Nastassia Arendse
10 minute read
13 Dec 2017
10:39 am

Bitcoin, blockchain, valuations and bubbles

Nastassia Arendse

Cutting through the hype with Citadel investment analyst Nishlen Govender.

This file photo shows a pile of Bitcoins, seen after Software engineer Mike Caldwell minted them at his shop in Sandy, Utah, on April 26, 2013

NASTASSIA ARENDSE:  The recent bitcoin mania has raised heated debate as to what the world’s largest cryptocurrency by market capitalisation is actually worth. I had a conversation with Nishlen Govender, who is an investment analyst at Citadel on what he thinks of bitcoin.

NISHLEN GOVENDER:  It’s a difficult question to answer. Let’s focus on what you might think the intrinsic value for bitcoin is, because that should drive its posture. Is bitcoin worth $16 000, $10 000, $5 000, $1 000? The difficulty comes in that no one has the true valuation criteria, and thus no one has some fair value that they that can anchor themselves onto.

The issue with institutional asset managers and corporates, government, etc – the generally smart money or the stable money, fundamental money – are starting to grapple with that idea. So I can’t physically buy bitcoin at $32 000 because I’m not sure if it’s cheap or expensive. An issue is that if that kind of investor can’t be met, you are sitting with a market that’s full of speculative investors with no true idea of what the value of bitcoin is, the currency is. That seems to be spurring the currency on to point where it’s so much and so familiar and so front of mind for everyone that investors are piling in – and it’s speculative in nature.

NASTASSIA ARENDSE:  When you talk to a lot of people who claim to be bitcoin experts, they all talk about this underlying technology, this blockchain. And if you are not investing in bitcoin and you don’t believe in this powerful technology that we have, my question then is, am I investing in the underlying technology of blockchain, or is it that people are being driven by what I call herd mentality – that you are investing in something that you may not necessarily understand?

NISHLEN GOVENDER:  It’s a brilliant question and you have to separate out the two ideas, because they are important. A few articles have now been written in various forums about blockchain, bitcoin and a few other topics in between. Blockchain is something we are fantastically excited about, but it’s important to realise that blockchain was the underlying technology that started the bitcoin craze, or started the bitcoin mania.

Now blockchain is the core part of bitcoin that allows us to keep a decent reliable ledger where you are able to function together, rather than needing things like banks or central banks.

Bitcoin is merely the currency that comes out of that as we all contribute to that ledger and update bitcoin and blockchain together. The issue with that is bitcoin has now become top of mind rather than the underlying blockchain. Blockchain is a fantastic technology, because it has uses among various industries, among various ways of doing things currently. And right now, instead of investing in bitcoin and trying to understand the true value of bitcoin, we are focusing on blockchain and what blockchain can used for.

We’ve obviously spoken to many market participants. They are starting to understand blockchain and use blockchain in their currency – take banks, for example. They are currently using blockchain to try and create decentralised systems between their investors, between participants in different parts of their organisations, to create this decentralised structure that hopefully is cheaper for the participants within and safer for them.

So, rather than invest in bitcoin, that group is expensive – we don’t know where to find some valuation criteria – rather look for where blockchain can be used in industry today that would make those industries more efficient, better, faster and safer, and to value industries where we can understand the tangible value.

NASTASSIA ARENDSE:  When it comes to regulation, I was speaking to an analyst who is quite into the blockchain –  where it’s going, etc. He was saying that we sort of misunderstand when we talk about regulation and where regulation comes from. He says that financial regulation is there to protect those who may not necessarily understand bitcoin, because he thinks this is a bubble. And with most bubbles it’s always people who come late to the party who end up being the losers. So that’s why we need financial regulation in order to protect those who may not understand how this thing is working. Where are we when it comes to financial regulation of bitcoin?

NISHLEN GOVENDER:  I think in all fairness to financial regulators, they are working as quickly as possible to try and create a framework where we can both understand and have reasonable regulation that supports the investment into cryptocurrencies. It is a topic that is extremely complicated and has various effects throughout our economies potentially. So I am still a supporter of them taking as long as possible to get the correct regulation in place that allows and facilitates investment without hampering it.

In many countries regulations stop us managers, for example, from having bitcoin as part of our portfolios. Like I said earlier, the investment by asset managers into cryptocurrencies forming a base of investors with long-term incentive to hold is good for cryptocurrencies. And current regulation stands against that a bit, but we have to consider that the regulators have an immense amount of work to do, to create proper frameworks for investment within cryptocurrencies. So it’s a little bit of … thought where you want to give them enough time so that we have proper frameworks in place, rather than rush it and create a system that doesn’t work correctly and hinders the process rather than helps it.

So in that regard we are still very much finding out both from an investor perspective and a regulatory perspective.

NASTASSIA ARENDSE:  Here’s a point where you can educate us. You were talking earlier about valuation of bitcoin. How would it work? How would you be able to value something, because we are not sure whether this is an asset class yet. So how would it work if you were to value bitcoin?

NISHLEN GOVENDER:  That’s the key question. There are so many different asset classes available to investors. There are reasonable ways that you could plan each of those to find its intrinsic value.

As a start we can look at the earnings that are currently based on potential earnings in future, discount that back and then work out what the share price is. We can do a similar thing when it comes to bonds and fixed-income securities. With currencies you can take relative interest rates, relative inflation rates, and find out the differentials to understand where currencies should be chosen. Unfortunately, most of those mechanisms are not available for bitcoin.

There are some interesting methods that people have come up with, but still there is a lot to be decided in terms of the assumption. Pick one method where we assume bitcoin trades at a certain level in terms of global money. For example, the US dollar in circulation today equates to about $1.5 trillion. And bitcoin’s marked up [somewhere] between $40 and $60 billion, depending on when you look at the price. So you could make an assertion that bitcoin’s market cap could grow to $1 trillion, two-thirds of US dollars in circulation. Then that is a large amount, considering that the US dollar is a fiat currency that we’ve used for years. If you see that growth in bitcoin, then you could come to a valuation where bitcoin should trade at $50 000, which is a lot more than where it is right now, around $17 000. … Say that happens in ten years and you put various required returns on that going forward, something we do in the equity world all the time, you could come out to fair values for bitcoin. For example, if I use a 40% discount rate, implying that I want a 40% return from my coin every year until it reached $50 000 or $1 trillion in circulation then bitcoin would currently be valued at $1 700 dollars, which … compares to $60 000.

So that put in context how the price then needs to reflect both the amount of coins in circulation and the relative trade at that point, together with a reasonable way for the price of the coin to reach that value. So what is the price today, how it beams in the future in terms of circulation of money, and how do we get there from here? So already we are pricing in quite a high valuation for bitcoin and its use therefore in financial markets going forward. We could discuss more, of course.

NASTASSIA ARENDSE:  Say you missed this bitcoin train because you think it’s too expensive – I don’t know anyone who has $16 000 just lying around like that – there are other cryptocurrencies that I’ve read about, like Ethereum and Monero, etc. Do you see people then flocking to those if they miss the bitcoin bus?

NISHLEN GOVENDER:  Definitely so. There are about a thousand cryptocurrencies and there are more appearing every single day. Some of them are larger than others. So bitcoin, Ethereum and Litecoin – those are the largest cryptocurrencies. There are others. It’s very easy on a Google search, as you can imagine, to find a list of them. Some of them are growing at fantastic rates. You emboss them bitcoin, depending on the period you look back. It’s important to realise that the first movers and those would be … to all the … of bitcoin. So they are attracting the most engine. Investors do need to find exchanges where they can buy the coin … and there are far more exchanges for the likes of bitcoin or if you are in the Litecoin. I do expect we have already seen people investing in other cryptocurrencies.

But it’s important to note that with a thousand cryptocurrencies there will be a point where there are less of them available as the dominant cryptocurrency becomes part of the way of life. If you think about vehicle manufacturers back in the 1920s or ’30s, when Henry Ford first started the movement – only a few of those are left. If you consider the tech bubble, when there were hundreds of IT companies with the premise of developing technology that we could all use in the future, very few have grown significant market caps like Apple and Microsoft and Intel, etc.

So, even though there are many cryptocurrencies that people are investing in, in all likelihood we will see a smaller group that dominate more than others – which is of course is a risk for those investing in a smaller currency.

NASTASSIA ARENDSE:  If for instance this is a bubble, as some people are willing that it could be, from your perspective what would the consequences be?

NISHLEN GOVENDER:  We could consider bull versus bear markets, bull markets where upward prices increase all the time, either very quickly or very slowly, and bear markets where in a very quick fraction of time markets collapse. We have seen various instances of that. We could see a retracement of the bitcoin price extremely quickly. That would result in many people selling for whatever reason, whether it’s fundamental or for some concern, and you would see then short sellers in a market and as that starts to build up, it would mean that they are hoping for the price of bitcoin to fall and would do everything in their power to release research and to provide information on why bitcoin would … Those sorts of things should be a concern.

But, as it stands, there aren’t as many sellers of bitcoin as you would imagine. As I said earlier, there are speculators in bitcoin who don’t have a fair value. So they are not selling because there is this fear of missing out on the next 20 or 30% increase. The result is also that there are no short sellers, because short sellers are too afraid of suffering significant losses as the currency continues to rise. You’ve got to look for the bubble where there isn’t necessarily downward pressure.

We’ve seen in the past downward pressure happens extremely quickly. In a speculative market anything that disrupts the norm, that causes confusion or causes alarm, could result in mass sales across the world. And very easily bitcoin could trade down from $16 000 to $1 000, just as quickly as it has risen up there. It’s something that investors should keep in mind.

NASTASSIA ARENDSE:  Thanks to Nishlen Govender from Citadel.

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