There is hardly any doubt that Bitcoin is more than a bit of an economic revelation. The cryptocurrency that was born out of the eponymous 2008 Bitcoin white paper and launched the following year has been catapulted to the forefront of global attention. The emergence of Bitcoin launched blockchain technology and introduced cryptocurrencies to the world. In less than a decade that Bitcoin has been around, it certainly has made the news a lot. One question that has defied any definitive solution has been the puzzle of just how to value Bitcoin. The answer may lie in an approach developed by a Swiss research team.
Correlation of Active Addresses & Price?
Source : bitinfocharts.com
The Value of Money
In today’s economic construct, the value of most assets is expressed in terms of money, usually in USD. This raises the question of how money is itself then valued. There have been a number of approaches to this particular query. There is a school of thought that ascribes the value of money to the cost incurred in producing money. Another school of thought prefers to see the value of money as the worth of the things that it can be exchanged for. While these approaches have a certain degree of merit especially with regard to fiat currency, they fail spectacularly when applied to Bitcoin.
Metcalfe’s Law
According to Spencer Wheatley and a group of colleagues working at ETH Zurich in Switzerland, the key parameter to be used in determining the value of bitcoin is in the size of the network of people who use it. This approach seems to link the value of Bitcoin to the value of its network and the latter is best expressed in terms of Metcalfe’s law. Robert Metcalfe, the person responsible for the creation of the Ethernet and the founder of 3Com is the originator of the Metcalfe Law.
Metcalfe’s Law states that the value of a network is proportional to the square of the number of the users of that network
In simple terms, it means that as the number of users of a network grows exponentially, the value of the network increases as well, and vice-versa.
Applying Metcalfe’s Law to the Value of Bitcoin
While Metcalfe’s law works in theory, applying it directly to the Bitcoin network is not practical. This is due to the fact that a basic assumption of Metcalfe’s law is that all nodes are connected with each other. Even if the analysis of the Bitcoin network is confined to the set of active users, it is highly unlikely that all nodes are connected with each other. As a result of this, Wheatley and co decided to tweak the parameters of Metcalfe’s law to come up with a probabilistic model that was more suited to the Bitcoin paradigm. According to their findings, the average number of connections that each node possessed was approximately 66.6 percent or two-thirds of the network. With this new finding, Metcalfe’s law was then tweaked to an exponent of 1.69, rather than that of 2.
Predicting the Value of Bitcoin
When applied to four previous Bitcoin crashed, the results obtained from the analysis showed that the tweaked Metcalfe law tallied with these previous crashes. In order to study these crashes, the team relied upon the work of a fellow Swiss-based researcher, professor Didier Sornette who developed a model that can predict the collapse of speculative bubbles.
Using an amalgam of these two approaches, the team was able to determine that the aforementioned Bitcoin crashes were for all intents and purposes, inevitable. Even if the events that led to the crashes such as the Mt. Gox hack and the news of the crypto ban in South Korea at the back of 2017 hadn’t occurred, some other event would have triggered the crashes.
“Our Metcalfe-based analysis indicates current support levels for the Bitcoin market in the range of 22–44 billion USD, at least four times less than the current level,”
A similar approach is used by Fundstrat’s Tom Lee through which uses a model in which they calculate the value of Bitcoin by using square number of users * average transaction value. Fundstrat believes that over 94% of the price activity can be explained by their variant of Metcalfe’s law.
Concerning the market at its present state, Metcalfe’s law still shows that Bitcoin is considerably overvalued. The extent to which the market is overvalued is in the region of 400 percent and the researchers say that it mirrors the situation in early 2014 when Bitcoin spent the whole year moving sideways and downwards.
Ref: arxiv.org/abs/1803.05663: Are Bitcoin Bubbles Predictable? Combining a Generalized Metcalfe’s Law and the LPPLS Model