How JPMorgan Private Bank views Bitcoin

Will the growth in value of the Bitcoin network follow Metcalfe’s Law? We’ll see.

Network effects exist in any multilateral system.

The magical network effect allows the value generated within the system to grow exponentially. With the addition of modern technology, the fermentation vacuum of the network effect has been repeatedly shortened.

Network effects have not been discussed in detail before as an important value building block within the Bitcoin system. This article from JP Morgan’s Private Banking Group examines the value of Bitcoin and whether it can outperform gold as a better store of value from a network effects perspective. Translated by Rhythmic BlockBeats.

What would make an immature asset like Bitcoin a strong contender in a strategic portfolio? Here’s how we should understand this investment opportunity.

As Bitcoin rapidly rises (in price and social buzz), we are all being forced to learn and understand more about the asset, and try to make sense of the puzzle: What is Bitcoin? How does it work? What is the blockchain? What does bitcoin mean to investors in the short and long term?

From our perspective, Bitcoin should be classified as a crypto asset (a store of value) rather than a cryptocurrency; the design of the network (too slow to trade) makes it impossible to use as a daily medium of exchange. That said, our goal in this article is not to introduce readers to the complex network and groundbreaking technical specifications behind Bitcoin. Instead, from an investor’s perspective, we aim to.

-focus on the value of Bitcoin’s network growth. While the likelihood of widespread adoption of Bitcoin is uncertain, Bitcoin’s ultimate success, like that of social networks, depends on the growth of this network’s users. During the bitcoin frenzy, institutional custodians have continued to increase their holdings. These key investors have driven Bitcoin’s maturation and become a milestone representing the network’s boom.

-Discuss the implications for the right investors. This is still an early and speculative era in Bitcoin’s development. At this stage, the right investor may allocate a small portion of their portfolio to bitcoin, similar to investing in call options that are likely to be underwater. As the network expands, we may see the potential for bitcoin to serve as a store of value in a portfolio, similar to gold, but in a transformative and more easily accumulated and traded form.

Bitcoin is like gold, but its value-storage properties are still emerging

While Bitcoin may not have a bright future as a cryptocurrency, it can serve as a store-of-value asset that shares key characteristics with gold. First, it is decentralized in terms of control. Bitcoin is issued and controlled without the influence of any entity, institution or government. The same is true of gold. In times of heightened economic or political uncertainty, this decentralized control is a key reason why gold can serve as a safe-haven asset – a role Bitcoin will eventually play as well. Second, like gold, the supply of bitcoin is finite; there will never be more than 21 million bitcoins. However, unlike gold, bitcoin is much more volatile.

So far, bitcoin’s price action has not been like that of gold. The difference in volatility is very large: 72% for bitcoin compared to 14% for gold. While gold has been almost as volatile as stocks, bitcoin’s volatility is in a class of its own. In addition, when other financial assets are volatile, gold is also volatile, but in the opposite direction. Usually during a pullback in stocks, the value of gold rises. Bitcoin’s price changes are not regular, sometimes not correlated with other financial assets, and sometimes in sync with growth stocks. While Bitcoin may not be performing like gold today, that doesn’t mean it won’t in the future as well. So what could make these gold-like characteristics even more remarkable?

As with social networks, Bitcoin’s value depends on its user base

For bitcoin to truly challenge gold in terms of strategic portfolio allocation, its ‘believer base’ needs to grow – this is the key to transforming bitcoin, from the immature asset it is today, into the global store of value asset it will be in the future.

In the wake of the New Crown epidemic, Bitcoin’s ‘legion of believers’ is expanding – with year-over-year growth in Bitcoin wallets increasing from 27% in mid-2020 to 50% by March 31, 2021. More importantly, institutional investors are also continuing to believe in Bitcoin – a milestone in the ‘adoption’ of crypto assets, as institutional capital tends to be ‘sticky’. A survey of nearly 400 U.S. institutional investors in 2020 found that 27% of respondents had some exposure to digital assets, up from 22% in 2019. (Their top three reasons for investing in crypto-assets were: their low correlation to other assets, the fact that crypto-assets are innovative technologies, and the upside potential of crypto-assets). Since the survey was conducted (June 2020), the operations of custodians have demonstrated a surge in their interest in crypto assets, and the increase in crypto-related content in earnings filings of S&P 500 companies has led some to speculate that institutions will adopt crypto assets more in mid-2021.

Institutional investor participation is increasing

How JPMorgan Private Bank views Bitcoin

Image Credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; March 31, 2021

As the Bitcoin network grows, the durability and value of crypto assets is expected to increase. This is similar to what we have seen with the growth of networks like Facebook. If there was only one person on the network, it would be worthless. If there were 100 people, it would be somewhat valuable, but with billions of people in the network, it would be very valuable.

Metcalfe Network Effect

Research on network effects was initiated by Robert Metcalfe (co-founder of Ethernet) in the early 1980’s and normalized in 1993. His analysis is based on the premise that the value of a network is greater than the actual number of users in its network, thanks to the power of ‘links’. As the number of users grows linearly, the number of strings in the network and their value grows exponentially. That is, if there are 100 users in the network, then the network is worth 100^2 = 10,000 instead of just 100. But this number may be overly optimistic because not all nodes are interconnected, so the model has been modified.

The value of a network grows exponentially with the number of its users

How JPMorgan Private Bank views Bitcoin

Image credit: Yoo, Christopher S., “Network Effects in Action” (2020). Faculty Scholarship at Penn Law. 2236.

Metcalfe’s Law helps us understand why Facebook is now a nearly $1 trillion company. From 2014 to 2020, if we relate historical monthly active users to the price of outstanding shares, we can estimate Facebook’s historical stock price as a function of n^1.7 (the original ratio is n^2), using the “generalized Metcalfe’s Law”. This means that the price of the stock can be expressed as a function of the number of active users. For example, as of December 31, 2020, the number of monthly active users is 2.8 billion; this means that the total value of FB is about 2.8^1.7, or a market cap of $725 billion, or about $255 per share (very close to the actual market cap of $778 billion at the end of the year, or $273 per share). The model suggests that every 10% increase in the number of active users since 2014 translates into a 17% increase in Facebook’s value.

Facebook’s share price can be estimated based on the number of its users

How JPMorgan Private Bank views Bitcoin

Image credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; December 31, 2020

However, this index has not been static throughout the life of Facebook stock, and the value generated by each marginal user has changed as Facebook has continued to mature and continue to innovate. Early on, investors may have been skeptical that the network would make it to maturity and that they would not pay for the potential value generated by users – this is reflected in the below-average Metcalfe index in early 2010. However, as the network becomes more likely to reach maturity, the index rises rapidly in mid-2010 and eventually levels off, suggesting that ultimately additional users are not adding as much incremental value.

As the network moves into maturity, the impact of additional users on Facebook prices is declining

How JPMorgan Private Bank views Bitcoin

Image Credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; December 31, 2020

The evolution of Facebook and the value of the network captured by Metcalfe’s Law is very instructive when considering Bitcoin. We are not using Facebook as an analogy and using Metcalfe’s Law to get an imprecise target price. Nor do we ignore the fact that the Facebook network can be more easily monetized through advertising. This analogy demonstrates the power of a mature network. Today, by all dimensions, the Bitcoin network is still immature, with only 70 million Bitcoin wallets in total and less than 1% global adoption; this means that the incremental impact of new users on the price (i.e. its index) is still rising. Furthermore, the generalized Metcalfe’s law index, at the current bitcoin price, has a value of n^1.54. This index indicates that bitcoin investors value bitcoin in line with Metcalfe’s law, yet the price is off.

The number of bitcoin wallets is part of its price function

How JPMorgan Private Bank views Bitcoin

Image credit:, Bloomberg Finance L.P., J.P. Morgan Private Bank; March 31, 2021

Admittedly, there are still many unknowns about the future of Bitcoin. For example, what impact might government regulation have? Until we know who and how Bitcoin and other crypto assets will be regulated, it is difficult to discern its impact on the growth of the network. If regulations are put in place to protect investors, then ultimately these regulations could contribute to creating a more desirable and durable network. Of course, Bitcoin is not without its competitors. There are over 4,000 crypto assets today. We expect only one or a few winners to remain in the end. Each survivor will represent a specific track and have a different mission. That is, it could be a battle for trade, a store of value, and already an on-chain application platform. Bitcoin’s first-mover advantage (according to April 2021 data, Bitcoin’s market cap is about half of the total crypto market cap) may be its best guarantee as digital gold.

What does this mean for investors?

In our view, Bitcoin has reached a key milestone on its path to widespread adoption, with institutional investors gaining confidence in the network. Because the price of Bitcoin remains very volatile and its correlation with other mainstream assets has been inconsistent, a small allocation is possible for some investors. Imagine that if Bitcoin is widely adopted, your investment could make several times as much, or if Bitcoin doesn’t pan out, your investment is just an underwater option.

Bitcoin’s inconsistent correlation makes it suitable for only a small allocation in the early days

How JPMorgan Private Bank views Bitcoin

Image credit: Bloomberg Finance L.P., J.P. Morgan Private Bank. Among the indices are: Gold Index, US Dollar Index, S&P 500 Growth Index, IEF Index (7-10 year US Treasury Bond Index); April 23, 2021

Eventually, if Bitcoin reaches maturity, we expect it to look more like gold. At that stage, Bitcoin will fit into portfolio strategies that allocate a lot of money to gold. But we’re not at that point yet.

In order for bitcoin to cross the threshold from being a ‘call option worth considering’ to a strategic portfolio asset, we need to see its volatility stabilize in the future, so that when other mainstream assets fluctuate in price, the volatility of bitcoin’s price is no longer so outrageous, and this is what will make bitcoin stand out from other crypto assets and be the ultimate winner.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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