What does JPMorgan Private Bank think about Bitcoin?

The magical network effect makes the value generated in the system grow exponentially. With the support of modern technology, the fermentation vacuum period of the network effect has been shortened again and again.

As an important value component of the Bitcoin system, network effects have not been discussed in detail before. This article is from JPMorgan Chase Private Banking, and analyzes and discusses the value of Bitcoin from the perspective of network effects and whether it can surpass gold as a better value storage tool. BlockBeats translated the original article:

“What would make an immature asset like Bitcoin a viable contender for a strategic portfolio? This is how we should understand the investment opportunity.”

During the meteoric rise of Bitcoin (in both price and social buzz), we have all been forced to learn and understand more about this asset and try to understand various difficult questions: What is Bitcoin? How does it work? What is blockchain? What does Bitcoin mean for investors in the short and long term?

From our perspective, Bitcoin should be classified as a cryptoasset (a store of value) rather than a cryptocurrency; the design of the network (transactions are too slow) makes it unusable as a medium of daily exchange. That said, our goal in this article is not to educate readers about the complex network and groundbreaking technical specifications behind Bitcoin. Instead, from an investor’s perspective, we aim to:

- Focus on the value of Bitcoin network growth. While the likelihood of widespread adoption is uncertain, Bitcoin's ultimate success, like that of a social network, depends on the growth of its users. Institutional asset managers have continued to increase their holdings during the Bitcoin craze. These key investors have driven Bitcoin's maturity and become milestones that represent the prosperity of the network.

-Discuss implications for the right investor. It is still early and speculative times in Bitcoin’s development. At this stage, the right investor may allocate a small portion of their portfolio to Bitcoin, similar to investing in a call option that is likely underwater. As the network expands, we may see Bitcoin potentially function as a store of value in portfolios, similar to gold, but in a transformative, more easily accumulated and traded form.

Bitcoin is like gold, but its store of value properties are still emerging

While Bitcoin may not have a bright future as a cryptocurrency, it can serve as a store of value asset that shares key characteristics with gold. First, its control is decentralized. The issuance and control of Bitcoin are not influenced by any one entity, institution, or government. The same is true for gold. This decentralized control is a big reason why gold can serve as a safe haven asset during times of heightened economic or political uncertainty—a role that Bitcoin will eventually fulfill as well. Second, like gold, the supply of Bitcoin is limited; there will never be more than 21 million Bitcoins. Unlike gold, however, Bitcoin is much more volatile.

So far, Bitcoin's price action has not been like gold. The volatility difference is huge: 72% for Bitcoin, compared to 14% for gold. While gold's volatility is already almost as high as stocks, Bitcoin's volatility is in a league of its own. Additionally, when other financial assets move, gold moves as well, but in the opposite direction. Typically during pullbacks in stocks, gold rises in value. Bitcoin's price moves erratically, sometimes with no correlation to other financial assets, and other times in sync with growth stocks. While Bitcoin may not behave like gold today, that doesn't mean it won't in the future. So, what makes these gold-like characteristics even more pronounced?

Like social networks, Bitcoin’s value depends on its number of users

In order for Bitcoin to truly challenge gold’s position in strategic portfolio allocation, its “believer base” needs to continue to grow - this is the key to transforming Bitcoin from an immature asset today to a global store of value asset in the future.

In the wake of the COVID-19 pandemic, Bitcoin’s “army of believers” continues to expand—the year-over-year growth rate of Bitcoin wallets increased from 27% in mid-2020 to 50% as of March 31, 2021. More importantly, institutional investors are also continuing to believe in Bitcoin—a milestone for the “adoption” of crypto assets, as institutional capital tends to be “sticky.” A 2020 survey of nearly 400 U.S. institutional investors found that 27% of respondents had some exposure to digital assets, up from 22% in 2019. (Their top three reasons for investing in crypto assets were: low correlation with other assets, innovative technology, and the upside potential of crypto assets). Since the survey (June 2020) was conducted, asset management firms’ operations have shown a surge in their interest in crypto assets, and crypto-related content has also increased in S&P 500 company earnings filings, leading some to speculate that institutions will adopt more crypto assets in mid-2021.

Institutional investor participation is increasing

Image source: Bloomberg Finance LP, JP Morgan Private Bank; March 31, 2021

As the Bitcoin network grows, the durability and value of the crypto asset will also increase. This is similar to what we have seen with the growth of networks like Facebook. If there is only one person on the network, it will be worthless. If there are 100 people, it will have some value, but with billions of people on the network, its value will be very large.

Metcalfe Network Effect

Research on network effects was started by Robert Metcalfe (co-founder of Ethernet) in the early 1980s and formalized in 1993. His analysis was based on the premise that the value of a network is greater than the actual number of users in it, thanks to the power of "links". As the number of users grows linearly, the number of connections in the network and their value grows exponentially. That is, if there are 100 users in the network, the network is worth 100^2 = 10,000 instead of just 100. But this number may be overly optimistic because not all nodes can be connected to each other, so the model has been modified.

The value of a network grows exponentially with the number of its users

Image source: Yoo, Christopher S., "Network Effects in Action" (2020). Faculty Scholarship at Penn Law. 2236.

Metcalfe's Law helps us understand why Facebook is now a nearly $1 trillion company. From 2014 to 2020, by relating historical monthly active users to the price of outstanding shares, we can use the "Generalized Metcalfe's Law" to estimate Facebook's historical stock price as a function of n^1.7 (the original scale is n^2). This means that the price of a stock can be expressed as a function of the number of active users. For example, as of December 31, 2020, there were 2.8 billion monthly active users; this means that FB's total value is about 2.8^1.7, or a market value of $725 billion, or about $255 per share (very close to the actual market value of $778 billion at the end of the year, or $273 per share). The model shows that since 2014, every 10% increase in the number of active users will translate into a 17% increase in Facebook's value.

Facebook's stock price can be estimated based on its number of users

Image source: Bloomberg Finance LP, JP Morgan Private Bank; December 31, 2020

However, the index has not remained static over the life of Facebook’s stock, as the value generated by each marginal user has changed as Facebook has matured and continued to innovate. Early on, investors may have doubted whether the network would reach maturity, and they were not willing to pay for the potential value of users - this was reflected in the below-average Metcalfe index in the early 2010s. However, as the probability of the network entering maturity became higher and higher, the index rose rapidly in the mid-2010s and eventually leveled off, indicating that in the end, additional users did not add that much incremental value.

As the network matures, the impact of new users on Facebook's price is decreasing

Image source: Bloomberg Finance LP, JP Morgan Private Bank; December 31, 2020

The evolution of Facebook and the value of the network captured by Metcalfe’s Law are instructive when considering Bitcoin. We are not using Facebook as a metaphor to get an imprecise target price through Metcalfe’s Law. Nor do we ignore the fact that the Facebook network can be monetized more easily through advertising. This analogy shows the power of a mature network. Today, the Bitcoin network is still immature in all dimensions, with only 70 million Bitcoin wallets and less than 1% global adoption; this means that the incremental impact of new users on the price (i.e., its index) is still rising. In addition, at the current Bitcoin price, the value of the generalized Metcalfe’s Law index is n^1.54. This index shows that Bitcoin investors’ valuation of Bitcoin is consistent with Metcalfe’s Law, but the price is deviating.

The number of Bitcoin wallets is part of its price function

Image source: Blockchain.com, Bloomberg Finance LP, JP Morgan Private Bank; March 31, 2021

Admittedly, there are still many unknowns about the future of Bitcoin. For example, what impact might government regulation have? It is difficult to discern the impact on the development of the network until we know who and how Bitcoin and other crypto assets will be regulated. If regulations are enacted to protect investors, then ultimately these regulations can contribute to building a more ideal and durable network. Of course, Bitcoin is not without competitors. Today there are more than 4,000 crypto assets. We expect that there will only be one or a few winners left in the end. Each survivor will represent a specific track and have a different mission. In other words, this may be a battle between trading, value storage, and on-chain application platforms. Bitcoin's first-mover advantage (according to data from April 2021, Bitcoin's market value accounts for about half of the total market value of the crypto market) may be its best guarantee as digital gold.

What does this mean for investors?

In our view, Bitcoin has reached a critical milestone on the road to widespread adoption, with growing confidence in the network among institutional investors. As Bitcoin prices remain highly volatile and its correlation with other mainstream assets has not been consistent, a small allocation can be made for some investors. Imagine that if Bitcoin is widely adopted, your investment may earn several times, or if Bitcoin does not succeed, your investment is just an underwater option.

Bitcoin’s inconsistent correlation makes it suitable for only small allocations in its early days

Image source: Bloomberg Finance LP, JP Morgan Private Bank. The indexes include: Gold Index, US Dollar Index, S&P 500 Growth Index, IEF Index (7-10 Year US Treasury Bond Index); April 23, 2021

Eventually, if Bitcoin enters a mature phase, we expect it to look more like gold. At that stage, Bitcoin will fit into portfolio strategies that have a significant allocation to gold. But we are not there yet.

In order for Bitcoin to cross the threshold from being a "call option worth considering" to a strategic portfolio asset, we need to see its volatility stabilize in the future, so that when other mainstream asset prices fluctuate, the volatility of Bitcoin's price is no longer so outrageous, which will enable Bitcoin to stand out from other crypto assets and become the ultimate winner.