Bitcoin Valuation Part II(a): What Might Work

Jan 11 17:01 2018 Print This Article

We need to distinguish between a fair value and what price an instrument trades at. Economic and financial theory is almost invariably about the first part, and the second is not viewed as respectable. However, Bitcoin as an instrument is an excellent example how observed prices are actually determined by the actions of human beings, and not mathematical models. If we wanted to have a more formal approach, we need to look at the valuation of Bitcoin on a macro basis, and not arguments about the valuation of one Bitcoin on the margin.Anyone looking for a price target for Bitcoin might as well stop reading right now. For reasons described below, I will not give anything that resembles an investment recommendation in Bitcoin. An addition issue is that the information that would be useful for Bitcoin valuation is not really in the public domain. This article is a continuation of Part I, where I described what will not work. Unfortunately, I had not written the whole set of articles, and what I described as "Part II" has ended up as multiple parts. Hence, this is Part II(a).An Instrument Trades at What Someone is Willing to Pay for it (or Sell it For)If I had not signed my life away with non-disclosure agreements, I could point out some unusual movements in Canadian dollar fixed income relative value relationships (outside of the Financial Crisis, where everything was unusual). Also, I could explain exactly why those movements occurred.That said, the only way to validate my story would be to subpoena a lot of market makers, and there is absolutely no reason for anyone to do that. Therefore, almost all academics would completely ignore my story, and would rather explain it based on some model or another. An economist would grumble about supply and demand curves. A financial academic would make up a story about risk premia. A physicists that dabbles in finance would come up with a story how prices are set by the random movements of investors, just like atoms (or whatever).The fact that academics will insist on the wrong answer, in order to sound "scientific" -- probably tells us all we need to know about science in the context of finance. However, they have a point: there is no way of advancing our knowledge of finance by just saying that prices are whatever investors transact at. Therefore, we want some kind of valuation model.Additionally, the observation does not help you much unless you have access to information on flows and positioning. Market makers in financial markets are in centre of a web of information gathering, and so they attempt to use their knowledge of positioning in a way to push weak hands into unfavourable trades. However, once that information flow is cut off, the trading advantage disappears. (Historically, there were a number of star proprietary traders that went off to form hedge funds and fell flat on their face. My understanding is that hedge fund investors have smartened up on this front, and so this happens less often now.)Nevertheless, there is an important principle to keep in mind. Financial markets are not one person, one vote, rather one dollar, one vote. Models that pretend all investors are equal is an egalitarian fantasy. The movements of the big investors are what matters. When applied to Bitcoin, that means we need to think about the behaviour of the big holders of the instrument.We Need to Think MacroIf we do want to attempt to come up with a valuation metric, we cannot use incremental analysis (what can we do with one Bitcoin?). That was the subject of Part I. Instead, we need to look at the entirety of the Bitcoin economy, and use its interactions with the rest of the world, to get a handle on valuations.This is similar to the valuation of equities that do not pay a dividend. The control of the corporation presumably has some value (unless creditors take over), and so we need to come up with an enterprise value (dividing by the number of shares to get a share price target). This is not really that radical, but we need to be careful. One idea would be to compare the total capitalisation of Bitcoin to the equity market capitalisation some other payment network. Unfortunately for that idea, ownership of one Bitcoin does not give you any ownership of transaction fee profits; transaction fee profits (or losses) are earned by the miners.One added complication is the relationship of Bitcoin to other crypto-currencies. One common valuation metric that is quoted is the relative size of market capitalisation of the various crypto-currencies, and the role of Bitcoin allegedly is to act as a senior currency among the group. This implies that some relative value investors will trade in a way to keep relative prices stable (in some sense) between the crypto-currencies. We then have to value the entire crypto complex as a whole, and then attribute a portion to Bitcoin.The difficulty with that approach is that unless there is a guaranteed conversion privilege (which I believe does not exist), any investor that attempts to preserve an off-market parity is acting exactly like a central bank that is attempting to defend an unsustainable exchange rate peg. It will be successful -- until it runs out of ammunition. For this reason, each crypto-currency (that is not convertible to something else) has to be valued on a stand-alone basis if one wants to be safe.Enterprise Value Does Not WorkThe first thing to keep in mind is that the Bitcoin architecture requires the continuous use of energy. (One could presumably print out a hexadecimal dump of the blockchain, but that would not be a particular useful store of value, other than as a curio.) Until there is a significant Bitcoin "real economy" (as discussed in the previous post), those energy costs would be denominated in some fiat currency. The miners effectively need to raise fiat currency to pay their utility bills. This could be done by drawing down existing fiat currency holdings, which implies a fiat currency drain to finance positions in Bitcoin. Unless the miners have extremely deep pockets in fiat currency (a hard-to-estimate question), they will need to sell Bitcoin that ends up in the hands of some investor that wishes to buy Bitcoin using fiat currency. (Yes, there could be some intermediaries along the way.) If we want to believe that Bitcoin will survive in some form of steady state (a hidden assumption in valuation exercises), it seems that Bitcoin needs to attract net fiat currency inflows to cover energy costs. Therefore, if we wanted to think of the entire Bitcoin complex as a consolidated entity, it has an expected negative cash flow in fiat terms, under the plausible assumption that there are no utilities that wish to hold ever-increasing amounts of Bitcoin.(It is entirely possible that creative utilities will offer electricity contracts that are fixed in Bitcoin terms. All we need are creative investment bankers that can structure a product that allows them to find investors to take the other side of the utilities' hedges. However, such financial engineering has just laid off the existing risk to some other party, and so the underlying flows still exist. Such hedges will have a finite life span, and when they roll off, the new contract terms would be exposed to the future market price of energy. In any event, it is entirely possible that the miners believe their own press releases, and would not consider hedging their energy cost risk.)As an aggregated entity, "Bitcoin Inc." is going to have negative cash flow in fiat terms. However, that just tells us that using an enterprise valuation metric on the aggregate Bitcoin economy does not work. All it needs for a positive valuation is a reason for continued net inflows, which plausibly exist (as I will discuss in the next part). However, this aggregated analysis suggests that the physical intuition that an energy price spike is dangerous for Bitcoin can be easily understood in financial terms.To summarise the argument in my follow up article (I hope the last), Bitcoin's valuation depends upon what price existing holders can demand, yet keep net flows balanced with the energy cost drain.No Recommendations From MeThere is no way I could offer a recommendation to buy or sell Bitcoin, which is one reason I cannot offer a fair value target. The reason is that I am unaware of any legal precedents involving Bitcoin in an investment environment, nor is there is any reason that such precedents would apply both in my home jurisdiction and the legal jurisdiction of my readers.Take a very simple example why this area is a legal minefield for advisors. How does Bitcoin fit into one's plans for leaving an inheritance?

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About Article Author

Bond Economics

Bond Economics is about economics and finance, viewed from the point of view of a fixed income quantitative analyst. The site offers commentary about market trends, but does not offer investment advice. The objective is to look at what are the driving forces in the developed economies and markets, looking through the short-term distractions. There are also articles written to explain how to to develop models to analyse economies or fixed income securities. Author, Brian Romanchuck is a consultant and on the Advisory Board of the Global Investment Strategy Institute (link). Previously, he worked at the Caisse de dépôt et placement du Québec from 2006-2013, starting as an analyst and ending as the head of the Fixed Income Quantitative Analysis team. From 1998-2005 he worked at BCA Research, an economic research firm based in Montréal. He has a doctorate in control systems engineering at the University of Cambridge, after a bachelor's in electrical engineering at McGill University. In addition, he held post-doctoral positions at Cambridge and McGill before moving to work in finance.

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