Three Key Differences Between Traditional And Cryptoasset Markets
What is the real
market value of cryptocurrencies like Bitcoin?
What is the real market value of cryptocurrencies like Bitcoin?
The numbers used to explain the performance of Bitcoin and other
cryptocurrencies are less meaningful than most assume.
Cryptocurrencies are not exactly like stocks, and cryptocurrency
exchanges do not work like traditional securities markets. As a result, many
cryptoasset investment strategies based on conventional definitions of market
share, capitalization, volatility, and trading volume are deeply flawed.
Misleading numbers mean that cryptocurrency valuation and adoption are poorly
understood, which creates a false perception by the media and investors about
cryptocurrencies such as Bitcoin.
One implication of this analysis is that Bitcoin has captured the vast
majority of the long-term upside in the cryptocurrency market despite having
about half the nominal market share.
Most cryptocurrencies and crypto exchanges manipulate numbers in ways
that publicly traded companies and traditional exchanges like NASDAQ and NYSE
wouldn’t dream of. As a result, “market capitalization” and “trading volume”
are at best rough and relative measures of cryptocurrency adoption. Even when
intentional manipulation is not involved, cryptoasset markets fundamentally
just do not function like securities markets. It’s important to understand
these differences to asses the state of cryptocurrency and cryptoasset
adoption.
Let’s look at three important differences between how cryptocurrencies
and traditional securities markets work:
1. Cryptocurrency Valuation Comes Almost Entirely
from Speculation on Future Adoption
The first major difference between Bitcoin and securities is that the
vast majority of the market value of Bitcoin comes from the speculation on
future adoption. Today, Bitcoin is being used as practical money and a store of
value in countries by a few million users.
Bitcoin is already useful and superior to government-issued money in
countries suffering from hyperinflation such as Venezuela and Zimbabwe. Bitcoin
is also used to bypass currency controls in China and India. Even in these
cases, Bitcoin competes with other less-than-legal alternatives due to the lack
of ecosystem adoption and government prohibitions. In developed countries,
Bitcoin is only used by its most devoted followers, as the traditional
financial system is still far easier to use.
However, the number of current Bitcoin use cases is vastly overshadowed
by expectations that it will supplement assets such as precious metals and fiat
currencies such as the dollar in the future. In short, the majority of
Bitcoin’s value derives from speculation on the future adoption of Bitcoin as a
practical payment network.
The problem is that investors have very little evidence to predict the
future value of Bitcoin. The scope of possibilities includes Bitcoin failing
entirely, becoming a small but viable alternative in specific use cases,
supplementing gold and dollars as a viable substitute, or becoming the world’s new reserve
currency.
One of the signs of this lack of certainty is the percentage of Bitcoin
traded daily. Bitcoin’s daily volume—as of April 2020—is worth $36 billion out
of a $126 billion valuation, or about 10 percent. Apple’s volume is $6.2 billion out of a
$1.17 trillion valuation—or about 0.5 percent. Bitcoin is much more volatile
than stocks—it has more than ten times the volatility of a typical security,
and virtually all other non-pegged cryptocurrencies are far more volatile than Bitcoin.
People hold Apple stock because it has a track record of successful products
and loyal customers whereas most Bitcoin holders own to speculate on future
adoption and price growth.
2. Cryptocurrency Markets Have Thin Order Books
Compared to Traditional Securities Exchanges
Another important difference between crypto and traditional markets is
the size of their order books. A traditional stock like Apple is transacted on
a single exchange, with tens of millions of stocks available to trade daily
from many thousands of buyers and sellers. As a result, securities markets like
NYSE and NASDAQ have minimal slippage—they can efficiently process large
orders and the current market price.
Bitcoin owners, on the other hand, keep most of their assets in offline
wallets, with only a small percentage on vulnerable markets (which are often
hacked, defrauded, etc). As a result, a million-dollar Bitcoin order might have
a major effect on a given exchange, with a ripple effect on other exchanges.
For example, the sale of Bitcoins formerly held by Mt Gox caused dramatic price drops,
even though only 1 percent of the outstanding Bitcoins were up for sale. This
effect is far more pronounced with other cryptocurrencies, which explains why
$500 billion was wiped out during 2018.
Here is a hypothetical example:
Suppose that I create a new “Vex Coin” with an initial quantity of one
million coins. I pay “ABC Exchange” 10 Bitcoin to list my count and get my
friend Joe to buy one “Vex Coin” for $100 worth of Bitcoin. My brand new coin
is now worth $100 million, which at time of writing would put it at #50 in the
CoinMarketCap list of all cryptocurrencies. I just created a $100 million
market cap with a $100 investment! Now, suppose I issue nine million additional
coins. Vex Coin now has a $1 billion valuation! A report by the Blockchain Transparency Institute claims
that 70 of the top 100 exchanges are faking volume numbers, either by lying
outright or wash trading.
Wash trading strategies include free trades, paying customers a small
percentage to place trades, or secretly running bots on their own exchange
masquerading as real customers. These “market maker bots” are a very common way
to launch a new exchange and create fake volume in order to drive up rankings
of both exchanges and coins.
The relatively greater difficulty in faking Bitcoin prices and volume is
why I believe that Bitcoin has captured nearly all the value in the
cryptocurrency space, despite the fact that its nominal share of cryptoasset market
capital has been as low as 30 percent in 2018. In fact, I believe that the
alignment of Bitcoin’s (or whatever coin emerges as the leader) nominal market
share to its true market value will be one of the key signs of maturation in
the cryptoasset space.
3. The Valuation of Cryptoassets Is Backed by
Relatively Little Real-World Investment
The third important difference between crypto and traditional securities
is the ratio of investment cost to market cap. The total value of a
corporation’s stock is based on investors belief in its profit-making potential
in the future. This profit-making ability is enabled by the money invested to
buy its stock.
Take a company like Apple, with a market cap of $1.17 trillion. The
majority of that valuation represents created wealth—that is, Apple’s stock
offering was for a far smaller amount than its current valuation. Nevertheless,
investors have given Apple hundreds of billions to fund its growth over the
last several decades by buying its stock. In recent years, IPOs have averaged a 21 percent
return over the last few years, which is a healthy but modest
return on investment. Compare this to Bitcoin:
Bitcoin is an open network, not a private entity, so its market cap is
the total value of all Bitcoins at the current market price, and the investment
cost is the total investment in the Bitcoin ecosystem. Currently (April 2020),
sites that track the “market cap” of cryptocurrencies like coinmarketcap.com report
a market capitalization for Bitcoin of $126 billion.
We have no way to track the total amount of fiat currency (i.e. dollars)
spent to buy that Bitcoin, but we know exactly how much profit (in
Bitcoin) miners have made from mining Bitcoin. Bitcoin mining
is a competitive market process, and profit margins are thin or
non-existent, so we can assume that most minted Bitcoins were traded
for fiat (dollars) to pay for expenses, such as buying mining hardware, and
electricity. If Bitcoin miners sold Bitcoin on the same day they mined it to
pay for operating expenses, they would have earned $5.3 billion. This is 4
percent of Bitcoin’s market cap.
Mining is only a part of the Bitcoin ecosystem—exchanges like Kraken and
Coinbase, and Gemini and merchant services such as Bitpay have invested in the
Bitcoin ecosystem, but these are not large companies. In short, Bitcoin’s value
on paper is backed by relatively little investment in its ecosystem.
This is not a bad thing if you believe in the world-changing potential
of cryptocurrencies. However, it is important to understand the relationship of
a cryptocurrency to the resources it has at its disposal. For example,
Litecoin, with a valuation of nearly $2 billion dollars has two full-time developers.
Bitcoin Is Not Vaporware but Most Other
Cryptocurrencies Are
There are hundreds of developers working on blockchain ecosystem development at
companies such as Blockstream, Bitpay, Coinbase, Gemini, Satoshi Labs, and
others. However, Apple has 132,000 employees and revenue of $266 billion to
back up its trillion-dollar market cap. The market cap of all cryptocurrencies
is about $200 billion, but I would guess there are about 100 mostly volunteer Bitcoin Core
contributors and a few thousand people employed in Bitcoin
ecosystem startups.
Bitcoin is the best-case scenario. The majority of cryptocurrencies are
vaporware, with virtually no technical teams. Bitcoin uses a proof-of-work coin-creation
model, whereas the majority of coins (such as ERC20 coins) use a proof-of-stake
model, which does not use mining, or involves minimal mining. Their mining
costs are zero, though they might still have R&D, personnel, marketing
costs, etc. Most cryptocurrencies are get-rich-quick schemes, with little
vision, technical innovation, or market adoption.
A typical coin founder team contracts out the technical work of creating
a new coin and has no technical staff or ongoing development ecosystem. Their
market cap is based on inflated trade volumes and their coin minting strategy
is designed solely to prop up the price long enough for all the founders to
realize their profits before the price collapses.
To take a typical example, look up a cryptocurrencies’ GitHub account,
which records the contributions that developers are making to it. Here is Bitcoin Gold. There is typically a burst of
activity around the launch date, followed by a lot of marketing hype and little
or no technical work. Most cryptocurrencies have no paid developers or
open-source developer communities.
Corporations can spend money on technical innovation, and I suspect that
many cryptocurrency investors assume that the cryptocurrency valuations reflect
an ability to deliver on their promise. The reality is that exchange
manipulation and inflated volume numbers mean that real demand for most
cryptocurrencies is very low. The founding teams cannot fund development by
selling their closely-held stash because the coin’s price would collapse before
more than a tiny fraction could be sold.
As a result, most projects have only a few people, and no ongoing
technical development. Based on my review of GitHub open source code contributions to top
cryptocurrencies, the majority of projects have zero dedicated
blockchain architects, and in fact, zero full-time contributors of any kind.
Once you get past the top currencies such as Bitcoin, Ethereum, Stellar, etc.,
most coins have few developers and little activity.
The above criticism may seem like I’m bearish on cryptocurrencies, but
that’s not my intention. I want to help separate the hype and speculation around
cryptocurrencies from the underlying fundamentals. The primary drivers of
cryptocurrency price stability will be adoption for non-speculative purposes
and an understanding of the fundamentals driving Bitcoin adoption. We need to
understand the maturation of the blockchain ecosystem in order to have a
measured and calm response to currency volatility and retain a positive outlook
on the future.
The Three Stages of Crypto Ecosystem Maturation
Cryptocurrency development will likely proceed in three stages: discovery,
infrastructure, and adoption. The discovery stage was from
2008-2013 when the community identified the basic concepts and tools of
cryptocurrencies. The infrastructure stage started around the
time that people realized the need to build alternatives to the failed Mt Gox
exchange in 2013. The current infrastructure phase involves the creation of an
ecosystem that provides foolproof custody solutions for consumers, trusted
intermediaries, and a diverse network of vendors who accept Bitcoin. Once a mature
infrastructure is in place for cryptocurrencies, the stage will be set
for adoption.
Unfortunately, real innovations in cryptocurrency space are being hidden
behind the veil of speculative hype. For example, over the last year, more than
half of Bitcoin users adopted a new Segwit address format that increases
security and transaction capacity. Lightning Network reached $6.5
million Bitcoin capacity and 12,000 Nodes. This is a second-layer Bitcoin
network that has enough capacity for every single human being to use his own
Bitcoin wallet. (Bitcoin Cash has a competing vision of scaling to “50
transactions/day for 10 billion humans” on-chain.)
A meaningful assessment of Bitcoin’s value lies in understanding the
ecosystem’s readiness for institutional and consumer adoption. The ecosystem is
still extremely immature, and the tools are nowhere near ready for a typical
consumer, but that landscape is rapidly changing and setting the stage for mass
consumer adoption.
A version of this article originally appeared at Vellum Capital.
David Veksler is
the former Director of Technology at the Foundation for Economic Education and
CTO of Royalty Exchange.
Image source: Pixabay
Tuesday,
April 21, 2020
Reprinted from the US-based website
of the Foundation for Economic Education, in terms of the site’s copyright
allowances.
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