iCapital Market Pulse: What Is Crypto Really Worth?

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The broad U.S. equity market has had a sluggish start to August, with returns flat month to date. This has not been the case for many crypto assets: Bitcoin rallied +10%, Ethereum is up +26%, and blockchain-linked companies returned +24% month to date.¹ With Coinbase reporting today (August 10), investors will seek to gauge how trading volumes held up against the crypto volatility in the second quarter. The key questions on investors’ minds are: What’s crypto really worth and is the recent pullback in crypto assets a buying opportunity? We offer our thoughts in this week’s Market Pulse.
 

The crypto ecosystem is here to stay and its adoption is growing

Cryptocurrency is digital technology that enables peer-to-peer (P2P) payments or other valuable data transfers without a bank or a government intermediary, which makes it cheaper, quicker, and more private. A flurry of activity this year in cryptocurrencies points to growing retail and institutional acceptance.

• The number of addresses for cryptocurrencies – a signal of increased adoption — surged this year (though growth has stalled since May). Addresses with positive balances for Bitcoin and Ethereum have reached 38 million and nearly 60 million, respectively.

• A growing number of businesses are investing their cash in cryptocurrencies and accepting them for trading and/or transactions. These include Square, Paypal, Tesla, Robinhood, and Overstock.com, to name a few. According to a recent survey, up to 36% of U.S. small to medium-sized business accepted Bitcoin in 2020.²

• Banks are ramping up their efforts to offer blockchain payments to their customers. For example, Signature Bank offers 24-7-365 real-time blockchain payments to its commercial customers, and JPMorgan created Liink, a proprietary blockchain payments platform for financial institutions and corporate users.

• Consumers are increasingly trading, transacting, and investing in cryptocurrencies. For example, Ethereum’s daily transaction count averaged near 1.28 million in 2021, versus 942,000 in 2020.³ Second quarter trading volumes for Coinbase were approximately $450 billion, according to data from CoinGecko. Crypto funds’ assets under management have been rising, with the five largest regulated U.S. digital asset managers holding over $46 billion of crypto.⁴

• Finally, over $16 billion has been raised year to date by private equity (mostly venture capital) to fund crypto/blockchain ecosystem companies. This is more than the last three years combined.⁵

How much is crypto worth?

What is the fair value of Bitcoin and other crypto assets? There are a number of valuations models, but these three resonate with us: demand-based network value, supply-based stock-to-flow, and cost-of-production models. These valuation methods suggest that the fair price of Bitcoin is between $11,000 and $33,164 on the low-end but could scale up to $81,867 or $118,544 on future assumptions on the high-end. This is a significant spread and it points to the volatile and speculative nature of cryptocurrency investing. No model is perfect, but these three can provide a framework and help investors begin to anchor the range of potential outcomes for Bitcoin and other digital currencies.

• The demand-based model based on Metcalfe’s law states that a network’s value is proportional to its user base squared.⁶ As the number of Bitcoin and Ethereum addresses increase, so should the network value and market capitalization of the cryptocurrencies. Indeed, the rise in cryptocurrency addresses with non-zero balances helped explain 81%⁷ and 93.8%⁸ of cryptocurrency and Bitcoin market cap appreciation, respectively. As Bitcoin approaches 41 million addresses, the fair value price level should be approximately $33,000. As the expected number of addresses grows further, so could the price level. For example, if addresses a little more than double, Bitcoin’s valuation could be $118,544.⁹

• The supply-based stock-to-flow model applies the concept often used in supply-constrained natural resources, such as gold and silver, and assumes that Bitcoin’s value should be related to how long it takes to replace existing supply. Bitcoin’s supply is approximately 18.7 million and is constrained to 21 million in total, according to its protocol. The Bitcoin stock-to-flow model currently suggests the price should be around $81,867.¹⁰

• The cost-of-production approach evaluates the marginal cost to produce cryptocurrencies and factors in miners’ costs including equipment (such as semiconductor chips, which are rising in cost and complexity), electricity, and any additional labor. This is currently estimated at around $11,000 for Bitcoin. As long as mining activity continues, the cost of production represents a valuation floor through which the price of Bitcoin is unlikely to sink.

If the long-term outlook for crypto is so bullish, how do we explain its recent short-term volatility?

Like any currency, there are short-term, medium-term, and long-term factors that determine  valuations. For example, market sentiment often dictates short-term demand for the U.S. dollar, while interest rate differentials determine fair value medium-term.

For crypto assets, despite the longer-term valuation models described above, there are several sources of short-term volatility. First, fluctuations in miners’ inventory (whether they are selling their mined BTCs or hoarding them) could have a big impact on price since they account for the highest percentage of total Bitcoin flowing to exchanges (above 25%). Second, regulation and other headlines may impact the overall levels of exchange trading activity. For example, trading activity slowed since May as regulatory uncertainties around crypto rose. Third, while an estimated 79% of Bitcoin holders are presumed to be long-term, traders account for 21% of supply¹¹ and can drive short-term price swings.

Why and how does crypto fit into an investment portfolio?

The annualized daily volatility of 70%-90% for cryptocurrencies easily tops all other assets. And rightfully so as risks still abound for this early-stage technology. Despite near-term volatility, our long-term conviction is that the adoption of cryptocurrencies will continue to grow and investors may want to add an allocation to their portfolios. Indeed, 45% of recently surveyed family offices are interested in cryptocurrencies investments, while 15% have already invested in Bitcoin.¹² Here are three potential benefits of holding cryptocurrencies:  

• Fiat currency diversification and alternative means of payment for those who don’t want to rely on banks and government intermediaries either because of trust, added fees, or surging monetary supply due to central bank QE;
• Exposure to the supply-constrained characteristics of “digital gold”;
• Growth of technology that provides a cheaper, quicker, more efficient, real-time way to transfer funds between people and institutions, domestically and cross-border, and in the process, could disrupt the global $200 trillion consumer payments market and more.¹³

Personally, the disruptive technology application appeals the most to me. And I would be sizing this allocation in a diversified portfolio accordingly — as a highly volatile Info Tech security with promising potential but also plenty of idiosyncratic risk.

Last but not least, the applications of crypto are numerous (from payments, to other de-centralized finance (DeFi) concepts, to IoT, digital identity, and other smart contracts) and we’re just scratching the surface. With well over 4,000 tokens for various applications and potentially rapid shifts in adoption, we would consider diversifying crypto holdings among several key tokens with promising potential.