Bitcoin is basically a coin flip

Bitcoin (BTC-USD) crashed last week, when crypto exchange FTX (FTT-USD) crashed and stopped processing withdrawals. The move was consistent with what was observed in previous crypto exchange failures. Bitcoin’s price fell 43% in first quarter of 2014, when the crypto exchange Mt. Gox collapsed; similar price movements were observed during Celsius (CEL-USD) bankruptcy.

When I saw Bitcoin crash in the wake of FTX’s collapse, I tweeted that a near-term reversal was likely, but that fundamental investors should stay away from Bitcoin regardless. Ultimately, the short-term reversal happened, but it turned to the downside again later, when the Binance (BNB-USD) deal fell through.

Why do I think fundamental investors should stay away from Bitcoin, despite predicting an upside?

It has to do with the factors that drive the supply and demand of 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 are not 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 almost impossible to obtain.

Sources of Demand for Bitcoin

The speculative demand for Bitcoin is well known. The coin is by far the most popular cryptocurrency, promoted by business celebrities such as 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, a lot of money is invested in speculating on Bitcoin’s price.

The problem with speculative demand for anything is that it tends to disappear. If an investor buys something hoping it will go up in the short term, they may get frustrated and sell when it goes down instead. An MIT study found that panic selling was particularly likely to occur during very large market movements.

Speculative demand can disappear for a number of reasons. It has a particularly strong tendency to disappear during periods of monetary austerity. When interest rates rise, it becomes more expensive to borrow funds with which you can speculate. This makes speculation seem “less logical” in periods of rising interest rates – such as the one we are in now.

The transaction demand for Bitcoin is difficult to measure. Bitcoin’s blockchain only records the exchange of Bitcoin, it does not tell you if the Bitcoin was spent on an item or sold by a trader. For this reason, it is difficult to estimate how much Bitcoin is spent on goods and services. A study by Chainalysis found that merchants accounted for between 0.5% and 1% of all Bitcoin transactions in various countries sampled. Another study once put 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 used for real-world transactions. Adding up merchants’ profit and loss accounts provides a floor estimate, but it does not capture transactions from informal businesses, which are among Bitcoin’s biggest users. Black market vendors and non-public businesses do not release public accounts, so we can only “see” the Bitcoin transactions reported by public companies, 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 this is not standard practice. The Bank of Canada, for example, has released reports on cryptocurrency, but they contain little information on transactional versus speculative use. The report just linked contains some conceptual material about 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 may seem bullish. If we know that 1% of Bitcoin transactions are merchants’ reported amount, we can safely assume that the total amount (including black market and unregistered businesses) is higher. Unfortunately, the really critical problem with this floor estimate is that it emphasizes the difficulty of getting the true statistic. The apparently “encouraging” nature of the estimate being low is overwhelmed by the unavailability of the real statistics. To make a valuation you need hard data, and much of the necessary data for a Bitcoin value is not available.

How a fundamental valuation of Bitcoin might work

A fundamental valuation of Bitcoin could work if it were possible to access transaction data and separate it from volume data. If we had the latter, we could calculate a “volume to transaction ratio” that would provide a quick and easy measure of how much Bitcoin trading is used for actual purchases. Bitcoin does not generate cash flows accruing to the holder, but it has utility: it can be used to buy things, even if you are unable to open a bank account. In this sense, we can think of Bitcoin as having a convenience return, an inherent advantage of holding an asset directly. People who invest in commodities for the long term do not have the benefit of cash flow analysis; however, they can reasonably suggest that demand for a good will continue to exist if the good has something inherently desirable about it. Bitcoin’s ability to be used in transactions, even by people without bank accounts, may be one such “inherently desirable feature.”

There are many people in the world who do not have access to 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 the use by criminals,” but this is missing the bigger picture. Not everyone who is treated as a criminal is actually a criminal. Governments sometimes subvert state power over political dissidents, and this use of state power often includes closing people’s bank accounts. The Human Rights Foundation lists at least four different countries that close the bank accounts of political dissidents. There was one case where a protest movement in such a country used Bitcoin to circumvent bank closures. The protesters in this country collected $2 million in Bitcoin donations after closing their bank accounts. 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 article.

The big takeaway is that Bitcoin isn’t just useful for criminals. It is useful for anyone who has attracted the wrath of governments or banks, whether they are criminals or not. Given that the banks are centrally controlled organizations, it is reasonable to assume that they will continue to close the accounts of unpopular people. Banks have the power to close people’s accounts and they are run by people. It is therefore entirely possible for them to unfairly close people’s accounts, humans being as fallible as they are. Bitcoin provides a way for people locked out of the banking system to send and receive money. Therefore, some transactional Bitcoin use is likely to persist.

So a fundamental analysis of Bitcoin is theoretically possible. We can treat Bitcoin’s independence from the banking system as a convenience return, and analyze it as a commodity. Just as oil traders bet on higher oil prices when OPEC cuts production, we can bet on higher Bitcoin prices when de-banking events increase in major countries. Unfortunately, the data on the transaction usage of Bitcoin is not available. When a catalyst appears that appears favorable to Bitcoin, you can reasonably assume that the price will go up, but you cannot arrive at a specific estimate of fair value. It is 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 cannot be perceived.

The bottom line

The point of Bitcoin is that it has a non-zero value, but it is not known. The most ardent Bitcoin bears, who see the value of BTC going to zero, ignore the real world uses that Bitcoin has. Most trading in Bitcoin is speculative, but there are cases where it proves useful, especially in countries where human rights are weakened. The situations where Bitcoin is needed are not everyday occurrences, they are more like emergencies, but they do happen. For this reason, I do not believe that Bitcoin will go to zero. I believe the real value of Bitcoin is lower than today’s price, but well above $0.

The problem is to find out what the real value actually is. Data on transactional usage of Bitcoin is hard to find. It can be virtually impossible to find: the Bitcoin ledger does not record what goods Bitcoins were spent on, it only records exchanges. If a person selling things for Bitcoin does not tell the authorities about it, their transactional use of Bitcoin will never be recorded in a form useful to statisticians. All we really know about Bitcoin is the supply cap and trading volume, and the volume that comes from speculation cannot be assumed to last: bubbles historically tend to burst. So, Bitcoin is not a suitable asset for fundamental oriented investors. It lacks the data transparency required to calculate fair value. If you are part of a social movement, or a programmer working with blockchain technology, you can get practical benefits from holding Bitcoin. If you are a value investor, look elsewhere.