Reading 2022-08-22

Metadata

• Ref:: cfainstitute
• Title:: Cryptoassets - The Guide to Bitcoin, Blockchain, and CryptoCurrency for Investment Professional
• Author:: Matt Hougan & David Lawant
• Year of publication:: 2021
• Category:: Book
• Topic:: #topic.cryptoasset
• Related:: Calibre Library id:"=1299"

Notes from reading

Bitcoin was created by a pseudonymous computer programmer, working under the alias “Satoshi Nakamoto,” who published a white paper on 31 October 2008 titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. The author described a vision for how individuals could hold, send, and receive items of value digitally, without any trusted intermediary (e.g., a bank or payment processor) in the middle.

The Problem Bitcoin Was Designed to Solve

• Allowing money or items of value to move the way text messages do between any two people and without any central intermediary

Nakamoto’s solution to this problem was to create a single distributed database that is accessible to everyone—where anyone in the world can view balances and submit transactions at any time—but where the ledger is not controlled by any single corporation, govern- ment, person, or entity. In other words, a “distributed ledger” that is “permissionless” and is maintained on a “decentralized” basis.

How a Bitcoin Transaction Works

• a bitcoin transaction from start to finish
• Let’s say that Alice has 10 bitcoin that she wants to send to Bob.
• Step 1: Alice proposes her transaction to the network
  • Alice sends a message to all the computers that run a copy of the up-to-date database (“the Bitcoin network”) that says, effectively, “I want to send 10 bitcoin to Bob.” Alice has a unique password (called a “private key”) that lets her sign the message so that the network knows the message is coming from her and not from anyone else. Computers in the bitcoin network can easily confirm that Alice has 10 bitcoin to send because they each have a copy of the current database
  • at this point the transaction has only been proposed; no computer has updated its copy of the ledger yet
• Step 2:
  • This is where a special participant in the network enters: “bitcoin miners.” Miners are computers that are scattered around the world. Their job is to aggregate groups of valid new transactions, such as Alice’s, and propose them for settlement. These groups of transactions are called “blocks,” which is where the “block” in “blockchain” comes from
  • At any given time, thousands of these computers are competing with each other for the right to settle the next block. The competition involves solving a challenging mathematical puzzle, and miners can propose a new block only if they solve the current puzzle
  • Whoever finds the solution first is entitled to a reward, which consists of newly minted bitcoin and potentially transaction fees, which have been paid by the entity initiating the transaction
  • The reward is significant: Each new block currently comes with a reward of 6.25 newly minted bitcoin, worth roughly $70,000 at the moment. 1 This payment is what incentivizes miners to perform the work necessary to verify transactions and maintain the database.
• Step 3:
  • Once a miner does solve the puzzle, however, it can post the solution and propose a block of transactions to the network
  • when a miner posts a solution and a block of transactions, other members of the network check the work
  • If the transactions are valid and the puzzle solution is correct, network participants update their copy of the database to reflect the new transactions. At that point, Alice’s transaction is considered settled

What impact might this new database architecture (blockchain) have on the world?

• Capability 1: Rapid, Low-Cost, 24/7 Settlement
  • this kind of settlement speed represents a material improvement for many other types of transactions and use cases, including large transactions and transactions for which the current financial system charges very high fees (e.g., international remittance, wires)
• Capability 2: The Creation of Scarcity and Property Rights in the Digital World
  • Because the underlying blockchain database is available to everyone without being controlled by anyone, cryptoassets can provide ownership guarantees that were previously nonexistent in the digital world
• Capability 3: Digital Contracts (“Programmable Money”)
  • cryptoasset-powered blockchains allow users to effectively program money with certain rules and conditions, as you would program any software
  • With money programmable like software, you can create transactions with such conditions as the following:
    • Alice transfers cryptoasset X to Bob, but only after Carol agrees—which looks a lot like an escrow account
    • Alice transfers cryptoasset X to Bob, but only after a certain amount of time—which looks a lot like a trust
    • Alice sends cryptoasset X to Bob, but only if Carol wins the race; if Carol loses, Bob sends cryptoasset Y to Alice—which looks a lot like a contract

Ethereum’s developers designed it to be “Turing complete,” a computer science term that means it can be programmed to do anything a general computer can do. The additional flexibility makes Ethereum a “better” blockchain than bitcoin, but this functionality comes at a cost, more likely to have a bug or vulnerability.

Bitcoin’s simplicity is part of what makes it extremely secure and what gives people confidence putting large sums of money into it—perfect for serving as “digital gold.”

Ethereum’s flexibility and dynamism entail a level of technical risk that would be unacceptable for bitcoin, but that allows other interesting applications to flourish

Crypto As An Investment Opportunity

The five most widely used cryptoasset valuation techniques.

The unfortunate reality is that none of the proposed valuation models are as sound or academically defensible as traditional discounted cash flow analysis is for equities or interest and credit models are for debt. Cryptoassets are more similar to commodities or currencies than to cash-flow-producing instruments, such as equities or debt, and valuation frameworks for commodities and currencies are challenging.

Approach 1: Total Addressable Market

The most popular approach to value cryptoassets is to estimate their addressable markets and compare that estimate with their current market capitalization.

For instance, many people believe that bitcoin is competing with gold as a nonsovereign store of value. At current prices of roughly $2,000 per ounce, the total stock of gold held above ground amounts to approximately $13 trillion.

The maximum number of bitcoin that will ever be available is 21 million. And so, the thinking goes that if bitcoin matches gold as a nonsovereign store of value, each bitcoin would be worth roughly $620,000 (on a fully diluted basis); if bitcoin captures 10% of the gold market, each bitcoin would be worth roughly $62,000; and so on. With its current market capitalization of roughly $200 billion, bitcoin captures less than 2% of the value stored in gold.

The clear advantage of this approach is its simplicity.

Approach 2: The Equation of Exchange (MV = PQ)

The equation is borrowed from traditional models of valuing currencies and is based on the assumption that a currency’s value is related to the size of the market it supports and to its velocity as it moves through that market

As an easy example using round numbers, let us assume bitcoin will process 100 billion transactions (Q) of $100 each (P) per year. Then P × Q = 100 billion × $100 = $10 trillion per year. If on top of that we assume that bitcoin has a velocity of 5 (in other words, on average, one bitcoin changes hands five times per year), we arrive at a potential market capitalization of $10 trillion per year/5 per year = $2 trillion. If we divide this number by the fully diluted amount of bitcoin outstanding (21 million), it yields a price target of $2 trillion/21 million, or $95,238 per bitcoin. If we assume further that this level will be achieved in five years, we can discount this amount by an appropriate rate and arrive at an estimated present value.

According to data from the Federal Reserve, one key measure of money velocity (MZM - Money at Zero Maturity) has ranged between 0.9 and 3.5 over the past 30 years.

Approach 3: Valuing Cryptoassets as a Network

A third approach to valuing cryptoassets is borrowed from “Metcalfe’s law,” a popular theory in technology that states that the value of a network is proportional to the square of the number of participants. If you consider a social network, such as Facebook, Instagram, or LinkedIn, for instance, its value when it has a single user is zero. If, however, a second user is added, the network becomes valuable. As more users are added, the network’s value grows.

The Metcalfe valuation method makes intuitive sense, given that daily active users are a proxy for interest in and adoption of a cryptocurrency.

Approach 4: Cost of Production Valuation

The theory holds that crypto, just like any commodity, is subject to traditional pricing challenges on the supply side. Crypto miners—the computers that process transactions and are rewarded with the underlying cryptoasset—spend fiat money to produce each marginal cryptoasset, through both energy and hardware expenditures.

Viewing bitcoin as a commodity and according to traditional microeconomic theory, the cost of producing each marginal bitcoin should align with the price of that bitcoin. If bitcoin mining were to become unprofitable, miners could simply turn their attention to another cryptoasset or exit the market altogether. As a result, the value of each bitcoin can be estimated by examining the marginal cost of mining (specifically, the electricity burned in running the computations as part of mining) versus the expected yield of new bitcoin.

This model fails to account for or explain the massive short-term volatility of bitcoin’s price or the fact that bitcoin’s mining difficulty is programmatically adjusted on a biweekly basis depending on the level of effort miners have focused on it.

Approach 5: Stock-to-Flow Model

The stock-to-flow model states that bitcoin’s price is a reflection of its scarcity and that scarcity can be measured by the stock-to-flow ratio—the relationship between the extant value of bitcoin and the amount of new bitcoin being produced each year.

The stock-to-flow model is intended to apply only to bitcoin and is appealing to some who see scarcity as the dominating characteristic of "hard monetary" assets (assets with a strictly capped supply).

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Footnotes

1. Data as of 30 September 2020, based on a closing price of $10,784, as reported at https://coinmarketcap.com.˄