The Power Of Bitcoin’s Network Effect - NYDIG
The Power of Bitcoin’sNetwork EffectGREG CIPOL AROROSS STEVENS, PH.D.Global Head of ResearchFounder & Executive ChairmanEXECUTIVE SUMMARY Bitcoin’s improving network fundamentals, increased investor holding periods, andreliably diminishing new supply make it a compelling long-term investment. Adoption of Bitcoin is at an all-time high, with the number of addresses that holdbitcoin now 25.6M. Engagement is rapidly rising, with the number of unique daily active Bitcoin addressesapproaching 900,000. Investors are holding bitcoin for increasingly longer periods, with 63.2% of totalsupply currently held for at least 1 year. We believe increasing holdings periods will drive future price appreciation givenbitcoin’s fixed supply and shrinking supply growth – 88% of all bitcoins ever to existhave already been created, and bitcoin’s supply growth, now at only 1.3% annually, ison an automatic and asymptotic journey to zero. NOV 2020WWW.NYDIG.COM I INFO@NYDIG.COMOur valuation framework is based on Metcalfe’s Law. Supporting our hypothesis thatbitcoin’s usefulness as a store of value is driven by its monetary network effects, wefind that Bitcoin’s valuation can be well explained by the square of its user base.BITCOIN’S IMPROVING FUNDAMENTALS I 1
OVERVIEWIncreasing fundamental demand combined with a fixed supply and automatically declining supplygrowth make a compelling case for bitcoin as an alternative investment for institutional investors.Examining addresses that hold bitcoin balances and daily active addresses, we show that networkadoption and network usage are each growing. Regarding supply, average investor holding periodsare rising, with the percentage of total bitcoin supply held for at least one year recently hitting anall-time high. We also see record highs in the number of addresses that control large bitcoin balances,which we define as at least 1,000 bitcoins. This development supports our direct, and accelerating,experience at NYDIG: bitcoin is being increasingly adopted by institutional investors.These positive network fundamentals are set against the backdrop of bitcoin’s automaticallydiminishing new supply and its ultimate cap. There will only ever be 21M bitcoin. Bitcoin’s supplygrowth, which asymptotically approaches 0% over time, is now down to 1.3% annually, on par withthe annual growth in gold supply. While far from perfect, gold is bitcoin’s closest real-world analogy.The ultimate supply of bitcoin is fundamentally limited by the design of the system itself and cannotbe increased regardless of its value or the level of demand. Bitcoin is the first store of value in historyfor which its supply is entirely unaffected by increased demand.To value bitcoin, we apply Metcalfe’s Law, which states that a network’s value is proportional to thesquare of the number of its users. Applying Metcalfe’s Law to Bitcoin’s network, we find that bitcoin’shistorical valuation levels are well explained by the square of its addresses. Applying this relationshipto potential future network growth of 15%-25% per year suggests a price level range of 51,611 – 118,544 in 5 years.BITCOIN’S FUNDAMENTAL GROW THBitcoin is both a technology (Bitcoin – uppercase B) and an asset (bitcoin - lowercase b). Bitcoin thetechnology is an open-source software protocol (akin to HTTP for web browsers or SMTP for email). Itallows the tens of thousands of computers that currently, and independently, run the Bitcoin softwareto hold, send, and receive bitcoin, the native asset of the Bitcoin protocol. Together, these computersform an internet-like network stretching around the world, which neither requires nor permits acentralized coordinating entity and accepts anyone, anywhere to run its open-source software.Just like certain other durable and time-tested stores of value such as gold and art, bitcoin does notproduce income, nor confer to its owners any rights to dividends, voting, or governance. Further,unlike gold, the growth in bitcoin supply reliably diminishes over time and eventually ceasesaltogether. Someone who “owns bitcoin” more accurately controls a private key, the digital signaturewhich gives them the right to update address balances on Bitcoin’s global ledger, thereby transferringbitcoin from one entity to another. To obtain bitcoin, one must either a) “mine” it into existencethrough a computationally intensive (i.e., expensive) process that forms part of the Bitcoin protocol,b) receive it in exchange for goods and services, or, most commonly, c) purchase it on the secondarymarket. In short, there is a cost to acquiring every bitcoin.NEW TECHNOLOGY, ANALOGOUS FUNDAMENTAL SWhile much of Bitcoin’s technology and terminology is unique to the digital asset ecosystem, we candraw analogies to metrics from traditional assets or technologies, such as user growth, engagement,transaction volume, and holding period. Although the identity of each bitcoin holder is pseudonymous,all transactions are public on the blockchain, giving everyone – including us – a clear picture of allunderlying network activity.WWW.NYDIG.COM I INFO@NYDIG.COMBITCOIN’S IMPROVING FUNDAMENTALS I 2
USER BA SE AT AN ALL-TIME HIGH AND GROWINGThere arecurrently 25.6Maddresses onBitcoin, anall-time high.While Bitcoin does not have a precise definition of “users”, a good proxy is public addresses, which aresimply (virtual) locations where owners can send or receive bitcoin. Ownership of a public addresscomes from controlling its private key, which allows users to “spend” bitcoin. While multiple publicaddresses can be derived from a single private key, we believe that public addresses holding morethan 1 are a reasonable proxy for users.There are currently 25.6M addresses on Bitcoin, an all-time high. The upward trajectory of publicaddresses is an important metric for network adoption and market cap.FIGURE 130.0NUMBER OF ADDRESSES (M)User 22013201420152016201720182019Number of Addresses2020Source: GlassnodeUSER ENGAGEMENT TRENDING BACK TO THE HIGHSCurrently,about 900,000addresses areactive on atypical day.User engagement is an important measure of any network’s health. For example, social medianetworks closely track their daily active users (DAU) as a measure of engagement. For Bitcoin, wehave a similar measurement – daily active addresses – which we define as the number of uniqueaddresses that engage in at least one transaction on a given day. Currently, about 900,000 addressesare active on a typical day. While Bitcoin has yet to return to the prior peak of daily active addressesseen in 2017, engagement has been increasing meaningfully in recent years.1,400,000EngagementProxy:Daily ActiveAddressesNUMBER OF ADDRESSESFIGURE 09201020112012Daily Active Addresses - 7 Day AverageWWW.NYDIG.COM I ce: GlassnodeBITCOIN’S IMPROVING FUNDAMENTALS I 3
BITCOINERS ARE INCRE ASINGLY TURNING INTO LONG-TERM HOLDERSA growingpercentage ofbitcoin supplyis being heldfor longer.Examining when any individual bitcoin was last moved on the blockchain, as a percentage of allbitcoin in existence, reveals the behavior of longer-term investors with certainty. Our analysis revealsan important trend: a larger percentage of total bitcoin supply is being held for longer periods.Currently, 62.5% of all bitcoin has been held, or more precisely, not moved, for 12 months or longer.Examining even longer holding periods, we see that 44.6% and 32.3% of all bitcoin have been heldfor at least 2 and 3 years, respectively. This speaks to bitcoin increasingly being used for its primaryuse case: long-term wealth storage. Should this trend continue, which we believe it will, there will bematerial implications for future available sell liquidity.FIGURE 3100PERCENTAGE OF SUPPLY (%)Percentage ofSupply Heldfor Greaterthan 1 0182019 1 Year2020Source: GlassnodeNUMBER OF L ARGE OWNERS HITS AN ALL-TIME HIGHThe number of unique addresses that hold over 1,000 bitcoins, a reasonable proxy for institutionalinvestors, recently hit an all-time high. However, this total number, only 2,218, is still strikingly small,which suggests that the ecosystem remains in the very, very earliest stages of institutional adoption.There have been several companies that have adopted bitcoin for treasury reserve investmentpurposes, starting with Stone Ridge Holdings Group (2017), MicroStrategy (2020), and Square (2020),as well several well-respected investors who recently came out in support of the asset, such as PaulTudor Jones, Bill Miller, and Stan Druckenmiller. We believe this trend will continue.FIGURE 42,5002,000NUMBER OF ADDRESSESNumber ofAddresseswith LargeBalances1,5001,000500020092010 1,000 BitcoinWWW.NYDIG.COM I 2020Source: GlassnodeBITCOIN’S IMPROVING FUNDAMENTALS I 4
BILLIONS OF DOLL ARS OF INVESTED CAPITAL SECUREBITCOIN’S BLOCKCHAINSince 2011, 20B hasbeen paid toBitcoin miners.Miners are paid transaction and block reward fees to find new blocks and permanently recordtransactions on Bitcoin’s blockchain. These fees are sometimes referred to as Bitcoin’s “security budget”because they represent the revenue miners receive in return for maintaining the safe functioning ofthe protocol. Since 2011, 20B has been paid to miners to secure Bitcoin’s blockchain. With miningrevenues currently running at about 11M per day, the annual run rate mining revenue is about 4B.Because the security of the Bitcoin network is a necessary and critical driver of its value, miningfees – and miners – are very important. The fact that miners are required to make the network secureis a feature, not a bug, and kicks off a virtuous cycle. The more capital that’s invested in bitcoin mining,the safer the Bitcoin network. The safer the Bitcoin network, the more attractive bitcoin is as a store ofvalue. The more attractive bitcoin is as a store of value, the more profitable mining is as a business. Asmining becomes more profitable, it attracts more miners. With more miners, computational networksecurity increases. More network security makes bitcoin more valuable. The cycle repeats.FIGURE 5AnnualMining Fees,MillionsYE ARTR ANSACTIONFEES ( )BLOCKREWARDS ( )TOTAL( 191565,0295,184YTD 20202033,5963,799TOTAL1,22418,74019,964Source: Coin MetricsBITCOIN CAPE X IS ALRE ADY NE ARLY HALF OF GOLD MINING CAPE X 3.9B was spenton Bitcoin networkcapex last year, and2020 is growingfollowing the Mayreward halving.FIGURE 6Bitcoin CapexCompared toGold MinersOur research shows that bitcoin miners in aggregate already spend 44% of the capex of the 10 largestpublic gold miners per year. In 2019, the 10 largest gold miners collectively spent 8.7B on capex. Inthat same year, bitcoin miners collected revenues of 5.2B. Bitcoin miners have a capital intensityratio (capex to revenue) of about 75%. As shown in Figure 6, applying this capital intensity ratio toBitcoin mining revenue suggests an astonishing 3.9B was spent on Bitcoin network capex last year,and 2020 is growing following the May reward halving. While Bitcoin network capex vs. gold miningcapex is not particularly relevant for anything, and in particular has nothing to do with the efficacy ofthe bitcoin network, we nevertheless find the framing fascinating and a powerful way to underscorejust how mature and scaled the rapidly-growing global bitcoin mining industry already has become.GOLD MINING CAPE X IN MILLIONS ( M)BITCOIN NET WORK CAPE X IN MILLIONS ( M)MINING COMPANY2019 CAPE XBITCOIN NET WORK2019 CAPE XBarrick Gold1,701Bitcoin Miner Revenue ( M)5,184Newmont Mining1,463Capital Intensity (%)75Kinross Gold1,105ESTIMATED NETWORK CAPEX ( M)3,888Agnico Eagle Mines883Polyus822Newcrest Mining789PERCENTAGE OF GOLDMINER CAPE X (%)44AngloGold Ashanti703Source: Bloomberg, Glassnode, NYDIGGold Fields613Polymetal International436Harmony Gold232TOTAL GOLD MINING CAPE X8,747WWW.NYDIG.COM I INFO@NYDIG.COMBITCOIN’S IMPROVING FUNDAMENTALS I 5
FUNDAMENTAL DRIVEN DEMAND COLLIDES WITH DWINDLING SUPPLYBitcoin’s fixed supply of 21M bitcoin is produced in ever-decreasing amounts, making bitcoin inflationresistant. The protocol produces 144 blocks every day, on average, and rewards the miners of each blockwith a specific amount of bitcoin. At launch in 2009, this reward amount was 50 bitcoin per block. Every210,000 blocks, which is predictably and reliably every 4 years, this bitcoin reward is halved. This rewardhalving is what drives the declining growth rate in bitcoin’s supply, which asymptotically approaches0% between now and the year 2140. Currently running at 1.3% per year, the growth in bitcoin’s supplyis on par with the historical annual growth in the supply of gold.Gold has been a reliable store of value primarily because of its scarcity and low annual supplygrowth – before bitcoin, no form of money has ever had a reliably lower annual supply growth rate thangold. While bitcoin’s growth rate is on par with gold today, the next halving in 2024 will put Bitcoin’sgrowth rate below 1%, lower than the lower bound of gold’s supply growth over any point during thepast 100 years.Bitcoin is longpast the point ofbeing catchable.Some observers believe that bitcoin’s fixed supply is irrelevant because any other digital asset couldcopy the Bitcoin code and serve as a replacement. This perspective misses a critical point. While Bitcoin’scode is infinitely and inexpensively replicable, its ecosystem is not. Bitcoin’s developers, users, miners,merchants, and exchanges, among others, drive the network effect that creates its 331B moat andunique prominence. Bitcoin-specific mining represents the overwhelming majority of all global energydedicated to the security of the entire digital asset industry. The bottom line: Bitcoin’s code base can becopied, but the credibility, and immutability, of its hard money policies cannot. Bitcoin is long past the10,000point of being catchable.FIGURE 71,000ANNUAL PERCENT 2201320142015Annual Bitcoin Supply Growth - 7 Day Average2.5Gold’sAnnualSupplyGrowth2.0ANNUAL PERCENT (%)FIGURE 820162017201820192020Source: GlassnodeGold Average1.51.00.50.0190019101920Annual Gold Supply GrowthWWW.NYDIG.COM I INFO@NYDIG.COM193019401950Gold Average1960197019801990200020102020Source: US Geological SurveyBITCOIN’S IMPROVING FUNDAMENTALS I 6
VALUING THE BITCOIN NET WORKValuing bitcoin, like valuing any asset, is subjective, and we approach this topic with humility. Unlikewith stocks or bonds, with bitcoin there are no cash flows to discount. Our approach is to first thinkof Bitcoin as a network, and then to look at other successful network business models to develop a basicvaluation framework.Money andlanguage werethe first, andremain themost important,human creatednetworks.The logic behind viewing Bitcoin as a network rests on our core insight that any successful money mustnecessarily be powered by a network effect. To see this, first, imagine a world in which no successfulmoney exists (e.g., increasingly Venezuela, Lebanon, and Turkey today, Zimbabwe 10 years ago, etc.).In such a world, people are reduced to bartering; that is, exchanging goods and services directlyfor other goods and services without an intermediate money. Viewed purely through the lens of amonetary network, such an economy is extraordinarily inefficient, as it requires (n * (n 1))/2 prices,where n is the number of specific goods or services. In a simplified example of a modern economywith, say, one billion goods and services throughout a national supply chain, barter would requireabout 500 quadrillion individual prices. In contrast, with the introduction of a successful money, thatsame economy needs only one billion prices, one for each good and service. As n gets larger, thenetwork power of a successful money expands. Money and language were the first, and remain themost important, human created networks.One common critique of bitcoin is that, because it is rarely used as a medium of exchange, it cannot bea money. That critique misses a fundamental point about the nature of money. The fact that bitcoin,like gold, is not widely used in individual transactions today is irrelevant. For bitcoin to be a store ofvalue, the only requirement is that its holders expect to someday use it in a transaction, or else theywould not hold it in the first place. The revealed preferences of every person who owns bitcoin, eventhe fiercest HODLers (i.e., very, very long-term holders) like ourselves, necessarily implies that zeroBitcoiners believe that they (or their descendants) will never exchange bitcoin for something else atsome point in the future, even if that transaction is far into the future.In this overall context, it becomes clear why we believe that bitcoin’s fundamental value is bestmodeled as a network.Bitcoin’svaluation iswell describedby the mostfundamentalfactor intrinsicto its network:the number ofaddresses thathold bitcoin.METCALFE’S L AW AND BITCOINMetcalfe’s Law, named after the founder of Ethernet technology, Robert Metcalfe, states that thevalue of a network is proportional to the square of the number of its nodes, n2. Metcalfe’s conjecturehas empirical support from academic research on technology giants Google, Facebook, and Tencent,among others. Given our view that, as an emergent successful money, bitcoin’s fundamental valuederives from its network effects, bitcoin’s value should roughly adhere to Metcalfe’s Law. Building onand simplifying prior research in the area, our analysis shows that bitcoin’s valuation is well describedby the most fundamental factor intrinsic to its network: the number of addresses that hold bitcoin. Thismay be an important insight for investment professionals who, understandably, require anchoringaround a fundamental valuation framework as a necessary component of their allocation diligenceand analysis. Next, while acknowledging the statistical challenges of working with price levels ratherthan changes in price levels, we show that the total value of Bitcoin’s network is well explained, withan R squared of 93.8%, simply by the square of its user base, n2.WWW.NYDIG.COM I INFO@NYDIG.COMBITCOIN’S IMPROVING FUNDAMENTALS I 7
BITCOIN MARKET CAP E XPL AINED BY THE SQUARE OF ITS USER BA SEWhile not precisely equal to the number of people or institutions holding bitcoin, the number ofaddresses holding bitcoin is an intuitive and parsimonious proxy for Bitcoin’s user base. Our expandingmonthly regression analysis beginning in 2011 shows that the number of Bitcoin addresses squaredexplains 93.8% of the variation in the level of Bitcoin's market cap.FIGURE 9300Scatter Plotof Bitcoin’sMarket Capand AddressesSquaredMARKET CAP ( B)2502001501005000100200300400500600700ADDRESSES SQUARED (T)2011201220132014201520162017201820192020Source: Glassnode, NYDIGCONSTRUCTING A MODEL PRICEUsing the observed number of monthly Bitcoin addresses and the measured factor coefficients with anexpanding window, we construct an estimated market cap for Bitcoin and compare that point estimateto its observed market cap. As shown in Figure 10, and both acknowledging and underscoring that thisis an entirely in-sample analysis, the estimated and actual price levels follow closely.FIGURE 1010,000.00LOG PRICE OF BITCOIN ( )Bitcoin’sModel Pricevs ActualPrice1,000.00100.0010.001.0020112012Model Price of BitcoinWWW.NYDIG.COM I INFO@NYDIG.COM201320142015Actual Price of Bitcoin20162017201820192020Source: Glassnode, NYDIGBITCOIN’S IMPROVING FUNDAMENTALS I 8
FUTURE MARKET CAP LE VEL S BA SED ON USER GROW THThe framework we have outlined may be instructive in estimating potential future Bitcoin market cap,and therefore price level. By showing what we believe to be a reasonable r
More network security makes bitcoin more valuable. The cycle repeats. BITCOIN CAPEX IS ALREADY NEARLY HALF OF GOLD MINING CAPEX Our research shows that bitcoin miners in aggregate already spend 44% of the capex of the 10 largest public gold miners per year. In 2019, the 10 largest gold miners collectively spent 8.7B on capex.
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