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Between Sky And Earth - A New Approach To Bitcoin Valuation

|Includes: Winklevoss Bitcoin Trust ETF (COIN)

Alan Greenspan and the Silicon Valley couldn't disagree more. The former FED chairman called Bitcoin (BITCN) a bubble with no intrinsic value while Chris Dixon from Andreessen Horowitz called it a "technological breakthrough" and the "first plausible protocol for an economic protocol for the Internet". The reality will be in between, but where?

Trust is the core of Bitcoin's value

Buying Bitcoin is essentially trusting that it can later be exchanged for another currency or for goods and services. Trust in this context has two dimensions: It's trusting that there will be other parties accepting/buying Bitcoin at a later point and that Bitcoin will not lose it's value in the meanwhile. The level of trust determines the feasible use cases:

  1. A criminal user of Bitcoin requires almost no trust. The user is willing to leave his counterparty with a profit in order to do illicit transfers such as avoiding capital controls in China or money laundering. Given the profit opportunity and anonymity, counterparties will exist, and the criminal user worries little about Bitcoin volatility.
  2. A transactional user of Bitcoin requires short-term trust in its acceptance and stability. The user has a tolerance for Bitcoin volatility up to the cost of alternative transaction channels such as Western Union, Paypal or debit cards. The user also needs wide Bitcoin acceptance by corporations.
  3. An investment user of Bitcoin requires long-term trust in its acceptance and stability. The user either seeks the value storage function like gold or the speculative function of risky assets. In any case, the user seeks a constant or increasing value of Bitcoin in the long-term.

The main enabler for Bitcoin to be a transactional or investment currency is low volatility, around 1% per month - lower than the transaction cost of alternative channels and comparable to the volatility of well-established currencies.

Bitcoin's structural weaknesses prevent low volatility

Bitcoin enthusiasts regularly cite its limited supply to be the enabler of low volatility. Indeed, Bitcoin has no central bank that can drive volatility by printing money, like many central banks historically did. However, two of Bitcoin's main features, its anonymity and its P2P structure, will prevent it from becoming a low volatility currency.

Bitcoin's most resilient users (lowest level of trust needed) are criminal users. The traditional instruments of central regulation and oversight (e.g., Anti-Money Laundering laws, or also the Chinese capital controls) cannot be implemented in Bitcoin due to its P2P structure and anonymity. Any user can have his Bitcoins on his computer like cash (no Know-Your-Customer required) and transfers are not subject to any central clearance or limitations.

With a deepening market, Bitcoin will attract more criminal users and therefore the attention of regulators, like other digital currencies did before. Since no rules can be implemented into the Bitcoin system, action by governments will be radical and limiting the use of Bitcoin. Governments took first actions in China, Thailand and Europe. While governments may not be able to wipe out Bitcoin, they can destabilize Bitcoin significantly and therefore increase Bitcoin's volatility, and they can limit the legal acceptance of Bitcoin by corporations.

Bitcoin's inability for central regulation also means that it is vulnerable for market fallacies such price manipulation, driving volatility further.

Bitcoin will survive as a currency for pirates

Having the deepest market of all crypto-currencies and with its resilient P2P structure, Bitcoin has good chances to become the currency of choice of criminals and pirates. Volatility will remain high and even pirates will not hold it for prolonged periods. This means that Bitcoin will become a high velocity currency. The fastest digital transaction currencies such as M-Pesa or formerly E-Gold change hands at more than 100x per year whereas a the USD as a reserve currency only turns at a velocity of around 2x (measured by M2).

For Bitcoin, I estimate that a velocity of 15-25 is realistic, accounting for pirates holding balances, lengthier payout procedures, speculators and "lost" Bitcoins that cannot be recovered due to lost keys. Currently, Bitcoin velocity is around 4x. I expect Bitcoin to accelerate with increasing awareness that Bitcoin will not reach the threshold to become a low volatility currency.

Bitcoin valuation model at $300-600

The IMF estimates that the total amount of illicit financial flows is between $500bn and $1trn per year. As a pirate currency, Bitcoin will capture a part of this market. Current daily average volumes indicate that Bitcoin now captures 3-4% with its run-rate volume of $32bn per year, although still including significant speculative activity. In the long-run, I estimate that Bitcoin could grab 10-20% of the market of illicit financial flows and therefore turn over $75-150bn per year. Applying a velocity of 20x, the resulting valuation per Bitcoin is $300-600. At a yearly volume of $75bn and a velocity of 20x, Bitcoin will have a market cap of $3.75bn, divided by 12.2m Bitcoins outstanding (as of Jan 2014) gives a value of $307.

Sensitivity table for Bitcoin valuation
(Sensitivity table of Bitcoin valuation in $)

Having derived a likely scenario from Bitcoin's structural features and the stakeholders, we have arrived at a more balanced valuation between sky-high valuations of over $100,000 and the down-to-earth skeptics who see a bubble bursting.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.