Bitcoin Valuation Job I: The Incorrect Answers

The rising of Bitcoin (and other crypto-currencies) appears that it volition cause got a negative cyberspace outcome for most law-abiding citizens, but it has provided us alongside a rather wonderful pedagogy opportunity. It underlines the weaknesses of existing analytical techniques. (I discussed Bitcoin inwards a previous article, but I used it to select a sideswipe at DSGE models, as well as I didn't bother giving the right answer.)

Due to article length, this article volition hash out wrong valuation techniques. Part II volition give the right methodology.... 

My Key Theoretical Assumption: There is No Bitcoin Economy

I do non concur myself out equally an proficient on Bitcoin, as well as so I desire to brand clear that the next supposition is a approximate on my part, based on my scanning diverse discussions of the crypto-currency. The supposition is that at that topographic point are almost no long-term commercial contracts that are denominated inwards Bitcoin. Any quoted prices for goods as well as services seen for Bitcoin are essentially prices laid inwards about other currency, as well as translated into Bitcoin at about telephone commutation rate. Since Bitcoin is a purely online currency, such a translation is a relatively lilliputian affair.

Equivalently, this agency that nosotros cannot purchase goods as well as services at relatively gummy prices inwards Bitcoin terms. I tin flame top away to the shop as well as cause got a pretty goodness catch what groceries volition cost, fifty-fifty inwards during inflationary periods (I grew upwards inwards the 1970s).

It should live noted I am ignoring prices for other crypto-currencies. Based on descriptions that I cause got seen, Bitcoin is the "senior currency" amid crypto-currencies, as well as so other cryptos may live quoted inwards Bitcoin terms. However, whatsoever stability inwards cross-rates betwixt crypto-currencies does non thing for the cross-rate versus the fiat currencies, which is what I am interested inwards analysing.

One instance that comes upwards for a pure Bitcoin transaction is ransomware. Hackers seize command of about computer, as well as demand a ransom inwards Bitcoin inwards lodge to unlock it. It mightiness look that the amount of Bitcoin demanded is arbitrary, as well as mightiness look sticky. However, at that topographic point is withal a hit of plausibility for ransomware demands, expressed inwards fiat currency. If individual seized command of a household's figurer as well as demanded a ransom that is equivalent to $10,000,000, it is most probable that the demand would live ignored, as well as the identify volition only purchase a novel computer. Going the other way, it appears unlikely that people volition commit (what I assume is) a felony to gain $1.

However, if at that topographic point developed a network of firms as well as workers who laid contracts inwards Bitcoin terms, it would create a truthful Bitcoin economy, as well as it could live valued using purchasing powerfulness parity. Purchasing powerfulness parity only gives a unsmooth catch of valuation, but fifty-fifty so, fifty-fifty sticking inside an lodge of magnitude of fair value would greatly cut back volatility.

Failed Technique: Transaction Demand

One possible technique is to assume that transaction demand tin flame pivot downwards the price. Find the publish of transactions, multiply it yesteryear about magic parameter, as well as you lot teach fair value for Bitcoin.

Considering that most transactions inwards Bitcoin look to live speculative transactions to purchase the currency, that implies that fair value rises the to a greater extent than speculative activity occurs! If i were to assume model-consistent expectations, it seems real hard to consider that whatsoever finite publish is the fair value.

Based on the yesteryear behavior of the Monetarist-inclined, i could imagine attempts to "correct" the "money stock" numbers so that the money demand model gives the right answer. For example, stripping out speculative transactions. However, since transactions are anonymous, at that topographic point is no obvious way that could live done.

In whatsoever event, the technique is tautological. We cause got no way of inferring the demand piece of work for Bitcoin, as well as so nosotros would only terminate upwards setting the parameter to jibe observed Bitcoin prices. The fair value of Bitcoin ends upwards equalling the observed marketplace price, which is non giving us a lot of information.

Failed Technique: Supply as well as Demand Curves

The outset basic employment for using classic supply-and-demand curves is that it is unclear what existent Blue Planet information the "quantity" inwards them corresponds to. If nosotros follow the analogy to monetary economics, it is the stock of Bitcoin.

However, inwards monetary models (include stock-flow consistent models), the fundamental dorsum tin flame purchase or sell Treasury bills to adapt the render of money. In Bitcoin, at that topographic point stock of coins is essentially fixed. (It is fixed inwards betwixt the "mining of coins," spell mining only slow adds coins towards the theoretical maximum. At best, all miners tin flame do is adapt the stair of mining.)

Since quantity render is largely fixed, all the supply-demand plication formalism tells us that the observed marketplace cost is where the fixed quantity hits the demand curve. The volatility of Bitcoin prices implies that the demand plication is jumping all over the place.

We could examine to adjusting the stock of Bitcoin inwards about fashion to create an "effective supply" measure, but that would in all probability only plow into an practice inwards information mining.

John Cochrane's Rational Expectations Valuation

Professor Brad DeLong has a non real flattering description of a John Cochrane article on whether Bitcoin is inwards a bubble. Technically, I call back John Cochrane's logic is valid -- inside the odd Blue Planet of mainstream economical logic.

I would wildly paraphrase Professor Cochrane's logic equally follows. (I must emphasise that I cause got completely made upwards the wording here, inwards lodge to utilization to a greater extent than familiar terminology.)

• We assume that the Blue Planet is modelled yesteryear a full general equilibrium model, as well as prices are laid yesteryear rational expectations.
• Bitcoin prices are inwards fact, prices.
• Therefore, the cost of Bitcoin is laid yesteryear agents using rational expectations, as well as thus the agents (and the price) are rational.

Sure that sounds ridiculous. The employment (based on my terminology) is the utilization of the intelligence rational. It has a technical pregnant inwards finance as well as economics, but it also has a mutual linguistic communication meaning. We tend to associate "irrational" alongside "crazy," so that nosotros call back that if prices are laid yesteryear rational expectations, the investors are non crazy.

If nosotros replaced "rational expectations" alongside a to a greater extent than neutral "model-consistent expectations," nosotros tin flame instantly consider the employment alongside Cochrane's argument. He has a lot of hand-waving, but non an actual model. (As I hash out later, invoking volatility does non cutting the mustard.)

The Nice Fat Zero Option

At about point, it volition live real like shooting fish in a barrel to value Bitcoin. Once all the servers top away dark, all the records volition effectively cease to exist. It volition live literally impossible to purchase or sell Bitcoin, as well as so it would cause got no value. The inquiry is timing.

• An optimist would say that the servers volition only live stopped yesteryear about cosmological catastrophe. Perhaps Bitcoin volition cause got taken off to top away the galactic crypto-currency before then!
• A pessimist mightiness struggle that authorities intervention/an angry mob alongside pitchforks/hacking could terminate the era of Bitcoin any infinitesimal now.

The null valuation is mesmerising (even John Cochrane discusses it), but I call back nosotros cannot teach likewise distracted yesteryear it (unless you lot cause got about argue to position a describe of piece of work solid timeline on the termination date). We tin flame brand similar arguments close fiat currency as well as non-dividend paying equities, as well as yet they cause got value. Also, nosotros utilization infinite horizon discounting inwards dividend discount models, as well as for valuing consols as well as preferred shares. Unless nosotros tin flame pivot downwards the termination date, the convention is to assume that the hereafter is shrouded inwards uncertainty, as well as brand an supposition that the safety volition live a going concern for whatsoever finite horizon.

Obviously, whatsoever discounted cash flow analysis should contain the probability of termination, but the outcome is highly sensitive to the assumed timeline.

Can We Do a Non-Trivial Cash Flow Valuation?

One may instantly annotation that it is possible to give a definitive Bitcoin valuation using discounted cash flows: i Bitcoin (instrument) has the Net Present Value (NPV) of i Bitcoin (unit of account). This human relationship holds yesteryear definition. (It is painful to consider how it could live anything else. This is less truthful of other currencies, where nosotros tin flame cause got multiple "monetary" instruments that tin flame conceivably merchandise away from par.)

However, nobody cares close the NPV measured inwards Bitcoin, they desire it measured inwards about (fiat) currency. I volition assume that the fiat currency is USA dollars.

Furthermore, for this article, I am assuming that nosotros are attempting to do the valuation solely using marginal arguments. That is, nosotros are using the same form of valuation techniques that are used inwards fiscal theory: nosotros are attempting to value Bitcoin based solely on the behavior of i unit of measurement of the instrument, as well as nosotros are non taking into describe of piece of work organisation human relationship the stock of the instrument. (As an sharp reader may guess, this supposition needs to live relaxed when nosotros are doing the right valuation technique, which is the dependent champaign of the adjacent article.)

As an instrument, Bitcoin is designed to never make USA dollar cash flows. So nosotros cannot apply whatsoever off-the-shelf valuation tricks. Instead, nosotros require to regain away of pinning downwards a hereafter price, as well as so discount it to a acquaint value.

If nosotros had a credible political party that stated a willingness to purchase large amounts of Bitcoin at a sure as shooting price, that mightiness create lower bound for the price. For example, if the Fed announced that it volition purchase whatsoever Bitcoin offered to it on Jan 1, 2019 at $100,000 per Bitcoin, that would presumably live plenty for people to assume that the hereafter value is $100,000. However, this is only a lower bound. If the Fed announced that it would purchase all Bitcoin offered to it adjacent calendar week at $1 per Bitcoin, it is probable that nobody would select them upwards on the offering (and the marketplace cost would stay higher upwards $1).

The "credibility" of the buyer also matters. I could offering to purchase one-billionth of a Bitcoin for $1 -- that is, valuing i Bitcoin at $1 billion. However, nobody sensible thinks that an offering to purchase $1 worth of Bitcoin volition motility its cost yesteryear that amount.

In whatsoever event, at that topographic point are no such fixed offers to purchase Bitcoin around. And despite John Cochrane's assumptions, the illicit utilization of Bitcoin is non plenty to create a fixed hereafter price. For anyone who is using Bitcoin to transact, as well as non equally a shop of value, the USA dollar-Bitcoin telephone commutation charge per unit of measurement is largely a slice of trivia. As I discussed earlier, Bitcoin prices look to live only fiat currency (e.g., USA dollar) prices translated into Bitcoin. So long equally the "market makers" cause got a sufficient stock of Bitcoin, they tin flame back upwards the same flow inwards USA dollar terms across a huge hit of Bitcoin prices.

(My notion of marketplace makers hither are holders of Bitcoin who are willing to purchase as well as sell inwards the exchanges inwards a way that allows render as well as demand to meet, as well as they presumably human activity inwards a way to assist stabilise the telephone commutation rate. Of course, they are in all probability non people alongside "market maker" on their describe of piece of work organisation cards, but are investors that wishing to merchandise the swings inwards Bitcoin.)

If nosotros only brand upwards a hereafter cost for the telephone commutation rate, nosotros are exclusively reliant on the Greater Fool Theory. For example, nosotros could assume that individual volition pay $1 1000000 adjacent twelvemonth for a Bitcoin, as well as so nosotros are in all probability buying at a cost lower than that (modulo the extremely depression nominal discount rate). We could examine throwing inwards premia to describe of piece of work organisation human relationship for volatility (or other effects), but that is only a distraction. The effects of volatility as well as so forth would only outcome inwards a pct discount/premium over a raw valuation, so if nosotros double the assumed hereafter price, nosotros double the calculated fair value.

(One could examine to utilization the Greater Fool Theory to struggle that the fair value of Bitcoin is infinite. Since at that topographic point are no obvious upper limits to the valuation if nosotros bound ourselves to marginal arguments, as well as everyone knows it, nosotros should ever live able to regain a Greater Fool willing to pay to a greater extent than than whatsoever arbitrary price. This evidently does non piece of work when nosotros facial expression at the right valuation technique.)

Almost a Solution: Commodity Arbitrage

If about credible entity offered to sell or purchase a commodity at a fixed Bitcoin price, nosotros could so utilization commodity marketplace arbitrage to teach a unsmooth catch for fair value. For example, if firms started pricing Western Canada Select (a degree of heavy unsmooth oil from the tar sands) inwards Bitcoin, unloose energy marketplace traders would so live able to compare its cost to other grades of crude, as well as so create upwards one's hear what their relative attractiveness is.

However, my opening supposition (that at that topographic point was no Bitcoin-denominated legitimate industry) precludes this option. However, it should live clear that if Bitcoin were acceptable to commodity producers, Bitcoin could so prepare a valuation anchor.

Almost Solution: Energy Cost of Mining

Unless the Bitcoin miners managed to wangle contracts denominated inwards Bitcoin, their energy-intensive activities are denominated inwards a fiat currency. If the spot cost of Bitcoin is much higher than the expected cost of discovering i coin, so they cause got an incentive to ramp upwards mining activities.

However, this linkage is extremely weak. In add-on to getting novel coins, miners earn Bitcoin based on transaction fees. Even if the expected cost of mining a novel money is extremely high relative to the spot price, they tin flame pay for their activities yesteryear raising transaction fees. (This is how the organisation is supposed to last in i lawsuit the difficulty of regain becomes extremely high equally the publish of coins closes inwards on the maximum.)

Meanwhile, Bitcoin mining is ridiculously energy-intensive, as well as so it is non possible to convey novel capacity online real quickly.

Finally, fifty-fifty if the regain of novel coins is stopped, that does nix to eliminate whatsoever overhang of holders that mightiness desire to sell.

Concluding Remarks

The bit component of this analysis volition drib the supposition that nosotros tin flame cost Bitcoin at the margin, as well as nosotros tin flame so come upwards up alongside a way to call back close valuation.

This serial ended upwards beingness split into 3 articles.

• Part II(a)
• Part II(b)

Disclaimer: No, I don't ain whatsoever crypto-currency, either direct or inwards about derivative form.

(c) Brian Romanchuk 2018