Bitcoins Value: Altcoins
It has been difficult to determine what exactly gives Bitcoin its value. Many economists reject the idea that a virtual currency has any intrinsic value, and merely is a product of speculative request. Others maintain that the ‘moneyness’ of Bitcoin – its utility as a medium of exchange and store of value – confers value. But what if Bitcoins are not ‘money’ at all? Over the past year I have sifted through the data, and after a thorough analysis judge that Bitcoin does indeed have value. Only perhaps not for the reasons that many enthusiasts believe.
BTC Price Volatility and Noise
The evident place to begin an investigation into what determines the value of Bitcoin is to track how its market price fluctuates under various circumstances. Logical questions to ask include: Does the price go up as more mining effort is directed at it? Is Bitcoin price correlated with other financial assets such as the stock market, gold, or the dollar? Does geo-political financial risk cause people to bid up its price?
The problem was, however, that the price volatility of Bitcoin in relation to national fiat currencies was enormous. While volatility in and of itself is not always a bad thing, the case of the the massive run up in market price in late two thousand thirteen to early two thousand fourteen is very likely due to market manipulation and fraudulent activity. The Willy Report has found concrete evidence that trading bots operating at the Mt. Gox exchange were artificially pumping up the price of bitcoin by using the dollars held in customer accounts. When those dollars ran out and the price of Bitcoin began to decline, Mt. Gox itself collapsed leaving its user base empty passed. This sort of noise conflates any earnest effort to investigate the questions posed above.
One positive result of the entire Mt. Gox debacle is that by driving the price to unnaturally high levels, it spurred the interest of many casual observers as well as the media who had largely written off the cryptocurrency as a fad limited to the field of geekdom. As a result of $1,000+ valuations, a flurry of entrepreneurship and capital investment entered the Bitcoin space where it wouldn’t have before. Of course, the subsequent demise of Mt. Gox and the fall in price to the $200 range didn’t bode well for Bitcoin afterwords, it is critical to understand that a $1,000 valuation was never real and was fully unwarranted at the time.
Altcoins Provide Answers
Fortunately, there exists an entire cryptocurrency ecosystem accomplish with alternate cryptocurrencies, ‘altcoins’, created as forks to the Bitcoin blockchain or as attempts to rectify certain perceived flaws in the Bitcoin code. Scrypt was introduced as an ‘ASIC-proof’ mining algorithm as Bitcoin’s SHA-256 became predominated by these application-specific microchips, rendering solo miners and their GPU equipments obsolete. Other altcoins were created to permit for certain fresh applications. Namecoin was intended to become an alternative to DNS domain name service for the .name internet domain. Peercoin was intended to permit Proof-of-Stake to coexist alongside Proof-of-Workstore value cotsikis.si mining. Dogecoin was created as a practical joke to the Bitcoin community, but gained mass appeal nonetheless.
Regardless, all of these various cryptocurrencies existed alongside Bitcoin, and many had tradeable currency pairs on various exchanges. By disrobing away the dollar, euro, and yuan exchange rates, much of that previous noise and volatility disappeared. What remained was a remarkably stable BTC-denominated universe of cryptocurrencies. Trading bots functioned by interfacing with exchanges’ APIs to take advantage of any arbitrage chance that may arise. Soon, these markets became fairly efficient in terms of relative pricing of cryptocurrencies. If one coin currency pair became out of whack, these trading bots would very quickly take advantage of that chance and put everything back in line.
Despite the many differences among the altcoins, they all collective a common lineage back to Bitcoin, and that meant a set of common attributes that could be measured, compared, and analyzed. All of these coins had the following: A value for the block prize; the targeted time inbetween blocks; the number of blocks to be found before re-targeting the difficulty; the mining algorithm employed; how many total coins will ever come to exist; the halving schedule; and how long each has been in existence. There were also outside variables such as the amount of hashing power directed at a certain coin, which influences its mining difficulty. And of course, the market price in terms of Altcoin/BTC.
Taking all of these variables into account, numerous regression analysis was employed to evaluate how meaningful these inputs were at conferring relative value, if at all. The results were surprising. Very first, it doesn’t matter how long a coin has been around; the date of the genesis block was largely irrelevant. 2nd, the amount of coins ever to exist does not matter for relative value. Bitcoin’s twenty one million cap, 42Coin’s cap at 42, or Peercoin’s infinite future supply played no role in value formation. Furthermore, the price of a coin was uncorrelated with its market cap. While the 42Coin commanded an exchange price of almost five BTC, its market cap was less than $50,000 all told. The exchange rate had little to do with the money supply.
What is statistically significant turns out to be the rate of coin formation for a given unit of hashing power. 42Coin isn’t trading at five BTC because there will only be a a few dozen to exist, rather it is because the block prize is a mere 0.000042 coins. The larger the block prize, the less valuable the altcoin is at exchange. Scrypt is a more challenging algorithm to solve than SHA-256, so for a given unit of computational effort, effectively less Scrypt coins can be mined – and all else equal, a coin with a tighter algorithm is more valuable. As the mining difficulty of a coin increases, a unit of hashing power will find less coins over that interval – the higher the difficulty of a coin, the more valuable.
Bitcoin Regulates Altcoin Production
Taken together, the main driver of relative value in cryptocurrencies is how many coins a unit of hashpower can find on average over some interval, say in a day. In other words, value seems to be related to the production side. Mining, then, could be thought of as a competitive market where producers (miners) rival with each other to mine for coins and then bring them to market. Of course, some miners hoard their stash for speculation or for reasons of loyalty and sense of community. But assuming that the majority of miners are rational and driven by the profit motive, the altcoin-producing economy might actually serve as an analog for competitive commodity production.
Bitcoin benefits from path-dependence. It was the very first mover in the space of blockchain-based virtual currencies, and it has the greatest market depth as well as social and merchant acceptance. Today, it is fairly effortless to find a merchant to accept Bitcoin for payment whether it be for a cup of coffee at a neighborhood cafe, a fresh sofa from an online store, or an international flight on a major airline. You would be hard-pressed, however, to find a ticket from Fresh York – Los Angeles in exchange for Litecoin, Darkcoin, or Dogecoin, the three largest altcoin behind Bitcoin. Anybody wanting to use cryptyocurrency to transact with the real economy these days must do so with Bitcoin, and therefore one would have to exchange their altcoins for Bitcoins. A rational, profit-motivated producer of cryptocurrencies would only determine to point their mining effort at an altcoin, then, if they could exchange them for effectively more Bitcoins than mining for Bitcoin directly. Otherwise they will elect to mine for Bitcoin instead by default. Multi-pools that steer a miner’s effort automatically to the most profitable coin is an example of this in practice.
This point cannot be understated: The only reason to mine for an altcoin is because it provides the chance to exchange them for more Bitcoin than mining for Bitcoin directly. Take for example the choice to mine inbetween Bitcoin and some hypothetical altcoin, XYZCoin, and my mining equipment can produce an expected one BTC/day. The same mining equipment can produce an expected 33,000 XYZ/day. If the market bid is 0.00003996, I can exchange my XYZ and get 33,000 x 0.00003996 = 1.32 BTC/day, making XYZCoin mining 32% more profitable than BTC.
Two coerces will act on XYZCoin to eliminate this chance for excess profits. Very first, I will keep producing XYZCoin and selling them in the market, driving down its price until it reaches 0.00003030 in our example. At the same time, the extra mining power coming in XYZCoin mining will drive up its difficulty, reducing the amount of XYZCoin expected given the hashpower in my mining equipment. Because the market price can adjust continuously, but the difficulty adjustment happens only incrementally, there is a probability that when the difficulty adjustment will overshoot rendering XYZ not identically as profitable to mine as Bitcoin (which economic theory would suggest), but less profitable.
This doesn’t mean that Bitcoin is the optimal technical achievement of the blockchain. Bitcoin has flaws and limitations, and there are certainly altcoins out there that address and resolve many of those problems. History does not always prize the best, however. The VHS won out over the technologically superior BetaMax. USB over Firewire. TCP/IP over ISO/OSI. QWERTY Keyboards. Internal combustion engines. History is littered with sub-optimal technologies becoming the most widely accepted stable equilibrium – and these equilibria are amazingly difficult to dis-entrench.
The implications are significant. When altcoins are produced they are done so, on average, in order to sell them in comeback for Bitcoin. This means that altcoins are always for sale, and their market price over time should decline relative to Bitcoin. In fact, this downward trend has been the observable case for the majority of altcoins to date.