Hi all!
Macro tensions are showing no signs of letting up, compounded by growing interest in cryptocurrencies from central banks at the helm of very large economies (cough, China).
In spite of the uncertainty and turmoil, the price has been trading in a relatively stable range, which would be good news if it weren’t for the fact that THE BRIEFING this week talks about bitcoin volatility and how it’s not going away any time soon 🤷♀️.
We have another introductory report to offer you, this time on valuation techniques. How do you value an asset that has no cash flows? We don’t have the answer, but we introduce a series of theories and metrics that shed light on cryptocurrency fundamentals and could point to the evolution of its market value. You can download it for free here.
Read on…
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What Bitcoin’s Valuation Says About its Volatility
THE TAKEAWAY: Bitcoin’s volatility is unlikely to diminish, even with greater liquidity, because of its fundamental valuation drivers.
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Most of us think we understand the term “volatility.” We digest headlines about tense political situations around the world; we are wary of explosive chemical compounds; some of us have had relationships with their fair share of ups and downs.
“Volatility” implies sharp and unpredictable changes, and usually has negative connotations. Even when it comes to financial markets, we intuitively shy away from investments that would produce wild swings in our wealth.
But volatility, in finance, is usually misunderstood. Even the most commonly accepted calculation is often incorrectly applied.
Its desirability is also confusing. Investors hate it, unless it makes them money. Traders love it, unless it means too high a risk premium.
And few of us understand where it comes from. Many think that it’s the result of low liquidity*. This intuitively makes sense: with thin trading volume, a large order can push prices sharply up or down. But empirical studies show that it’s actually the other way around: volatility leads to low liquidity, through the wider spread market makers apply to compensate the additional risk of holding a volatile asset in their inventory.
(*The misconception also stems from our mistaken conflation of low liquidity and low volume – it is possible to have high volume and low liquidity, but that’s for another post.)
This confusion matters in the crypto sector. Bitcoin’s volatility has often been cited as the reason why it will never make a good store of value, a reliable payment token or a solid portfolio hedge. Many of us fall into the trap of assuming that as the market matures, volatility will decrease. This leads us to believe in use cases that may not ever be appropriate; it can also lead us to apply incorrect crypto asset valuation methods, portfolio weightings and derivative strategies that could have a material impact on our bottom line.
So it’s worth picking apart some of the assumptions, and looking at why bitcoin’s unique characteristics can help us better understand market fundamentals more broadly.
Changing uncertainty
First, there are different types of market volatility. Academic literature provides an array of variations, each with its distinct formula and limitations. Jump-diffusion models used to value assets hint at a helpful differentiation. “Jump” volatility results, as its name implies, from a sudden event. “Diffuse” volatility, however, is part of the standard trading patterns of an asset, its “usual” variation.
With this we can start to see that, when we assume that greater liquidity will dampen price swings, we’re talking about “jump” volatility. “Diffuse” volatility, however, is a more intrinsic concept.
The standard deviation calculation – the most commonly applied measure of volatility – incorporates the destabilizing effect of sharp moves by using the square of large deviations (otherwise they could be offset and masked by small ones). But this exaggerates the effect of outliers, which are often the result of “jump” volatility. These are likely to diminish as transaction volume grows, leading to a misleadingly downward-sloping volatility graph.
JP Koning proposes an alternative calculation that uses the deviation from the middle value rather than the average, which reduces the effect of outliers and shows a more intrinsic volatility measure. As the below chart shows, this has not noticeably decreased over the years.
 (chart from Moneyness blog)
Now let’s look at why this might be. A clue lies in the methods used to value bitcoin.
Fundamental value
Bitcoin is one of the few “real assets” traded in markets today, in that it does not derive its value from another asset.
What’s more, it is a “real asset” with no discernible income stream. This makes it very difficult to value. Even junior analysts can calculate the “fair value” of an asset that spins off cash flows or that returns a certain amount at the end of its life. Bitcoin has no cash flows, and there is no “end of life,” let alone an identifiable value.
So, what drives the value of bitcoin?
Many theories have been put forward, some of which we describe in our report “Crypto’s New Fundamentals.” And as the market evolves, some may rise in favor while others get forgotten or superseded.
For now, though, the main driver of bitcoin’s value is sentiment: it’s worth what the market thinks it’s worth. In the absence of fundamentals, investors try to figure out what other investors are going to think. Keynes likened this to a contest in which “we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Gold is in a similar situation, in that it is also a “real asset” with no income stream and a market value largely driven by sentiment.
So, why is its volatility so much lower?  (chart from Woobull)
Because of “radical uncertainty.”
Changing narratives
In his book “The End of Alchemy”, Mervyn King explains that under “radical uncertainty,” market prices are determined, not by fundamentals, but by narratives about fundamentals.
Bitcoin is a new technology, and as such, we don’t yet know what its end use will be. Everyone has their theory, but as with all new technologies, no-one can be certain, which makes its narrative changeable.
Gold, on the other hand, is neither new nor a technology. It has been around for millennia, and its narrative is not uncertain. Sentiment plays an important part in its valuation, and scientists may yet uncover an innovative use for the metal that affects both demand and price. But its “story” is well established, which gives it a lower volatility profile.
For now, bitcoin’s fundamentals are its narrative, and the uncertainty about bitcoin’s “story” means that its volatility is unlikely to diminish any time soon.
A more prominent role
This matters for its eventual use case: will it always be too volatile to be used as a payment token, store of value, etc.? This in turn impacts its narrative, which affects its valuation and volatility, which affects its eventual use case. The self-perpetuating loop will eventually be broken as the sector matures and bitcoin’s role as an alternative asset class becomes more firmly consolidated – when uncertainty diminishes and its “intrinsic value” becomes easier to quantify.
But until then, its price will continue to be driven by market sentiment, which is susceptible to changeable narratives that in turn are formed by global developments and also by market sentiment.
Until then, market shifts will continue to be amplified in either direction, whatever the trading volume.
Rather than fret about this, we should accept and even embrace it. Increasingly sophisticated providers are working on improving the access to and interpretation of sentiment data, which strengthens our analytical tools. Crypto Twitter provides an engrossing platform to gauge the sector’s mood. And the identification of the impact of narrative and sentiment on an asset class will open up new avenues of investigation that is likely to spill over into other areas of investing.
What’s more, volatility may be inconvenient for some and uncomfortable for many. But it is also an important component of superior returns. Perhaps the tools and skills we develop to hone our bitcoin valuation techniques will enable a more masterful handling of volatility’s inherent uncertainty, and allow for a deeper appreciation of what it has to offer.
– Noelle Acheson |
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Genesis is one of the world’s largest digital currency trading and lending firms. We offer investors the ability to buy, sell, borrow and lend a multitude of assets in a trusted and regulated way. For more information visit: www.genesistrading.com or email us at info@genesistrading.com.
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* you're busy, I know - these are the six items I'd get to first if I were in a rush
BIG IDEAS
*A most peaceful revolution (Nic Carter) – The political evolution and significance of bitcoin; long, but a must-read.
Some Thoughts On Crypto (AVC) – Venture capitalist Fred Wilson reminds us that blockchain development is rife with hurdles and setbacks, but his conviction in the potential is still solid.
*Crypto Is For Diversification; Not Negative Correlation (Altcoin Magazine) – The focus on bitcoin’s short-term role as a “macro hedge” misunderstands its long-term value proposition; it’s about lack of correlation, which makes it a strong diversification asset.
Mind your Satoshi’s & your Bitcoin will be Worth Much More… (CoinRoutes) – Crypto investors tend to overlook small differences in trading costs, to their detriment; this is especially important given the asset’s appreciation potential.
*Monthly Bitcoin Outlook August 2019 (Delphi Digital, paywall) – The crypto research firm released their latest monthly bitcoin report which shows data that supports the idea that most of the current price action is dictated by short-term traders, and that investors are in a holding pattern.
Record Bitcoin-Yuan Divergence Suggests New Trade-War Fallout (Bloomberg, paywall) – The negative correlation reached record levels in the past week, which could indicate increased bitcoin demand from Chinese residents looking for a hedge against further yuan depreciation.
Bitcoin in a Deflationary Age (Messari) – Deflation reduces the demand for inflation hedges, but negative interest rates increase the demand for alternatives to cash.
Crypto and the Latency Arms Race: Towards Speed Bumps and OTC Trading (CoinDesk) – Max Boonen, CEO of crypto OTC firm B2C2, picks apart the role of high frequency trading in crypto markets.
Majority of Asset Managers Expect to Increase Allocation to Crypto (TabbFORUM) – A recent survey revealed that nearly half of all buy-side participants plan to increase allocation to crypto assets in the next five years.
Cryptocurrency Not Proven Safe Haven Says Investor Mark Mobius (CoinDesk) – The founding partner of Mobius Capital Partners still believes that cryptocurrencies only hold utility as far as others are willing to use them, and that a gold-backed cryptocurrency run on the blockchain would be of interest.
MARKETS
*The Post Trade: Settlement solutions are popping up in crypto, but large traders aren’t impressed (The Block, paywall) – Industry sources say the additional costs don’t justify the benefit.
Bitcoin is Correlated to . . . the VIX? (Blockforce) – Bitcoin is exhibiting an elevated short-term correlation with the volatility index, especially when it is above 20.
Behind Bitcoin’s Price Rally: What Makes This Time Different (SFOX) – In part it’s the increasingly tense global macro situation; but largely, it’s increasing institutional interest.
VanEck, SolidX to Offer Bitcoin ETF-Like Product to Institutions (CoinDesk) – The companies will use an SEC exemption that will allow shares in their VanEck SolidX Bitcoin Trust, similar to an ETF but listed on the OTC Link ATS platform, to be offered to institutions such as hedge funds and banks, but not to retail investors.
What’s in a name? Musings on VanEck’s plan to offer a new way for investors to buy bitcoin (The Block, paywall) – The “limited ETF” isn’t an ETF at all.
Massive $1 Billion Bitcoin Whale Transaction Makes Waves (CoinDesk) – An example of the extraordinary data trail that cryptocurrency transactions leave.
Paxos Launches Gold-Backed Cryptocurrency (CoinDesk) – Each ethereum-based Pax Gold (PAXG) token represents legal title to a physical bar of gold, and has been approved by the New York Department of Financial Services.
Franklin Templeton to Track Money Fund Shares on Stellar Blockchain (CoinDesk) – Not all blockchain-based markets innovation is about a new type of asset; sometimes it’s a new way of moving traditional ones.
CRUNCHING NUMBERS
*Bitcoin has ‘superior’ historical risk adjusted returns compared to gold and the S&P 500, but why should anyone care? (The Block, paywall) – Why we shouldn’t use the Sharpe ratio to justify a bitcoin allocation in our portfolio.
Five Fascinating Data Visualizations that will Help You Understand Centralized Crypto Exchanges (intotheblock) – How exchange funds flow.
Skew (@skew_markets@skew_markets) has added some intriguing macro charts to their dashboard, including returns of and correlations between bitcoin, gold and the S&P 500.
REGULATORS AT WORK
SEC Chair Clayton: Would-Be Bitcoin ETFs Have ‘Work Left to Be Done’ (CoinDesk) – Speaking on CNBC, SEC Chairman Jay Clayton acknowledged that “progress is being made” in the crypto space to allow a bitcoin ETF to launch, though potential price manipulation and custody considerations were still a concern.
The State of Security Token Regulations in Asia (CoinDesk) – What’s going on the regulatory front in Thailand, Singapore and Hong Kong.
Crypto Firms Serving Netherlands Must Register With Dutch Central Bank (CoinDesk) – From January 2020, any firm with Dutch clients that is involved in the conversion of crypto to fiat currencies or offering crypto deposit services must register with the De Nederlandsche Bank, to comply with EU anti-money laundering rules.
SECURITY TOKENS
tZERO CEO Saum Noursalehi Issues Update on Company Progress (Business Wire) – An open letter from the head of the Medici Group security token platform that addresses issues such as Overstock CEO Patrick Byrne’s resignation, a recent SEC enquiry and progress since the last update.
STABLECOINS
JPMorgan Fears New Breed of Crypto Like Libra Face ‘Gridlock’ (Bloomberg, paywall) – Stablecoins could fail to function well in periods of stress, according to analysts at JPMorgan, due to a lack of short-term liquidity facilities common in other payments systems, as well as the threat of negative yields which would impact reserve returns.
Tether Launches Chinese Yuan-Pegged Stablecoin on the Ethereum Blockchain (CoinDesk) – Reports hint that the reserves will be stored in a bank in Belgium.
Binance Launches Dollar-Backed Crypto Stablecoin With NYDFS Blessing (CoinDesk) – Binance USD (BUSD), created in partnership with the Paxos Trust Company, will be backed by U.S. dollars on a 1:1 ratio.
PODCASTS
THE SCOOP: Frank Chaparro and Chad Cascarilla, CEO of Paxos, chatted about the crypto markets, the nuances of stablecoins and other blockchain-based assets, and the difference between property and securities.
https://overcast.fm/+Rt6pa5jhY
UNCONFIRMED: Laura Shin spoke to Yan Liberman, cofounder at Delphi Digital, about the recent evolution of bitcoin dominance and where its likely to be heading (spoiler: up), what’s holding ethereum back, and how blockchain data can point to sentiment.
BLOCK CRUNCH: Jason Choi interviewed Mark Lamb, CEO of crypto derivatives exchange CoinFLEX, about the advantages of physical delivery over cash-settled bitcoin futures, how market manipulation works, the evolving demand for crypto futures and why crypto is safer for retail than other derivatives markets.
LEDGER CAST: Crypto lawyer Jake Chervinsky explained the reasoning behind the SEC’s reluctance to approve a bitcoin ETF, what the new VanEck bitcoin vehicle represents, and the legal challenges facing decentralized platforms.
WHAT BITCOIN DID: Peter McCormack and crypto lawyers Preston Byrne and Jake Chervinsky dove into the strategy, motives and hurdles of the Libra project.
THE BLOCKCHAIN VC: Tomer Federman interviewed, well, me (!) about institutional involvement in crypto markets, the momentum behind regulatory interest as well as Libra and ETFs.
A-HA!
*Reid Hoffman’s New ‘Hamilton’-Inspired Crypto Rap Video Is Straight Fire (CoinDesk) – You have to see this.
Everybody was Kung Fu fighting? (Albert Bridge Capital) – An interesting twist on the active vs passive investing tug-of-war playing out in the markets.
China’s Crypto Competitor Is Being Built in a Secret Office with Restricted Access (CoinDesk) – This is worth keeping an eye on, as it is likely to trigger a lot of other
JPMorgan Creates ‘Volfefe’ Index to Track Trump Tweet Impact (Bloomberg, paywall) – Another intriguing example of sentiment data analysis.
Why Listening to Sad Music Makes You Feel Better (elemental) – It’s not just the comfort and solace, it’s also the feeling of connection to other human beings.
New Media, Old Story (The Secret History of the Future, podcast) – An entertaining history of ham radios and blogging, and speculation on what the next innovative media might look like.
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FUNDING
U.K.-licensed Nickel Asset Management has raised $50 million for a fund aimed to make profits off the volatility of cryptocurrencies.
According to reports, crypto wallet and data provider Blockchain is raising a $50 million VC fund to invest in industry startups and cryptocurrencies.
Norwegian savings bank Sparebanken Øst has taken a 16.3% stake in Norwegian Block Exchange (NBX), a crypto exchange set up by Bjørn Kjos, founder and former CEO of Norwegian Air Shuttle.
Blockchain forensics firm Elliptic has raised $23 million in a Series B funding round led by Tokyo-based financial institution SBI Holdings.
FIRMS
Crypto exchange and trust company Gemini has launched Gemini Clearing, a fully electronic clearing and settlement solution for off-exchange or over-the-counter crypto trades between Gemini accounts.
Gemini has also introduced sub-accounts for institutions.
Cryptocurrency custody provider Legacy Trust is launching one of the first digital assets-based pension plans.
PEOPLE
Crypto exchange and trust company Gemini has hired Noah Perlman, former Global Head of Financial Crimes at Morgan Stanley, as Chief Compliance Officer.
Angelina Kwan, Chief Operating Officer at crypto exchange BitMEX, is leaving the firm.
Have a tip? Drop me a line at noelle@coindesk.com. |
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We have a new report for you, this time on bitcoin valuation methods. How do you value something that has no cash flows and no established fundamental value? We don’t have the answer, but in this report we hope to introduce ways of looking at bitcoin and ether that could help to develop valuation theses, as well as various metrics that have been proposed as valuation tools.
You can download the report for free here.
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Previous newsletters: 38, 39, 40, 41, 42, 43, 44, 45, 46, 47, 48, 49
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CoinDesk is not an investment advisor. This newsletter is for informational purposes only, and any comments here do not constitute investment advice. |
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Institutional Crypto - What bitcoin’s valuation says about its volatility