Introduction
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Too many people are riding the bitcoin roller coaster blind. Owning an asset and not fully understanding its worth, or even attempting to determine its worth, and risks is like riding a roller coaster blind. You only know if you are going up or down as you feel the rush of gravity. This is an unsound way to invest, unless you are just in bitcoin for entertainment. Below, I provide a framework for valuing bitcoin; I provide a detailed look at the upside and downside of an investment.
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The Most Optimistic Scenario
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Bitcoin may have a value, like a currency, if it is a store of wealth and can be used as a medium of exchange. Given this, we can value bitcoin based on its potential share of money supply.
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Money supply is measured in several ways. M1 includes the sum of currency held by the public and transaction deposits at depository institutions. Clearly, these funds are readily available to make purchases (i.e., a medium of exchange). M2 is a broader definition, and includes M1 plus savings deposits, small-denomination time deposits, and retail money market mutual fund shares. These funds are also reasonably liquid, so they are also relevant as a medium of exchange.
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Money supply growth times the velocity of money – how many times money is used to make transactions – equals nominal GDP (figure 2). GDP essentially measures sales of an economy, and one needs money to transact these sales, so money supply has value. However, the value of that supply can erode with inflation. Figure 3 shows that if M2 grows more quickly than real GDP then inflation normally rises (possibly with a lag). Thus, it is unusual that inflation has been tame (velocity has declined) in the face of massive QE in the US and around the world. While it is a little bit of a stretch, fear of currency debasing could be one benefit of and a driver to bitcoin as a currency. Scarcity of money influences its value; scarcity of money supply is determined by central bank policies and central banks have been aggressive so money is abundant. However, scarcity of bitcoin is dependent on the total supply available to be mined. This is 21 million by 2140 (estimated) – over 120 years from now and only 4 million above today’s levels. Plus, each additional coin is more difficult to mine than the last (so it becomes more valuable based on cost rising as time passes). Thus, bitcoin could be a better store of value than sovereign currencies over the long-term. However, its value as a store of wealth is only above $0 if it is also a medium of exchange..
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The value of money is also based its ability to be utilized to buy things (a medium of exchange). Hence, bitcoin’s value can be determined based on how much it is used to buy goods and services. Figure 4 provides several scenarios.
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Let’s first base bitcoin’s value on M1. US M1 amounted to over $3.6 trillion at the end of November. At 1% of M1, the value of all bitcoins is $36 billion. If there are 21 million bitcoins, then the value per coin is $1,723. However, only approximately 17 million coins have been mined, and the value rises to $2,128 if we assume only these coins. Plus, some of bitcoins have been lost (estimated at 4 million); if there are only 13 million coins, then the value per coin is $2,783 at 1% of M1. If the share rises to 5%, then the value jumps to $13,914.
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However, this is not the whole story. Bitcoin could become a global currency, not just a US currency. Thus, we need to consider global money supply. According to the CIA (2016), US M1 is 8.8% of the world stock of narrow money. Thus, if bitcoin is 5% of global M1, then it is worth $157,368 per coin (based on 13 million coins).
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If we extend the analysis and assume bitcoin should be compared to M2 instead of M1, then the value of bitcoin is even higher. Using the same methodology as above, the value is $6,546 (21 million coins, 1% US market share) to $362,873 (13 million coins, 5% world market share).
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This analysis provides some of the most bullish values for bitcoin. Importantly, it ignores many of the risks of investment and the very important fact that bitcoin is not the only cryptocurrency (it does not have 100% share). These considerations are discussed later.
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Bitcoin versus Gold
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We can also attempt to value bitcoin based on comparison to gold, but the relationship is loose at best since gold no longer backs up currencies – most countries left the gold standard at some point in the last century. Gold is still considered by many to be a defensive investment – a place to invest when the world is falling apart. However, at least currently, bitcoin does not share gold’s defensive properties and appears to be primarily a means of making money as opposed to protecting against loss.
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On the other hand, bitcoin and gold do share some attributes such as scarcity, both possibly being a store of value that keeps up with inflation, and it is difficult to determine both of their “intrinsic” values.
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- There is a limited supply of gold. According the World Gold Council, 90% of all of the world’s gold has been mined. Bitcoin is limited to 21 million coins, of which about 17 million have been mined. It is also more expensive to mine as fewer and fewer bitcoins/gold remain undiscovered.
- Many people probably believe that gold rises with inflation over the long-term. As noted earlier, perhaps bitcoin will rise over time as mining costs increase so bitcoin’s price appreciation should at least keep up with inflation. Cost of production often sets a floor on value (this is discussed later).
- A friend once said to me that the price of gold is “whatever people are willing to pay for it.” This is approximately right since gold has few uses. I recall Warren Buffett at the 2011 Berkshire Hathaway Annual Meeting echoing this view. He indicated something like the following: gold does not produce anything for you (it does have some industrial uses) – it does not pay interest, dividends, and won’t grow earnings. Similarly, if bitcoin does nothing for you – it does not become a medium of exchange – then it is like gold. Its value is whatever people are willing to pay for it without any real anchor to the value (unlike gold, it is not currently considered a safe investment). At least gold is shiny and can be worn and given as a present; although, I suppose one could give bitcoin as a present even though it is invisible and you better not lose your private key to your wealth.
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See figure 5. The World Gold Council suggests that 187,200 tons of gold have been mined since the beginning of civilization. At $1,250/ounce, this equals a total value of $7.5 trillion. If bitcoin just became 1% of the value of gold, it would be worth $4,405 per bitcoin. At 5%, its value would rise to $22,024, and it would be worth $440,471 at 100% of the value of gold.
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What Can Go Wrong
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I have now discussed the most optimistic scenarios. However, an investment in bitcoin is not without very substantial risks. A great investor will always think about the what ifs – the what can go wrong scenarios. The key to winning as an investor is not losing.
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Risks of a bitcoin investment range from a large and growing array of competitors, regulation, high volatility, bubble-like conditions, futures trading, slow transaction speed and low velocity of money, cost of mining below current prices, and concerns about trust and security.
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Competition
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There are at least 1324 cryptocurrencies. The value of bitcoin computed earlier assumes that bitcoin has 100% market share. Bitcoin has a substantial lead (18X larger than the second largest by market value), but whether it continues is an important question. Of these cryptocurrencies, perhaps a dozen or so are dominant (12 are above $1 billion in value), but the list could grow. If there are 10 equally dominant players in the end, then bitcoin’s value is about $36,000 in the optimistic scenario above where cryptocurrencies are 5% of M2.
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Bitcoin is leading the race today, but this does not necessarily mean it will lead tomorrow. Remember what happened to America Online? At the start of the Internet, it was the dominant provider. AOL offered something that was a novelty (access to the Internet), but access is now a commodity. Time Warner and AOL eventually joined at the peak of the technology bubble and created the most value destructive merger of all time. Internet is now much faster (AOL was dial up). Similarly, new currencies are trying to improve upon bitcoin. Will they be successful? While scarcity can drive up the price per bitcoin, it can also make it less useful as a medium of exchange (most items cost less than $19,000) and open the door for other competitors; although, since people can trade fractions of a bitcoin, this is less of a concern.
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Who will emerge as the fiercest competitor? I expect the top candidates probably not being considered enough include central banks and the financial institutions that cryptocurrencies are attempting to replace. This is not a wild idea. Janet Yellen, on her way out of the Fed, discussed government-issued digital currencies. She noted that it is something central banks are looking into, but not something the Fed is “seriously considering at this stage.” However, the Fed (Bernanke) was also not worried about housing being a bubble just before it burst and its view probably changed quickly. When backed into a corner and when faced with a threat of becoming extinct, people come out swinging. What if central banks or financial institutions band together to create their own cryptocurrency? I am not well versed enough in cryptocurrencies to understand the details of such a defensive tactic, but I am an investment expert (and a valuation and behavioral finance expert) and understand that the unexpected is often overlooked when one considers the risks of high growth investments.
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Regulation
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One defense governments (central banks) have in their arsenal is regulation. This can be used to prevent loss of control over currency, and could be justified as a method to clamp down on illegal activity. A benefit of bitcoin is anonymity; however, this means that criminals and terrorists can use bitcoin for unlawful activities. Europe is looking to regulate bitcoin. Japan has 11 regulated bitcoin exchanges, China has banned the sale of cryptocurrencies and tokens, etc. Regulation is a threat to bitcoin’s continued rise and existence.
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Volatility
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As noted earlier, currency has value based on being a medium of exchange and a store of value. Given the astronomical rise of bitcoin, and sometimes spectacular falls, the coin is much too volatile to be considered a monetary instrument with a reliable store of value. However, perhaps new futures trading on the CBOE and CME will lead to more stable prices.
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Bubble-like/Leverage & ETFs
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Bubbles are much more common than people predict. They may manifest themselves and impact entire economies (e.g., Internet bubble, housing bubble) or particular sectors or industries. Each bubble is normally initially accompanied by (1) some type of fundamental development, (2) is propelled by leverage, (3) is eventually doubted as prices continue to rise, and (4) then the bubble bursts.
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Step 1: I am speculating here, but the popularity of cryptocurrencies could have resulted from people’s fear of government being a big brother (i.e., watching over one’s shoulder). Not only criminals are concerned about anonymity. People may not trust their governments, especially following the financial crisis and in countries where governments are less honest. In the US, some people were taken aback by revelations by Snowden in 2013 about the National Security Agency’s snooping tactics. Of course, computing power has enabled the rise of cryptocurrencies and this was not necessarily available until recently. Young people in emerging markets are online and are propelling the digital payment trend. Also, as mentioned earlier, fear of currency debasing from worldwide quantitative easing could be driving people to cryptocurrencies.
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Step 2: Debt is also driving the buying frenzy. Joseph Borg, President of the North American Securities Administrators Association, told CNBC that people are taking out mortgages to buy bitcoin. That type of crazy is reminiscent of the Internet bubble and housing bubble. ETFs in cryptocurrencies have also emerged. Trading on options exchanges began the last few weeks. Most bubbles are accompanied by rising debt to fuel the trend and new ways to invest and get rich; however, it normally ends poorly at least for latecomers.
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Step 3: Is there doubt? Have prices continued to rise? Yes and Yes. People may be forgetting that 5% of the time, since late 2010, bitcoin was down 29% from month earlier prices (see figure 7). It is a very volatile investment. It does not always go up.
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I began my investing career in 1992. During that time, I have observed many bubbles encompassing eight of the 11 sectors of the market: financials, real estate, technology (and telecom), utilities, healthcare, materials, and energy. We could also add consumer discretionary if you include Internet retailers or the fact that autos went bankrupt during the last recession at least in part because of too much leverage. This just leaves industrials and consumer staples as non-bubble sectors; however, industrials stocks tend to rise/fall with the economy and was recently propelled by the energy and materials bubbles. Here is a sampling from the last 25 years (see figure 8 for price charts):
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- The first was the financial craze of the 1990s that was fueled by mergers and acquisitions. This mania continued through 1997 before taking a temporary back seat to the technology bubble. However, as technology crashed, financials outperformance ensued and did not peak again until 2003. The later surge may have been propelled by the repeal of Glass-Steagal, which separated investment banking from commercial banking, and rising consumer leverage (e.g., housing). The financial bubble did not end well.
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- Next came the Internet bubble, and we all know how that ended.
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- A lesser known bubble in utilities was heating up at the time of the Internet bubble, but did not crash until a little later. This bubble was fueled by deregulation of generation in the US and resulted in many new independent power producers. Expenditures to expand generation was frequently financed with debt, and generators were often focused on natural gas as a fuel source since gas prices were low and natural gas plants were quicker to build. Of course, then a recession hit, so there was less demand for this new supply of electricity, at the same time as natural gas prices soared. In the end, these debt laden companies performed very poorly.
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- The rise of gold began as Internet stocks tumbled. Everyone hated gold in the 1990s, but when risk raided its ugly head people gravitated to the shiny metal. Eventually, the price of gold soared from about $250/oz in 2001 (the bottom was approximately coincident with the top of the Internet bubble) to about $1,800/oz in 2012 when it had become a speculative bubble. Advertisements on TV told you how to sell your gold, kiosks in the malls appeared where you could sell your gold, gold ETFs offered you another way to invest in the metal, etc. Gold is now about $1,250/oz.
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- At the same time gold was rising, other metals were also in their heyday. Oil demand and demand for other commodities were being driven by China’s rapid growth. However, its growth eventually slowed. New technologies enabled fracking and US shale supply growth outstripped demand and prices of oil tumbled. By the way, many of these exploration and production companies were highly leveraged. Guess what happened to them?
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- Of course, the housing bubble in the first decade of the 2000s was a little crazy. Few people saw the end coming, and the ramifications of ignoring risks were enormous for the world. We still feel them.
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- One would have thought that memories would be fresh from the housing bubble and we would not see bubbles for some time afterward. However, it seems that speculation accompanies about every new gizmo or growth opportunity. Just a few years ago, there was a mania in mid-cap biotechnology stocks (biotech was up 871% versus the S&P 500 which was up 58% from February 2008 through May 2015). Since May 2015, biotech is down 17% versus the S&P 500 which rose 26%.
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Is the rise of bitcoin a lasting trend? Perhaps. Is bitcoin just another bubble that will crash and burn like the rest? Maybe. Given that I can easily recall the above-noted manias that all ended badly, I am probably biased to believe bitcoin is in bubble trouble territory; however, I also know that it is difficult to determine when a bubble will pop (this one could rise much further as my analysis above shows). Unfortunately for others – especially the younger investing crowd who have not experienced bubbles – the best teacher is experience. Experience makes one more aware of risks, which it appears that many people are ignoring when it comes to bitcoin. Experienced investors also tend to base their decisions on value, and I have seen few (if any) good attempts at valuing bitcoin’s intrinsic worth until this piece.
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CBOE and CME-Legitimacy and Shorting
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Last summer, my students and I had a chance to tour the CBOE, walk the floor of the exchange, and discuss the implications of the CBOE trading futures on bitcoin (the CBOE and CME started trading bitcoin futures over the last month). Our host suggested that once bitcoin futures started trading that the currency would become more legitimate and the price would become less volatile. However, at least initially, more legitimacy probably helped propel bitcoin’s recent run up of about $10,000 over the last month.
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Professional investors have pretty much stayed out of the bitcoin craze, so prices have been driven by individual investors who are often less sophisticated. The entry of institutional investors may reduce volatility and be positive long-term (as bitcoin perhaps becomes a store of wealth); however, there is a flip side. More demand from institutional investors could push up the price much further as buying demand outstrips selling supply, and allowing institutional investors to short futures in bitcoin could lead to corrections as well. Also, lower volatile means the days with super high returns is over. Could that make people shy away from bitcoin?
Slow Transaction Speed/Velocity of Money
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A benefit of bitcoin is low transaction costs which averaged much lower than $10 for much of the year ($10 on $10,000 is only 0.1%). This compares to a fee of over 2% for credit cards. However, the more people who make payments with bitcoin the slower the transaction speed and the higher the cost (above $20 recently). Bitcoin can transact at a rate of about four per second, while Visa can transact over 20,000 per second (some sources say it is more than 50,000). This is a real problem for bitcoin. Competitor cryptocurrencies are trying to solve it. Could this limitation eventually lead to bitcoin’s loss of market share or its demise?
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The transaction volume (only about 280,000 coins per day) is still anemic, but it is continuing to rise. This compares to Visa which has 150,000 million transactions per day. Thus, bitcoin transactions must grow over 500 times just to be competitive with Visa.
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To put this in perspective, Visa had $1.4 trillion in purchase volume in the first half of 2015, or an annualized rate of $2.8 trillion. In 2015, world GDP was $116.7 trillion. Thus, Visa had just under 2.5% share of world transactions. Using the same math as shown in figure 4, and assuming bitcoin transactions grow over 500 times to have the same share (about 2.5%) of the world money supply as Visa has in transactions, the value of bitcoin (assuming it has 100% market share of cryptocurrencies) is $181,436. Given its transaction volume is 0.2% (1/500) of Visa’s share of transactions, we should divide $181,436 to compute today’s value. This is $363 (this is not a typo). Let’s say bitcoin ends up with only ¼ of cryptocurrency transactions, then the value falls to $91. However, $91 is still above bitcoin’s worth if it is a fraud, as Jamie Dimon says. I suppose, at a minimum it is fun to trade so bitcoin does have entertainment value.
While transaction speed is low and is a concern, trading volume on major bitcoin exchanges is picking up. It has recently grown to about $2 billion per day on major bitcoin exchanges. This compares to about $40 billion on the NYSE, so bitcoin trading is very active. Trading volume normally rises when there is enthusiasm about a move.
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Cost of Mining as a Floor
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Real assets such as gold, oil, other metals, housing, and other real estate have an underlying value that provides a floor to prices. That underlying value is the cost to replicate the asset. In bitcoin’s case, the cost of the asset is the cost of the electricity (and any other technology costs) to produce a coin. According to one analysis, this could be over $4,000 just for electricity (before other technology costs), but the range is wide (one estimate is $1,500) and varies based on geography (and electricity costs). As the number of unmined bitcoins dwindles, the difficulty of mining will continue to rise and the cost to mine will inflate. Thus, the floor will continue to rise over time up to 2140 when the last bitcoin is estimated to be mined. This may provide a floor to the cryptocurrency as long as it is not a fad and has some type of value as a medium of exchange.
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Trust/Security
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Over time, a new idea or product generates legitimacy and acceptance. Bitcoin and other cryptocurrencies must be deemed to be safe places to store one’s wealth before they could replace banks (except for perhaps the thief who values anonymity above all else). There are numerous security risks, and as the price of bitcoin rises there is more incentive for crooks to steal coins. Besides security, there was a case where more than $300 million of ether was accidentally lost. An article in MIT Technology Review notes that quantum computers could break bitcoin security within 10 years. Bitcoins have even been lost (in one instance, 7,500 bitcoins) because of a misplaced key. I will say this again, a misplaced key cost someone about $135 million. A bank does not require you to keep a key to keep your money safe.
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Financial institutions protect deposits. Regulation exists to assure depositors that their money is safe. Please refer back to the competitor section. If central banks and financial institutions get into the cryptocurrency game, who would you rather conduct transactions and store cryptocurrency: (1) a central bank/financial institution or (2) a group of computer wizards who could be the same people who hack into businesses and steal social security numbers and money? Of course, one could lose anonymity factor with cryptocurrency offerings by financial institutions and central banks, but that may be worth the cost of security to most people.