Off the Chain Capital’s President Brian Dixon sat down with Interactive Broker’s Andrew Wilkinson to discuss how to value Bitcoin as well as trends in energy impacting blockchain miners.
Note: Any performance figures mentioned in this podcast are as of the date of recording (September 21, 2022).
Summary – IBKR Podcasts Ep. 42
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Brian Dixon
Off the Chain Capital is a registered investment advisor with the SEC. So, before we jump in today, I just want to get a quick disclaimer out of the way. Some of the information that we’re going to be discussing today is likely going to contain forward-looking information and so please do not place any undue reliance on the statements that I make as they’re not any type of guarantees of future performance and they’re just my beliefs. And what I think is going on with the digital asset ecosystem. In addition, it’s important to remember that digital assets do contain a high degree of risk and uncertainty.
Andrew Wilkinson
Excellent. Thank you very much Brian Dixon for joining us today. Welcome everybody to today’s IBKR podcast. Brian Dixon is with Off the Chain Capital and Brian recently joined me at ibkrwebinars.com where we talked about Bitcoin and blockchain and valuations and his view off the world through the lens of blockchain and Bitcoin. So, we’re going to delve into a few of the issues we uncovered there. Brian, the first thing I wanted to ask you about was this recent Ethereum upgrade that was recently completed and its intention or what one of the side issues there was to reduce the power consumption used to create this cryptocurrency by 99%. Do you comment on that story in large, how things went, and about crypto, mining and electric usage in general, because my understanding is that that’s a big kind of red flag in terms of ESG for the crypto space.
Brian Dixon
Yeah, I’d be happy to. So, we’re going to break this down in several sections. First and foremost, within the market, there is a lot of confusion and misinformation around the energy consumption and the types of energy used in the digital asset ecosystem. So, I’ll get into that. But before I discuss that, let’s talk specifically around Ethereum. So, there are two types of blockchains. There’s what’s called a proof of work blockchain and a proof of stake blockchain. So today, now that Ethereum has gone through this merge process, the most dominant proof of work blockchain is Bitcoin. And so what a proof of work blockchain is, is you have a series of computers that are basically solving these advanced math problems or algorithms, and they’re putting in this energy to mine and that the mining process on proof of work is that these computers will work to compute and determine the answers to these very sophisticated math problems. And then when they figure it out, they get rewarded with the digital asset. So, in this case Bitcoin.
It was the same process for Ethereum as well, because Ethereum had been proof of work all the way up until just recently when this merge went successful. So, the proof of work blockchains are really where you hear around a lot of the energy stuff. And there’s a lot of ESG related articles and broadcasts that will come out specific to proof of work blockchains. So, a lot of that information that you read in the media unfortunately is not usually very accurate and they don’t place it in context with the true metrics behind the type of energy and how the energy is used in the digital asset space. So, what happened with Ethereum specifically is it was one of these proof of work blockchains, since it launched all the way up just until recently, and in a transition to what is called a proof of stake blockchain. So, it is true that proof of stake blockchains use approximately 99% less energy than what a proof of work blockchain would use, which is the former underlying technological protocol that it was just like what Bitcoin is.
And so what occurred is with proof of stake, instead of going through this energy investment to mine the digital assets, with proof of stake, you have the digital assets released into circulation and you have something that are called validator nodes. And basically, how those work is you will have these pools of assets that will contribute them to what’s called “staking”. And staking is another way to verify the network and authenticate transactions, the same way that Bitcoin miners would do that for the Bitcoin mining network. So, it’s just a different way to go about trying to solve a similar challenge where you verify this and secure the network. And proof of stake is where the vast majority of the digital asset market is today.
The only dominant proof of work blockchain that exists that owns the vast majority of the proof of work market share still is Bitcoin. There are a couple other ones, but the main one is Bitcoin. Now, with Ethereum becoming proof of stake, it is this new underlying base technology. Now it is true that it consumes less energy than a proof of work protocol. However, when you do that, you are giving things up. So as an example, when a theory emerged from proof of work to proof of stake, people now look at Ethereum as much more of a highly centralized protocol as opposed to a decentralized protocol with Bitcoin, that is just a piece of software and there’s no CEO or Board of directors making the decisions for Bitcoin; there’s no marketing team.
But with Ethereum, it’s actually controlled by a very small group of people now that own a lot of the staking and validator network. So don’t get me wrong, Ethereum has created a ton of value over the years, and there’s very unique and novel business applications that have been built on it. But now that it’s transitioned over to proof of stake, I look at it as more of a software business that’s much more centralized, and there can still be tremendous value that’s accreted in time, but it’s it can’t be viewed the same as Bitcoin anymore, because it no longer has that opportunity to be largely decentralized, it does have a small group of people that control the network and they are going to be making these decisions in time and they can change things if they choose to. Whereas Bitcoin you can’t encounter that. But specific to the energy side, yes, its proof of stake does consume a lot less energy.
Now a couple things I want to bring up regarding energy with digital assets that’s very important.
We’ve come to this point in society, I think where there’s so much information around energy that’s being used, trying to track and get to net zero carbon, and we have to remember that using energy is not a bad thing. We use energy for all sorts of stuff, every single day. But you want to make sure the way you’re investing that energy is in good, valuable outcomes, and you want to do your best to use green, renewable energy if possible. And that’s exactly what Bitcoin does with its proof of work blockchain. And the reason that is, because when you add up all the energy consumption for the Bitcoin network, according to Cambridge University’s most recent energy study on Bitcoin, it reflected that it uses 0.06% of the world energy consumption. So that is a very, very nominal amount of energy.
In addition to that, in terms of renewable energy, Bitcoin has the highest renewable fuel mix make-up of any other industry in the world. In fact, over 50% of the mining operations that mined Bitcoin is being done via green and renewable energy. And it’s also sparking the highest innovation in renewable energy than any other industry. One of the unique things we’re seeing specific to the Bitcoin protocol in terms of capturing and harvesting wasted energy is through flaring that occurs with natural gas. So, there’s companies now that can actually capture the flaring so it doesn’t get burnt up into the atmosphere, which is very harmful, and they can redistribute that flaring down into a Bitcoin miner to power the Bitcoin miners.
So, it’s creating true innovations in the energy space and it’s also creating a lot of grid infrastructure. So utility companies that are more forward-thinking and working with the Bitcoin miners, they’re actually looking at these Bitcoin mining companies is what they call guardians of the grid. And the reason they call them that is because Bitcoin mining customer is unlike any other customer than an energy company could have. They usually prefer to operate off stranded utility assets in the middle of remote locations. So, they want areas that most customers would never want to be around. And so, it allows these utility energy providers to leverage stranded assets or maybe assets that haven’t been used for a long time with these Bitcoin miners. In addition to that, the power that these Bitcoin miners have is they can actually curtail their entire mining operation at a flip of a switch within a couple minutes and shut everything down and curtail it, which can better help balance the peak load environments, which is a huge advantage to energy utility providers, especially during peak hours, like in the morning before people go to work, or in the evening when they’re at home and they’re using more energy.
These Bitcoin miners can actually curtail that energy to better balance that peak load phase throughout the day. And so, when we look at these now, yes, it is true that that proof of work blockchains do use energy, but in my opinion it’s probably the most one of the most efficient uses of energy that we have because you were translating digital electrical energy into digital monetary value. And more and more time goes on I’m a big believer that in time we will have a digital asset like Bitcoin that is the new monetary standard for the planet, and you’re going to need a proof of work system that’s securing it and providing that transparency and authentication. And what Ethereum is going to do now that it shifted over with this new proof of stake is it’s in time it’s going to allow it to lower the transaction fees for different types of Ethereum transactions. It is much less energy consumptive than what it was before. But it’s not to say that we’re not seeing truly remarkable innovation in energy in the crypto space.
It’s just a new way to validate the network. But with that, you are losing some of the benefits that you had before around security of the network and further centralization of the network. So, this is some of the ways that I look at this merge. It was it was a tremendous technological feat that it happened. I think it was a very ambitious technological project. It took many years of development. They did a lot of test runs before they did this successful one recently. And now that it’s happened, I think it’s really good for the ecosystem at large. But there are tradeoffs to moving from proof of work to proof of stake.
Andrew Wilkinson
We’ll come back to transaction volume in a minute. First of all, I want to address the circulation, so back go back 10-years, Bitcoin circulation was around 10-million coins and today 19-million coins and I believe the maximum is going to be what, 21-22 million?
Brian Dixon
21.
Andrew Wilkinson
So, at the same time Bitcoin wallet addresses have grown from zero to 69 million. So, is this because wallets or crypt those storage is a new technology or is it telling us something different?
Brian Dixon
So, I believe what this is telling us is that we are going through a new, what I call an opt in, opt out phase. And what I mean by that is, if you look all throughout history in civilizations, there is always a point in time when a civilization goes through a paradigm shift through new technology. And when that happens, people will opt out of a former failing system, and they will opt into the new emerging system.
And I believe that’s what we’re seeing today with digital assets. So, if you look at Bitcoin specifically that you noted about the growing wallets, you’re correct. There’s 19 million coins that have been mined and are in existence today, and there will be 21 million that are mined in total. The last Bitcoin will not be mined until the year 2140, so today 90% of all Bitcoin that will ever be created or have been created and issued in circulation. And the new Bitcoin continued to be mined every 10 minutes, and by the year 2140, the final 21st millionth Bitcoin will be mined. And so, as we go through that process, what I think is happening is we have this Fiat standard that we’ve been on for about 50-years since Richard Nixon took us off the gold standard in 1971.
So, Fiat is still a pretty early experiment and I think what we’re seeing with the central banks around the world printing more and more money and it’s causing the economic whiplash and the devaluation of the currency and inflation, people are starting to wake up. And they understand that their time and energy and labor that they put in to generating dollars, the monetary value that they create from their hard work and labor that they put in is now getting stolen from them, because as more dollars are issued into circulation, more individuals now have less purchasing power because the goods and services that we go out and purchase all the time are becoming more expensive and our dollars are worth less. And so, you know, this is really accelerated over the last couple years throughout the pandemic as we had just tremendous amount of money being printed by all the central banks around the world to stimulate the economy. And what’s happening in my eyes is we’re going through this phase of people wanting to opt out of a traditional Fiat system and opt into the emerging technological system which is a Bitcoin monetary standard.
So, what this is telling us is that we are going through what I call and what we look at is called S curve analysis. So, what S curve analysis is, is every time there’s a mega technological trend, then it goes through a S curve of adoption, and that’s what’s happening today. And with an S curve adoption, how the analysis works is it takes about the first 10-years for this new technology that gains adoption to go from zero to 10% adoption. And then it takes the second 10-years to go from 10 to 90% adoption. And this is exactly what we’re seeing today with Bitcoin and you can actually take the same analysis and put it through all the trends of the past that created mega adoption.
So, automobiles, the printing press, fax machines, the Internet, smartphones, they all follow this very similar pattern where the first 10-years is the venture stage where it’s, you know, working through the technology and getting everything more evolved, and people start to adopt it and we go from approximately zero to 10% adoption. And the second 10-years, it goes from 10 to 90% adoption. And that’s what we’re seeing today. Except what’s unique is that when it comes to crypto, it’s actually going through this S curve at a more accelerated pace than the Internet adoption did in the late 90s, early 2000s. And so, as we get closer and closer to the 21 million, that’ll be circulated many years from now, more and more people adopt that. This is because people are opting into a new system. It’s a parallel system that’s being created right now, and people are looking for a new solution so they can maintain their purchasing power. And that’s exactly what Bitcoin does, because there will only ever be 21 million Bitcoin. It’s hardcoded and engineered into the Bitcoin software code and cannot be changed.
And so, because of that, one Bitcoin is always worth one Bitcoin, whereas one U.S. dollar 50-years ago is not worth one U.S. dollar today, because of all the dollars that have been printed all the time and the inflation that impacts from that. So, this is what’s happening right now. I think we’re seeing this exponential growth of people downloading and transacting in Bitcoin wallets because they’re looking for an alternative parallel system and they are no longer interested and will continue to be less interested in time with the Fiat money standard because of how it’s stealing their time and energy away from them.
Andrew Wilkinson
So, let’s talk about that transaction volume. You told me recently that transaction volume is about $3-trillion per year in Bitcoin. Could you put some perspective on that relative to other payment providers such as Visa, MasterCard, Amex? What does that transaction volume look like? How does it compare?
Brian Dixon
Yeah, absolutely. So, if we’re looking at transaction volume by some of the largest credit card processors in the world, Bitcoin right now is sitting right in the middle. So, like you noted, Bitcoin is doing $3-trillion in transactions. That was through the year 2021, Bitcoin did $3-trillion in transactions. Now it is ahead of both American Express and Discover. So, to put that in context, in 2021, Discover did about $0.5-trillion in transactions. American Express did $1.3-trillion and then Bitcoin was at $3-trillion and in the next two payment processors that are above it still is MasterCard, which did $7.7 trillion in 2021 and Visa did $13.5 trillion in 2021. So, it’s not going to be long with the continued adoption of Bitcoin that we’re going to see it surpass both Visa and MasterCard and become the new dominant transaction mechanism for the planet.
Andrew Wilkinson
Talking of adoption, let’s move on then to where this adoption is concentrated, it’s really amongst millennials, right? So where does that show up in in data between different generations? And what are the implications over the next generation, do you think?
Brian Dixon
Yeah. So, you’re correct. So, it’s definitely far more being adopted by people in the millennial demographic and younger. And according to Charles Schwab, the amount of wealth that’s going to be transferred over the next 25 years from the older generation, the baby boomer generations down to the Millennial generations and less, is approximately $68-trillion of wealth. And since the millennials and younger are the ones that are adopting Bitcoin and digital assets, I believe we’re going to see a really interesting trend if people are continuing to accumulate digital assets. And if we look at a breakdown today of a millennial’s portfolio, the fifth largest holding in a millennial’s portfolio today, based on this same study that I noted from Charles Schwab, is that Grayscale’s Bitcoin Trust is the fifth largest holding. So, the Grayscale Bitcoin Trust is a private trust instrument where Bitcoin is the underlying asset. And so, what that tells us is that it’s the fifth largest holding today and we’re seeing trends that is starting to increase in digital assets are making up larger percentages of millennials’ portfolio. So, as we have $68 trillion that’s going to be transferring from the older generations down to the younger generations over the next couple decades, we are going to start to see really interesting dynamics in the digital asset space, because if the trend continues, we’re going to see Bitcoin and other digital assets that are going to make up larger percentages of the millennial and younger younger’s portfolio and it’ll be a very interesting trend to file. As more types of digital assets created, we’re getting much more diversified in this space because now there’s all sorts of different crypto assets that people can acquire for different use cases. Whether it’s, you know, trying to replace the Fiat standard, whether it’s digital smart contracts, whether it’s in FT or decentralized finance, there’s a wide variety of different types of utility. Use cases in the crypto space that we’re seeing more and more people add as a diversified part of their portfolio.
Andrew Wilkinson
My final question Brian is on valuation. Could can you speak in general about how does somebody go about valuing blockchain or Bitcoin? Well, what is it’s not an easy thing for anyone to do. What, what kind of advice do you have for individual investors who want to do some research and understand how valuation might be applied?
Brian Dixon
Of course. So, there’s four specific models that we look at it off the chain that help us understand if a digital asset is fairly valued, undervalued or overvalued. I’m going to lay out these examples with Bitcoin. So, Bitcoin has four key valuation models that I think are very helpful in people understanding the value of Bitcoin. And when you’re looking at a digital asset and blockchain, you’re valuing a network. It’s a software network, so you have to think about it very differently than analyzing a company that has traditional revenues in EBITDA and things of that nature. You have to look at it like a software network.
One of the ways that you can value a blockchain is through a trendline analysis. So, basically if you’re looking at Bitcoin as an example, you are mapping out the historical price of the asset and then you are plotting out the future price of that asset on a trendline on algorithmic scale. And then that can help give you an understanding if the asset is fairly valued, undervalued or overvalued. So, that’s one way. It’s basic trendline analysis.
Another way that you can look at valuing Bitcoin is through what’s called Metcalfe’s law. Now this is the software network component that I noted. So, with Metcalfe’s law, what you do is you square the number of users that are participating in that network and then you multiply it by the transactional value. So, with this what it does is it basically creates two numbers. It creates a regression price, which should be basically the intrinsic value of Bitcoin, and then you can compare that against what the actual market price is of Bitcoin. And that’s another thing you can look at from a valuation perspective to understand is it overvalued, fairly valued or undervalued. So, Metcalfe’s law is a really key one. That’s how you value a network. That same model can be used for things like Uber and Netflix and things of that nature when you’re valuing these different software networks.
The last two ways that I think are important to help understand how to value Bitcoin is the stock-to-flow model. So, this was created by an individual that’s an anonymous pseudonym name. Plan B was a former institutional asset manager and then he went all in on Bitcoin a couple years ago and he developed the Bitcoin stock-to-flow model. So traditionally, stock-to-flow models are used to help measure the value of scarce assets and commodities like palladium, platinum, gold, things of that nature. The stock is the amount of that asset that’s in circulation and the flow is the predictable amount that’s being put into circulation on a timeline. And so, with gold, you know, if as an example we relatively know how much gold is going to be issued in circulation over time, we know what the current stock of that is, so we can measure that on a stock-to-flow ratio and try to understand if that asset is fairly valued, overvalued or undervalued.
So, when we apply that to Bitcoin, since we know that 19 million Bitcoin approximately have already been mined and we know exactly what the issuance schedule is of Bitcoin and we know the last one will be mined in the year 2140 and there’s going to be 21 million in total, you can leverage this same stock-to-flow model to help you understand and value Bitcoin. And so, when you place that on there, there’s two core ways to do it. One is the traditional stock-to-flow ratio, where we’re using U.S. dollars to help you understand what that model shows that Bitcoin should be valued at, and you can compare that against what it’s valued at today. But an even more accurate model than the US dollars one is if you replace U.S. dollars with gold and it’s the gold-to-Bitcoin stock-to-flow ratio. So, basically what you’re doing here is you’re replacing dollars as the monetary unit with ounces of gold. And this one actually has a 99% correlation to the historical price of Bitcoin. And so, this is another great valuation technique that you can use to try to understand and determine if Bitcoin is overvalued, fairly valued or undervalued. So, these are the core different models that we look at when we help trying to understand where Bitcoin is floating in the market in terms of a valuation perspective.
Andrew Wilkinson
Some fantastic insight there. Thank you. I love the approach to your research, Brian. It’s fascinating material. Thank you very much. You’re very welcome. Thanks for joining me today on IBKR podcasts Brian Dixon, CEO of Off the Chain Capital. And don’t forget folks, you can find more information at ibkrwebinars.com if you want to go and review the recent webinar that I referred to earlier. Brian, thanks so much for. Joining me.
Brian Dixon
Thanks again. Take care.
Andrew Wilkinson
Bye for now.
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