Research Notes

Financial services strategy consulting firm, Quinlan & Associates, has released a landmark 156-page report on the cryptocurrency space, the largest and most detailed examination of the industry to date [LINK TO REPORT PAGE].

The report, titled ‘Fool’s Gold? Unearthing The World of Cryptocurrency’, takes an in-depth look at the fundamental functions of cryptocurrencies and the surrounding ecosystem, powered by blockchain technology.

The report also seeks to demystify the ongoing debate in financial markets (and the wider economy) around the true value of Bitcoin and its future outlook through detailed valuation models.

EXECUTIVE SUMMARY

Cryptocurrencies have been heralded as the revolution of the financial system since its proof of concept by Wei Dai and Nick Szabo in 1998, followed by Satoshi Nakamoto’s whitepaper detailing a ‘peer-to-peer electronic cash system’ and open source code, which is now known as Bitcoin.

Underpinned by blockchain technology, cryptocurrencies promised an end to third party institutions and barriers to financial transactions. And in recent years, they have exploded onto the scene at an exponential rate. At its 2017 peak, there were over 1,300 cryptocurrencies in existence, with a combined market capitalisation of nearly USD 650 billion, rivalling the GDP of nations such as Saudi Arabia. Bitcoin (BTC) itself, the most popular cryptocurrency, has touched market capitalisations similar to economies such as Malaysia and Vietnam.

The sudden rise of the cryptocurrency market has generated heated debate by both believers and critics alike for its value, future potential, and use cases. At the centre of this discussion is BTC, with its meteoric price rise capturing daily headlines in mainstream and social media alike, with speculators rushing to the market in the hopes of joining the wave of overnight millionaires. A plethora of inter-related industries have also spawned, including wallets and payment services, crypto exchanges, and mining, as entrepreneurs across the globe look to capitalise on new revenue pools that have opened up on the back of this technological revolution.

To appreciate the recent rise of cryptocurrencies and their future potential, one must understand the underlying technology, surrounding ecosystem, and the place of cryptocurrencies in financial markets (and the wider economy). Our report details the aforementioned criteria, utilising BTC as the exemplar for current cryptocurrencies in place at the time of writing. We also drew further insights from interviews with a wide range of industry stakeholders, as well as survey responses from over 1,500 individuals working predominantly in financial services, FinTech, consulting, and technology.

Most current iterations of cryptocurrencies are, at their core, meant to operate as currencies. However, currencies have, for many centuries, needed to meet a number of specific criteria to be recognised as such – namely, acting as a unit of account, a medium of exchange, and a store of value. Despite fulfilling most of the characteristics of a traditional fiat currency, cryptocurrencies are largely being utilised as speculative investment assets, leading to considerable volatility in their value. This lack of stability, together with soaring valuations, means they are rarely used for payments. In order to achieve status as a legitimate currency, the public must spend cryptocurrencies widely to determine a credible benchmark for their actual value, encouraging businesses to accept them as a medium of payment (hence making them more liquid in the long run). Until then, most cryptocurrencies, including BTC, will continue to exist in a speculative capacity, with all the undertones of being a bubble.

2017 saw the price of BTC surpass the asset price inflation of the 17th century tulip mania, while rendering “bubbles” such as dotcom a mere blip by comparison. Its strong – albeit slowly unwinding – correlation to alternative cryptocurrencies also indicates a collapse in the price of BTC could lead to a rapid downfall for the broader non-fiat cryptocurrency market.

A number of factors underpinned BTC’s price rise in 2017. In the earlier part of the year, many of the gains could be tied to ongoing discourse around its potential regulatory legitimacy. Since then, however, its popularity – and infamy – has appeared to fuel a widespread “fear of missing out” (FOMO), a classic characteristic of most bubbles. Yet, consensus regarding its future value remains literally non-existent, with valuations ranging from USD 0 to as high as USD 1,000,000. Moreover, the majority of these predictions do not appear to be based on any robust, quantitative methods, but are more a reflection of individual opinion.

To determine whether BTC is indeed a bubble, we looked to calculate its value using two overarching approaches: (1) as an asset; and (2) as a currency.

As an asset, we valued Bitcoin using a cost of production approach and a store of value approach, resulting in values of USD 2,161 and USD 687 respectively. To value BTC as a currency, we estimated its utilisation for both legal, retail transactions payments, as well as payments in the black market. After significant testing, we calculated the price of BTC 1 to be USD 1,780.

Irrespective of the valuation methodology employed, we found the price of BTC deviates significantly from its current price of ~USD 14,000. For the longer-term, we are even less optimistic around the future price of BTC and believe it will ultimately be ruled out as a mainstream form of payment. We see this exerting greater downward pressure on its price and forecast it to trade at ~USD 810 by 2020, if not even lower. We therefore believe that BTC, at its current valuation, is a bubble waiting to burst.

While our views on the price (and future applications of BTC) remain muted, our outlook for the broader cryptocurrency industry remains much more sanguine. Existing cryptocurrencies that were designed to replace fiat currencies, such as BTC, are unlikely to act as viable substitutes to the money or currency system we have in place today, due to their inherent challenge to central bank and government functions – namely, fiscal and monetary policy. However, cryptocurrencies with associated utility applications (such as Ethereum’s ETH), as well as fiat cryptocurrencies attached to a sovereign nation, are likely to grow in significance, given the ability of the underlying blockchain technology to provide meaningful enhancements to current payment systems, as well as their broader applications beyond being used as speculative assets (e.g. facilitating the execution of smart contracts).

Although a sharp decline in the price of BTC in 2018 is likely to take the value of other nonutility cryptocurrencies with it, we see the correlation with utility cryptocurrencies being much less pronounced. While we anticipate valuations to decline in the short-term in response to the widespread unwinding of the digital currency space, valuations of utility cryptocurrencies are likely to recover and dominate the market in the long-term. We forecast total market capitalisation of private cryptocurrencies to be USD 407 billion by 2020. We also see fiat cryptocurrencies gaining momentum as governments accelerate their research and piloting efforts, with potential to be a USD 150 billion market by 2020.

While we believe BTC can largely be viewed as fool’s gold at present, digital currencies will continue to unearth major enhancements to the global payments system in years to come.

Source: Platinum: Fool’s Gold – Quinlan & Associates