The 21 Levers of Bitcoin Price- Part II
#4. Future network size expectations:
One of the factors that determines the price of Bitcoin today is the expected size of the network in the future. If users expect the bitcoin network to be larger in the future, the current market price for bitcoin will tend to be higher, all else being equal. Because there is no way to quantify what people expect the future network size to be, the best way to track this variable is across time.
In traditional centralized networks, the opacity of pricing is a hindrance for users to accurately factor future demand for the network. In monopoly network scenarios, sophisticated users who consider the impact of current prices on future network value determine the value of the network more than unsophisticated users who are unresponsive to prices, and in competitive oligopolies, they are determined by unsophisticated users. The distribution of sophisticated vs unsophisticated users varies between different networks, depending on how much price transparency exists, and therefore modelign network value becomes complicated.
But two features distinguish Bitcoin network from centralized networks, when it comes to future network size expectations.
- Because bitcoin network is priced openly in the market through BTC, it blurs the distinction between sophisticated and unsophisticated users, and makes bitcoin’s network value closely dependent on current user base’s future expectations of future user numbers.
- Unlike centralized networks, in bitcoin, there is very insignificant “pricing power” wielded by miners. This is due to current transaction fees constituting an insignificant fraction of mining fees compared to block reward. This also simplifies and eliminates the opacity of pricing hindering users from forming rational responsive expectations of future user base.
Sensitivity to security: In an intersting finding, Pagnotta and Buraschi show that if the network is very secure, the change in the size of a network has less effect on its price. If the network security decreases, price increasingly depends on network size. This is presumably because for highly secure networks, the incremental value a new user contributes to the security of the network itself is marginal. If true, this finding has important implications for Bitcoin and other cryptocurrencies, especially those that use the same hashing algorithms that larger networks use in their Proofs of work.
Significance: Although the future network size expectations cannot be measured in absolute terms, accurate and consistent accounting of new entrants into the system (through fiat gateways, for example), as well as their sentiments about Bitcoin adoption by others over time can provide valuable insights into this.
#5. Network Structure or Topology :
Centralized entities depend on a trusted, enforceable hierarchical structure to provide a specific service. Think paypal, visa or banks. This structure of the firm requires all the actors to know and trust their surrounding nodes. This coordination is expensive and imposes transaction costs for creating and maintaining these hierarchies. The central entity can typically set the price of the service due to network effects and other barriers to entry, thus capturing a significant fraction of network value. This is the dominant business model in networks. Think Facebook, Google, Telecom companies, Visa etc.
In centralized networks, because transactions and traffic are also verified or routed through a central point, these points become magnets for political and social censorship. A truly Decentralized Network overcomes this limitation by distributing the network effect across many nodes or in bitcoin, “Miners”.
Disintermediation and decentralization reduces transaction costs:
For example, Alice can send bitcoin to Bob, without ever having a direct relationship with any of the intermediaries involved (miners that confirm and relay that transaction, other full nodes that verify that transaction, the developers that implemented the client, mining rig manufacturers etc). This massively reduces transaction and legal costs as well as increases social scalability.
This decentralization makes Bitcoin valuable, and the manner of decentralization does affect the value of the bitcoin network. However, there is no good model of network topology to measure decentralization, though attempts have been made in that direction.
A good measure of decentralization must take into account, factors such as centralization in code submission (problematic due to a lack of universally verifiable identity for developers), how many full nodes there are and how they are distributed, and how much centralization exists in mining pools etc.
Unfortunately, each one of these dimensions is hard to quantify using a general measure, and some are entirely subjective.
Relative importance of Full nodes vs Miners for decentralization:
Because miners are the ones that write to the ledger, a lot of controversy has focused on miner hashpower centralization. However, focus on mining hashpower centralization misses the important factor that although miners can collude/centralize and double spend, any one who runs a full node holds balances and accounts, can verify all the transactions independently, and will reject blocks that include invalid transactions. This significantly reduces the power miners have over the network.
For example: If I’m run a bunch of Ethereum nodes on one AWS instance, and the data centers are located in different geographic/political jurisdictions, does this score high on “geographic decentralization” dimension but low on “systemic centralization” dimension? How are these dimensions weighted?
Quantifying decentralization and other parameters that impact bitcoin network security and censorship resistance is an underdeveloped area of research, but I expect this to change soon.
#6. Demand for Censorship Resistance:
If no one cares about censorship resistance, value of Bitcoin network over the long term will be zero (Bitcoin might still have speculative value in the short to intermediate term even if no one values censorship resistance now, because some may believe that others may value censorship resistance in the future. But, at some point rational valuations will return it’s price to zero). If everyone values censorship resistance highly, Bitcoin will be valued very highly today.
What contributes to bitcoin’s Censorship Resistance? It’s the transaction fees. More specifically, it is the difference in fees charged by censoring miners vs uncensoring miners that gives bitcoin its censorship resistance. This does not depend on block rewards or how they decay. Currently, there is no softfork enforcement to censor certain transactions, so it is assumed that when censorship from some miners does become a threat, the fee market may be able to counter it.
Because Censorship Resistance is an essential attribute of bitcoin’s value proposition, it is valuable to track the demand for it. A reasonable proxy measure is the number of people being censored by the current financial system (the assumption being that the demand for CR comes from those that are being censored now, therefore the more censoring in the current financial system, the more the demand for censorship resistance).
#7. Network Security or “Trust”:
In the context of Bitcoin, trust in the network depends on aggregate hash power of the network as well as no single entity controlling >50% hash power.
For any network, the value of the network is proportional to the product of it’s Network size and it’s average “value” provided to a user. In bitcoin, network value could be zero if bitcoin’s primary value, Trust in the network, is zero. The network value also tends to zero if, despite a high ampunt of trust and hash power, if the user size is zero, as common sense would suggests.
To track this across time, Hashpower and aggregate user numbers as well as transaction throughput can be measured from publicly available data.
#8. Immutability:
In a simple world, mutable and immutable are binary terms. If a ledger has been changed, it is immutable, and if it has not been, it is mutable. However, reality is more complicated, and Bitcoin as well as Ethereum ledgers have been been changed for various reasons. The DAO issue lead to the forking of Ethereum and ETC for example. Even Bitcoin, widely considered to be immutable, had a ledger rewrite that was forced by technical glitches.
Given this context, the degree of “immutability” is more of a perceived property of a network than an actual empirical fact. And, given further that different hard forks on different networks were driven by different motivations, it is futile to try to rank the degree of mutability of different ledgers objectively. If people value immutability, the value of the network would roughly be inversely proportional to the number of mutations, but that has not been the case empirically.
It appears that immutability is not a key determinant of a network’s perceived value, at least in the short term. The high price multiples of ETH/ETC is an interesting example of the relative importance of immutability vs “protocol functionality” to speculators driving the prices of various network tokens.
#9. Mining Costs:
Mining cost provides a security guarantee to users by raising the unforgeable costliness (HT @tokenhash for suggesting this). The more work and energy it takes to mine a block, the more assurance it provides the user that the coin is hard to forge. In addition, mining cost is generally considered a proxy for the floor beneath the market price of Bitcoin, although it does not hold true in the long run, as marginal demand is a much more important factor.
Because trust in the security of bitcoin network depends on the cost of the attack, as the cost required to attack Bitcoin decreases, network trust decreases. If the number of miners and hash power are held constant, the marginal cost of electricity and hardware will have a measurable effect on bitcoin price. As the cost of mining decreases (meaning ASIC and electricity costs become cheaper) the price of Bitcoin decreases [Pagnotta and Bursachi, Proposition 3].
But miner numbers and hash power are not constant and get adjusted in response to Bitcoin prices (an increase in cost leads to diversion of hash power, and vice versa). Since a change in hash power also changes the security of the network by changing the cost of a double spend attack, the impact of mining costs on price changes is negated, and is expected to be insignificant.
#10. Miner’s Expectations:
The amount of mining power provided by miners today is determined by the miner’s expectation of the price of bitcoin in the future.
To intuit this, imagine that you are a mining rig operator. If you do not expect the cost of Bitcoin to cover your capex and opex at a future time and yield a profit, you would not enter the mining business. How much profit you expect directly depends on your expectations of where Bitcoin price would be, after you get your block reward.
This means that network trust tends towards the future price expectations of miners. There is no good way to measure how miner expectations of Bitcoin price are changing, but measuring the coin age and movement of coins from Miner’s wallets, if possible, is a good way to track this over time. If most miners are HODLing and not selling their coinable rewards, it is a signal that suggests that the price of bitcoin will increase and vice versa.
When there are huge or abrupt deviations of market price of Bitcoin from miner’s expectations of future price, it may provide a profitable arbitrage opportunity. (The only caveat to this are periods of price/hashrate spirals in section #15, which complicate this analysis).
Many thanks to Dan Held, Eric Voskuil, Donald McIntyre, Eric Martindale, Stephan Livera, Curtis Spencer and others who helped me with comments and feedback.
