Bitcoin Valuation as a Fiat Hedge With Information and Substitution Effects

About the author: John Vandivier is a graduate student at George Mason with formal credentials in policy, economics and political science. He also dabbles in philosophy and apologetics. His blog discusses all of the above at www.thegenerallifeblog.blogspot.com.*

In this article bitcoin is valued by predicting the approach of the market value of bitcoin to the intrinsic value of bitcoin as a fiat hedge over time according to the rate of information spread and including price dilution from substitution effects of alternative cryptocurrencies.

Chamath Palihapitiya is an intelligent and succesful venture capitalist who made a small error in thinking. While I trust his calculation of the world hedge value of gold to be about 9 T USD and agree that bitcoin can be used as such a hedge because of its decentralized nature, he failed to realize that many other cryptocurrencies such as Litecoin and Feathercoin have the ability to do the same thing. This substitution effect will dilute bitcoin's value.

Another error in thinking is one I don't think Chamath made, but one which many people who listened to his comments will have made. Bitcoin will not have a market price based on a value of 9 T anytime soon. This is because value as a fiat hedge is an intrinsic valuation not a market valuation.

As information spreads across a market bitcoin demand will increase and market value will approach intrinsic value. In the long run market value is equal to intrinsic value under free market theories which presume free and perfect information. Other than the long-run we must include information effects over time if we wish to accurately model the market value.

The specific details on the data used and methodology are available here. To summarize the results, it is predicted that bitcoin information will not be sufficiently spread through the global market before January 2019. In the mean time, other cryptocurrencies are diluting Bitcoin's share of the entire cryptocurrency market at a rate of about .7% per month. A good mid-term forecast would be for December 2013. This is late enough to avoid the short-term distortions we will notice from ASIC arrivals and Mt Gox's coming support of litecoin, yet early enough that we should minimize inaccuracy from extrapolation and divergence from current data.

According to projected spread of information and corresponding demand growth the cryptocurrency market should be worth 290 B in December 2013. After factoring in dilution from substitution the bitcoin market cap is projected to be worth 266 B. Finally, individual bitcoins will be further diluted by the additional bitcoins mined during that time, each of which comprises a share of the market value. Block 267000 will be mined in December and at that time each coin will be worth 2200 USD/Coin.

This forecast should not be considered reliable because it includes certain false assumptions. It is only exercise in theoretical valuation to be used alongside other valuation methods. This forecast can be improved in various ways including measurement the search to demand correlation and measuring the degree of substitutability of bitcoin for gold. This forecast assumes that anyone who knows about bitcoin will demand bitcoin and also that bitcoin is fully substitutable for gold, however both of these assumptions are demonstrably false in some cases. A person may want to hold both gold and bitcoin to diversify their risk. A person may search for bitcoin information and be lead to think it is undesirable.

Being statistically ignorant of these correction values we should expect them to each be 50%. Correcting for these values would give a more realistic expected December valuation of 550 USD/Coin.