Longtime readers know I am largely a crypto skeptic. Specifically I am one of those annoying the-principles-underlying-crypto-are-undeniably-transformational-but-I-am-skeptical-of-the-investability-today people. However, there is one crypto myth I cannot really abide and that is the myth that the start of futures trading is responsible for the crypto drawdown that started in January 2018.
I first wrote about this issue of Bitcoin futures here.
But this isn’t that complicated. The reality is that BTC futures volumes are low. Like really low in comparison to volumes for BTC overall. Below is the data for BTC:
Source: data.bitcoinity.org
And here is the data from CME Group for its contract (note: multiply by 5 because each CME contract is for 5 BTC):
Source: CME Grou
Let’s double that to account for the fact that CBOE offers its own Bitcoin futures. Even then you are talking about maybe 30,000 BTC worth of total volume. I struggle to believe these meager volumes are pushing the market around.
More importantly, just because I sell a BTC futures contract does not mean the spot price of BTC automatically drops.
Someone has got to push the sell button in the spot market for that to happen. My selling of BTC futures does not in and of itself compel anyone to sell spot BTC. It may encourage someone to to come in and take a position based on how my order impacts the term structure of BTC futures in relation to the spot price. But that is a very different proposition from “I am short Bitcoin futures so now the spot market is falling.”
Now maybe there is data out there beyond someone lining up dates that shows a clear causal relationship between the BTC selloff and the start of futures trading, but I have yet to see it (if you have such data please get in touch).
Otherwise, repeat after me: correlation is not causation.
I have been having some interesting conversations recently regarding the latest trials and travails of cryptocurrency investors. The issue many of them are facing is what to do now having made returns of 5x, 10x, or more.
Do you let it ride and shoot for 1000x?
Do you lock in your profits now?
Something else?
In traditional markets, such as equity and fixed income, fundamental analysis helps with these issues. If you own Proctor & Gamble (PG) stock, and one day PG falls 50% for no reason other than that traders are bouncing the stock price around, you either: a) do nothing, or b) buy more. Although the market price has plummeted, there is no change in the intrinsic value of what you own (a slice of PG cash flows). In this case your valuation anchors you on what is important (intrinsic value) instead of the noise (the change in market price).
The challenge with cryptocurrency is that there is no intrinsic value for you to anchor on–at least not in the conventional sense. Holding forever and collecting your cash flows is not an option. There are no cash flows to collect. All you’ve got are supply and demand, and supply and demand are notoriously fickle over short time periods.
I have a pet theory that despite the meteoric rise in the price of Bitcoin, the average investor return is much, much lower. This would be consistent with investor behavior in traditional financial markets:
Of the municipal bond category, Morningstar’s Russ Kinnell wrote:
It’s surprising that the rather stable muni-bond fund group could be so misused, but it has been going on for a while. The problem here is that there are very risk-averse investors and a sector with scary headlines. The good news rarely makes headlines. Rather, investors hear about Puerto Rico’s crushing debt and Meredith Whitney’s ill-informed doomsday call. Those news events spurred muni investors to sell, which led to a drop in muni-bond prices and a spike in yields. Thus, they created a buying opportunity just as investors were fleeing. This speaks to the downside of trying to time the market and the benefit of staying focused on the long term.
I am increasingly involved in discussions about how futures trading will impact the spot price of Bitcoin. While I am far from a Bitcoin bull, I have attacked the notion that futures trading will somehow trigger a major correction in spot Bitcoin prices. This post will explain why.
First things first.
This is an intellectual exercise. It is not an investment recommendation. Do not under any circumstances make any decisions with real money (crypto or fiat) based on what you read here. See also my disclaimer at right. If you are serious about putting money into cryptocurrency, do yourself a big favor and consult with a professional advisor who can provide guidance based on your unique circumstances.
Also, if you are not familiar with futures terminology, you are going to have to bone up on the following:
Futures
Term Structure of Futures
Contango
Backwardation
Futures Arbitrage
Khan Academy has a series of videos that looks decent. I simply don’t have the time to post a comprehensive introduction to futures on this blog. And frankly, if you are not willing to invest some time learning about markets and investing, you probably shouldn’t be spending time reading about digital lottery tickets in the first place.
Now, if you can explain to me why there is no arbitrage opportunity available on a 1-year Bitcoin forward priced at $12,600 with spot Bitcoin at $12,000, assuming a riskfree interest rate of 5%, you will follow my argument.
Why Bitcoin Futures Trading Will Not Trigger A Selloff
Whether the addition of futures trading will be bullish or bearish for Bitcoin depends entirely on the marginal trader of Bitcoin futures. The bear case assumes the market for Bitcoin futures will be dominated by hedgers and short speculators, and that this in turn will exert downward pressure on spot Bitcoin prices.
I disagree for two reasons:
First, market sentiment is euphoric. While there are certainly Bitcoin bears out there, it is difficult to imagine that they will dominate in futures trading. More likely futures will be viewed as a cheap way to get (leveraged) exposure to Bitcoin without the custody issues associated with owning Bitcoin outright in the spot market. I simply do not believe a bunch of professional traders are going to come out of the woodwork to short an asset with no intrinsic value, that people feel justified owning at $10 or $400,000. As a directional short Bitcoin is potentially lethal. Doubly so due to the leverage embedded in futures trading.
Thus, the term structure of Bitcoin futures is likely to be contango. Other than volatility and uncertainty there isn’t much reason for Bitcoin futures to trade in backwardation. If the spot market were wavering there might be an argument otherwise. But as noted above the spot market is euphoric. Therefore, futures traders looking for arbitrage opportunities will most likely be shorting longer dated Bitcoin futures and buying spot Bitcoin as a hedge (the goal being to earn roll yield with no directional exposure to Bitcoin prices). This argues for upward pressure on Bitcoin prices in the short term.
In order for futures trading to pressure spot Bitcoin downward, the term structure of Bitcoin futures will have to backwardate. This will encourage arbitrageurs to sell Bitcoin in the spot market and go long Bitcoin futures, putting downward pressure on spot Bitcoin prices.
What would cause the Bitcoin futures curve to backwardate? The Bitcoin narrative would have to break. Apologies in advance to enthusiasts but Bitcoin doesn’t trade on fundamentals right now. It trades on momentum (a.k.a sentiment). Skilled short sellers are not going to put big positions on unless the narrative breaks and sentiment turns. Otherwise they are going to get squeezed. Hard.
I never, ever, ever get involved in what I would call open-ended situations. . . . I have avoided pie-in-the-sky names. To use an analogy, I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I’m interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground. Instead of open-ended situations, I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets. I look for change, I look for ‘if this goes away tomorrow will anyone miss them’?
Building off yesterday’s post today I will unveil a Bitcoin valuation.
Before we go any further I must emphasize that I am sharing this information as an intellectual exercise and for entertainment purposes only. This is not an investment recommendation and the output of this model should not be used to make investment decisions. You should consult with a financial advisor before making any investment decision. In the interest of full disclosure you should also know that I currently own neither cryptoassets nor exchange traded cryptoasset products (ETPs and ETNs).
The theoretical underpinning from this model is taken from Burniske and Tatar’s book, Cryptoassets. The authors propose adapting the Equation of Exchange (MV = PY) for valuing cryptocurrencies.
What the equation of exchange tells us is that the money supply times the velocity with which money circulates (left side) must equal the price level times real output (right side, a.k.a nominal output). So:
M = Money Supply
V = Velocity of Money
P = Price Level
Y = Real Output
I will apply the model to Bitcoin using data from blockchain.info. Many of my inputs will be rounded but I have always believed that perfect is the enemy of good when it comes to investing and valuation in particular. I am not sweating the small stuff. You are welcome to redo the work to two decimal points if spurious precision is your thing.
Anyway, we start with the supply of Bitcoin. This is easy. There will only ever be 21 million Bitcoins (unless of course the code is changed and that is a governance issue for the time being not a valuation issue). To be conservative I will assume all 21 million Bitcoin are in circulation for the valuation calculation.
The velocity of Bitcoin is a bit fuzzier but I can try to approximate the number using Bitcoin transaction data. According to the data Bitcoin transaction volumes are fairly stable oscillating around 200,000. We can annualize this by multiplying by 365 which equals about 73,000,000. We divide 73,000,000,000 by the current Bitcoin supply of about 16 million to get a velocity of about 4.56.
Price in USD is the variable we solve for. So we will pass over it for now.
With output we make a small adjustment and use output in USD terms as it will be easier to place our assumptions in context that way. This is about $1bn per day currently which we can annualize to about $365bn. That is estimated output today. What we need for our model is to also estimate the output at some point in the future. For the sake of this exercise let’s say in five years we think the USD equivalent transaction output for the Bitcoin network will be $1tn. This is a critical variable and some readers may think I am being overly conservative. Maybe so but do consider that this represents a compound annual growth rate of 112% a year.
We set up the model as follows:
21,000,000 x 4.56 = P ($1,000,000,000,000)
Solve for P using basic algebra and you get about .000096 BTC/USD. To make this number intelligible we take the reciprocal 1/.000096 to get USD/BTC which (using a spreadsheet for spurious precision) is about $10,443. That is a the estimated value of one Bitcoin five years from now.
For the final step we simply discount this price 5 years at our required rate of return. Since discount rate estimation is a pain and something of a guessing game in the best of times I like to simply choose a desired hurdle rate. For an asset like BTC I think 30% is reasonable given the risks and the immaturity of the asset class.
So discounting $10,443 for 5 years at 30% I estimate the value of one BTC today at $2,813. A summary of these calculations is included below.
Contrary to what some may think modeling is not about predicting the future. Rather it is about being explicit with your assumptions. This helps you test your assumptions for reasonableness. It also helps you identify the key variables you need to get right. Finally, it helps you build and maintain conviction in the face of market price volatility.
With Bitcoin here are the key variables:
How big can it get? -> How much “share” of global transaction volume will it take?
How long will it take to get there?
To what extent will it be used to transact versus as a store of value? The lower the velocity the more it is being used as a store of value and vice versa.
How much reward do you require given the risks?
You might disagree with my results and that is fine. However, I would ask you to consider where our views differ in the context of this model. Is it because you believe Bitcoin will get “bigger” and/or that it will get there “faster”? Is it because you think Bitcoin is less risky than I do?
I hope to update this valuation from time to time as Bitcoin evolves as an asset.
In closing, I would like to once again emphasize:
I am sharing this information as an intellectual exercise and for entertainment purposes only. This is not an investment recommendation and the output of this model should not be used to make investment decisions. You should consult with a financial advisor before making any investment decision. In the interest of full disclosure you should also know that I currently own neither cryptoassets nor exchange traded cryptoasset products (ETPs and ETNs).
In my previous post on valuing Bitcoin I settled on supply/demand balance as the “least-bad” valuation model. I have been thinking more on how one might actual implement this in practice. The supply side is fairly straightforward. There are lots of free calculators that allow you to play with cost assumptions for Bitcoin miners. Now, there are probably going to be places in the world where an astute Bitcoin miner can arbitrage differences in electricity costs. But for now that’s splitting hairs.
The far trickier part is the demand side.
The reason is that while there are lots of use cases for Bitcoin, far and away the most prevalent is speculative trading. Therefore, if you take network activity at face value you are probably missing the fact that there is some reflexivity in those statistics. It’s basically a circular error problem. Speculative trading activity drives up network activity which drives up miner’s costs which causes the equilibrium price to rise. BUT, if speculative trading activity slackens (e.g. Bitcoin is in an asset bubble that deflates in the future) then the reverse will occur on the way down.
So in my view what you need to do is account for potential increases or decreases in speculative trading activity (and other kinds of activity) in your model. To do this you would need data that segments different transaction types.
The trick is finding that data.
As always this is not an investment recommendation. It is written for entertainment purposes only. As my thorough disclosure states very clearly, you should never make any investment decision based on something some random dude writes on the internet. Everything I am saying here could be wrong. In fact it is likely wrong. If you are looking for a recommendation on whether to own Bitcoin or any other cryptocurrency you should consult with a trusted financial advisor.
The volume of BitCoin transactions originating in China is simply enormous. A New York Times article referenced in my prior post contains the following infographic (this is a little dated):
Source: New York Times via Chainalysis
Note the vast difference in volumes between China, the US and Europe. Why do the Chinese love BitCoin so much?
In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can’t take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).
Rates are regulated – low. Inflation is high and ex-ante the return to Chinese savers is negative.
Despite negative real returns Chinese save in huge quantity. This may be because of the “four grandparent policy” as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).
Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.
This pool of savings (part of what Ben Bernanke once described as the “excess of global savings”) has global implications – and these will be explored in a forthcoming posts.
But here I state the obvious.
If you were forced to save huge amounts of money at negative real rates of return wouldn’t gold look attractive?
And, I would add, wouldn’t BitCoins now look even more attractive than gold? If you are an average Chinese household hoarding gold, that strikes me as a tremendous undertaking. You would have to find a way to store the gold, secure the gold — on top of that it is not particularly easy to transact in gold.
BitCoin presents a convenient solution to these issues. Who cares if the Chinese government officially bans cryptocurrency exchanges? For BitCoin at least the whole point is to own an asset that is independent of conventional monetary policy (and, one might add, conventional capital controls). The storage costs strike me as much, much lower. In Cuba people circulated banned American media on flash drives. In China, hoarding BitCoins would be similarly straightforward.
Recall that when Jamie Dimon let loose with his tirade against BitCoin, he also said the following:
The only good argument I’ve ever heard … is that if you were in Venezuela or Ecuador or North Korea.. or if you were a drug dealer, a murderer, stuff like that, you are better off dealing in bitcoin than in US dollars, you are better off bypassing the system of your country even if what I just said is true. There may be a market for that but it’s a limited market.
This is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere or consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.
What this post is about are three different mental models one might use or adapt in analyzing the current price of BitCoin or another digital asset with similar characteristics.
First some background. I am fortunate to be friends with some very smart people with diverse sets of interests. We enjoy nerding out over similar topics: business strategy, financial analysis, technology, markets, entrepreneurship. If we can nerd out in person over a bottle of whiskey, all the better. Unfortunately now many years out of college several of us live in different cities. So we created a Slack group where we more or less maintain a running dialogue. Several of the longest running threads in our Slack group deal with cryptocurrencies.
I am not going to spend time or energy on background information in this post. There are smarter and more knowledgeable people than me all over the internet who can bring you up to speed on cyrptocurrencies. However, you should read the original BitCoin whitepaper. Primary sources matter. It doesn’t matter if you don’t understand every last detail. I certainly don’t.
The specific problem we were confronting on Slack was which type of mental model one might apply to a cryptocurrency like BitCoin to determine whether it is overpriced or underpriced at current market rates.
For example, there is an old saw about bank stocks that goes something like this: buy them at 1x book value and sell them at 2x book value. Whether 1x or 2x is the right multiple is irrelevant for the purposes of this discussion. The point is that the mental model for a bank or finance company revolves around the book value of its equity.
So what mental models might apply to cryptocurrency? We debated three on Slack:
1. Purchasing Power Parity (PPP)
2. Relative Value vs. Gold
3. Supply/Demand Balance
Purchasing Power Parity
Purchasing power parity is the classic approach to assessing whether one currency is overvalued or undervalued relative to another (the key underlying assumption here is that BitCoin should be treated as a currency). PPP asserts that similar baskets of goods and services should trade for similar prices around the world. The Economist half-jokingly created The Big Mac Index in 1986 to analyze currency valuations around the world. Today The Economist has a dedicated web page devoted to Big Mac Index data, and the data has formed the basis for many books and academic studies. Here is what the Big Mac Index looks like today:
Source: The Economist
Pros: Intuitive, straightforward, much of the data is readily available. Captures the fact that BitCoin inflation should remain subdued versus fiat currencies over time (the supply of BitCoins is fixed at around 21 million whereas there is no limit on the amount of cash a government can print).
Cons: Goods and services are not priced “natively” in BitCoin. Starbucks does not say “a Grande Mocha costs $4 or 1 BTC” (indeed if that were the case BTC at $3,500 would seem wildly overvalued). This essentially blows up the PPP approach. Although personally I believe that if cryptocurrency truly goes mainstream, we will eventually get to the point where goods and services are priced natively in BTC and the PPP approach may have more analytical utility.
Relative Value vs. Gold
This was a simple thought experiment I conducted. Would I rather have an ounce of gold or 1 BitCoin? At the time I asked this question an ounce of gold was trading for about $1,300 and 1 BTC was trading for around $3,500. The intuition here is that gold and BitCoins essentially function as stores of value, where the market simply “agrees” on the value to assign each unit.
Pros: Exceptionally straightforward. Captures the notion that both gold and BitCoins have value more or less “because we agreed they have value” (if someone can explain to me why gold is considered to be a store of value, please drop me a line in the comments. Sorry gold bugs — I must confess I have never really understood why gold is so revered as a store of value).
Cons: Differences in unit measures. My comparison above makes 1 BTC look overvalued versus one ounce gold. But if you looked at the total value of the respective markets, BTC is worth an aggregate $50 billion while gold is worth an aggregate $9 trillion or so. On that basis, gold looks wildly expensive versus BTC.
We went around in circles on this for a long time. Personally, I still feel it is a useful thought experiment, though it raises hackles with others.
Supply/Demand Balance
A commodity like oil trades where supply and demand balance. On the demand side, human civilization requires a certain number of barrels of oil per day to function. This is something that can be estimated. On the supply side, it costs an exploration and production company a certain amount of money to get the oil out of the ground. So if it costs $50 to get a barrel worth of oil out of the ground, over the long term that sets a kind of floor for oil prices. Below that level, companies will not be able to cover their costs, more and more will go bankrupt and eventually the price will correct back toward an equilibrium level. This is of course a massive simplification but it illustrates the key principles.
Likewise, the BitCoin infrastructure is underpinned by the “miners” of the coins. Miners deploy the computing power that powers the network. They are incentivized to do this through the award of BTC for verifying transactions. The interesting wrinkle is that the system adjusts dynamically so that as more computing power is deployed on the network, it becomes more difficult to mine BTC (the awards get relatively smaller). At the same time, the miners’ costs rise, primarily due to ever-increasing electricity consumption. The reverse happens as computing power leaves the network (say, if unprofitable mining operations shut down). Several years ago you could mine BitCoin economically on a commercial laptop. Now profitable BitCoin mining requires significant scale and capital investment.
BitCoin’s supply side economics are relatively straightforward to understand at a high level. The demand side is more challenging. For me the most significant impediment to modeling the demand side is that the majority of BitCoin transaction activity currently appears to be speculative trading. If the data in the linked article is to be believed, less than 1% of transactions are related to actual payment processing, with exponentially higher volumes driven by trading activity. This creates some reflexivity as relates to “network fundamentals.” More trading activity -> more transactions -> implies higher demand. However, that self-reinforcing momentum can easily unwind again on the way back down. I do not have an easy answer for how to deal with this, but I have the sense that it is of critical importance.
Conclusions (Such That They Are)
If you are a BitCoin trading enthusiast, and you are still reading this, I imagine that you are thinking something along the lines of “this idiot spent 1,000 words on that!? I am no closer to understanding whether now is a good time to buy!”
To reiterate: this is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere and consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.
All useful analysis is rooted in finding the right questions to ask. Looking at a simple bank stock, for example, the right questions are along these lines: what is a fair estimate of book value per share? Is the quality of the loan book truly reflected on the balance sheet? If not, how do I adjust those numbers to more accurately reflect reality? Usually these questions will lead you to further questions centered on the breakdown of the bank’s loan book and the quality of its underwriting standards.
Similarly, the first step toward assessing whether BitCoin is overpriced or underpriced involves identifying the right questions to ask about its fundamentals.
