In late-2017 I wrote a series of posts pointing out the extent to which Bitcoin was highly overvalued and that it was likely to fall back in 2018, which it duly did. But if we thought the digital currency was overvalued three years ago at a rate below 20,000 against the dollar, what should we make of a rate which this week spiked above 57,000?
The boom in context
We should not forget that this is not the first surge in the price of Bitcoin – indeed there have been five documented instances of a bubble prior to the latest one with each boom followed by a bust. Bitcoin started trading in April 2011 at parity to the dollar but by June it was trading at $32 – a gain of 3100% within just three months – although it subsequently collapsed back to $2 by November. In 2012 and 2013, there were three further boom and bust cycles with the final one resulting in Bitcoin breaking through $1000 for the first time. The inevitable collapse that followed meant that it did not break through the $1000 barrier again until early-2017. That year proved to be a watershed for the original cryptocurrency which started the year below $1000 but at one point broke through $19,000 to put the concept of digital currencies firmly into the public consciousness. Arguably the success of 2017 was one of the key factors prompting central banks to take the concept of digital currencies more seriously and their programmes in this regard have since come on by leaps and bounds.
The most recent Bitcoin surge really only got going last October and broke through its previous high just before Christmas. It today stands at 4.5 times the previous peak in December 2017. A number of explanations have been put forward for the surge. One argument that does not hold water is that it is being driven by the search for an inflation hedge on fears that the huge stimulus put in place to combat the Covid pandemic will ultimately spill over into prices. After all gold, which is a more traditional inflation hedge, is down 13% from its peak last summer.
A more plausible explanation is that Bitcoin is finding wider acceptance across the institutional investor universe. For example BNY Mellon recently announcing that it plans to hold Bitcoin and other cryptocurrencies on behalf of its clients, putting it on a par with traditional assets such as US Treasury bonds and equities. Earlier this month, Tesla announced that it has bought $1.5 billion worth of Bitcoin for “more flexibility to further diversify and maximize returns on our cash” and plans to accept payments in Bitcoin “subject to applicable laws and initially on a limited basis.” It is hard to avoid the feeling that there is a momentum effect behind Bitcoin with supply creating its own demand in a modern-day version of Say’s Law. This does not necessarily mean that it is a good investment. After all, in the seventeenth century there was a huge demand for tulips which pushed the price of bulbs to extraordinarily high levels before they crashed back to earth.
More cons than pros
That there is a role for digital currencies is undeniable but I continue to harbour major doubts about the suitability of Bitcoin to meet the claims that its proponents make for it. One claim is that since supply of the digital currency is limited to 21 million units (of which 18.6 million have already been “mined”) its relative scarcity means it has attractive properties as a store of value. But the huge price volatility recorded over recent years undermines claims that Bitcoin acts as a form of digital gold (it may do so in future but that time is not now). I also continue to harbour doubts about the security aspects of Bitcoin, which I have outlined in detail in previous posts. A monetary system residing on computer servers which do not enjoy the backing of a state guarantee is only one hack away from disaster, and as quantum computers become a more realistic prospect it is not inconceivable that they could eventually be used to gain control of the blockchain upon which the currency depends.
If Bitcoin cannot be trusted as a store of value, does it have a future as a medium of exchange? The arguments here are more favourable. But there is a trust issue: After all, it is associated with transactions of dubious provenance when parties wish to remain anonymous (e.g. on the dark web) which may limit its appeal. It is unlikely that most people would want to be paid in Bitcoin, preferring instead the comfort of currency units that they are familiar with. In the words of Janet Yellen, Bitcoin is also an “inefficient” way to conduct monetary transactions largely because “the amount of energy consumed in those transactions is staggering.” The amount of computing power required to “mine” Bitcoin implies that if it were a country it would be in the world’s top 30 electricity consumers, with the University of Cambridge Electricity Consumption Index suggesting that it now consumes more power than Argentina on an annual basis (chart 2).
On the basis of what goes up must come down, it is likely that the huge surge we have seen in Bitcoin prices over recent months will be reversed. Recent experience suggests that Bitcoin has followed a series of Gartner Hype Cycles in which the price surges as initial hype builds, followed by a collapse as disappointment sets in but then recovers slowly as investors climb the “slope of enlightenment” (chart 3). It is unlikely that the current cycle will prove to be any different.
Given the massive volatility in Bitcoin of late, it is worth asking whether it is possible to determine an equilibrium price which in turn might give us some steer on where the price goes from here. Based on US data, around 0.2% of total consumer expenditure is financed using Bitcoin[1]. On the basis that consumer spending accounts for an average of 62% of GDP on a global basis and that the IMF forecasts world GDP this year will hit $91 trillion, this implies global consumer spending of $56 trillion. Further assuming that 0.2% of this is accounted for by Bitcoin, this suggests that the total value of Bitcoin for transactions purposes is around $113 billion (note that the market cap of Bitcoin is around $927bn – around 8 times this figure).
Since Bitcoin was originally designed as a peer-to-peer online payment system (see the original Nakamoto paper) I would argue that the value for transaction purposes gives us a fair steer on the current equilibrium value. This turns out to be a figure in the region of $6100 (derived as the transactions market value ($113 billion) divided by the number of Bitcoin in existence (18.6 million)). This does not mean that Bitcoin will necessarily revert to this level. For one thing, the equilibrium value will rise as the level of nominal spending rises. It will also rise if the share of spending accounted for by Bitcoin increases. Current elevated levels can be viewed as an attempt by a forward-looking market to guess future fair value levels.
To give some scenarios of how fair value might evolve, I used estimates based on IMF forecasts to derive global consumer spending out to 2025 and assume that it grows at a rate of 5% per annum thereafter. The supply of Bitcoin is assumed to expand by just over 6% by 2050. If Bitcoin continues to account for only 0.2% of all transactions, the fair value rises steadily to reach around $24,000 by 2050 (chart 4) which is still only half current levels. If, however, we assume that the share of transactions financed by the digital currency increases to 0.5% of the total, the fair value rises to around $57,000 on a 30-year horizon.
This is an attempt to demonstrate that if demand for Bitcoin for transactions purposes increases whilst its supply is fixed in the long-run, the price should inevitably rise. This does not necessarily mean that it will. The whole cryptocurrency edifice may come crashing down if confidence is shaken for some reason (e.g. fraud or the security underpinning it is compromised by advances in computing). It may also be supplanted by central bank controlled cryptocurrencies. But much as I believe Bitcoin is overvalued, if you believe that it is here to stay maybe current elevated price levels may not look out of place in the longer term.
No comments:
Post a Comment