A matter of faith: How can anyone rationally value cryptocurrency?
Pros: Trust measures can capture a wide range of theories. Cons: It's literally faith-based economics.
"Most investors seem to agree that the ongoing viability of any asset including currencies comes down to intrinsic value," writes Paul Brodsky of Pantera Capital, one of the world's foremost crypto investment firms. Intrinsic value, he says, could be defined as the valuation of something through fundamental analysis without reference to its market value.
The obvious catch then is that any pure cryptocurrency such as bitcoin or Litecoin – functional tokens such as GNT or Ether are a different story – should be fairly valued at zero. It produces no yields and creates no value. To the contrary, it swallows huge amounts of energy.
Fiat currency is in the same boat.
"To define the intrinsic value of a cryptocurrency, like bitcoin, it makes sense to first try to define the intrinsic value of generally-accepted fiat currencies," Brodsky writes, "like the dollar, the euro and the bolivar... which is precisely the point: currencies have no mathematical framework for finding discrete intrinsic values."
Trust, he says, is the defining feature that runs through all currencies and gives them value. The key difference between the US dollar, the euro and the bolivar is the amount of trust that people have in them.
So, how should a rational investor tally up faith?
A matter of faith
Faith can be imbued by tangible factors, Brodsky argues. Consider the differences between the US dollar, the euro and the bolivar. At the pointy end, the factors which drive the perceived value of a currency work by imbuing its users with trust.
- USD: Backed by, "in order of immediate importance... a relatively strong government, a compliant tax paying population, a respected and influential central bank, insurance on assets denominated in dollars, control over global shipping lanes and a powerful military that could, if necessary, enforce shipping lane compliance. All in all, it's a pretty powerful set of conditions that elicits widespread trust for dollar holders/users," Brodsky says.
- Euro: "The euro is ultimately backed by, well, almost none of what backs the dollar. The only arrow in its quiver that elicits faith today is its relatively recent popular adoption."
- Bolivar: "The Venezuelan government is a failed currency, supported by the Venezuelan government but not its people. The Venezuelan government has sought to overcome this by launching a permissioned cryptocurrency, the Petro, pegged to oil and gold. The Petro has so far shown little promise of popular adoption because, not surprisingly, it is sponsored and controlled by a government no one trusts."
Of course the more pressing reason the Petro failed is because it was never released, rather than a lack of confidence. In fact, there's been a remarkable amount of confidence and optimism around the Petro despite it being a train wreck in almost every way. But the philosophical point remains the same – that trust is the key element which gives a currency value – so let's just roll with it.
"Whether a currency is state-sponsored or not, trust is the key feature – maybe the only feature – that ultimately determines it's (sic) intrinsic value and ongoing viability," Brodsky says. "In fact, we could argue that the intrinsic value of any physical, paper or digital asset is really best measured by the amount of generally perceived faith in it relative to other assets competing for utility and wealth storage."
As squishy as it is, this matter of faith might be the most solid possible foundation on which to make sense of bitcoin's value and one of the only ways of rationally capturing its utter irrationality. Much like a certain element of faith – and trusting that others will have faith – is needed to capture the irrationality of valuing gemstones, art, collectibles or fiat currency as anything other more than the materials they're made out of.
Choose your own ritual
There are a lot of different ways people try to make sense of bitcoin's price.
- Bitcoin is a pyramid scheme whose sole value is derived from the greater fool theory
- Bitcoin is a scam whose prices have been manipulated upwards to take advantage of FOMO
- Bitcoin has inherent value derived from the energy and effort put into its creation
- Bitcoin serves a functional purpose in running the world's most reliable global immutability machine because it's a coin operated machine.
- Bitcoin has practical value as a censor-proof transaction instrument
- Bitcoin has value as an appreciating asset based on scarcity and anticipated shifts in supply and demand
There's often a lot of nitpicking around these theories, and arguments over which it really is, and most people tend to approach it in line with their own experiences.
Some libertarian pseudo-economists love the idea of inherent value derived from effort, much to the chagrin of other libertarian pseudo-economists who extol the virtues of pure supply and demand while noting that bitcoin can't have intrinsic value because only gold is allowed to have inherent value.
Meanwhile, actual economists tend to nod at its intended purpose but maintain that it's overvalued. Traditional investors like Warren Buffet see it as a greater fool's asset because their experience only has room for dividend-paying investments, and Jordan Belfort sees it as a scam because that's just his background.
Most people probably believe in different elements to different degrees. Some people will ritualistically draw up technical analyses to chart supply and demand, but those don't mean much to someone who thinks the markets are being manipulated. Some go in with the intention of being a lesser fool while others plan to hodl until the end of time.
These don't have to be mutually exclusive though. Brodsky's argument that it's all a matter of trust, and a bit of faith, can accommodate all of them. Faith means getting belief wherever you find it, which squares perfectly with the many faces of bitcoin.
The original faith argument may have simply been intended to evaluate cryptocurrencies purely as functional currencies like any other, but its squishiness is exactly why it can accommodate everyone who buys bitcoin for all their different reasons, and therefore might be better at predicting the future than any of the more narrow theories above.
Qualifying and quantifying faith
So if faith is a good measurement because it captures all possible motivations for buying bitcoin, then how does one measure faith in bitcoin?
Well, with bitcoin price of course.
You can't write a clear equation about how much trust (how many trusts?) go into each thousand dollars, but it might still be possible to look at it in the broader strokes question of whether trust in bitcoin will increase or decrease in the future, whether one project will instil more faith than another and whether trust in fiat will increase or decrease relative to cryptocurrencies in the future.
Framed in this way, Brodsky argues, the picture for crypto assets is quite rosy.
Right now trust is low, he says, which means the prices are too. Anyone getting into crypto now does so despite a range of trust-inhibiting downsides.
"Cases of fraud, abuse, theft and unsophistication are well known," he says. "Such mistrust is further confirmed to skeptics by the broad market's extraordinary high level of price volatility."
As these problems are reduced, prices might be expected to grow. Custody solutions, wider use among institutional investors, crypto insurance solutions and wider adoption of crypto payment systems might all play a part in increasing overall trust in the space in the future.
The role of fiat currency here is important, not only as a kind of competitor but also as a benchmark for trust. Cryptocurrency adoption is unsurprisingly exceptionally high in Venezuela and other countries where the local currency has collapsed. But, adding further credence to the squishy faith theory, cryptocurrency has also tended to take off more quickly in places where faith in existing governments is weaker, even before that lack of faith has much practical impacts on local fiat value or function.
It's no coincidence that after bubbling for a while cryptocurrency came to a boil in South Korea right as a bizarre scandal rocked confidence in authorities, even without the won suffering too badly.
Beyond that, simple diversification might be a solid selling point for anyone with anything less than complete and utter undying faith in the existing monetary system, Brodsky says.
"Crypto nuts can't be as sure as they think they are that the tokens they are betting on will be the winners, and fiat fat cats can't be as sure as they think they are that the current global monetary system will be the first purely faith-based regime to survive longer than sixty years, or that incumbent commercial businesses with valuations approaching a trillion dollars will generate a reasonable ROI.
"As it stands, most investors are trusting governments and central banks to maintain the value of 100 percent of their portfolios... trust may be binary (humans either do or don't trust something) but portfolio management need not be. As always, diversification remains a prudent course.
"If one is convinced that the days of recessions are behind us, that fiat denominated debt will be easily serviced and repaid in perpetuity and that all the world's peoples and all the world's currencies will be perpetually stable then one need not seek even a small position in digital assets. Such is the implicit bet one makes by being 100 percent exposed to fiat currencies and assets denominated in them. Snarky but true."
The only way to capture all perspectives of cryptocurrency value is to take it as a matter of faith. On the one hand, the phrase "faith-based economics" will instil a certain sense of dread in most analysts. On the other hand, the crypto markets are nothing if not ineffable.
Disclosure: At the time of writing, the author holds ETH, IOTA, ICX, VET, XLM, BTC and ADA.