Why Bitcoin Is The Investment Of The Decade

| About: Bitcoin Investment (GBTC)

Summary

The hype around Bitcoin is warranted.

Bitcoin cannot, and does not need to, dislodge fiat currency.

But it will benefit from transactional demand and "store of value" demand.

At current valuations, you get half a niche payment disruptor, with a gold disruptor thrown in for free.

GBTC is still a feasible short-term play on Bitcoin.

We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.

- Bill Gates

There’s been a lot of buzz around Bitcoin, partly on the back of its rapid appreciation and partly on the disruption potential of the technology itself. In this article, I’d like to firstly clarify some misconceptions surrounding Bitcoin and postulate what a fair value should be.

Misconception #1 - Bitcoin is an Unreliable Store of Value

The conventional thinking behind this misconception is that Bitcoin is too volatile, and hence it cannot truly be a store of value. A popular benchmark is oil prices and currencies for instance, which are orders of magnitude less volatile than Bitcoin.

But this line of thinking misses one key point - trust. No matter how volatile the asset, it can and will be a store of value so long as people believe it is. Take a look at gold’s annualized volatility versus Bitcoin below.

(Source: Fundstrat)

The right side of the chart somewhat validates the naysayers' point about volatility over the past couple of years. But look how far Bitcoin vol has trended down over the last three years. In fact, at certain points of time in recent history, Bitcoin was actually as volatile, if not even less so, as gold.

Now let’s turn back to when gold was freely priced, back in the ‘70s. What we see is that “early” gold’s annualized volatility was similarly high versus Bitcoin’s, yet it was used as a store of value - because people believed it was.

In this regard, gold and Bitcoin were both born out of the same fundamental distrust in the existing financial system. In the ‘70s it was the Great Inflation, and in ‘08 it was the banking system, and subsequently, centralized monetary policy decision making.

In a way, Bitcoin’s digitized, decentralized and unregulated nature speaks to the distrust in today’s financial system far better than gold. Among other things, it can help users avoid high taxes, capital controls and confiscation.

As it moves further into the mainstream and adoption increases, I suspect the substitution effect will become more prevalent, driving down demand for gold in favor of alternatives such as Bitcoin. As gold prices fall as a result of falling demand, the perception of such traditional safe havens as a store of value will begin to be questioned. This will, in turn, kick-start a network/ multiplier effect, driving safe haven flows into Bitcoin and will slowly unravel this misconception.

Misconception #2 - Bitcoin is an Unreliable Payment Method

The overarching misconception surrounding this seems to stem from the unregulated nature of Bitcoin as well as security concerns.

The Mt. Gox bankruptcy in 2014 is a case in point, illustrating the susceptibility of exchanges to convert fiat to BTC and vice-versa, and wallet software to facilitate transactions. At one point in 2013, Mt. Gox was handling over 70% of all Bitcoin transactions. But in early 2014, it filed for bankruptcy protection and announced $450 million worth of Bitcoins (BTC850k) were lost due to a “hack”.

It is important, however, not to conflate security risks stemming from the enablers (exchanges) and agents (hackers) versus the technology itself, which has thus far proven foolproof. If anything, inevitable regulation of the agents transacting Bitcoin will help improve its viability as a medium of exchange.

But it is important not to miss the forest (technology) for the trees (bad press). The strongest argument for Bitcoin’s intrinsic value is not only its ability to function as a decentralized, digitized medium of exchange, but also the safest and cheapest one.

In practice, the blockchain on which Bitcoin operates is safer than conventional payment systems. From the merchants' perspective, transactions are secure, irreversible and do not contain customer info (preventing fraud/ chargeback claims). For consumers, Bitcoin is decentralized and, therefore, cannot be manipulated by any single party.

To understand why it is the cheapest, take a look at the traditional “four party” payment system below. This system entails a bloated ecosystem consisting of: 1) the merchant, 2) consumer, 3) the card issuing firm and 4) the card network. This results in a typical cost to a US-based merchant of ~2-2.5% (including the merchant acquirer).

(Source: Goldman Sachs)

On the other hand, the decentralized nature of Bitcoin (enabled by the blockchain) eliminates the need for a central clearinghouse or financial institution to act as a third party to financial transactions. Instead, the network uses a peer-to-peer system where network users (miners) independently verify transactions and are then rewarded for their work with newly minted Bitcoins.

The effective cost of a Bitcoin transaction is thus lowered - to the tune of ~1.5% (1% versus 2.5% in the traditional “four party” model).

Misconception #3 - Bitcoin Cannot be a Currency, So it Will Fail

Conventional wisdom is that Bitcoin is a “digital currency,” and thus, its raison d'etre should be fulfilling the three core criteria every currency must fulfill: 1) store of value, 2) medium of exchange and 3) unit of account. I do agree with mainstream thinking that Bitcoin is nowhere close to becoming legal tender, although it compares very well to both fiat currency and gold.

(Source: Canaccord Genuity)

In any case, Bitcoin’s inability to become a mainstream currency is already priced into cryptocurrency valuations. Compared to traditional currency circulations, the cryptocurrency market is still small (note that cryptos have a more global reach versus USD and EUR).

Screenshot (9).png

(Source: S&P)

Here’s what investors seem to miss - Bitcoin does not need to become a currency to derive its intrinsic value. The addressable market of Bitcoin as any one of the three criteria is enough to provide major upside for investors going forward.

I reflected this using three different viewpoints culminating in the following valuation approaches.

Bitcoin Valuation #1 - Bitcoin as a Network

The first method to valuing Bitcoin looks at its value as a network. To gauge this value, we’ll need to delve into a concept called Metcalfe’s Law, which postulates that the value of a network is proportional to the square of the number of participants.

(Source: ITLaw)

The law would thus imply that Bitcoin is explained by an exponential function where a linear increase in members would entail a quadratic increase in members. Extending this law to Bitcoin’s value in practice shows that Bitcoin is linked to both volume and exponentially to the number of users.

Modeling Bitcoin using two variables - 1) unique addresses (proxy for accounts) (n^2) and 2) estimated transactions per user (proxy for usage) (linear) - helps explain 94% of the price movement.

(Source: Fundstrat)

With that in mind, tweaking the two key regression variables gives us an idea of how Bitcoin prices might trend going forward. Plugging in both a rise in unique addresses and transaction vol/user of 50% and 30% YoY respectively, in line with current run rates, gives a $5,977 target price.

Mid-Aug Value

Projected mid-2018 Value

YoY %

Unique Addresses

650,889

976,349

50

Transaction Volume per User

$4,050

$5,265

30

Implied Value

$4,300

$5,977

39

(Source: Fundstrat)

Now, I’d argue this estimate is very conservative, considering it extends the run rate for unique addresses (50%) but exponentially drops the transaction volume trajectory (30% YoY versus 2000% YoY in the prior year).

Bitcoin Valuation #2 - Bitcoin as Alt Gold

The second valuation approach pertains to Bitcoin’s appeal as a store of value.

At present, gold is perhaps the best proxy for Bitcoin’s potential total addressable market (TAM), due to its nature as the purest play on the store of value theme. For an idea of market size at stake, gold is currently the fourth-largest asset class with ~$7.5 trillion outstanding.

Screenshot (11).png

(Source: Fundstrat)

With an ~$70-80 billion market cap, Bitcoin is worth ~1% of gold holdings. Of total gold outstanding, ~17.5% is held by central banks as reserves.

Central Bank

Non-Central Bank

Gold Holdings

17.5%

82.5%

(Source: Bloomberg)

Now, what if 1% of gold holdings rotated out of gold and into Bitcoin? The answer is huge - for every 1% shift, Bitcoin would have ~99% upside. A shift solely from central bank holdings would offer 17% upside per %pt shift. This implies a potential $4,000-5,000 incremental value for every 1% pt from gold alone ($9,000-10,000 price assuming 1% substitution).

$ billion gain per %pt of gold

BTC Upside per %pt of gold

Central Bank

13.148

17.34%

Non CB

61.852

81.55%

Total

75

98.89%

(Source: Bloomberg, Author Estimates)

Bitcoin Valuation #3 - Bitcoin as an Alt Payment Method

Another approach to valuing Bitcoin is as an alternative payment method in competition with the likes of Visa (NYSE:V), MasterCard (NYSE:MA) and PayPal (NASDAQ:PYPL). In this space, it offers significant benefits over alternatives, as the current ~1% cost per transaction is far below that in online payments (3-8%) and remittance (5-10%).

Now, because Bitcoin does not generate cash flow, a commodity-like analysis of supply-demand dynamics can be employed to estimate its value as an alternative payment system.

Assuming the % of supply held for investment/dormant falls gradually at ~2% (in line with analyst estimates at Cowen) as a greater proportion of Bitcoin is used for transactions, this should bring us up to ~19.5 million available for transactions by 2025. Meanwhile, total BTC in circulation is projected according to a 4-year reward-halving schedule.

Supply

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

Total BTC in Circulation

13,125,000

14,437,500

15,750,000

16,406,250

17,062,500

17,718,750

18,375,000

18,703,125

19,031,250

19,359,375

19,687,500

20,343,750

% of total

63%

69%

75%

78%

81%

84%

88%

89%

91%

92%

94%

97%

Held for Investment or Dormat %

26%

24%

22%

20%

18%

16%

14%

12%

10%

8%

6%

4%

Held as Working Capital %

74%

76%

78%

80%

82%

84%

86%

88%

90%

92%

94%

96%

Bitcoin Available for Transactions

9712500

10972500

12285000

13125000

13991250

14883750

15802500

16458750

17128125

17810625

18506250

19530000

(Source: Blockchain.info, Author's estimates)

While supply is relatively easy to model, I have limited much of the demand for BTC to niche payment applications where Bitcoin offers significant benefits over alternatives - online payments (especially cross-border), remittance, micro payments, “banking” for the unbanked, as well as a catch-all "other" category that includes black market activity and any other future application, such as machine-to-machine (Internet of Things) and anchoring other blockchains.

Further assuming: 1) velocity levels ranging from 5.5 for unbanked and other applications (current velocity of Bitcoin) and 12 times for payments and remittance, and 2) rapidly growing share, the demand schedule is illustrated below.

Demand ($ billion)

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

Online Payments

1,500.00

1,725.00

1,983.75

2,281.31

2,623.51

3,017.04

3,379.08

3,784.57

4,238.72

4,747.36

5,317.05

5,955.09

Remittances

435.00

456.75

479.59

503.57

528.75

555.18

582.94

612.09

642.69

674.83

708.57

744.00

Micro Transactions

540.00

567.00

595.35

625.12

656.37

689.19

723.65

759.83

797.83

837.72

879.60

923.58

Unbanked

4,305.00

4,434.15

4,567.17

4,704.19

4,845.32

4,990.67

5,140.40

5,294.61

5,453.45

5,617.05

5,785.56

5,959.13

Other

1,829.00

1,883.87

1,940.39

1,998.60

2,058.56

2,120.31

2,183.92

2,249.44

2,316.92

2,386.43

2,458.02

2,531.76

(Source: Cowen Research, Author's estimates)

Matching projected supply and demand using a 30% discount rate yields ~90% upside for Bitcoin from mid-August levels of ~$4300.

BTC Price

4300

Excess Value Based on Future Demand

$3,866.87

PV $USD/BTC

$8,166.87

Discount Rate

30%

Upside

89.93%

(Source: Author's estimates)

Why the GBTC Premium is Here to Stay

One way to passively invest in Bitcoin while removing potential pain points is through the Bitcoin Investment Trust (OTCQX:GBTC). Each share of the open-ended trust represents about 1/10th of a Bitcoin, and investors must hold their shares for a one-year period before they become eligible to trade on secondary markets.

Despite its seemingly absurd 80%+ premium to NAV, GBTC may be a viable option for investors unable to purchase Bitcoin directly. Leaving aside the fact that it offsets risks surrounding where to buy Bitcoin, security and storage, legal issues, and tax ramifications, there are a few fundamental issues most investors miss when predicting the downfall of the GBTC premium.

1. Limited supply

On paper, GBTC is an “open-ended trust” that is authorized to create an unlimited number of shares in baskets of 100 shares. However, initial shares are only available via private placement to accredited investors, and shares created in this manner are subject to a one-year lockup requirement. This inherently limits the supply of shares on the secondary market and allows the market price per share to drift (at a premium or discount) from the NAV per share akin to a closed-end fund.

2. IRA demand

The huge premium reflects huge demand from non-accredited investors. A lot of GBTC demand is coming from folks with retirement accounts. GBTC allows them to put their retirement funds to work with zero tax implications, while gaining BTC exposure where they wouldn’t otherwise have.

3. There is no way to arbitrage the GBTC-BTC premium

GBTC has restricted supply, and thus, arbitraging the premium is not possible. Consensus thinking is that the difference can be arbitraged by buying more Bitcoin on the open market to back additional GBTC shares and then sell those new shares.

But GBTC is not an ETF, nor does it function like one.

Per ETF.com:

In an ETF, large premiums and discounts are arbitraged away through the creation/redemption mechanism. When a premium becomes large, authorized participants will buy up the underlying, deliver it to the ETF provider in exchange for ETF shares, and sell them for a profit, pushing the ETF market price back towards the fund's NAV.

After January 19 this year, Grayscale completely stopped issuing shares in connection with an SEC filing it made, which means what little ability to arbitrage the premium away there was before is now completely gone.

(Source: Yahoo Finance)

4. GBTC also holds Bitcoin Cash

Accounting for the fact that GBTC also holds Bitcoin Cash for every dollar of Bitcoin held, we get a more palatable premium of ~67%. While this value seems large compared to other investment vehicles, GBTC has traded at much higher premiums of up to ~186%, and has only traded at a discount for one day - the market price traded at a (0.1%) discount in October '15. As long as demand holds up and supply remains constricted, a ~67% premium does not look too lofty.

Key Risks

The key risk to buying into GBTC is further regulatory consideration for COIN or if another Bitcoin ETF comes to market and competes with the trust in its current form. Due to the relative efficiencies of an ETF structure, GBTC would likely see an exodus of assets as investors gravitate toward the superior ETF structure. You’ll notice in the chart above that the premium fell almost to parity when the Winklevoss Bitcoin Trust ETF (Pending:COIN) was under regulatory consideration in March (the SEC has also rejected one other Bitcoin ETF - the SolidX Bitcoin Trust).

With Bitcoin, the key challenge will come with scalability, as a lot of the efficiencies offered presently would be challenged as the number of transactions increase. Meanwhile, security and regulatory concerns are risks as well, but I’d be inclined to view any dips as buying opportunities unless they relate directly to the technology itself.

Conclusion

Overall, Bitcoin offers significant opportunity as an investment to either fulfill a market niche with applicability in the areas of general merchant payments, international payments and micropayments or to supplant gold as a store of value, or both.

As I see it, buying into Bitcoin today gives you half an alternative payment system, with a gold disruptor thrown in for free. Regardless of your view on Bitcoin, valuations even at these levels are extremely attractive.

Balanced against this potential opportunity for Bitcoin are several issues or risks. Some of these are likely to be permanent, while other issues may eventually be addressed (regulation, security, scalability, etc.).

At its core, however, Bitcoin is a fundamentally superior alternative to legacy payment systems, as well as a compelling alternative to gold. As mainstream adoption increases and existing misconceptions clear, we should see huge upside to Bitcoin long term, while GBTC’s premium should persist in the short term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Bitcoin.

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