Where Does Bitcoin Get Its Value From?
/
Where does Bitcoin get its value from? The question is straightforward but of course the answer can get complicated. After all, it’s not 100% clear whether our narratives ascribe value or merely describe something after the fact.
Bitcoin is not a stock or a bond, nor is it a commodity in the traditional way that we think about soybeans, petroleum, or gold for example. However, Bitcoin does have many interesting properties – such as a limited supply and a known issuance rate. So, let’s keep it simple and just stick to supply and demand. After all, with a known supply we only have to solve for half of the equation.
So how can we quantify demand? Robert Metcalfe suggested that the number of useful connections in a telecommunications network could simply be squared to determine the value of the entire network. It makes sense if you think about it. If only two people have telephones, then they can only call each other. But if everyone has a telephone, now anyone can call anyone (for better or worse).
The math seems to pen out in recent times as well, with the number of active social media accounts roughly equating to the market cap of Facebook, Twitter, and Tencent. But does it work with Bitcoin?
It turns out that the answer is “roughly, yes.” But from here we encounter new problems. First of all, exactly how many Bitcoin users are there? Second, if we can determine the number of Bitcoin users, what can we learn from that data? Are the number of users growing? If so, at what rate? And finally, what does the n-squared value tell us about the price of Bitcoin today?
First of all, due to Bitcoin’s pseudonymous nature, nobody can actually tell you how many Bitcoin users there are. We can count the number of Bitcoin addresses, but even then, a single person may have multiple addresses and exchanges may use a single address for many users.
Probably the most straightforward approach is to simply use the number of active Bitcoin addresses, or the number of addresses that have a nonzero balance. Using this methodology, we find that as of August 30th, 2020 the “n-squared value” of the Bitcoin network should be around $934B, while the current market cap is around $216B. That certainly seems encouraging, indicating that Bitcoin could be due for a massive repricing event to get back in line with Metcalfe’s model.
However, this approach has its limitations. For starters, Bitcoin’s market cap hasn’t come close to the implied value using Metcalfe’s Law since 2011. Furthermore, it doesn’t make much sense that the number of users should be the only relevant variable in the true value of Bitcoin. After all, some users are much more active than others. Some users hold more Bitcoin than others. Some people use Bitcoin as a tool for preserving their wealth, while others are engaged in active trading / speculation.
To keep things from going off the rails in terms of complexity, let’s focus on the concept of the number of users and the total activity they produce. For example, if you had lots of users, but those users were quite inactive, then you end up with a “complacent majority.” It may sound great to have lots of people with telephones, but if nobody ever called anyone else, what’s the point?
Likewise, if you had only a few users but those users were very active then you would have a “hyperactive minority.” And again, a few active people are not bad, but there’s only so much you can do with a limited number of participants.
Then there’s the case of a few participants, who are also mostly inactive. Imagine Bingo Night at the retirement home. Not very exciting.
Finally, we have the situation where a lot of participants are engaging in a lot of activity. This is where you want to be. In this scenario we have what I call a “robust network.” So how can we quantify this situation and apply it to Bitcoin?
I propose that using daily transactions (or nonzero transfers) times the number of unique addresses is an improvement on the Metcalfe’s Law approach. This would be something like the number of telephones times the number of calls per day. Using this approach, we find that Network Value comes much closer to the actual Bitcoin Market Cap. In fact, the Bitcoin market cap actually crossed over the Network Value as recently as 2018.
We can take this a step further by dividing the current market cap by the Network Value. By doing this transformation, we find that Bitcoin’s Network Ratio trends towards 1. And with each major price cycle, Bitcoin seems to vary less and less from this value.
To sum up, the value of the Bitcoin network is undeniably related to the number and activity levels of the users. By applying the Network Ratio framework, we can see that Bitcoin’s price is trending towards greater stability around what may be considered its “fair value.”
The good news for Bitcoin investors today is that in the long run the volatility is decreasing, the new issuance is programmatically guaranteed to decline every four years, the number of users is still increasing, and the activity of these users is increasing as well. While short-term price action will always be difficult to predict, the long-term outlook for Bitcoin is very bullish.
