long as the world remains flush with cash people will continue to invest in cryptocurrencies. The most one can loe is 100%, but upside potential is potentially >1000%! There are many hundreds to choose from, but we stick to the largest as we belive only a few will survive the test of time. People are demanding a secure, anonymous, convenient, and scalable alternative to fiat currencies away from the prying eyes of governments with the power to unilaterally print money. This, and price speculation, are ultimately what’s driving up the price of cryptocurrencies. As long as the acceptance rate remains positive the price momentum is likely to continue.
The cryptocurrencies that survive have the potential to disrupt the foreign exchange market; which transacts over $5 Trillian per day. There are many other markets crypto could disrupt, but this one alone is large enough to justify much higher prices. This will only be possible for cryptocurrency with scalable technological plumbing and robust governance procedures. More work needs to be done to examine the currencies that are out there to determine which can truly stand the test of time.
Feel free to share your own thoughts on how to value cryptocurrencies like Bitcoin and Ether. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: IntuitEcon Team owns Bitcoin and Ether. These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.