bitcoin – Bubble or Beginning? Both! Part II

When I last wrote on bitcoin, the price was somewhere in the vicinity of $4,500. Bitcoin’s price continues to defy gravity. Not just defy gravity, the price has gone up vertically! It has more than tripled in three months since I last wrote. I don’t know of any other asset/currency that has moved up in value so fast….ever.
Is this a bubble? Even if one considers the possibility that this is not a bubble, one is left with the unanswered question what could have possibly changed over the last year (1500%+), month (100%+), or week (40%+) to have warranted such drastic changes in value.
There can be a handful of potential reasons:

  1. there has been a rapid adoption of the bitcoin “currency”
  2. it is in the “design” of Bitcoin system
  3. we are witnessing mass speculation on the bitcoin “asset”

I think we can safely agree the explanation cannot be rapidly growing adoption. To justify a $15,000 value for a bitcoin, assuming it has the same velocity as a US dollar, it would need to represent 6% of all transactions. That is far from true today: even the lead users might not use bitcoin that frequently.
Of course, as discussed in a previous blog, the velocity of bitcoin is far slower and it only represents a much smaller share of transactions. This “slow velocity” or constrained supply of bitcoin is what I believe is responsible for the rapid price increases. Moreover, demand from ICOs and speculators is squeezing that supply.
To cross check this understanding and the design of the network, I researched bitcoin mining economics, and here is what I found. Most of this data comes from Blockchain.infoand is readily available to anyone to replicate these calculations.

  1. Bitcoin is a very poor payment system. The cost of running the Bitcoin network is ~$6.5M/day and the transaction fee covers only $3M/day. The fee doesn’t cover the cost of running the network despite the fee per transaction already being an insane $50+/transaction. Per some observers, the cost per transaction on the bitcoin network is 1000x more expensive vs Visa/Mastercard network.
  2. Mining today (at $15,000 per coin) is very profitable, but only because of the mining reward. The reward for confirming a block for the network is 12.5 bitcoins. This represents today 80% of the revenue that the network makes. With this reward there is a strong incentive to mine coins (75%+ gross margin), without this reward, there is no incentive to mine.
  3. And in case you wonder who pays for this mining reward, it is everyone who owns a bitcoin. Mining reward (today) corresponds to an annual 3.5% tax on all bitcoin owners.
  4. But the long term supply of bitcoin is limited to 21M coins, and the system is designed such that the mining reward for solving the block should half every four years.
  5. Here in lies the the circularity. There are only two ways to keep the mining network running economically
  • Raising the transaction fee further from $50/transaction: That will kill any hope for wider adoption of the bitcoin. An even higher transaction fee per block, which may or may not get spread over more than the 3000 transactions that are within a block today (depends on real world adoption). Energy (or silicon costs) are unlikely to half every four years, as the cryptography problem keeps getting harder over time in order to keep the time to solve a block around 10mins (to offset more and more hash power coming from more miners on the network).
  • An increasing bitcoin price to pay for the networks energy/silicon bill: If energy costs were to stay where they are (which they wont given the every increasing complexity of the cryptography problem to keep time to solve a block at 10 mins) and halving of mining reward every 4 years, that would require the bitcoin price (in steady state) to double every four years. That is almost 20% p.a. increase designed in….. forever!

While trying to further cross check the order of magnitude of these numbers, I came across a paper by Harald Vranken (where he looks at environmental sustainability of bitcoins) which came to similar conclusions but in Feb 2017… bitcoin price has of course changed quite a bit (10x) since then.
Having discussed 1 and 2… we are left with 3. And while it is not a conclusion supported with unquestionable evidence, it is a conclusion from deduction (and a couple of anecdotes). The design of bitcoin network would support “only” a 20% per annum increase in its value. With bitcoins having gained 15x value over the course of 2017, it seems likely the reason for this rapid rise is the result of mass speculation. While I don’t have evidence, I have anecdotes of people either inquiring about investing in bitcoins or being already invested in it. These acquaintances have no background in finance or in investing. Typically, that is a sign of an end of a bull run!
I stand by the not-so-headline making conclusion I drew last time – it is both a beginning and a bubble! While there is value in bitcoin, I don’t know why it should be $15,000! With bitcoin now trading on future contracts, I don’t know which way we are headed next.
What do you think? Please do share your thoughts.
Disclaimer: This is a discussion of broad technology trends and not investment advice. Any investment decisions made are your own and at your own risk. All views, opinions, and statements are my own.
Exhibit 1: The Bitcoin network’s Daily P&L (as of Dec 9, 2017) 

Exhibit 2: Harald’s view of Daily Revenue/Costs of Bitcoin mining (as of Feb 2017). The price of bitcoin has gone up >10x since then…. 

Exhibit 3: Detailed Calculations and sources for Daily Revenues and Costs for the Bitcoin network

bitcoin: Bubble or Beginning? Both!

This blog first appeared on the here.
There is no denying that the recent cryptocurrency boom resembles the one we saw among dotcom companies in the late 1990s. Celebrities then were taking equity stakes in start-ups in exchange for promoting them, and we are seeing a similar trend today[i].
In the late 1990s, over a period of just four months, the Nasdaq Index almost doubled, while over a similar period this year, the value of bitcoin shot up fivefold.
Exhibit 1: Larger than dotcom boom?

How has this happened?

Andy Kessler[ii] at the Wall Street Journal recently poured cold water on bitcoin’s appreciation by suggesting that the currency is possibly ten times overpriced. While I appreciate the simplicity of the analysis and the quick conclusion that it brings us to, I think it is also worth questioning the underlying assumption. That assumption is that bitcoin’s worth is in its utility as a payment service, like Visa or Mastercard (or ‘software as a service’ as the author calls it). Of course, with that logic, the author’s conclusion of its value around $300 is fair (in fact bitcoin’s not that good as a payment service…it takes 10 minutes to complete a block transaction).
But I disagree that that is all there is to bitcoin. It is not just an application, it is an alternative currency. Its value, thus, is in its usage. The more people use it, the more real and valuable it becomes.
I have written previously on what is special about bitcoin. To recap the most important (soft) feature of bitcoin:

Finally, a currency must have some value associated with it. In the case of normal bank notes, the central bank underwrites that value and users trust the central bank (or the government). Somehow bitcoin has gained trust of its users as a store of value and as more people use it, the more that trust grows. In a way, a currency system is the world’s oldest network effects model – a currency has value, because its users agree there is value in it . From that perspective, bitcoin isn’t a fad anymore; its users are willing to trade one bitcoin for almost USD 735.

If bitcoin is a replacement for fiat currency, then the comparison to a Visa/MasterCard payment system is not relevant. Instead, bitcoin should be compared to a fiat currency, where one could argue, trust is in short supply these days. In contrast, the supply of bitcoins is slowing and will saturate at 21 million coins. Then, the value of a bitcoin is determined by the demand for bitcoin-financed transactions. (In comparison, the monetary base for US dollar has grown about 4x over the past 10 years. See here.)

Initial coin offerings (ICOs)

The proliferation of ICOs as a funding mechanism for new ideas created immense demand for bitcoin/ethereum/other cryptocurrencies. ICOs raise money in the form of bitcoin/ethereum tokens (hence generating demand) and in turn issue their own tokens, representing digital equity in the particular ICO.
This is what has boosted the values of cryptocurrencies. If usage or adoption drives the value of a currency, the cryptocurrency has invented its own economy to drive that usage.
Exhibit 2: Illustrative diagram: ICO’s creating demand for cryptocurrencies and boosting their price.

Looking at the rapid rise in the price of cryptocurrencies and the rapid rise in ICO offerings, I would assume causation here. By the end of August 2017, 89 ICO coin sales worth $1.1 billion had been conducted year-to-date, ten times as much as in all of 2016[iii],[iv]. Of this amount, about $500 million was raised in June alone[v]. Participation by “investors” in these ICOs is funded by bitcoin/ether/other cryptocurrencies.
If that is the incremental demand for these currencies, which led to the price rises, it would suggest that the “velocity” of cryptocurrencies is very poor compared to a US dollar (about 25-60 times slower). As such, in a very perverse way, the poor transactional characteristics of cryptocurrencies are most likely[vi] responsible for the rise in their value. By creating a very tight supply of cryptocurrency, even a mere $0.5bn/month demand (for ICO) has been enough to create sky rocketing valuations.
Exhibit 3: Why is bitcoin trading so high?

Note: I have assumed the transactions supported by USD are roughly the size of US GDP ($20T). 

Is it different this time?

To be fair, the demand for an ICO (and hence bitcoin/ethereum) should reflect the quality of the businesses they are funding. I am sure there are some gems that will come out of this mania, just like during the internet boom, but unfortunately most businesses appear to be just riding a euphoric wave. Another mind boggling statistic is that ICO funding took over traditional venture capital funding in mid-2017.
The conclusion is a mixed one: While this is unlikely to end well, bitcoin has established itself as an alternative currency.
Disclaimer: This is a discussion of broad technology trends and not investment advice. Any investment decisions made are your own and at your own risk.
All views, opinions, and statements are my own.
[ii] I am by no means undermining his analysis or the person. While I agree with the conclusion (bitcoins are overpriced, most likely), I just do not agree with the comparison with payment networks.
[vi] I welcome other explanations but I haven’t come across a better one (yet). This is the best I have (for now) come up with.