Bitcoin pricing (1) and network value

Difficulty of the article:

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.

Network valuations

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

or

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.