Soaring Bitcoin’s value in ‘challenging territory’

The speculative mania by retail investors that characterised the Bitcoin surge during 2017 was unfortunately evident again. Picture: AFP

A leading strategist has warned that Bitcoin’s valuation and positioning backdrop is “a lot more challenging” after a spectacular run-up in the past few weeks.

After quadrupling in 2020, the cryptocurrency has had an extremely volatile start to the year.

It surged 19 per cent to a record high of $US34,792.47 in the first three days of 2021, then dived 19 per cent to $US28,019.06 in its sharpest two-day fall since March last year. It subsequently bounced to $US32,871.29 and was trading around $US31,000 late on Tuesday.

“While we cannot exclude the possibility that the current speculative mania will propagate ­further, pushing the Bitcoin price up towards the consensus region of between $US50,000 and $US100,000, we believe that such price levels would prove unsustainable,” JPMorgan Chase’s head of global quantitative and derivative strategy, Nikolaos Panigirtzoglou, told clients in a ­report on Monday.

The spectacular Bitcoin rally of the past few weeks has moved Bitcoin into “more challenging territory” not only in terms of its positioning backdrop, but also in terms of its valuation.

His comments came as Anthony Scaramucci’s SkyBridge Capital confirmed it had launched a Bitcoin-focused fund. Its SkyBridge Bitcoin Fund now has $US310m ($403m) invested in the cryptocurrency.

Valuation validation

JPMorgan’s preferred methods of valuing Bitcoin are to compare its market capitalisation and volatility to the gold market, and also to consider the “mining” cost or intrinsic value.

Bitcoin’s competition with gold is arguably well under way with more than $US3bn of inflows into the Grayscale Bitcoin Trust and more than $US7bn of outflows from gold ETFs since mid-October.

This competition with gold as an “alternative” currency is set to continue for years due to the rise of Millennials and their preference for “digital gold” over traditional gold.

Considering the size of the gold market, a “crowding out” of the precious metal as an “alternative” currency implies big upside for Bitcoin in the long term, according to Mr Panigirtzoglou.

He noted that privately held gold bars and coins amounted to $US2.7 trillion, including gold ETFs. Thus, the market capitalisation of Bitcoin — currently $US575bn — would have to rise 4.6 times from here, implying a theoretical Bitcoin price of $US146,000, in order to match the total private sector investment in gold via ETFs or bars and coins.

However, this upside potential, based on an equalisation of the market capitalisation of Bitcoin to that of gold for investment purposes, depends on the volatility of Bitcoin converging to that of gold.

For institutional investors, the volatility of each class matters in terms of portfolio risk management — the higher the volatility of an asset class, the higher the risk capital consumed by each asset class.

Unsustainable price target

“It is thus unrealistic to expect that the allocations to Bitcoin by institutional investors will match those of gold without a convergence in volatilities,” Mr Panigirtzoglou said. “A convergence in volatilities between Bitcoin and gold is unlikely to happen quickly and is in our mind a multi-year process. This implies that the above $US146,000 theoretical Bitcoin price target should be considered a long-term target, and thus an unsustainable price target for this year.”

Furthermore, Mr Panigirtzoglou argues that in terms of risk capital — taking account of the vastly lower volatility of gold compared to Bitcoin and the volatilities of the biggest Bitcoin and gold funds — the value of Bitcoin has largely equalised with gold ­already.

The three-month historic volatility of Bitcoin is 57 per cent, versus 17 per cent for gold.

In other words, the ratio of the two volatilities suggests that Bitcoin currently consumes 3.4 times more risk capital than gold. It gets worse if one looks at the biggest Bitcoin and gold funds.

The three-month historical volatility for the Grayscale Bitcoin Trust stands at 87 per cent versus 17 per cent for GLD, the largest gold ETF by assets under management, so the ratio of those two volatilities suggests that the Grayscale Bitcoin Trust currently consumes 5.1 times more risk capital than gold.

Combining the two ways of comparing the volatility of Bitcoin and gold suggests the cryptocurrency consumes 4.3 times more risk capital than the precious metal.

That is very close to the 4.6:1 ratio needed to equalise the market cap of Bitcoin to that of gold for investment purposes. In other words, Bitcoin has already almost equalised gold in risk capital terms.

“In our opinion this challenges the consensus idea that a price in the $US50,000-$US100,000 region is a sustainable Bitcoin target for 2021 in the absence of a significant decline in Bitcoin volatility,” Mr Panigirtzoglou said.

Intrinsic value

Looking at the “mining cost” or intrinsic value of Bitcoin, the ratio of the Bitcoin market price to its intrinsic value is higher than its previous mid-2019 peak and matches its end-2017 peak near 3.5 times, again raising concerns about valuations.

With more than 18 million Bitcoins mined of a maximum supply of 21 million, new coin gen­eration is a smaller percentage of the existing supply, so the influence of the production cost on the price has probably diminished, so the market price is probably driving the production cost.

But that doesn’t mean Bitcoin’s price will diverge from its mining cost on a sustained basis.

“Similar to gold, when the Bitcoin market price is well above the production cost, mining activity and mining difficulty should increase, pushing the cost of production up towards the market price,” Mr Panigirtzoglou said.

“But similar to previous episodes, some of that convergence could happen with an adjustment in the market price also. We thus view the acute divergence as another valuation challenge.”

On positioning, he noted that the institutional inflow into Bitcoin was what distinguishes 2020 from 2017, as evidenced by flows into the Grayscale Bitcoin Trust — favoured by many institutional investors for regulatory reasons — but he said it was wrong to view all these institutional flows of last year as entirely driven by long-term investors.

“We believe that a significant component of last year’s institutional flows into Bitcoin may reflect speculative investors seeking to front-run other more real-money institutional investors,” he said. “The frothy positioning in CME Bitcoin futures is one manifestation of this speculative institutional flow which encompasses momentum traders such as CTAs and quantitative crypto funds.”

The speculative mania by retail investors that characterised the Bitcoin surge during 2017 was unfortunately evident again. He argued that the broadening of corporate support for Bitcoin, via PayPal and Square, had been facilitating and enhancing the usage of Bitcoin by Millennials.

One proxy suggestive of increased retail participation is the growth in new account openings on “traditional” cryptocurrency exchanges. Since November, there had been a proportionally similar pick-up in new wallets as that seen in the retail-driven spikes that preceded the 2017 and 2019 peaks.