Might Metcalfe’s Law Govern Bitcoin’s Price?

Bitcoin is a challenging asset to value. With many assets we can consider the stream of future cashflows the asset might generate to back into a valuation. Not so with Bitcoin given it generates no cash.

Of course, this lack of cashflows, has led many to conclude Bitcoin is a bubble. Yet, gold has value without generating cash. Yes, you can sell gold and receive payment, but that’s true of Bitcoin too. Given this dynamic, Timothy Peterson in a paper in the Alternative Investment Analyst Review has a novel approach for valuing bitcoin factoring in network effects.

Metcalf’s Law

The core of Peterson’s argument is Metcalf’s law. It focuses on network effects. The more people on a network the more valuable it is. For example, if you were the only person on Facebook or TikTok it would not be useful. Yet, with billions of users on these services they are very useful.

A similar dynamic occurs with transactions. For example, if you’re selling a ticket to a Taylor Swift concert to one person, you may not get a good price, or any price at all.

However, if you offer a ticket to a hundred people you’ll likely find an interested buyer. By offering it to millions people, as ticket exchanges do, you may well get the maximum price possible. Essentially the more people on a network, the more valuable the network is. Bitcoin can be considered a network.

Bitcoin Implications

How do these network effects matter to Bitcoin? In the early days to trade it you needed to have a Bitcoin wallet. That wasn’t a painless process, only a few diehard believers did so.

Even now, you have to use various services to trade Bitcoin and it’s certainly not yet fully mainstream. For example, though things are changing, you can’t get Bitcoins from an ATM or buy it in most traditional brokerage accounts without jumping through various hoops.

Peterson argues we can measure this relatively effectively through the number of Bitcoin wallets. For example, in late 2011 there were just 369 Bitcoin wallets and the price was around $2. Then in 2017, Bitcoin’s price was in the thousands of dollars with about 20 million wallets. Today, with 60 million Bitcoin wallets the price is in the tens of thousands of dollars.

Of course, it’s not quite this simple, the supply of Bitcoin matters too. However, the main driver of price, following this line of thinking, is the broadening network of owners of Bitcoin.

Correlation Is Not Causation

We should also note that as with all statistical analysis we should be cautious. Bitcoin’s price has exploded. Anything else that’s seen explosive growth may appear like a potential cause of the price increase. Bitcoin wallets are one candidate here. Still this may not be a causal relationship. Yet, the theory is somewhat intuitive and has had merit in other fields.

Implications

This argument does suggest that as Bitcoin becomes more mainstream and more easily tradable, so its price could rise further.

That said, interestingly, Peterson finds Bitcoin’s price hasn’t always followed Metcalfe’s law. In 2013, Bitcoin’s price spiked beyond what Metcalf’s law suggested, and Peterson believes this may have been price manipulation rather than a more conventional supply and demand dynamic.

In the absence of other firm yardsticks for Bitcoin’s value, perhaps we should watch the network. As it becomes easier to transact in Bitcoin, or add it to your brokerage account as simply as you can add a stock, maybe its price will rise further. Though, of course, this is just one perspective on Bitcoin’s value. For example, the Lindy effect provides another interesting perspective.