What is the real market value of cryptocurrencies like Bitcoin?
The numbers used to explain the performance of Bitcoin and other cryptocurrencies are less meaningful than most assume.
Cryptocurrencies are not exactly like stocks, and cryptocurrency exchanges do not work like traditional securities markets. As a result, many cryptoasset investment strategies based on conventional definitions of market share, capitalization, volatility, and trading volume are deeply flawed. Misleading numbers mean that cryptocurrency valuation and adoption are poorly understood, which creates a false perception by the media and investors about cryptocurrencies such as Bitcoin.
One implication of this analysis is that Bitcoin has captured the vast majority of the long-term upside in the cryptocurrency market despite having about half the nominal market share.
Most cryptocurrencies and crypto exchanges manipulate numbers in ways that publicly traded companies and traditional exchanges like NASDAQ and NYSE wouldn’t dream of. As a result, “market capitalization” and “trading volume” are at best rough and relative measures of cryptocurrency adoption. Even when intentional manipulation is not involved, cryptoasset markets fundamentally just do not function like securities markets. It’s important to understand these differences to asses the state of cryptocurrency and cryptoasset adoption.
Let’s look at three important differences between how cryptocurrencies and traditional securities markets work:
1. Cryptocurrency Valuation Comes Almost Entirely from Speculation on Future Adoption
The first major difference between Bitcoin and securities is that the vast majority of the market value of Bitcoin comes from the speculation on future adoption. Today, Bitcoin is being used as practical money and a store of value in countries by a few million users.
Bitcoin is already useful and superior to government-issued money in countries suffering from hyperinflation such as Venezuela and Zimbabwe. Bitcoin is also used to bypass currency controls in China and India. Even in these cases, Bitcoin competes with other less-than-legal alternatives due to the lack of ecosystem adoption and government prohibitions. In developed countries, Bitcoin is only used by its most devoted followers, as the traditional financial system is still far easier to use.
However, the number of current Bitcoin use cases is vastly overshadowed by expectations that it will supplement assets such as precious metals and fiat currencies such as the dollar in the future. In short, the majority of Bitcoin’s value derives from speculation on the future adoption of Bitcoin as a practical payment network.
The problem is that investors have very little evidence to predict the future value of Bitcoin. The scope of possibilities includes Bitcoin failing entirely, becoming a small but viable alternative in specific use cases, supplementing gold and dollars as a viable substitute, or becoming the world’s new reserve currency.
One of the signs of this lack of certainty is the percentage of Bitcoin traded daily. Bitcoin’s daily volume—as of April 2020—is worth $36 billion out of a $126 billion valuation, or about 10 percent. Apple’s volume is $6.2 billion out of a $1.17 trillion valuation—or about 0.5 percent. Bitcoin is much more volatile than stocks—it has more than ten times the volatility of a typical security, and virtually all other non-pegged cryptocurrencies are far more volatile than Bitcoin. People hold Apple stock because it has a track record of successful products and loyal customers whereas most Bitcoin holders own to speculate on future adoption and price growth.
2. Cryptocurrency Markets Have Thin Order Books Compared to Traditional Securities Exchanges
Another important difference between crypto and traditional markets is the size of their order books. A traditional stock like Apple is transacted on a single exchange, with tens of millions of stocks available to trade daily from many thousands of buyers and sellers. As a result, securities markets like NYSE and NASDAQ have minimal slippage—they can efficiently process large orders and the current market price.
Bitcoin owners, on the other hand, keep most of their assets in offline wallets, with only a small percentage on vulnerable markets (which are often hacked, defrauded, etc). As a result, a million-dollar Bitcoin order might have a major effect on a given exchange, with a ripple effect on other exchanges. For example, the sale of Bitcoins formerly held by Mt Gox caused dramatic price drops, even though only 1 percent of the outstanding Bitcoins were up for sale. This effect is far more pronounced with other cryptocurrencies, which explains why $500 billion was wiped out during 2018.
Here is a hypothetical example:
Suppose that I create a new “Vex Coin” with an initial quantity of one million coins. I pay “ABC Exchange” 10 Bitcoin to list my count and get my friend Joe to buy one “Vex Coin” for $100 worth of Bitcoin. My brand new coin is now worth $100 million, which at time of writing would put it at #50 in the CoinMarketCap list of all cryptocurrencies. I just created a $100 million market cap with a $100 investment! Now, suppose I issue nine million additional coins. Vex Coin now has a $1 billion valuation! A report by the Blockchain Transparency Institute claims that 70 of the top 100 exchanges are faking volume numbers, either by lying outright or wash trading.
Wash trading strategies include free trades, paying customers a small percentage to place trades, or secretly running bots on their own exchange masquerading as real customers. These “market maker bots” are a very common way to launch a new exchange and create fake volume in order to drive up rankings of both exchanges and coins.
The relatively greater difficulty in faking Bitcoin prices and volume is why I believe that Bitcoin has captured nearly all the value in the cryptocurrency space, despite the fact that its nominal share of cryptoasset market capital has been as low as 30 percent in 2018. In fact, I believe that the alignment of Bitcoin’s (or whatever coin emerges as the leader) nominal market share to its true market value will be one of the key signs of maturation in the cryptoasset space.
3. The Valuation of Cryptoassets Is Backed by Relatively Little Real-World Investment
The third important difference between crypto and traditional securities is the ratio of investment cost to market cap. The total value of a corporation’s stock is based on investors belief in its profit-making potential in the future. This profit-making ability is enabled by the money invested to buy its stock.
Take a company like Apple, with a market cap of $1.17 trillion. The majority of that valuation represents created wealth—that is, Apple’s stock offering was for a far smaller amount than its current valuation. Nevertheless, investors have given Apple hundreds of billions to fund its growth over the last several decades by buying its stock. In recent years, IPOs have averaged a 21 percent return over the last few years, which is a healthy but modest return on investment. Compare this to Bitcoin:
Bitcoin is an open network, not a private entity, so its market cap is the total value of all Bitcoins at the current market price, and the investment cost is the total investment in the Bitcoin ecosystem. Currently (April 2020), sites that track the “market cap” of cryptocurrencies like coinmarketcap.com report a market capitalization for Bitcoin of $126 billion.
We have no way to track the total amount of fiat currency (i.e. dollars) spent to buy that Bitcoin, but we know exactly how much profit (in Bitcoin) miners have made from mining Bitcoin. Bitcoin mining is a competitive market process, and profit margins are thin or non-existent, so we can assume that most minted Bitcoins were traded for fiat (dollars) to pay for expenses, such as buying mining hardware, and electricity. If Bitcoin miners sold Bitcoin on the same day they mined it to pay for operating expenses, they would have earned $5.3 billion. This is 4 percent of Bitcoin’s market cap.
Mining is only a part of the Bitcoin ecosystem—exchanges like Kraken and Coinbase, and Gemini and merchant services such as Bitpay have invested in the Bitcoin ecosystem, but these are not large companies. In short, Bitcoin’s value on paper is backed by relatively little investment in its ecosystem.
This is not a bad thing if you believe in the world-changing potential of cryptocurrencies. However, it is important to understand the relationship of a cryptocurrency to the resources it has at its disposal. For example, Litecoin, with a valuation of nearly $2 billion dollars has two full-time developers.
Bitcoin Is Not Vaporware but Most Other Cryptocurrencies Are
There are hundreds of developers working on blockchain ecosystem development at companies such as Blockstream, Bitpay, Coinbase, Gemini, Satoshi Labs, and others. However, Apple has 132,000 employees and revenue of $266 billion to back up its trillion-dollar market cap. The market cap of all cryptocurrencies is about $200 billion, but I would guess there are about 100 mostly volunteer Bitcoin Core contributors and a few thousand people employed in Bitcoin ecosystem startups.
Bitcoin is the best-case scenario. The majority of cryptocurrencies are vaporware, with virtually no technical teams. Bitcoin uses a proof-of-work coin-creation model, whereas the majority of coins (such as ERC20 coins) use a proof-of-stake model, which does not use mining, or involves minimal mining. Their mining costs are zero, though they might still have R&D, personnel, marketing costs, etc. Most cryptocurrencies are get-rich-quick schemes, with little vision, technical innovation, or market adoption.
A typical coin founder team contracts out the technical work of creating a new coin and has no technical staff or ongoing development ecosystem. Their market cap is based on inflated trade volumes and their coin minting strategy is designed solely to prop up the price long enough for all the founders to realize their profits before the price collapses.
To take a typical example, look up a cryptocurrencies’ GitHub account, which records the contributions that developers are making to it. Here is Bitcoin Gold. There is typically a burst of activity around the launch date, followed by a lot of marketing hype and little or no technical work. Most cryptocurrencies have no paid developers or open-source developer communities.
Corporations can spend money on technical innovation, and I suspect that many cryptocurrency investors assume that the cryptocurrency valuations reflect an ability to deliver on their promise. The reality is that exchange manipulation and inflated volume numbers mean that real demand for most cryptocurrencies is very low. The founding teams cannot fund development by selling their closely-held stash because the coin's price would collapse before more than a tiny fraction could be sold.
As a result, most projects have only a few people, and no ongoing technical development. Based on my review of GitHub open source code contributions to top cryptocurrencies, the majority of projects have zero dedicated blockchain architects, and in fact, zero full-time contributors of any kind. Once you get past the top currencies such as Bitcoin, Ethereum, Stellar, etc., most coins have few developers and little activity.
The above criticism may seem like I’m bearish on cryptocurrencies, but that’s not my intention. I want to help separate the hype and speculation around cryptocurrencies from the underlying fundamentals. The primary drivers of cryptocurrency price stability will be adoption for non-speculative purposes and an understanding of the fundamentals driving Bitcoin adoption. We need to understand the maturation of the blockchain ecosystem in order to have a measured and calm response to currency volatility and retain a positive outlook on the future.
The Three Stages of Crypto Ecosystem Maturation
Cryptocurrency development will likely proceed in three stages: discovery, infrastructure, and adoption. The discovery stage was from 2008-2013 when the community identified the basic concepts and tools of cryptocurrencies. The infrastructure stage started around the time that people realized the need to build alternatives to the failed Mt Gox exchange in 2013. The current infrastructure phase involves the creation of an ecosystem that provides foolproof custody solutions for consumers, trusted intermediaries, and a diverse network of vendors who accept Bitcoin. Once a mature infrastructure is in place for cryptocurrencies, the stage will be set for adoption.
Unfortunately, real innovations in cryptocurrency space are being hidden behind the veil of speculative hype. For example, over the last year, more than half of Bitcoin users adopted a new Segwit address format that increases security and transaction capacity. Lightning Network reached $6.5 million Bitcoin capacity and 12,000 Nodes. This is a second-layer Bitcoin network that has enough capacity for every single human being to use his own Bitcoin wallet. (Bitcoin Cash has a competing vision of scaling to “50 transactions/day for 10 billion humans” on-chain.)
A meaningful assessment of Bitcoin’s value lies in understanding the ecosystem’s readiness for institutional and consumer adoption. The ecosystem is still extremely immature, and the tools are nowhere near ready for a typical consumer, but that landscape is rapidly changing and setting the stage for mass consumer adoption.
A version of this article originally appeared at Vellum Capital.