Bitcoin price: Understand Metcalfe’s law and how it relates to cryptocurrency valuation

Bitcoin price: Understand Metcalfe’s law and how it relates to cryptocurrency valuation
on February 28, 2018

Bob Metcalfe is a computer networking pioneer whose work includes the invention of the Ethernet networking standard (what users normally call “the network cable”), founding the 3Com networking giant and, most importantly for us crypto investors, the formulation of Metcalfe’s Law.

Replace the phones by Bitcoin nodes!

Metcalfe’s Law states that the value of a network is proportional to the square of the number of participating nodes.

Due to Bitcoin’s peer-to-peer (P2P) nature, Metcalfe’s Law fit like a glove and investors quickly noticed a parallel between the rate of adoption of Bitcoin and the value of the cryptocurrency.

Metcalfe’s Law and Bitcoin Price

Tom Lee of FundStrat was one of the investors to note that Metcalfe’s Law applied perfectly to Bitcoin valuation.

In an interview with BusinessInsider, Lee claimed that as much as 94% of Bitcoin’s valuation could be determined based on Metcalfe’s Law alone. Based on this idea, FundStrat predicted a U$ 8000 price for Bitcoin in October of 2017, basically hitting bullseye and raising eyebrows in the crypto investment community.

An acclaimed paper by Ken Alabi, published on the Electronic Commerce Research and Applications research magazine also presents similar results. One of its conclusions is that Metcalfe’s Law correctly represented the valuations of three popular cryptocurrencies: Dash, Ethereum and Bitcoin:

The Bitcoin, Ethereum, and Dash networks were analyzed. The analysis shows that the networks were fairly well modeled by Metcalfe’s Law, which identifies the value of a network as proportional to the square of the number of its nodes, or end users.

Networks of Cryptocurrencies

There are obviously many other factors which must be taken into account for the valuation of cryptocurrencies.

For instance, cryptocurrencies are no longer just networks of nodes which exchange value between each other. With the popularization of large crypto exchanges such as Binance, Poloniex, Bitfinex, Bittrex and Coinbase’s GDAX exchange, to mention just a few, cryptos also form a value network in between themselves. Bitcoin can be freely exchanged for most other cryptocurrencies in real time. This generates a more complex model than would be possible to represent through Metcalfe’s Law applied individually to each cryptocurrency.

A complex relation exists between the USD valuation of cryptocurrencies and each different altcoin’s U$ valuation based on Bitcoin price. We have called most of this market capitalization out as fake. While this may seem extreme, it really is not because most cryptocurrencies do not trade directly in U$ denomination. When it is possible to buy cryptos in U$, their volume is usually far below that of Bitcoin. For instance, if you attempted to sell as much as 10% of all Bitcoin Cash into U$ at this time, Bitcoin’s U$ price would collapse as well since BCH must normally (admittedly not always) be converted to BTC before cashing out for fiat money.

We noticed this effect when it was publicized that Tether was under investigation by US regulators. Although USDT Tether total market cap is currently valued at U$ 2.2 billion, the announcement sent tsunami waves through all cryptocurrency valuations, taking much more than just U$ 2.2 billion of total market share down with it.

Metcalfe Applied to Bitcoin Price in 2018

If Metcalfe’s Law (ML) holds up for 2018, in order for BTC to quadruple in price, its adoption will have to double throughout the year. Considering the visibility obtained by cryptocurrencies, especially with the maturing millennial generation’s efficient social networks, it seems likely that the number of Bitcoin users may double in 2018.

Take, for instance, this quote of Mr. Mike Novogratz, found by ZeroHedge:

Speaking to CNBC’s Fast Money, Novogratz raised his price target aggressively, and predicted that bitcoin could quadruple in price by the end of 2018.

“Bitcoin could be at $40,000 at the end of 2018. It easily could,” Novogratz said. As for “Ethereum, which I think just touched $500 or is getting close, could be triple where it is as well.

He predicts that Bitcoin could reach U$40k this year. If Metcalfe’s Law holds, then this is exactly what would happen if the number of Bitcoin users doubled throughout this year. Or maybe Mr. Novogratz employed ML himself and we’re using circular logic? Either way, when you look at it this way, $40k Bitcoin does not seem that far away in the horizon.

Conclusion

It is easy to see how most of the optimistic predictions of Bitcoin price are based on exponential growth. Whether it’s John McAfee’s explicit style or word from suit and tie market analysts, the fact is most forecasts require BTC price to double several times over in order to be realized. Metcalfe’s Law matches this expectation precisely and, given the P2P nature of Bitcoin, it makes perfect sense that predictions based on it have been fairly accurate up to this point.