What is Bitcoin’s future?

Yvan Berthoux - 21 March 2018

Since its high of US$20,000 reached in mid-December last year, Bitcoin’s valuation has more than halved. There is a growing chorus of market participants and commentators predicting the demise of the cryptos. A chart that its detractors like to show is the Bitcoin price overlain with that of historical bubble episodes (such as Tulip Mania or the South Sea bubble) to infer that the shape of the cryptocurrency’s price chart looks like a classic bubble.

Bitcoins have no intrinsic value and we encounter the same problem in valuing Bitcoin as for gold, wine and objets d’art. Classical Finance Theory stipulates that the price of any asset should equal the value of future expected discount cash flows. Hence, how can assets like Bitcoin be valued that don’t generate or distribute any cash flows to investors?

There have been numerous attempts to establish a ‘fair value’ of Bitcoin. One ingenious approach, noting the co-movement of Bitcoin with the volume of Google search requests for Bitcoin-related terms, is to look at the weekly data from Google Trends calculator since 2013. However, it is difficult to extract a conclusion (Figure 1, left chart) as correlation does necessarily imply causation. The fact that Google Trends index has fallen from 100 in mid-December to 19 (as of March 18th) may well be a consequence of the drop in the price, rather than a predictor of its future price.  

Another interesting methodology uses Metcalfe’s Law, an influential formula for studying network effects and valuing online networks, which says that ‘the value of a telecommunications network is proportional to the square of the number of connected users of the system (n^2)’.  As the short-term development of Bitcoin is akin to that of a social network, Tom Lee from Fundstart Global Advisors uses a simple predictor, the square of number of users multiplied by the average transaction value. Using weekly data from the Blockchain website   (Figure 1, right chart), we observe that our short-term model predicts a Bitcoin price of US$10,000 (US$1,000 above the current spot price).

 

Long-term view: can Bitcoin become a reserve asset?

Beyond the factors that can impact the price of the digital currency in the short run, we are interested in the long-term view, which addresses the issue of Bitcoin’s future value more directly. Many analysts have tried to value Bitcoin in the long-run by assuming that it will capture some of gold’s current market capitalization. With a current spot price of US$1,330 per ounce and total of 187,000 tonnes of above-ground inventories, the total market cap for gold is roughly US$8 trillion. Hence, if Bitcoin – or the class of digital currencies – were to capture 5 to 10 percent of the of the precious metal’s market cap (equivalent to US$400bn to US$800bn), then a Bitcoin would be worth somewhere between US$24,000 and US$48,000.

However, if we think that Bitcoin could become a reserve asset, then the price of a unit could reach even higher levels. If we define a reserve asset as any asset that has no intrinsic value, we know from history that it can range from narrow money, such as cash and savings, to government bonds or shares in Google or Apple. Hence, if we assume that the aggregate value of global M1, gold, sovereign bonds and equities – the entire universe of reserve assets – totals around US$200 trillion, the current market capitalization of Bitcoin (US$150bn) represents less than 0.1 per cent of it, which is very low for a 21st century perfectly designed asset.

In addition, in a recent conversation with Raoul Pal and Worth Wray, Mark Hart from Corriente Advisors raised an interesting point on one of the most important determinants of the valuation of reserve assets: awareness. Historically, we know that an asset, of which no-one is aware, should be worth zero. However, in the long term, it is probable that the awareness of Bitcoin will exceed that of either gold bullion or government bond. This could sharply increase the demand for Bitcoin – or its successors – over time and put upside pressure on the price. Just imagine that the market capitalization of Bitcoin captures ‘just’ one percent of the total US$200 trillion of reserve assets: Bitcoin US$120,000, here we come?  


Figure 1

Data source: Eikon Reuters, Google Trends



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