Monday, November 13, 2017

Unavoidable questions in any meaningful price analysis

I consider my background in economics and price analysis to be a work in progress, and so I hesitate to post about cryptocurrency price movements and market behavior. That said, most analyses I see even from purportedly reputable sources ignore very basic and obvious questions. While I might not have firm answers, I can at least call out these obvious yet often ignored questions.

Any discussion about "appropriate" price for a unit, e.g. a bitcoin, must first explore "appropriate" market capitalization. The division of net money supply into units (e.g. bitcoins or satoshis) is as arbitrary as the division of a company's market capitalization into shares. The only economically meaningful unit is the company as a whole. In exactly the same sense, the only economically meaningful unit for a cryptocurrency is that cryptocurrency's market capitalization as a whole - and so this is where any analysis must start. At the end of the analysis, there is a mundane point of dividing capitalization by money supply so as to translate into a unit price, but that is of no economic significance whatsoever. Any analysis which starts out by examining the value of a "bitcoin" or a "satoshi" is therefore absurd. I wonder if this strangely common oversight is because we are accustomed to fractional reserve banking systems, where (unlike cryptocurrencies) the money supply is difficult to pin down.

But even that is not the start. No analysis should discuss "appropriate" market capitalization of a specific cryptocurrency until first considering the appropriate capitalization of cryptocurrencies taken together. After doing that, they should then formulate some argument as to what share of that net capitalization should constitute a specific cryptocurrency of interest (e.g. bitcoin). One might keep that pithy for example by saying that network effects should allocate the vast majority of net cryptocurrency market capitalization to just one single cryptocurrency, and then make the case that this cryptocurrency is the specific one under discussion (e.g. bitcoin perhaps due to first mover advantages). But some such claim should be made, as the validity of the analysis which follows must rely on it.

And how can one consider appropriate market capitalization of cryptocurrencies as a whole, without asking about viability? There are numerous existential risks which cryptocurrencies must survive, e.g. specter of cryptopocalypse (especially as quantum computation comes online), instability of code and protocol governance (especially as cryptographically naive money pours in), transition to palatable / scalable energy profile, continued acceptance by world governments, economic stability of competitive market among denationalized currencies (as first discussed by Hayek in 1976), etc. Some odds must be placed on long-term viability of the cryptocurrency space so that all subsequent analysis can be discounted accordingly.

I can't imagine that each article could reasonably address all of these points directly, but there should be articles addressing each in turn and they should reference each other. For example, any article saying bitcoin is presently under or overvalued should reference articles spelling out the underlying assumptions to which that particular author subscribes, so that there can emerge coherent schools of belief that can compete over relative merits.

If one did want to ignore the fundamentals entirely and only look at price movements, then one must first argue that the fundamentals are sufficiently stable and accounted for by market price to not dwarf other considerations. That seems like a difficult argument to make with a straight face. But if one were to take this approach, then all price movements should be considered on a logarithmic scale, as the calibration of units is itself one of the points being explicitly ignored.

Any price analysis which does not directly or indirectly (e.g. by reference to other articles) address these fundamentals would seem as credible as a roll of the dice.

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Eltoo

This https://blockstream.com/eltoo.pdf