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Why Bitcoin Is Not A Bubble

|Includes: First Bitcoin Capital Corp. (BITCF), BTSC, COIN, GBTC, GLD, GOLDX
Summary

Popular narratives state bitcoin is in a bubble because of recent price increases

Bitcoin is a new class of asset that should be valued in alignment with how it is designed and the benefits that investors will seek

$100B valuation is far from bubble territory

There appears to be an increase in the number of news articles on bitcoin and its rapid rise in price, suggesting it is in a bubble  A rapid increase in price is not, by itself, evidence of a bubble.  There must be a valuation metric that provides the evidence of a bubble.  In the dotcom era, PE ratios skyrocketed providing the evidence of irrational exuberance.  In the era of the housing crisis, the ratio of home values to rental income and the rate of mortgage defaults were evidence of home prices reaching bubble territory with mounting risks. If bitcoin is in a bubble today, what is the convincing valuation metric that provides the evidence? 

I do not think bitcoin is in bubble territory.  I give my explanation at the end of this post, which follows from some fundamentals of bitcoin, worth summarizing below:

Extremely Limited Supply

There are just under 17 million bitcoins in circulation today.  The supply is fixed, and there will only be 21 million bitcoins mined and brought into circulation.  The last bitcoin should arrive sometime around the year 2040. While this may seem like a large number, its is actually a pretty small number for a commodity investment.  There are fewer bitcoins than millionaires in the world. There are over 40 million millionaires globally, so there are at least two millionaires for every bitcoin.  If you look at a company stock float, e.g., Apple, there are over 5 billion shares. If there were only 21M shares of Apple stock, the price would be over $42,000 per share.  My point is that bitcoins are scarce unlike many other financial assets, and very few people will ever be able to own one.

The scarcity of bitcoin is not a defect, because bitcoins can be subdivided down to a Satoshi, or 1 hundredth of 1 millionth of a bitcoin (1 Satoshi = 0.00000001 BTC). If bitcoin ever does catch on broadly, we will be talking about standard fractions of bitcoins or multiples of Satoshi's. Everyone on the planet can participate and own some portion of a bitcoin, but only a very few individuals will own a whole bitcoin.

Given the limited supply, relatively small changes in bitcoin ownership can move the price significantly. There are about 250k transactions of bitcoin per day, or about 1.5% of available coins.  This may not seem like much but it is evidence of fairly high demand. Apple stock transacts about 0.5% of float per day, which is also in pretty high demand, but only 1/3 that of bitcoin.   The daily transaction volume is increasing faster than the supply of bitcoins is growing.  Investors (or speculators) in Bitcoin ought to have a thesis for why bitcoin ownership will either grow or decline. The change in ownership is really the only driver of price, since bitcoin (like other commodities) does not generate income or dividends.

Never Been Hacked

The bitcoin network has never been hacked successfully.  This is in stark contrast to the world's banking systems (including institutions that are deemed 'too big to fail', which have probably all been hacked.  Equally concerning are the hacks to the SWIFT payment system where millions of dollars were syphoned, multiple times. The frequency of security breaches in the conventional banking system seems to be rising, with more sizable losses.  Bitcoin's blockchain technology, which processes payments in a decentralized manner, makes it extremely difficult for hackers to succeed. No one since bitcoin's launch in 2009 has figured out how to hack it, which makes bitcoin arguably the most secure financial system in the world.

It is important to distinguish bitcoin wallets and exchanges from the bitcoin network which processes transactions using the blockchain. There have been some high profile security breaches of the private companies (like Mt Gox) that offer cryptocurrency wallets and enable transactions into and out of bitcoin. When hackers cracked into these exchange it was through faulty website security, and the hackers were able to steal bitcoins. While hackers have proven they can get into some exchanges, they have never been able to alter the blockchain or any transaction processing of bitcoin.

Free from regulation

If you own bitcoin, you can be completely anonymous in the bitcoin network. You never need to share any personal information when transacting bitcoin. No person or organization can determine how much bitcoin you own or how much you are transacting.  You lose your anonymity only when you transact bitcoin into the regulated financial system, and this is purely in your control as to how and when you do it. For example, you typically lose your anonymity when you spend bitcoin at a retailer, or convert your bitcoin into a country's currency, or you store your bitcoin in a private exchange where you typically are required to provide a credit card. In contrast, if you hold your own bitcoins and private keys and you transact only through the bitcoin network, no one can tell who you are or how much bitcoin you own. This means bitcoin offers investors a way to protect wealth from taxing authorities. To think this is desirable only to criminals and the underworld is naive.  The demand is there, particularly amongst some of the richest people in the world. The swiss banking industry, which was partly built around tax shielding and protecting the identity of its clients, manages about $1 trillion in assets today. 

It's not lost on investors that most regulated financial systems, where most of their wealth is stored, are hosted by countries that are increasingly in debt.  The US is nearly $20 trillion in debt. Europe seems to be in perpetual debt crisis. China and Japan have a debt levels 2x-3x higher than GDP. At some point these debts have to be paid, probably through a combination of taxation and monetary inflation. Neither is good for investors. We learned during the financial crisis that the world's financial systems are increasingly interdependent resulting in much more correlated market movements leading to reduced diversification and higher risk. All countries were affected by the financial crisis, and investors worldwide collectively lost an unprecedented amount of wealth. At the same time, there is mounting political will to increase taxes on the richest individuals in society, and there is a long historical trend in doing it. Prominent economists, e.g., best selling book author Thomas Pickety, advocate taxing wealth in addition to taxing income. The wealth tax is advocated not so much as a means to generate tax revenue as it is to give visibility to government authorities into who owns what assets in society.  Money stored in the world's regulated financial systems is exposed to increasing levels of systemic risks, whether its from crisis or taxing authorities.  The motivation for owning bitcoin grows with this risk.

Valuing Bitcoin

Cryptocurrencies, with Bitcoin as the leader, are the only practical assets that transact in highly secure, anonymous systems that operate independently from government authority. Its practical in that its an electronic rather than physical market, its transaction costs are zero (or near zero), and its liquid.

Who is going to buy bitcoins? Well, the top 1% of world's wealthiest individuals own about 35-40% of the world's assets. They are not obtuse to the fact they constitute an extreme political minority. The top 10% of the world's richest have investable capital, and that is a large number of individuals, about three quarters of a billion people.

What percent of wealth will the world's investors want to be hold anonymously, securely, and free from a taxing authority or confiscatory government? Today, the market capitalization of bitcoin is about $100B, and the valuation of all cryptocurrencies is about $200B. The sum total of the world's wealth is over $240T, so the cryptocurrency bubble narrative is based on a concern that 0.0001% held in cryptocurrencies is dangerously high.  The world's stock market capitalization is about $20T, and cryptocurrency ownership is 0.001% of this amount. Is this excessive, and does it constitute a risk to global financial systems? You can do the same calculation using the valuation of the world's money supply and you get a similarly small figure.

Is it unreasonable to think the wealthiest in the world would squirrel away $1T in cryptocurrencies (or 0.5% of the world's wealth)? If half of that investment goes to bitcoin (the other half to other cryptocurrencies), that's about $25,000 price per bitcoin. If plausible, how long will it take to happen? Greed is a great accelerator of activity. If a growing investor base agrees bitcoin is a safe haven, it will create momentum for more investors to evaluate bitcoin, which will result in sustained upward pricing pressure. All of this will stimulate innovation, providing tools to make it easier for investors to remain anonymous while keeping their bitcoins safe, and this, in turn, will lure more investors.

Once wealth is in bitcoin, why would it exit? For sure, individual investors will cash out based on their own personal needs and timing, but what is the case of mass exodus out of bitcoin? There would have to be a superior alternative for storing value, which means it has to come down to better security, since you cannot be any more anonymous or any more tax free than bitcoin. All other cryptocurrencies use the blockchain technology, so there is parity with bitcoin, not superiority. A more secure alternative will have to be an entirely new technology using something better than blockchain. That alternative will not only have to be announced, it will have to be proven that it is more secure. As quantum computing advances, perhaps a more secure alternative will emerge, but if that happens, it will be years from now. If it does happen (whether with quantum computing or other technology), you can be pretty sure a bitcoin bubble has arrived.

Given that bitcoin is a commodity and does not generate income, there will always be a preference for investors to keep the vast majority of their wealth in income generating assets which exist in the regulated financial systems of the world. As expectations of the income in these markets goes up and down, it will have an impact on the flows in and out of bitcoin and therefore an impact the price of bitcoin. When market returns are expected to be high, investors will want a greater percentage of wealth in the market and less in bitcoin. In this sense, bitcoin can become overvalued, resulting in a price decline. We are far from seeing this dynamic, since such a miniscule percentage of wealth is in bitcoin today.

I believe the investment thesis for bitcoin starts with estimating what percent of the world's wealth will investors want to hide securely and anonymously. Take that amount and divide it by the estimated number of coins in circulation for that time period, and that is your theoretical price target for bitcoin.  When I do the calculation, I get strong buy on bitcoin.

Disclosure: I am/we are long Bitcoin.