5 Reasons Why Bitcoin is Not a Bubble

Bitcoin is often described as a ‘bubble’. While bubbles do exist in the burgeoning world of cryptocurrencies, as they do in many other sectors, I’d like to argue that Bitcoin is not one.

It is important to differentiate between ‘bubble’ and speculation, which is part of every investment. The speculative aspect of the investment is the percentage of the asset price that relies on future expectations around the asset vs. the value it provides today. In early stage investing speculation is higher by magnitudes because many of the companies we invest in haven’t yet created real value (at least not in the form of profits) and all of their prices are derived from expectations of their future.

Bitcoin mine in Ordos, China

Speculation plays an important role in the venture capital world and promotes innovation because the greed it creates is what incentivizes entrepreneurs and investors to play their parts.

A bubble is created when the price of an asset is untied to rational fundamentals around the potential future value of said asset. Consider a market of $1 billion with no annual growth. A startup company aims to capture 10% of this market over the next 10 years but currently has only a team and a proof of concept. This market has already several incumbents that are established and each are valued at $50-$100 million. Assuming this startup has a strong value proposition and signaling from the market, one can imagine how this startup could be valued at $5–10 million. However, if I were to tell you that the company is currently valued at $200 million, it would signal that this asset is in a bubble because the volume and adoption this company would need to achieve in order to justify such a valuation is unimaginable and unattainable given the market size, industry structure and valuation.

Based on this example, it’s easy to see that many cryptocurrencies in circulation today have over inflated valuations. Many have a market cap (network value) of hundreds of millions of dollars while some of their initiatives haven’t even proven their worth by way of a product or adoption. Even some of the most successful real-world counterparts rarely reach such spectacular valuations as we see in the world of cryptocurrency, indicating that some of these asset prices are not tied to their respective market opportunities.

The investor’s job is to ask the right questions and analyze each asset thoughtfully, to rise above the hype and separate the bubbles from the real opportunities of wealth creation. While many of the tokens out there are part of this bubble, I strongly believe that Bitcoin is not one of them. While the price rose quite rapidly in the past year, it was off the back of some of the following real fundamentals:

1. The single most important feature making money ‘real’ is for people to believe in it and to want it. There is a real utility in Bitcoin as people are actively using it to store value and pay for goods. Just look at Japan’s massive adoption of Bitcoin and the suggestion that several major Japanese banks will start trading Bitcoin as a currency like the yen, dollar and euro. The complexity of Bitcoin should not have a negative impact on people's’ ability to believe or want it. Users rarely understand the underlying technologies of the products and services they use. Just look at the internet.

Bitcoin

2. Bitcoin supply is capped. There is a real growing community of people that are sick and tired of having their wealth controlled by centralized governments who constantly tax their citizens by diluting their value through the printing of money at the government’s discretion. This trend is good news for Bitcoin and the fact that its supply is finite, makes Bitcoin a far more effective and attractive store of value.

3. The market for ‘store of value’ is enormous. If adoption of Bitcoin continues to grow at the same rate and its supply is finite, network value could reach trillions. To illustrate this, the market for gold, primarily used as a store of value is ~7.8 trillion US dollars. Even if 5% of that market moves to Bitcoin, the impact on Bitcoin’s price would be huge.

4. The argument that Bitcoin can’t be a ‘store of value’ because of its volatility is not strong enough. A volatile currency is problematic, and Bitcoin’s volatility is a disadvantage, but its scarcity and growing adoption make it an effective store of value nonetheless. As network value grows, volatility will naturally decrease. Certain price fluctuations will remain due to the fact that fixed supply meets variable demand. Global economic activities and shocks in Bitcoin demand can always result in significant volatility, which is not different than that of gold.

5. When modelled using “the quantity theory of money" the value price of Bitcoin is justified. In our calculations, we do not include 1) lost coins due to loss of private keys or willful destruction and 2) coins that are HODLed. We do this, because in any given year these coins are not in circulation and therefore not available to the crypto-community. According to a study conducted by ARK Investment Management LLC & Coinbase, between 2012 and 2016, on average 54% of Coinbase users only purchased or held Bitcoin during the year and approached the cryptocurrency strictly as an investment. In addition, back in 2014, John W. Ratcliff concluded that around 30% of existing Bitcoins are lost, equating to 25% of existing coins today. Adding these figures together, we conclude that around 80% of outstanding Bitcoins are inactive. Given the average daily transaction volume of around $1 billion, the price of a Bitcoin today can be justified even when excluding discounted future expectations.

While not qualifying as a bubble, Bitcoin still holds risk. Regulatory uncertainty worldwide can destroy value for many investors. Another big risk is the distribution of Bitcoin. Around 3% of existing Bitcoin addresses hold approximately 97% of all Bitcoins in circulation. The individuals holding the majority of coins are called Bitcoin Whales. Investors need to be aware that the market could be manipulated by few individuals.

In the long run, the price of Bitcoin depends on the number of new users joining the community, be it as a store of value or to use as a medium of exchange. It is very important to understand that nowadays there are only a few people who own Bitcoin: only around 3.1 million wallets hold more than $100 worth of Bitcoin and only approximately 1.2 million wallets hold more than $1,000 worth of Bitcoin. That said, on January 1st, 2017 there were only around 11 million Blockchain wallets. Today there are 17.1 million, representing a growth of over 50%. We expect Bitcoin adoption to continue to increase exponentially.

The article was originally published on Medium.com.