- Are stablecoins to blame?
- Bitcoin valuation
- Is the model worth paying attention to?
- Investing in a global context
TerraUSD’s collapse has been blamed for the bitcoin price drop, but experts disagree. They believe the problem lies in bitcoin’s overvaluation. In mid-May, bitcoin was trading more than 30% below its April high and nearly 40% lower than in March. It has fallen nearly 60% since its high in November 2021.
The bitcoin value model can show how realistic people are about the current price, as well as what equilibrium price the first cryptocurrency will aim for in the near future.
Many blame the stablecoin market for causing the crash, and undoubtedly it played a role. TerraUSD, a so-called algorithmic stablecoin designed to never deviate significantly from $1, recently traded for just 10 cents. LUNA, the stablecoin that is part of Terra’s dollar peg maintenance algorithm, has become virtually worthless.
But if bitcoin was significantly overvalued to begin with, it was already vulnerable to falling. Terra and LUNA may have been the straws breaking the camel’s back, but if not for them, there would have been some other trigger instead.
The valuation model that showed bitcoin to be overvalued depends on Metcalfe’s law: formalizing the network effect. This effect exists when the total value of the network increases with the number of users. When Metcalfe’s law applies, this value is proportional to the square of the number of users.
Claude Erb, former portfolio manager at TCW Group, is an analyst who used Metcalfe’s law to construct a fair value model for bitcoins. Assuming that every bitcoin that has been mined so far represents one user in the bitcoin network, Erb calculated that the current fair value of a bitcoin is about $24,000.
The value of bitcoin was first calculated using this model in December 2020. At the time, it was around $12,000. Almost immediately after the results were published, bitcoin soared from about $20,000 to more than $60,000, leading many to stop paying attention to Erb’s model.
Since then, bitcoin has fallen while Erb’s model fair value estimates have risen, with the result that they are now close to each other. This has led many to bring the model back under scrutiny.
At the current moment, the model may not reflect the real value of BTC. This is often the case. But the fact that the price is inflated does not change the value of bitcoin – it acts as a kind of measure in the cryptocurrency space.
If you consider the model in a long time period, it certainly works. But it hardly reflects the real attractiveness of the cryptocurrency for users, and it does not show the current state of the market. When bitcoin trades well above or well below the model’s fair value calculation, the model assumes that its value will move closer in line with that figure.
In any case, it is important to recognize that every publicly traded security sometimes deviates greatly from fair value. Nevertheless, investors do not infer from these wide variations that the P/E ratio is useless as a valuation indicator. Such a view should be extended to Erb’s model.
Another reason to pay attention to Erb’s model is that it is plausible. Even if the value of the bitcoin network does not exactly grow according to Metcalfe’s Law (through the square of the number of connected users), it will definitely grow as more people own and use the cryptocurrency.
Nevertheless, as Erb admits, Metcalfe’s law model is not perfect. For example, many investors own more than one bitcoin, so the number of connected users on the network does not match the number of coins mined. In addition, a significant amount of BTC has been lost, further reducing the actual number of connected users.
Erb says he essentially offered his model as a challenge to those who think bitcoin’s value is much higher. “If someone wants to come up with a better fair value estimate for bitcoin than Metcalfe’s Law, fantastic,” he said.
While no alternative estimates of bitcoin’s fair value have been found, Erb’s model remains the most plausible estimate.