Today's price is a bit over $40,000, up about 500% in the last year, and 2x its 3 year old previous high. As the crypto surge continues, the key question that I discussed back when cryptos were crashing re-emerges – what is a Bitcoin (or any crypto) actually worth? And of course, if it collapses again, how far could it fall? The vast majority of available research and analysis on crypto prices focuses on some variant of price technicals, with limited discussion of fundamentals, value, and of supply and demand.
The reason for that is pretty clear – cryptos are a bit like the three blind men identifying an elephant, it’s not commonly accepted even among seasoned crypto analysts what the fundamentals actually are in this asset, let alone how to separate those from short term bubble, crash, and newness effects. As there hasn't been a lot written in academic papers or financial media laying out what a fundamental theory of value for cryptos is, and as cryptos seem to display elements of several types of asset classes, we have developed a list of the likely theories of value. Note we are specifically NOT attempting in this article to apply or test those theories to predict a price.
We considered 3 possible drivers of fundamentals:
1. An alternative to gold or a reserve currency as an alternate store of value
2. A medium of exchange where anonymity, permanent transaction record or protection from government intervention is at a premium
3. A measure of currency or commodity where value is derived from its host, network, or creator’s demand or popularity
Theories on How to Value a Crypto
Based on this, and value in other commodity and security markets, I’m interested in 7 possible theories we like on how to value a crypto, or at the very least serve as possible components in a model to value a crypto.
1. It’s Just Gold, Guys – Theory 1 states states a crypto is simply replacing gold as the alternate store of value - so it will end up equal to the price of an oz of gold at scale, since it’s just a better form of it. Given that the gold stock is still many times larger than the crypto stock, it is possible that current market moves are just noise in this theory. Another variant includes it trading at a fixed or banded ratio to gold, another alternate reserve currency, or a currency basket, or possibly even replacing, not additive to, the overall gold market capitalization. Given the recent price surges, the value is obviously way above an ounce of gold, but there is no fundamental reason that Bitcoin isn't simply rising and falling until it finds a normalized demand level, and then will settle there somewhat permanently.
2. There Can Only be One – Theory 2 argues that like the current reserve currencies or gold, that there is very little market need for multiple cryptos, and we should model the crypto market cap in total based on overall demand for cryptos, and then allocate almost all of the value to the likely “winner” or winners, and adjust for unit supply to get price.
3. Inflation is “Fixed” – Theory 3 argues that Bitcoin and cryptos, by nature of mining, essentially have a “built-in” rate of inflation or supply and fundamental value, and as a result ignoring short term trends of demand, price is a heavily a function of long term demand growth and that inflation rate. Another variant might be that it's the relative long term "inflation" rate to fiat inflation expectations that is the crucial value creation mechanism, meaning long run expected fiat inflation could result in wild increases in value, similar to falling interest rates impact on the long bond. More likely, it is a function of expectations of long term demand growth and that inflation rate, relative to expectations of a basket of expected long term fiat inflation rates.
4. Cost to Mine – Theory 4 argues that regardless of short term demand levels, a crypto’s primary financial attributes lie in its current marginal and expected long term cost to mine, and like a commodity, it should trade off of that cost/unit.
5. Derivative of Spend Demand – Theory 5 is that a crypto value is simply a function of the amount of non-financial transaction volumes in that crypto, or some other derivative of value of that host or network. This theory has the benefit of partially explaining why ICOs make sense as opposed to “shares” priced in Bitcoin or another crypto. It also has the benefit of explaining why Bitcoin and other cryptos tend to rise on announcements of new business payment applications and fall on negative regulation announcements.
6. The Monetary Theory of Bitcoin – Theory 6 is that Bitcoin is basically a hedge on monetary policy, and simply moves off of a baseline or one of the other theories inversely with loose monetary policy, or reactively to either government support or prohibitive action that impact its usability. One might argue that in this case monetary policy is global, and should be a GDP weighted basket of global currency policies.
7. Momentum or Luxury Financial Asset – Theory 7 states that a crypto is basically a financial luxury good, divorced from the cost of making it, and moves with the financial demand for Bitcoin, not spend demand, and as a result can move dramatically either in tandem or inverse with other cryptos, currencies, or commodities depending on consumer taste. Basically it looks like a collectible stamp or an index of artwork investments. After all, why is the art investment market, or the domain name market, in price equilibrium where it is as opposed to one-half or twice that level? Largely because of limitations on supply relative to overall investment demand, and changes in capital flows to that asset. This theory probably helps explain why more financial interest in the asset class, a new Bitcoin ETF or a bank or exchange enabling Bitcoin trading for example, results in price increases.
As cryptos are fairly complex assets with functional elements of a range of commodities, currencies, and securities, likely the real answer is a combination of these or other theories. For example, a model where the crypto trades off of gold adjusted for the relative cost to mine the crypto versus gold, or a supply and demand model where non-financial spend demand and the supply inflation rate for that crypto set value, in conjunction with some monetary policy effects. Were we
Regardless of the theory you like, a few interesting questions emerge:
Does an increase in the number of cryptos reduce or increase value of any given crypto or the overall market, and if so by how much and over what range?
In general, one might imagine that if the demand for cryptos was somewhat limited or even just “sticky”, more cryptos means less value for each crypto, and the crash is partially the market “remeaning” this thereom. I mean, if it is easy to create a whole new currency, demand for all cryptos is fairly fixed, then the ultra low marginal cost of supply of a whole new crypto might dominate value. One might also argue the converse that cyrptos derive value from their host or creator’s demand, and a new crypto creates new value and is additive to the market, or even by increasing the critical mass of cryptos, increases the value of all. It is likely that this answer changes over time, market size, or by some other variable.
What is actually driving the "perverse" microeconomic observation that crypto demand levels seems to rise with rising price levels?
Obviously classical microeconomics generally starts with the principle that all else equal, higher prices reduce quantity demanded of a commodity. We feel certain that rising prices of crypto is likely dynamically shifting demand curves for cryptos out, offsetting falling demand at any given level as confidence in the asset class future improves and depending upon which theory of value is dominating. However we also feel it is likely that rising prices are changing dynamics within the crypto market between various cryptos in interesting ways, as relative demand curves of different change, and demand curves for cryptos shift in different rates or even directions.
Does mining cost still have something to do with price, as it does in commodity markets?
I would think yes, as cost of supply ought to matter in most commodities, until you consider that would mean that if bitcoin had been designed with a different built in effective mining cost, it’s fundamental value would be different? Or that if I designed two similar cryptos today solely with different mining costs, they would be “worth” different amounts? Or more interesting, based on how do additions of new cryptos, which might function like a shifting supply curve or moving up the supply curve demanding on the parameters of your model, interact with the supply and demand curves for existing cryptos?
What is the impact of crypto price changes on gold price, or the US dollar as a reserve currency?
Arguably cryptos are a substitute for gold for given demand, and eventually for the dollar, and price increases in one all else equal should then negatively impact the other. However it is not clear that is happening, at least in noticeable levels not over the current ranges of relative market capitalization for each. It is possible, that higher price or higher demand levels for cryptos could increase the overall demand for a global reserve currency, as it makes a basket of reserve currencies more useful compared to local currencies, or carries gold along with it, catalyzing capital flows out of cash and into all alternate stores of value as its market capitalization grows.
What is the impact of interest rate changes on Bitcoin and crypto prices?
Another interesting question, whose answer might vary depending on the theory of value, from little or no to quite a lot. Likely at some level, when interest rates on go up on the currencies most used to buy Bitcoin, holding Bitcoin should be more costly, and it should fall, and vis versa, similar to gold. But of course it depends on whether interest rates are rising or falling from changes in inflation expectations or something else. We may have to wait for some Bitcoin denominated bond issuances before we can answer this. Of course, issuing or pricing bonds in a currency with the level of price volatility of a crypto, by companies or countries that do not make revenues in that currency, would be "interesting" to say the least. Some announcements of transactions of this type have been done recently, and might be worth analyzing.
How far could Bitcoin fall before “fundamentals” kick in?
This was the key question on everyone’s minds during the crypto crashes and less popular during its surges. Obviously it depends on your belief in which theory of value dominates, and which fundamental drivers that implies. Here are my favorite options in rough order of simplest to most complex:
1. To zero – there is little fundamental value here.
2. To the price of gold, or eventually to the number Bitcoins divided by the market capitalization of gold – if you like Theory 1 above, and think bitcoin is basically a better gold replacement.
3. About as far as the dotcom boom fell (80%) - if you are a behavioral economist and think bubbles have prototypical curves based on investor behavior.
4. To the marginal cost of mining – if you think it looks more like shale gas as a quick on/off commodity.
5. To where the marginal 30% of miners lose money on a cash basis – if you think it looks like a typical mined commodity like gold, copper, coal etc.
6. To where the financial traders represent a small fraction of volume and its value as a spend currency dominates or at least dramatically impacts daily transactions – if you think its basic value is as a medium of exchange.
7. To where a reasonable rate of return plus volatility and political risk premium can be made on long-term demand growth – if you think it’s basic value is as a financial store of value built on a new disruptive and useful medium of exchange.
As to how far Bitcoin could rise? We'll leave that to a future article.
Author Neal Dikeman is Editor of the Texas Free Press, began his career on Wall Street before founding multiple tech startups, is a venture capitalist at Energy Transition Ventures, author of upcoming book, DIY Wealth, and was recently the Libertarian Party Nominee for United States Senator in Texas. He is also the author of Why the Bitcoin Crash is a Libertarian Issue; The Congress App and Our Looming Federal Debt Crunch; and How do Endowments Measure Up Against Cheap Market Portfolios?