If there were ever a noisy market, the young cryptocurrency environment fits the definition. Rarely do we witness such competing and sometimes concerted efforts to both establish and destroy a new asset class. The participants in this cacophony of change in the financial structure span the spectrum of naïve neophytes and phenomenal prodigies. At one end are young, arrogant day-trading chartists who seek to maximize their social media audience. At another are sophisticated, long-established financial institutions with millennia of combined experience and quantitative computing power beyond belief. In between are governments, consumers, opportunists, celebrities, crooks, and investors, each weighing in on cryptocurrency with their varying degrees of experience, means, and motive.
We recently completed research that offers a simple explanation of price formation in the burgeoning and oft misunderstood cryptocurrency ecosystem. Using bitcoin as an example, we provide convincing empirical evidence that price formation is not a semi-random result of emotional investing but instead is founded on economic principles of value that have only recently begun to be recognized: network economics.
With only a few exceptions (2011, 2013, and 2017) bitcoin’s price has followed a predictable path. Mathematically, this path is attributable to Metcalfe’s law, which states that the value of a network grows exponentially over time. Most of the time, this value is reflected in bitcon’s market price.
The formula used is a special curve that assumes adoption rates change over time. For decades, this formula has been used to model viral infection, bacterial growth, tumor growth, and mobile phone proliferation.
A key application of our findings is the ability to evaluate data and marketplace news with the intent to separate meaningful information from misleading noise. Noise is a dominant driver of price and volatility in the short-term. It is not noteworthy that markets disseminate and consume noise about bitcoin or any other cryptocurrency. Forecasts of sky-high prices and doomsday crashes are common with bitcoin. In many cases, cryptocurrency information (positive and negative) is crafted in a convincing way by experienced and knowledgeable sources and presented by reputable media. In isolation, these predictions are indistinguishable from information, even though they are probably noise.
Though value is not observable, even an imperfect assessment of value serves to keep markets efficient. Over time price tends toward value. The model we have presented serves as a backdrop against which potential information can be evaluated. It does not predict that bitcoin’s price will soar or crash. Rather, it suggests that the probability of those extreme those events is very small because ultimately number of users drives price.
This paper onfirms past research that the long-term growth rate in users has considerable effect on the long-term price of bitcoin. Using observed data for both Facebook and Bitcoin, we examine the relationships between price, number of users, and time, and show that the resulting market capitalizations likely follow a unique growth function. This function, historically used to describe the growth of biological organisms like bacteria, tumors, and viruses, likely has some application to network economics.
“Bitcoin Grows Like a Virus” available for download at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3356098