What is Bitcoin’s Value ?

“In this sense, it’s more typical of a precious metal. Instead of the supply changing to keep the value the same, the supply is predetermined and the value changes. As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advantage of the increasing value” Satoshi Nakamoto (2009)

How to measure Bitcoin’s Value

Traditional equity & currency metrics do not apply to bitcoin. Bitcoin operates different. It functions as both: a network and an asset. An internet protocol with a native currency. The value of bitcoin the currency is tied to the use of Bitcoin the network “Bitcoin and network economics are areas which may be unfamiliar to many. Traditional currency models fail with bitcoin, but various mathematical laws which explain network connectivity offer compelling explanation of its value” (Metcalfe’s Law as a Model for Bitcoin’s value, Timothy Peterson (2018)).

The truth is that the notions of “cheap” and “expensive” are essentially meaningless in reference to monetary goods, like bitcoin. The price of a monetary good is not a reflection of its cash flow or how useful it is but, rather, is a measure of how widely adopted it has become for the various roles of money. Vijay Boypati – The Bullish Case for Bitcoin

In 2018 Timothy Peterson used Metcalfe’s Law to come up with an applicable model for Bitcoin’s value. Bitcoin functions as a network, as a result, Peterson was able to show that bitcoin’s medium- to long-term price follows Metcalfe’s law, which states that a network’s value is proportional to the square of the number of its users. As more people join a network, they add to the value of the network nonlinearly; i.e., the value of the network is proportional to the square of the number of users. 

The underlying mathematics for Metcalfe’s law is based on possible pairs of communication devices like fax machines or telephones. The concept was first introduced by George Glider in the early 1990’s, but is attributed to Bob Metcalfe, the inventor of Ethernet, one of the first computer network technologies. This law, like most other laws, assumes equality among the members’ network connections. The full math for Metcalfe’s reasoning leads to the sum of all possible pairings between user, so the value of the network of size n is 

𝑛(𝑛 − 1) / 2

• If there are 4 people on the network, there could be be 6 connections.  
• With 5 people on the network, the possible connections grow to 10. 
• With 6 people on the network, there are 15 possible connections. 
• With 7 people on the network, there are 21 possible connections. 
• With 12 people on the network, there are 66 possible connections.
• With 66 people on the network, there are 2145 possible connections and so forth …

As a result, networks grow exponential. It is not important if these networks operate national or international. This is in contrast to industrial-era economies that came before, in which ownership of physical or intellectual property originated from a single enterprise, an individual or company. Metcalfe’s law is well known in the computer sciences, but it is almost unheard of in economics. Until lately, adequate data has not existed to test network value models. However, it has recently been shown that Metcalfe’s law is evident in the valuations of Facebook, Tencent, and internet usage in general. 

Bitcoin is modelled as a medium of exchange, the first digital token currency on the internet that is transacted within a defined electronic network. Pure supply and demand-side approaches that model bitcoin’s value in the long term, are often misspecified because they ignore the non-proportional value added through the addition of a new user to the network. Metcalfe’s law, fits bitcoins value exceptionally well. This is supported by the methodological findings and data by Peterson. It helps that Bitcoin is the first widespread transparent network that is directly monetized with the inception of each Bitcoin wallet, because Bitcoin’s distributed ledger provides perhaps the most robust transaction dataset in history. Every transaction since it’s inception is recorded and publicly available in the Bitcoin block chain (Metcalfe’s Law as a Model for Bitcoin’s value, Timothy Peterson (2018)).

Classical currency models fail bitcoin, because they measure currencies based on international exchange rates, comparing the purchasing power of different currencies (The theory of purchasing power parity, PPP) or explain the behaviour of exchange rates by means of relevant economic variables. Grinberg (2011) clarifies that because bitcoins earn no interest by state backed institutions, its value is not related to country-specific differences in purchasing power. In addition, Ciaian (2016) and Kristoufek (2013) explain that macro-financial developments do not drive bitcoins price, because of its decentralized nature, a characteristic envisioned by  Austrian Economist, including Hayek in his research paper “Denationalization of Money: The Argument Refined”. The price action of bitcoin in 2020-21 has shown though, that is only conditionally true. As bitcoin has become somewhat mainstream, its price is becoming more and more connected to macro-economical and geo political happenings. Bitcoin is now the “go to asset” for anyone that wants to protect monetary energy against inflation and geo political shocks that affect national currencies. You can find a full list of the referenced papers at the bottom of this page.

Once the “network effect” is understood, it follows that the use of the Bitcoin network is dependent on the “soundness” of bitcoin the currency, which functions as the incentive for people to join and use the network. 

Contrary to popular opinion, money is not an “illusion”,- but something that people agreed upon to be used as money because of it’s intrinsic properties. This becomes clear when looking at gold, which is durable through time, inherits the same chemical properties anywhere in the world (possibly anywhere in the universe) and is scarce, which makes an excellent store of value and thus sound money. Inflation makes government issued currencies a bad store of value and thus money that is not sound.

Whether or not bitcoin is a great store of value, and therefore sound money,- depends on its intrinsic value proposition. An assessment has been done exceptionally well in Vijy Boyapati’s article “The Bullish Case for Bitcoin”, in which he concludes that bitcoin inherits sound money properties like no other existing money. He analyses bitcoins “soundness” evaluating it by eight properties of a store of value, namely: durability, portability, fungibility, verifiability, divisibility, scarcity, established history & censorship resistance.

• Durable: The Bitcoin network is as indestructible as the internet. 
• Portable: Bitcoin can be send anywhere in world at any time, where there is an internet or satellite connection. Gold is difficult to move.
• Fungible: Bitcoin is actually less fungible than gold, because its open ledger allows government agencies for example to list coins as “black coins”, once they were involved in a black market transaction etc. Gold is different, once metal adheres to the properties of the periodic table’s 79th element, it is gold. If it does not, it is not gold.
• Verifiable: Guaranteed by the bitcoin block chain, as a decentralised and easy to access permission-less ledger. Gold relies on central authorities.
• Divisible: A bitcoin is divisible in 100 million satoshi. Golds divisibility is limited.
• Scarce: This us the definition of value. If everyone could have it, why would they want it? Scarcity is inherent to bitcoin with its limited supply of 21 million. Because the supply of Bitcoin is fixed, drastic increases in demand do not lead to drastic increases in production. This creates absolute scarcity. Unlike gold, a drastic increase in gold demand would cause gold miners to increase their production.
• Censorship-resistant: Gold is difficult to move around and access easily restricted by governments, Bitcoin in contrast is censorship-resistant. 
• Established history: Bitcoin is in the process of establishing such history. Fiat money has failed to establish such history. Gold has such history and is therefore the best existing “store of value” judged on time.

There is an essential difference between bitcoin and gold. People own gold to gain an individual advantage. But people own bitcoin, to gain an individual advantage and help the collective, the bitcoin network, to grow. In this sense, Bitcoin represents a social-economical advancement. Participants who maintain the communal Bitcoin network out of self-interest, create benefits for others at the same time. Bitcoin inherited some neat features from gold, but it introduced a new dimension (Candle Hater). Bitcoin holds significant advantages over gold. Namely, that it is easier to store and to move around. A better more liquid store of value. In case of war or fiscal control bitcoin can be moved around

Ultimately, bitcoin is backed by the credibility of its monetary properties: “The emergent monetary properties in bitcoin are secured and reinforced through a combination of cryptography, a network of decentralised nodes enforcing a common set of consensus rules, and a robust mining network ensuring the integrity and immutability of bitcoin’s transaction ledger. The currency itself is the keystone which binds the system together, creating economic incentives that allow the security columns to function as a whole.” Bitcoin is Not Backed by Nothing by Parker Lewis

The dollar on contrast is backed by debt: “there is $73 trillion of debt (fixed maturity / fixed liability) in the U.S. credit system according to the Federal Reserve (z.1 report), but there are only $1.6 trillion actual dollars in the banking system. This is how the Fed manages the relative stability of the dollar. Debt creates future demand for dollars. In the Fed’s system, each dollar is leveraged approximately 40:1. If you borrow dollars today, you need to acquire dollars in the future to repay that debt, and currently, each dollar in the banking system is owed 40 times over. The relationship between the size of the credit system relative to the amount of dollars gives the dollar relative scarcity and stability. In aggregate, everyone needs dollars to repay dollar denominated credit.” Bitcoin is Not Backed by Nothing by Parker Lewis

Due to its superior properties to other stores of value, the properties of sound money, bitcoin is accepted as such. Bitcoin will eventually “sock up” a large proportion of the monetary energy that exist and become the dominant store of value. It’s sharp increase in value over the last decade, will continue. Every existing store of value including precious metals, bonds, government issued currencies or other financial instrument is already trending towards zero when priced in bitcoin. “Today, because we have broken money, many of us hold different assets with different attributes in order to store value and protect our wealth. But, with the emergence of a perfect money, that is immune to confiscation, inflation and corruption, that can be taken anywhere, anytime and sent or received by anyone for any reason, without requiring permission, we will see the monetary premium being stored in these other goods or assets diminish”. (A. Svetski)

CONCLUSION

Bitcoin research and educational company 21st Paradigm explain on their website that they “hold a fundamental belief that the primary driver of wealth in the 21st Century will not be what one does for a living, but rather how early one adopts Bitcoin as a primary store of value and unit of account for economic calculation, because the advent of absolute scarcity changes everything” – this sums up my view.

As a consequence, we will gradually move into Hyperbitcoinisation a term that was coined by Daniel Krawisz in 2014 and refers to the fact, that due to its superior properties to other stores of value, bitcoin will become the sole and dominant store of value, possibly acting as the global reserve currency and its network the dominant monetary network used to exchange value.

After we have established the soundness of bitcoin as money and the functionality of the Bitcoin network, we can assess different models that try to price bitcoin at fair value and assess how the price develops. The page “Models to price Bitcoin” list a collection of such models.

Other Resources

If you would like to understand the adoption curves of Bitcoin, I recommend you to read this article by Michael Levin.

If you would like to understand the price movement of bitcoin, check out “Why Does Bitcoin’s Price Make Random, Sudden Downward Moves? Written By Joe Burnett Research Analyst at Mimesis Capital. He has some good articles explaining the Bitcoin market and the market forces that govern bitcoins price on its way up. His Twitter thread on the “next parabolic bull run from $3,000 to $1,000,000 and beyond” from March 2020 is informative as well. 

To understand the importance of Bitcoin’s volatility Parker Lewis write up “Bitcoin Is Not Too Volatile” is great. As Robert Breedlove writes: “Entropy is the universal state of nature, a quality expressed as uncertainty and volatility in socioeconomic affairs. In the sense of being an accurate portrayal of reality, then, we can say: volatility is truth”.

In his writing “The Time Value of Bitcoin and LNRR” Nik Bhatia uses gold as an analogy to describe how bitcoin will evolve on its way to world reserve currency status in layers. The concept of layered money is not new in monetary history. Gold has served as money for millennia due to its unique chemical properties and its global network effects. But gold has acted as money only in its raw physical form, or on its “first layer”. Gold is a perfect example of how a layered money system evolves.

In the conclusion of the long term debt cycle and the rise of bitcoin” Dylan Leclair, explains “how it got to this point, and what the world will look like coming out the other side of the present crisis. He uses frameworks presented in Ray Dalio’s Principles for Navigating Big Debt Crises along with his own analysis to contextualize the global economic landscape, and how the emergence of bitcoin as a global monetary asset will serve as a release valve.”

For further reference I urge you to listen to the Podcast “Debt Cycles & the Rise of Bitcoin with Greg Foss & Dylan LeClair – What Bitcoin Did Podcast #374”. One of the key takeaways from the podcast is a fact that manny do not understand, the price of bitcoin, is not only a reflection of its demand, but also of the network value. The more expensive bitcoin becomes, the less risky it becomes, as the price is representative of its adoption curve and the strength of the network. If you do not own bitcoin, the best day to exchange your inflating fiat into bitcoin is now.

Referenced Papers

Peterson, T.F. (2017). “Metcalfe’s Law as a Model for Bitcoin’s Value”. Alternative Investment Analyst Review, Q2 2018, Vol. 7, No. 2, 9-18.
Carl Shapiro and Hal R. Varian (1999). Information Rules. Harvard Business Press. ISBN 978-0-87584-863-1.
Grinberg, R. “Bitcoin: An Innovative Alternative Digital Currency.” Hastings Science & Technology Law Journal, Vol. 4, No. 1 (2012), pp. 159-208.
Ciaian, P., M. Rajcaniova, and D. Kancs. “The Economics of Bitcoin Price Formation.” Applied Economics, Vol. 48, No. 19 (2015), pp. 1799–1815.
Kristoufek, L. “Bitcoin meets Google Trends and Wikipedia: Quantifying the relationship between phenomena of the Internet era.” Scientific Reports, Vol. 3, No 1, 2013.
Hayek, F.A. von. “Denationalization of Money: The Argument Refined.” Research paper, Institute of Economic Affairs, 1978.

P. Lewis (2019) “Bitcoin is Not Backed by Nothing”
Vijay Boypati – The Bullish Case for Bitcoin
Daniel Krawisz (2014) “Hyperbitcoinization Daniel Krawisz”
Croesus BTC (2021) “Am I Too Late for Bitcoin?”
Michael Levin (2021) “The Concluison Of The Long-Term Debt Cycle And The Rise Of Bitcoin”
Joe Burnett (2021) “”Why Does Bitcoin’s Price Make Random, Sudden Downward Moves?”

Continue reading: How Bitcoin uses energy

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