The global cryptocurrency sphere has taken a slight breather from an incredible rally from 18B total coin market cap at the start of 2017 to about 100B as of this writing, with Bitcoin (Pending:COIN) (BTC) and Ethereum (ETH) trading at $2303 and $318 respectively. In this article I will talk about the seemingly irrational exuberance in this new “asset class”, and discuss some of the arguments from both sides.
For those new to the cryptocurrency world, here is a quick summary of some important terms:
Cryptocurrency – A digital medium of exchange designed for peer-to-peer and payment transactions that utilizes blockchain technology to very and record transactions in a public distributed ledger.
Blockchain – Think about how transactions have been traditionally recorded, you have one book or excel sheet usually stored in one location. Sure you might have backups, but considering that there is generally one master copy, risks relating to tempering are high. With blockchain, you have multiple master copies, all stored in different locations. For each transaction on the blockchain, the respective transaction will have to be validated (proof-of-work) before confirmation and updating. Once recorded, the data in any given block cannot be altered retroactively without the alteration of all subsequent blocks and the collusion of the network. This decentralized system creates a highly secure platform and is very attractive to many organizations.
Currently, because of the huge increase in both the value and volume of transactions, the size limit of the individual block in the blockchain has caused certain issues with regards to transaction and validation time in bitcoin. Unfortunately, because of its decentralized system and large size, decreasing transaction timing has been somewhat of a challenge for bitcoin – especially with two very large and different opposing views on how this is to be achieved. Although I won’t go into too much details of the politics behind the two schools of thought, this has – to a lesser degree now – been a thorn in the price of bitcoin.
On 25 November 2016, Ernst and Young, released a press release stating that all Swiss employees will be provided digital wallets and bitcoin will be accepted as payments for its consultation services. Additionally, a bitcoin ATM will be installed in their offices in Switzerland. Many other large institutions and governments of developed countries have made progress in this digital transformation, be it in bitcoin or private blockchain development. And since April 1, 2017, bitcoin has been accepted as a legal payment method in Japan (not a joke). Clearly, the dawning of a cryptocurrency and blockchain age is very real. The question on many investors’ minds is, is its valuation justified?
A commonly repeated argument against bitcoin’s consideration as a currency is its high volatility. Consequently, such volatility is not absent from existing “currencies”. Mostly due to the fall in oil prices, the Venezuelan economy has been thrown into turmoil, with experts expecting inflation to go as high as 1600%. Unlike the Bolivar, a government can’t just print more Bitcoin. There’s no central agency regulating Bitcoin, allowing free market mechanisms to take hold. While the value of Bitcoin can (and does) change quite dramatically, the shifts aren’t as violent as the devaluation of Bolivar. In such situations, the true strength of bitcoin emerges. Unlike traditional currencies, you do not need to have a bank account or an intermediary to send/receive bitcoin. All you need is internet connection. Humanitarians can donate Bitcoin to those in need, who can then use Bitcoin to purchase goods through online retailers. Because of this, many Venezuelans are turning to Bitcoin as an alternative.
Which price is right?
With conventional valuation methods, it is impossible to determine a true price for bitcoin. It cannot be valued like a traditional currency because there are no economic nor interest rate factors in play. There are neither cash flows from which you can discount, nor EV/EBITDA-like margins you can compare against peers. I won’t even attempt to value it because any attempt would require too many assumptions and price derived would be nonsensical. That said, it is evident through the examples discussed that there is real substantial value here.
To give some context let’s take a look at one of the oldest asset class ever to exist: Gold
Even with gold, ex Federal Reserve Chairmen, Alan Greenspan and Ben Bernanke couldn’t agree on whether gold is considered a currency. As you can see from the historical price chart of gold above, it too experienced large swings in prices – particularly the 7x increase from about 2000-2011 and subsequent correction.
True, the increase in market cap for bitcoin is dramatically greater than that of gold, but the point is that the definition of “currency” is not as straight forward as many people think. So don’t be too quick to discount bitcoin as a form of currency with real value.
Potential for hacks
Wherever there is money to be made, there will always be the good guys who try to make it legally and ethically, and the bad guys who try to take as much as they can get away with. Yes, because it is on a digital platform, you experience the risk of an online attack that might completely deplete your wallet of its coins – as compared to if you had kept it as cash under your mattress. Just as robbers will continue to attempt to rob banks, the risk of a hack will always be present. Fortunately, the same way banks can protect themselves from such an event, there are also ways to protect your digital wallet.
With over 700 digital currencies in existence, by transitive properties from bitcoin, does it also mean that they all have real value? The answer is no. Just like how there were numerous internet companies going IPO in the late 90s, many of these “coins” are worthless. The second largest coin by market cap, Ethereum , has also gained significant exposure and coverage, which is reflected in the price. But how does ETH compare to BTC?
Unlike BTC which has a limit of 21 million bitcoins, there is no cap to ETH. There is a steady state at which new ETH is being created, and while limited, it is susceptible to the same inflationary risks as would a currency controlled by a central government; Except in this case, a 23 year old, Vitalik Buterin. While there is no denying what this man has accomplished in his young age, his position as the founder of ETH introduces a huge risk in its lack of decentralization. He has a very strong influence over everything that happens with ETH, which goes against one of the key ideas behind cryptocurrency.
A part of the value case of ETH over BTC are its “smart contracts”, which allows companies/projects to raise funds easily on its platform. It is common knowledge to ETH holders that 30 large organizations, known as the Enterprise Ethereum Alliance, which includes names like J.P. Morgan, and Microsoft, “use” ETH. Actually, what the alliance is utilizing are customized private versions of the decentralized computing network behind ETH, and incidentally, have zero exposure to the price swings or value of the currency. This does not necessarily mean that the platform has no value, but therein lies a common misconception and perhaps unseen risk to current/potential investors.
Ethereum Classic (ETC)
Ethereum Classic came into existence as a result of the decentralized autonomous organization (DAO) hard-fork. The DAO, a set of smart contracts developed on the platform, was subjected to a spectacular exploit in June 2016 where USD$50M in ETH was claimed by an anonymous entity. The fork served to isolate the compromised system resulting from the exploit. People who held ETH from before the DAO hard fork have both a balance of ETC and an equal amount of ETH. Exchanges that held customer funds in Ethereum also held in their control a proportional quantity of ETC after the hard fork but may have lost significant amounts due to the lack of replay protection that was not programmed in the DAO Hard Fork code released by the Ethereum Foundation and exchanges lack of knowledge of how to separate ETC from ETH and secure it. Subsequently, ETH was forked twice more in response to other attacks. While the effects of the other two hard-forks were less significant than the first, trades are usually halted in the event of a hard-fork, posing huge risks to holders of ETH. Imagine half of your coins being worth significantly less due to a hard fork.
Despite starting off the article putting forth a case for BTC, I strongly believe that the cryptocurrency sphere is currently in a bubble. Greed is rampant in this realm, where new investors are throwing money at questionable coins hoping either to make a quick profit from flipping the initial coin offering (NYSE:ICO), or for it to become the next BTC or ETH.
Another interesting thing that piqued my interest while doing research for this article is Waves Platform, which also benefited from the recent surge of money into cryptocurrency. It attempts to incorporate the benefits of a decentralized exchange and smart contracts, with a strong focus on auditability, ease of use and mass adoption. On the surface it looks to be able to perform the same functions as ETH and more without many of the risks involved. Given the weakness in cryptocurrency right now, I might initiate a position in this.
At these levels, it is likely that the prices continue to increase as more people learn about cryptocurrency and experience the “fear of missing out”. On the other side, you have many people looking at the increasing number of ICOs and thinking, “Why aren’t I doing one?” There is a lot of hot money flowing into cryptocurrencies right now, and can move out equally as quickly. When that happens, prices will come crashing down. BTC with a current dominance of 39.5% of the total market capitalization is positioned to benefit from that crash and subsequent consolidation. Which will create a more sustainable price level that will broaden the use cases of BTC.
Traders and investors in this field are advised to be extremely cautious when participating in lesser reputable offerings or buying into coins with little to no practical mass-adopting functions.
Disclosure: I am/we are long COIN.
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 may increase my position in bitcoin and initiate a position in Waves due to current market weakness.