Summary Last week Bitcoin crashed as the crypto exchange FTX ran out of money and stopped processing people's withdrawals. On the day of the crash, I predicted there'd be a near term reversal, but I also called Bitcoin unsuitable for fundamental investors. Bitcoin doesn't generate cash flows, therefore it is impossible to value it. It does have two factors that could be called fundamentals--the supply cap and transactional use--but the data on the latter is hard to find. Bitcoin has practical benefits to political dissidents and people facing persecution. For investors, it's a gamble, but there are people who can benefit from owning it. Bitcoin ( BTC-USD ) crashed last week, as the crypto exchange FTX (FTT-USD) went broke and stopped processing withdrawals. The move was consistent with what was observed in past crypto exchange bankruptcies. Bitcoin’s price fell 43% in the first quarter of 2014, when the crypto exchange Mt. Gox collapsed ; similar price movements were observed during the Celsius (CEL-USD) bankruptcy . When I saw Bitcoin crash in the wake of FTX’s collapse, I Tweeted out that a near term reversal was likely, but that fundamental investors should stay away from Bitcoin anyway. Ultimately, the short term reversal did occur , but it reversed to the downside again later, when the Binance (BNB-USD) deal fell through. Why do I think fundamentals-oriented investors should stay away from Bitcoin, despite having predicted an upside reversal? It has to do with the factors that drive the supply and demand for Bitcoin. BTC does not generate cash flows, release earnings, or have a balance sheet. Some of the companies associated with Bitcoin have these things, but they aren’t the only factors driving BTC’s price. Primarily, the demand for BTC comes from a) speculation; b) transactional use. Unfortunately, data on the latter is nearly impossible to obtain. Sources of Bitcoin Demand The speculative demand for Bitcoin is well known. The coin is by far the most popular cryptocurrency, promoted by business celebrities like Elon Musk, Jack Dorsey and Cathie Wood. There are entire internet communities dedicated to talking about nothing but Bitcoin , and they have millions of users. As you might expect, there is a lot of money invested into speculating on Bitcoin’s price. The problem with speculative demand for anything is that it tends to go away. If an investor buys something hoping it will go up in the short term, they may get frustrated and sell when it instead goes down. An MIT study found that panic selling was particularly likely to occur during very large market movements. Speculative demand can evaporate for any number of reasons. It has a particularly strong tendency to dissipate in periods of monetary tightening. When interest rates go up, it becomes more expensive to borrow funds with which to speculate. This makes speculation seem “less logical” in periods of rising interest rates–like the one we’re in now. The transactional demand for Bitcoin is hard to gauge. Bitcoin’s blockchain only records exchanges of Bitcoin, it doesn’t tell you whether Bitcoin was spent on a good or sold by a trader. For this reason, it’s difficult to estimate how much Bitcoin is being spent on goods and services. A study conducted by Chainalysis found that merchants accounted for between 0.5% and 1% of all Bitcoin transactions in various countries sampled. Another study once pegged the percentage at 33%, although the link to that study (on NewsBTC) no longer works. We may never know what percentage of all Bitcoin is being used for real world transactions. Adding up merchants’ income statements provides a floor estimate, but it doesn’t capture transactions by informal businesses, who are among Bitcoin’s biggest users. Black market vendors and non-public businesses don’t release public financial statements, so we can only “see” the Bitcoin transactions being reported by public corporations, and companies that choose to make voluntary disclosures for whatever reason. In some countries, the government may release reports on how much Bitcoin revenue small businesses reported, but it’s not standard practice. The Bank of Canada, for example, has released reports on cryptocurrency , but they contain little information on transactional vs speculative use. The report just linked contains some conceptual material on Bitcoin’s transactional use, but does not include the important statistic, which is “Bitcoin spent on goods and services as a percentage of all Bitcoins exchanged.” The fact that Chainalysis’ “0.5% to 1%” estimate is only a floor might appear bullish. If we know that 1% of Bitcoin transactions are merchants’ reported amounts, then we can safely assume that the total amount (including black market and non-registered businesses) is higher. Unfortunately, the really critical issue with this floor estimate is that it underscores the difficulty in getting the true statistic. The seemingly ‘encouraging’ nature of the estimate being low, is overpowered by the unavailability of the real statistic. To do a valuation, you need hard data, and a lot of the required data for a Bitcoin valuation isn’t available. How a Fundamentals Based Valuation of Bitcoin Might Work A fundamentals based valuation of Bitcoin might work if it were possible to access transaction data and separate it from volume data. If we had the latter, we could compute a “volume to transactions ratio” which would provide a quick and easy measure of how much Bitcoin trading is used for actual purchases. Bitcoin does not generate cash flows that accrue to the holder, but it does have utility: it can be used to buy things, even if you’re unable to open a bank account. In this sense, we could think of Bitcoin as having a convenience yield , an inherent benefit of holding an asset directly. People who invest in commodities long term do not have the benefit of cash flow analysis; however, they can reasonably posit that demand for a commodity will continue to exist if the commodity has something inherently desirable about it. Bitcoin’s ability to be used in transactions, even by people without bank accounts, may be such an “inherently desirable feature.” There are many people in the world who can’t access bank accounts. Most obviously, criminals cannot access them; people accused of money laundering often have their bank accounts closed. A cynic might say, “see, the only non-speculative use case for Bitcoin is its use by criminals,” but this is missing the bigger picture. Not everybody who is treated as a criminal is actually a criminal. Sometimes, governments bring down the power of the state on political dissidents, and this use of State power often includes closing peoples’ bank accounts. The Human Rights Foundation lists at least Four different countries that close the bank accounts of political dissidents. There was one instance where a protest movement in one such country used Bitcoin to get around bank closures. The protesters in this country successfully raised $2 million in Bitcoin donations after having their bank accounts closed. To avoid getting political, I will leave the name of the country and its alleged dictator out of the article, but you can find details about the situation in this Forbes piece . The big takeaway is that Bitcoin isn’t only useful to criminals. It’s useful to anybody who has attracted the ire of governments or banks, whether they are criminals or not. Given that banks are centrally controlled organizations, it’s reasonable to assume that they will continue closing the accounts of unpopular people. Banks have the power to close peoples’ accounts, and they are run by human beings. It is therefore quite possible for them to unfairly close peoples’ accounts, human beings being as fallible as they are. Bitcoin provides a way for people shut out of the banking system to send and receive money. Therefore, it’s likely that some transactional Bitcoin use will persist. So, a fundamental analysis of Bitcoin is theoretically possible. We could treat Bitcoin’s independence of the banking system as a convenience yield, and analyze it like a commodity. Much like oil traders bet on higher oil prices when OPEC cuts output, we could bet on higher Bitcoin prices when de-banking incidents increase in major countries. Unfortunately, the data on the transactional use of Bitcoin is not obtainable. When a catalyst occurs that seems favourable to Bitcoin, you can reasonably assume its price will go up, but you can’t arrive at a specific fair value estimate. It’s for this reason that Bitcoin’s price movements are similar to coin flipping. Absent very obvious catalysts, they are fundamentally random, driven by factors that can’t be perceived. The Bottom Line The bottom line about Bitcoin is that it has some non-zero value, but it isn’t knowable. The most ardent Bitcoin bears, who see the value of BTC going to zero, ignore the real world uses that Bitcoin has. Most Bitcoin trading is speculative, but there are cases when it proves useful, most notably in countries where human rights are weakening. The situations in which Bitcoin is needed are not everyday occurrences, they are more like emergencies, but they do happen. For this reason, I do not think that Bitcoin is going to zero. I think the fair value of Bitcoin is lower than the current price, but well above $0. The problem is finding out what that fair value really is. Data on transactional use of Bitcoin is hard to find. It may be essentially impossible to find: the Bitcoin ledger doesn’t record what items Bitcoins were spent on, it only records exchanges. If a person selling things for Bitcoin doesn’t tell the government about it, then their transactional use of Bitcoin will never be recorded in a form that’s useful to statisticians. All we really know about Bitcoin is the supply cap and the trading volume, and the volume that comes from speculation can’t be assumed to last: bubbles historically tend to burst. So, Bitcoin is not a suitable asset for fundamentals-oriented investors. It lacks the data transparency required to calculate its fair value. If you’re part of a social movement, or a programmer working on blockchain technology, you may derive practical benefits from holding Bitcoin. If you’re a value investor, look elsewhere.
