Tuesday 14 July 2020 9:00 am

Expectation drives price. Utility drives value.

Digital asset prices are driven by two factors; value and expectation of future value. When expectation of value increases at a faster rate than real value, you get a bubble. If real value grows faster than expectations of value, you get an opportunity.   

Looking back on the 2017 super-cycle it is painstakingly obvious that it was an enormous bubble – but few recognised quite how inflated prices had become at the time. I for one was left reeling at the 83% drawdown bitcoin experienced during 2018. Expectation of future value had made up an overwhelming share of my assessment of the price and when the dust settled, I set about finding a way to measure the real value. 

We are now almost two years on, and the digital asset landscape has grown and matured beyond recognition. As the world of decentralised finance (DeFi) evolves and decentralised applications (Dapps) become closer to being ‘user friendly’, real value is emerging from the ecosystem. Real value is driven by utility and once we understand it, we can measure it. I will come back to the relationship between utility and value shortly, but first, let’s take a look at the reverse of real value – expectation of value. 

On a philosophical level, price is just a number that we put on things. The more people that are familiar with a certain price level, the lower volatility it has. As consumers, we have a deeper understanding of the value of something, and the price we give it, if we are more familiar with it. A pint of milk, a loaf of bread, a tank of petrol. Stable prices lubricate the economy by providing a degree of certainty about what our money is worth.

The less familiar we are with a good, service or asset, the more elusive its real value – leaving ample room for expectation, rather than utility, to drive the price level.

Without a baseline value, the price is not determined by something’s worth but by the expectations of what it is worth – or worse, the expectations of what it could be worth. 

With a price based on expectation rather than value, markets swell up into a bubble and (almost) always pop. Is this a problem? Well, it depends if you are the first one in or the last one out. 

In classical free market economics, we are taught that the price equilibrium should sit at the intersection between the level of demand and supply in an economy. However, it is the nature of that demand which is important to recognise. There is a difference between utility driven demand and expectation driven demand. Utility driven demand is value generating by its very nature – think of commodities, utilities and lower-end retail. Petrol is bought for your motorbike in order to ride it through the Surrey hills, or, to ship your new apple watch across the seven seas. 

Expectation driven demand is quite the opposite – It is not value generating. In fact, it can be value destroying. Buying an asset because of an expectation that its price will increase means that we are pricing an expected future utility. As with all things in the future, they are uncertain. Pricing something based on the expectation that it will be useful in the future is risky. When you take away liquidity from a market – since, digital assets for example, are not an established market – you have a recipe for high volatility and speculation. 

Digital asset prices: Utility or expectation of future utility? 

Having set up a “hold-your-hand” brokerage in 2017 I have spent a lot of time speaking to those looking to buy their first digital asset. The question I often had was whether any of these digital assets actually has utility. 

The first-time people hear of bitcoin it sounds like magic internet money. The interpretation is that the price is entirely speculative. But, when you dig deeper into the bitcoin network, you uncover an impressive amount of utility already in existence today. 

Bitcoin has utility. 

Front and centre is the bitcoin network’s place as a global public ledger. The decentralised and distributed nature of which makes it ideal for the trust less exchange of information – including notarised documents, land property titles, gold certificates of deposit or money (bitcoins themselves!). Further, the combination of networking and collateralisation of an account facilitates micro-payments to be executed for fractions of a dollar.

Bitpesa is an FCA regulated company that supports businesses with foreign exchange payments between Europe and Africa. Bitpesa utilizes the bitcoin network to circumvent the costly and often slow process of international settlements, settling approximately $220MM in international transactions in 2017. 

Due to its exemplary security record and relative accessibility compared to other digital assets, bitcoin is also the reserve currency of the digital economy. It is a key source of liquidity across the wider digital asset ecosystem.

Bitcoin also has utility as a natively digital store of value – referred to as digital gold. Bitcoin’s pre-defined and transparent monetary policy is helping it to become increasingly popular as an inflation hedge – as shown by legendary hedge fund investors, Paul Tudor Jones. In addition to its tight dis-inflationary supply schedule, the Austrian school of economists view bitcoin’s digital gold status to be aligned with the way new bitcoin are created or mined. Their interpretation is that the value of something is driven by the relative amount of work that goes into creating it – needless to say they would not fare well at a drum and bass gig in the Tate Modern.

Once we understand the utility of The Bitcoin Network and bitcoin the asset, we can measure it to gauge whether the price is relatively lower or higher than the networks’ respective value. 

Measuring utility.

Once we understand where to look for utility, measuring it is just a case of finding the right data. The wonderful thing about public blockchain networks is that their economies are measurable. On Ethereum, we can view the number of active entities interacting across the network, the total value of loans generated across decentralised banks, the value of monetary exchange made through ‘stablecoins’, the total assets allocated through a decentralised fund management platform – and much more. For bitcoin, the primary utility remains its application as a payment network. Measuring the velocity of bitcoins and the value of transactions that are settled on the bitcoin ledger can give us an indication of whether the network utility is growing or shrinking. 

By measuring utility, we can understand the value of something. 

The more we understand its value drivers, the less we are able to speculate. Institutional investors looking to generate long term returns in this industry are not here because of a speculative punt on an expected future value, they are here as value investors. It is possible to conduct due diligence on digital assets and to have a structured approach towards capital allocation – you just need to start looking for the real utility that is there today, rather than the expectation of what tomorrow might hold. 

James Bennett in conversation with James Bowater. James is the CEO of ByteTree, a provider of applied on-chain data for digital asset investors.  He is also the director of ByteTree Asset Management, where he will launch an institutional facing bitcoin fund later this year. 

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