Valuing Bitcoin and Cryptocurrencies

A key measure of the size of the Bitcoin network is the hash rate*, the combined computing power of the miners operating the network. If the value of a network is dependent on its size, we should expect a correlation between Bitcoin's market capitalisation (the total number of bitcoins in existence x the price) and its hash rate, and for this to hold true for similar cryptocurrencies.

Bitcoin

For 2015 – 2017, I calculate Bitcoin’s average daily ratio of market cap:hash rate to be 8.2 (measured in $ per giga hashes per second), varying from 9.8 in 2015, 5.9 in 2016 and 8.8 in 2017, with a high of 24.2 (16 Dec 2017) and a low of 3.7 (24 Mar 2017). Currently (5 Jan 2018), the ratio is 21, indicating that Bitcoin is overvalued compared to its hash rate by about 140%.

However, the hash rate is growing fast. The daily hash rate averaged over a year quadrupled in 2016 (3.8x) and again in 2017 (4.2x)**. In my experience, once (payment) networks start growing, network effects typically result in fairly constant growth rates, so it is reasonable to expect the average of the daily hash rate to quadruple again in 2018 and possibly also in 2019. If so, the average Bitcoin price in 2018 could be a multiple over that in 2017, and again next year. You can do your own maths using your own assumptions on what these figures might be, but for reference, the average daily Bitcoin price in 2017 was $4,001 (and $567 in 2016).

Ethereum

Ethereum, created in 2015, shows similar characteristics to Bitcoin, although it has a very different market cap:hash rate ratio, averaging 278,000 ($ per giga hashes per second) in 2016 and 294,000 in 2017. I am unsure why the difference in the scale of this ratio between Bitcoin and Ethereum is so big, but possibly it is due to differences in their algorithms. In particular, Ethereum blocks are created every ~15 seconds v ~10 minutes in Bitcoin, and Ethereum uses a protocol called Ghost to promote decentralised mining, and the Ethash memory hard hashing algorithm to resist the use of ASICs (customised chips). Whereas with Bitcoin, mining tends to be concentrated in mining pools using Bitcoin mining ASICs.

Alternatively, it could just be that Ethereum is massively overvalued compared to Bitcoin. However, the Ethereum hash rate*** is growing very fast. The average daily hash rate in 2017 rose 17x over the average daily rate in 2016. This growth appears to be slowing a little, but even so, we could see some very interesting rises in the Ethereum market capitalisation in 2018 as its hash rate grows (again, you do the maths with your own assumptions).

Ripple

The other major cryptocurrency, Ripple (second to Bitcoin in market capitalisation) uses a consensus ledger rather a blockchain, and a different consensus mechanism to the proof-of-work used by Bitcoin and Ethereum, so this analysis is not applicable to Ripple.

Looking Forward

Time will tell if the relationship between cryptocurrency hash power and market capitalisation holds true in the long term where proof-of-work mining is used, but it helps understand the economics of Bitcoin and other public, permissionless, open cryptocurrency networks.

It also gives a glimpse of where Bitcoin may be heading – the hash rate growth will eventually slow, possibly leading to a constant hash rate and a stable price, but that could be years away.

I will look back this time next year to give an update.

Source: For this blog, I have used my own analysis on raw data downloaded from blockchain.info for Bitcoin, and from etherscan.io for Ethereum.

* A hash is a calculation in cryptography and proof-of-work algorithms. Miners compete to complete these calculations to create Bitcoin blocks and collect a reward (currently 12.5 btc per block). The more computing power a miner uses, the greater the chance of creating a block and winning the reward. As miners add more computing power, the Bitcoin code automatically increases the difficulty of the algorithms, requiring more calculations, so that the rate of block creation is kept constant at about one block per 10 minutes.

** The daily Bitcoin hash rate averaged 1.5bn giga hashes per second in 2016, and 6.3bn giga hashes per second in 2017.

*** The daily Ethereum hash rate averaged 4k giga hashes per second in 2016, and 64k giga hashes per second in 2017.