Bitcoins classification and fundamental value — part 1

Today everyone knows the word “cryptocurrency”. School children know it, even though they do not understand what a fiat currency means. Elder people know it, even though they perceive the word "crypto" more like a mantra than a property of a new financial instrument. The phenomenal growth demonstrated by Bitcoin, Ethereum and other cryptocurrencies, really deserves attention, the only question is - what is the reason for such growth? Pure emotional excitement or growth of a certain fundamental value? And in general, what is fundamental value of cryptocurrency and how to calculate it? In this article, we try to classify bitcoin, compare it with existing financial instruments, and identify its’ fundamental value.

We start directly with the attempt to classify bitcoin as any currently known financial instrument (then we can apply certain formulas, principles of valuation, etc.). First of all, it may seem that the term "crypto-currency" already hints that bitcoin is a kind of analogue of the country's money symbol, i.e. monetary unit. Let's try to evaluate it as a currency, i.e. assume that the price of bitcoin is nothing more than an exchange rate. In this case, the classical theory of finance, based on the absence of arbitrage, suggests that we start with purchasing power parity. Well, we have defined the equation, but can we apply it? The answer is "hardly". First, bitcoin is not a monetary unit of any country. This is a decentralized system that does not belong to any state (which is why we did not mention Japan - although it legitimized bitcoins, it has no control). Secondly, the possibility of earning an interest rate on bitcoin today is some sophisticated way of working with bitcoin, rather than a transaction with interest rate and maturity. In other words, it is possible to call bitcoin a monetary unit, but it is not entirely correct. In addition, if we try to analyze whether or not bitcoin performs all money functions (medium of exchange, value store, unit of account, and world money) we would never reach any unanimous conclusion.

If the crypto currency is not money, then what is it? At the annual IFTA conference held in Milan in October 2017, Ferdinando Amertano argued that bitcoins have much more in common with gold than currency. We must say that this position has many arguments to call bitcoins - "digital gold". The fact of the limitation of both already gives them more in common than all the arguments in favor of the currency. Then we can say that the crypto currency is a certain commodity (although the commodity is not a financial instrument in itself, but it is quoted mainly through futures and you can compare bitcoin with it). Here again a number of new contradictions come to the scene. A commodity is a product produced for sale. But in the previous paragraph we noted that bitcoins by functions strongly resemble (though not equal) money. The currency is not printed for sale - it has fundamentally different tasks that are pursued by crypto-currencies as well. In addition, we do not produce anything from bitcoins and do not consume. Again, we come across a number of arguments that do not allow us to equate bitcoin with a commodity.

At the current stage, we have only one type of financial instruments - equity (we do not consider debt and derivative financial instruments, since the bitcoins have nothing in common with them even at the most fundamental level). How can we assume that bitcoin is an equity instrument? This crypto currency can be characterized as a share in a system that has a known limit. But again, to assess how an equity instrument is impossible - there are no cash flows, when liquidating its value is zero, it is difficult to determine the value of a balance sheet or similar market purchases.

Now, we think it's clear that bitcoin is an independent phenomenon that has no analogues. What we are seeing is a paradigm shift, rather than just an innovation. In academic literature the term "commodity money" gets its’ popularity. This is a completely new market, which at the moment is a big mystery, including its’ fundamental values and price forecasts.