Bitcoin (BTC-USD) plunged last week, when cryptocurrency exchange FTX (FTT-USD) went bust and stopped processing withdrawals. The move was consistent with what has been observed in previous cryptocurrency bankruptcies. The price of Bitcoin has dropped by 43%. the first quarter of 2014, when the cryptocurrency exchange Mt. Gox collapsed; similar price movements have been observed during the Celsius (CEL-USD) failure.
When I saw Bitcoin crash in the wake of the FTX crash, I tweeted that a near-term reversal was likely, but that fundamental investors should still steer clear of Bitcoin. Eventually, the short-term reversal happened, but it turned down again later when the Binance (BNB-USD) deal failed.
Why do I think fundamental investors should steer clear of Bitcoin, despite predicting an upturn?
It has to do with the factors driving the supply and demand of Bitcoin. BTC does not generate cash flow, release earnings or have a balance sheet. Some of the companies associated with Bitcoin have these things, but they are not the only factors that determine the price of BTC. First, the demand for BTC comes from a) speculation; b) transactional use. Unfortunately, data on the latter is almost impossible to obtain.
Sources of Bitcoin Demand
The speculative demand for Bitcoin is well known. The coin is by far the most popular cryptocurrency, promoted by business celebrities such as Elon Musk, Jack Dorsey and Cathie Wood. There are entire internet communities dedicated to just talking about Bitcoin and they have millions of users. As you might expect, there is a lot of money invested in Bitcoin price speculation.
The problem with speculative demand for anything is that it tends to disappear. If an investor buys something hoping it will go up in the short term, he might get frustrated and sell when it goes down. An MIT study found that panic selling was especially likely to occur during very large market moves.
Speculative demand can evaporate for a variety of reasons. It has a particularly strong tendency to dissipate in times of monetary tightening. When interest rates go up, it becomes more expensive to borrow funds to speculate with. This makes speculation seem “less logical” in times of rising interest rates, such as the one we are in now.
The transactional demand for Bitcoin is difficult to gauge. The Bitcoin blockchain only records Bitcoin trades, it doesn’t tell you whether Bitcoin was spent on an asset or sold by a trader. For this reason, it is difficult to estimate how much Bitcoin is spent on goods and services. A study conducted by Chainalysis found that merchants accounted for between 0.5% and 1% of all Bitcoin transactions in various sampled countries. Another study once pegged the figure at 33%, though the link to that study (on NewsBTC) no longer works.
We may never know what percentage of all Bitcoin is used for real-world transactions. The sum of merchant tax returns provides a rough estimate, but does not capture the transactions of informal businesses, which are among the largest users of Bitcoin. Black market sellers and non-public companies do not release public financial reports, so we can only “see” Bitcoin transactions reported by public companies and companies that choose to make voluntary disclosures for any reason. In some countries, the government may publish reports on the amount of Bitcoin earnings reported by small businesses, but this is not standard practice. The Bank of Canada, for example, has published reports on cryptocurrency, but they contain little information on transactional versus speculative use. The newly linked report contains some conceptual material on the transactional use of Bitcoin, but does not include the important statistic, which is “Bitcoin spent on goods and services as a percentage of all Bitcoin traded.”
The fact that Chainalysis’s “0.5% to 1%” estimate is only a minimum might appear bullish. If we know that 1% of Bitcoin transactions are amounts reported by merchants, then we can safely assume that the total amount (including black market and unrecorded assets) is higher. Unfortunately, the real critical problem with this minimum estimate is that it underscores the difficulty of getting the true statistic. The seemingly “encouraging” nature of the low estimate is overwhelmed by the unavailability of the real statistic. To make an assessment, you need hard data, and much of the data required for a Bitcoin valuation isn’t available.
How a fundamental valuation of Bitcoin might work
A fundamentals-based valuation of Bitcoin could work if transaction data could be accessed and separated from volume data. If we had the latter, we could calculate a “volume to transaction ratio” that would provide a quick and easy measure of how much Bitcoin trading is used for actual purchases. Bitcoin doesn’t generate cash flows that accrue to the holder, but it does have utility: It can be used to buy things, even if you’re unable to open a bank account. In this sense, we could think of Bitcoin as a yield of convenience, an inherent advantage of directly owning an asset. People who invest in commodities for the long term don’t have the benefit of cash flow analysis; however, they can reasonably assume that demand for a commodity will continue to exist if the commodity has something inherently desirable about it. Bitcoin’s ability to be used in transactions, even by people without bank accounts, may be an “inherently desirable trait.”
There are many people in the world who cannot access bank accounts. Of course, criminals cannot access them; people accused of money laundering often have their bank accounts closed. A cynic might say, “you see, the only non-speculative use case for Bitcoin is its use by criminals”, but this lacks the bigger picture. Not everyone who is treated as a criminal is actually a criminal. Sometimes, governments reduce state power over political dissidents, and this use of state power often includes closing people’s bank accounts. The Human Rights Foundation lists at least four different countries closing the bank accounts of political dissidents. There was an instance where a protest movement in one of these countries used Bitcoin to bypass bank closures. Protesters in this country successfully raised $2 million in Bitcoin donations after their bank accounts were closed. To avoid getting political, I’ll leave the name of the country and its alleged dictator out of the article, but you can find details on the situation in this Forbes piece.
The big plus is that Bitcoin is not only useful for criminals. It’s useful to anyone who has drawn the ire of governments or banks, criminal or otherwise. Given that banks are centrally controlled organizations, it is reasonable to assume that they will continue to close the accounts of unpopular people. Banks have the power to close people’s accounts and are run by humans. It is therefore entirely possible that they unjustly close people’s accounts, humans being as fallible as they are. Bitcoin provides a way for people outside the banking system to send and receive money. Therefore, the transactional use of Bitcoin is likely to persist.
Thus, a fundamental analysis of Bitcoin is theoretically possible. We could treat Bitcoin’s independence from the banking system as a yield of convenience and analyze it as a commodity. Just as oil traders bet on higher oil prices when OPEC cuts production, we could bet on higher Bitcoin prices when de-banking incidents escalate in major countries. Unfortunately, data on the transactional use of Bitcoin is not available. When a catalyst occurs that seems favorable to Bitcoin, you can reasonably assume that its price will go up, but you can’t arrive at a specific estimate of fair value. It is for this reason that Bitcoin’s price movements are similar to a coin toss. In the absence of very obvious catalysts, they are fundamentally random, driven by factors that cannot be perceived.
The bottom line
The bottom line about Bitcoin is that it has a non-zero value, but it is not knowable. The most ardent Bitcoin bears, who see the value of BTC go to zero, ignore the real world uses that Bitcoin has. Most Bitcoin trading is speculative, but there are instances where it proves useful, particularly in countries where human rights are weakening. Situations where Bitcoin is needed are not commonplace, they are more like emergencies, but they happen. Because of this, I don’t think Bitcoin is going to zero. I think the fair value of Bitcoin is below the current price, but well above $0.
The problem is finding out what that fair value really is. Data on the transactional use of Bitcoin is hard to come by. It may be essentially impossible to find: the Bitcoin ledger doesn’t record what items Bitcoins were spent on, it only records trades. If a person selling things for Bitcoin doesn’t report it to the government, their transactional use of Bitcoin will never be recorded in a form useful to statisticians. All we really know about Bitcoin is the supply limit and trading volume, and the volume that comes from speculation cannot be assumed to last: bubbles historically tend to burst. Hence, Bitcoin is not a suitable asset for fundamentally oriented investors. The data transparency necessary to calculate the fair value is lacking. If you are part of a social movement or are a programmer working on blockchain technology, you may derive practical benefits from owning Bitcoin. If you are a value investor, look elsewhere.