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The true intrinsic value of most of crypto currencies is uneasy to determine, including for Bitcoin for which the number of ‘units’ to be created is totally transparent and perfectly known (as it is planed by the protocol) and the speculative value is essential for explaining the price formation. Therefore we are going to devote 2 successive articles to ask the principles for trying to get a more ‘objective’ pricing for Bitcoin.
Bitcoin has created a new business model that is clearly different from the others (traditional ones). Indeed, no used classical concepts for valuating Bitcoin can’t be applied. Before starting to talk about the first valuation basic theory for Bitcoin, let see why Bitcoin can be considered as a currency.
Looking at the 3 classical functions of a currency (unit of account, medium of payments and value storage ) :
1- Bitcoin is a unit of account as it can be used to measure the value of a good.
2- Bitcoin is also used as a medium of payment to exchange value. This is clearly what is occurring between the network’s members during transactions....
3- Bitcoin is a store of value, thanks to its technology and advanced cryptography that allow digital storing. The limited number of bitcoins to be created is a mechanism that makes Bitcoin an asset comparable to precious metals in a digital form.
However, Bitcoin is not officially listed and is not regulated. Lastly and thanks to the blockchain, Bitcoin is managed in a decentralized environment under a permanent consensus of its users while fiat currencies are under the control and the centralization of central banks. Then, the nature of Bitcoin and the commonly used fiat currencies is radically different.
It is time now to examine the most shared theoritical basis for assessing Bitcoin. What it is called the network value.
Let’s take the assumption, based on the observation, that the Bitcoin network is getting an effective service to its members. It’s about the decentralized and autonomous network, built around all computers that have uploaded the protocol. What is the main goal for this network ?
It is to solve the specific issue of transfering value on Internet (on this basis, Bitcoin is only considered as a medium of payment).
This is one of the major bring of the blockchain technology. In contrary to the traditional money transfers processes that need a trusted third party, the Bitcoin decentralized network and the protocol strength allow perfect and safety ‘peer to peer’ trades.
Therefore, it is this network value that is pushed forward for trying to estimate the current and future values of Bitcoin.
NVT ratio (Network Value to Transaction)
In this formula,
The network value is approximated by the Bitcoin Market Capitalization (equivalent to the number of outstanding Bitcoins (supply) multiplied by the last spot price) and
The daily on-chain transactions value is equivalent to the traded volumes over the last 24hours*
This means that the NVT ratio relies on the idea that we can use the network floating money as a proxy for valuating the network. Given the daily transaction value (traded volumes over the last 24h) and the Bitcoin price volatility, the NVT ratio can be estimated by a moving average calculation of the two parameters (smoothing the datas) . So this can be written as follows : .
NVT= Daily NV/90MA DTV
NVT=Daily average capitalization / DTV Moving average (over 90 days)
As the « data wizard » Willy Woo ** said, (Willy Woo has initiated the concept) , « When Bitcoin`s NVT is high, it indicates that its network valuation is outstripping the value being transmitted on its payment network, this can happen when the network is in high growth and investors are valuing it as a high return investment, or alternatively when the price is in an unsustainable bubble».
Briefly said, higher is the ratio and higher Bitcoin price is speculative, meaning that a market correction will take place soon, and vice versa.
Chart of the Bitcoin spot price (yellow) and NVT ratio (brown) since 2009
NVT line indicates an under/over estimation relative ( comparison with the 2 dotted lines) to the network value / Daily transactions value
Going more deeply in the concept of Network Value, Robet Metcalfe has defined the NVT ratio on the basis of the ‘ METCALFE’ law.
This is a theoritical and empirical law that defines the network effect.
The law defines the network utility as proportional to the square number of users (under conditions of homogeneity of the network nodes).
To valuate a network, this is defined straightforward as follows :
NV (network value)= C*n^2
(n being the network nodes number)
Following the rule of [(n*(n-1))/2] as the number of relationships within a network with n nodes
n=2 => 1 relation
n=5 => 10 relations
n=12 => 66 relations etc….
So, the relative value of the network, calculated by the Metcalfe formula (NVM) equals the logarithmic division of the current network value and the Metcalfe network value , and is :
NVM=logNV(current)-logNV(Metcalfe) or = log(NVcurrent/NVMetcalfe)
And corresponds to a value between -1 et +1.
Metcalfe law simply says that higher is the number of a network users and higher the network value is, on the basis of a quadratic growth function.
Criticizing but without challenging the strong growth function of a network value by Metcalfe , mathematician Andrew Odlyzko puts in doubt the quadratic growth of a network utility , as the Metcalfe definition. He thinks that the increase of the value is not so strong, involving that estimates of numerous networks are overestimating their values
For him, the growth function is a multiple of n*(logn) but not a multiple of n^ 2
As a conclusion, Bitcoin valuation based on networks utility seems to be a key approach, knowing that, on the one hand, Metcalfe law probably gives over estimates but on the other that Odlysko function gives under estimates.
About the editor…
A passion : Economics, behavioural finance and emerging digital assets
Yves started his career in the asset management in 1986 where he worked at different positions as manager of equity funds and diversified funds. at Crédit Commercial de France and later, at Barclays group in Paris. In 1998, he took the lead of equity funds and diversified funds, then of the whole fund management business at the French team of the Dutch Robeco group before joining Natixis Asset Management in 2012 as Director of the Equity Investment business unit. Yves left Natixis AM in 2018 to start as an independant player for professional investors and corporates (advisor and fund raiser).
He likes to engages in sports that test his endurance like running and swimming, Yves is also fascinated by social sciences, and more specifically by history and economics. But this is the economics mechanisms behavioural aspect and the markets behavioural analysis that are a constant source of thought and discussion. Since few years, the blockchain issue and emergence of crypto assets is a new field of passion and opportunities for him.
Financial markets and asset management
Financial markets and asset management