Bitcoin And Bubbles

Not a day passes without someone influential denouncing Bitcoin, often describing it as ‘a bubble’. Undeniably, bubbles do exist in the burgeoning world of cryptocurrencies but i’d argue that Bitcoin doesn’t fall into ‘the bubble’ category and instead question the skeptics’ motivations.

Before diving into Bitcoin, it is important to differentiate between bubble and speculation. In all types of investing there is speculation. 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. Let’s say the value it actually creates in the next 12 months vs. the value it is expected to create in the future. In this respect all our investments have a degree of speculation. In early stage investing that 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. You can think of it as:

This speculation plays an important role in the venture capital world and innovation in general because the greed it creates is what incentivizes entrepreneurs and investors to play a part (found a startup or invest in one), making at least part of these dreams – around 3% – a reality. The thriving global startup ecosystem, responsible for building the likes of Facebook, Uber, Snapshat and WeWork, that has billions of dollars of investment money pumped into it each year, is built on this exact premise.

So, what makes a bubble? When the price of an asset is untied to rational fundamentals around the potential future value of said asset. Let’s take for example, a market of $1bn and assume there is 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-$100m. Assuming this startup has a strong value proposition and signaling from the market, one can imagine how this startup could be valued at $5-10m. However, if I were to tell you that the company is currently valued at $500m, this could 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 (in present value terms) is unimaginable and unattainable given the market size, industry structure and valuation.

Taking this example, it’s relatively easy to see how most 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.

In the same vein, and conducting very similar analysis I often believe that many of the traditional startups that exist are in a bubbIe when I can’t imagine how the valuation today will ever translate into its future promise. Therefore, I view it as the job of the investor 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. And I believe that there are several such opportunities in the realm of blockchain as there are in the traditional VC environment.

In fact, I see many similarities in the framework between investing in traditional startups and crypto assets. At the same time, I also see there being one big difference – liquidity, which makes the risk/reward ratios more appealing by order of magnitude and more investable by the broader public. The fact that traditional startups are currently not liquid makes them more speculative than other asset classes. Why? For the fact that success depends on a liquidation event, which may not even reach fruition despite the startup having even justified its value during certain points along its lifecycle.

Furthermore, in contrast to other asset classes, I have just one point in time in which to conduct my analysis. Unfortunately, it’s the point in time at which I have the least amount of information, as the company is still in its very early stages. Yet, despite this fact, I need to make a long term decision to invest and there’s no way of turning back. YOU NEEDS TO HOLD EVERY SINGLE STARTUP INVESTMENT YOU MAKE even though you may have became smarter, learnt more, or simply have decided that you no longerbelieve in the company. To illustrate this point, when I invest in a startup, it’s not to say that the next day the startup can be acquired at its valuation by anyone “real”, or that there is a market of people willing to buy my position at this price. This is a real issue and something several equity crowdfunding platforms are trying to mitigate through secondary sales (including ourselves).

In contrast, in the crypto world, while expected return profiles are similar to that of traditional startups and arguably better, especially if you are a long term investor, you can literally buy and sell your portfolio every day (or maybe every week if you own smaller coins), just like a mutual fund. Liquidity is sometimes thin but I am always surprised at how I’m able to trade some of the most esoteric coins thanks to decentralized technology.

And yes, many of the tokens out there are part of this bubble, but 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 for money to be real is for people to believe in it and to want it. There is a real utility here as people are actively using it to store value and use it to pay for goods. Just look at Japan’s massive adoption of Bitcoin and the suggestions that several major Japanese banks will start trading Bitcoin as a currency like the yen, dollar and euro. Moreover, in the long run, the complexity of Bitcoin will not have a negative impact on adoption. Only rarely, do users understand the underlying technology of the products and services they use (e.g. the internet).

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 governments discretion. Sadly, this trend is growing and the fact that the supply is finite makes Bitcoin a far more effective and attractive store of value.

3. The market for “store of value” is enormous and so you can easily see how if adoption grows at this rate and supply is finite, network value could reach trillions. To illustrate this, the market for gold which is used only as a store of value is ~7.8 trillion US dollars.

4. The argument that Bitcoin can’t be a store of value because of its volatility is not strong enough. I can see why a volatile currency is problematic and I can also see why the volatility here is a disadvantage but if something is scarce and adoption is growing, it can be an effective store of value as it has been over the years for Bitcoin hodlers (those who ‘Hold On for Dear Life’). Furthermore, as network value grows, naturally, volatility will decrease. Although we don’t expect volatility to reach the level of traditional fiat currencies. Certain price fluctuations will remain due to the fact that fix supply meets variable demand. Global economic activities and shocks in Bitcoin demand can always result in significant volatility (similar to that of gold).

5. Applying ”the quantity theory of money”, as provided below, you can see that the price of Bitcoin could have already been justified at $10k even today.

(Click on image to enlarge)

(Click on image to enlarge)

Now even though Bitcoin is not in a bubble, it doesn’t mean it doesn’t hold risk. For example the regulatory uncertainty worldwide can destroy value for many investors, especially if their time horizon is short. Another big risk is the distribution of Bitcoin. Most coins, are held by a few individuals, the so called “Bitcoin Whales” (around 3% of existing Bitcoin addresses hold approx. 97% of all Bitcoins in circulation). Therefore, as an investor, you need to be aware that the market could be manipulated by just a few. This can result in an event called “Slaying of the Bearwhale” in the Bitcoin scene (for example: on October 6th, 2014, somebody sent 26,000 Bitcoins to Bitstamp to sell them [price remained at US$300 for several hours which was well below its former trading value]). While each address can represent more than one individual, as for example exchange addresses. On the other hand, most Bitcoin owners have several addresses.

In the long run, the price of Bitcoin depends on the number of new users joining the community, be it as store of value or to use it as a medium of exchange. It is very important to understand that nowadays there are only a few people who own Bitcoin (on a global scale). In fact, today only around 3.1m wallets hold more than US$100 worth of Bitcoin and only approx. 1.2m wallets hold more than US$1,000 worth of Bitcoin. While on the 1^st of January 2017 (see graph below), there existed only around 11m Blockchain wallets, today there exist 17.1mn wallets (+55,5% YTD). We expect adoption to continue increasing exponentially.

(Click on image to enlarge)

To conclude, based on our analysis above, not only is Bitcoin not in a bubble. In fact it is undervalued in many respects, and not just on future speculative value but on actual utility value that can be justified today. So my recommendation, is that if you haven’t done so already, go ahead and take advantage of the skepticism that is still out there to buy Bitcoins at a good price.