plan-bitcoin-memeFundamental analysis is a methodology used by investors,  in which the ‘real world’ value of an investment is estimated, and then compared to the more speculative price at which it is trading on financial markets, in order to judge the potential for future price gains or losses. It is based on the assumption that short term price may differ greatly from underlying value, due to the nature of financial markets, but that over a longer time horizon the two will tend to converge. Investors can therefore profit by using this methodology to gauge whether something is undervalued or overvalued, and then buy or sell accordingly.

The use of fundamental analysis is most closely associated with stock markets. Stock traders will examine a company’s accounts, looking at a range of data including income, expenditure, profits, assets, and liabilities. To a lesser extent these techniques are also used by foreign exchange, or ‘forex’, traders to examine the value of a currency. In this case an investor will analyze the financial data relating to a country’s economy, including things like gross domestic product (GDP), unemployment, interest rates, national debt, surveys of industrial production and consumer spending, political developments, and so on. One of the main differences between stocks and currency is that a company stock may, to some extent at least, be said to have an objective value based on a static set of fundamental quantities at a given moment in time, whereas in forex markets it only really makes sense to consider relative values of particular pairs based on dynamic changes in the fundamentals.

Fundamental Analysis for Bitcoin: Why it Works

The nature of blockchain based digital currencies such as Bitcoin means that they may be particularly amenable to fundamental analysis. This is because the range and reliability of fundamental economic data available for analysts to use is greater in many areas for Bitcoin than for a regular fiat currency.

In most traditional fiat currency economies a substantial part of the economic activity from which fundamental data is derived takes place using cash – which is entirely anonymous and cannot be studied directly. This means that indirect data must be used; for example the takings of major retailers may be used as a proxy measure to gauge consumer spending. Even digital payments, which are tracked, take place using proprietary systems and will most likely not be immediately and openly available for analysis by investors.

Bitcoin, and other natively digital currencies which use a form of distributed consensus such as a blockchain, have a public record of every transaction which has ever taken place, which anybody with an internet connection can freely access. This means that not only is there a greater depth of fundamental data available for analysis, but also that the data used can be drawn directly from source rather than through proxy measures and surveys, making it more accurate and reliable.

Bitcoin Economics: A Beginner’s Guide to the Data

Here are some common types and sources of data that can be used in Bitcoin fundamental analysis.

Inflation & Monetary Supply

inflation-memeThere are no specific metrics for Bitcoin’s inflation rate, because it is used in most countries around the world so there is no single set of prices to use. Theoretically it should be possible to calculate inflation by region and then create a weighted average using some measure of adoption in each country, such as exchange volume distribution by national fiat, but the usefulness of this is debatable.

We do, however, have a good metric for changes in monetary supply through the number of new coins generated per day. When people talk about inflation and deflation in relation to BTC they are almost certainly referring to inflation in the monetary supply. This monetary supply inflation started off at a very high level in the early days of the network, and will decline geometrically until it eventually hits zero at the maximum supply cap of 21 million coins. This decline happens in discrete jumps, with the block reward (which determines the average number of coins generated per hour) cut by 50% in each jump. This happens approximately every four years. The number of coins currently being generated per day can be found via a block explorer.

Blockchain.info runs a block explorer which has some interesting stats for the past 24 hours: https://blockchain.info/stats

Because there will always be some level of attrition due to lost or abandoned wallets, the actual monetary supply inflation rate in practical terms is lower than the rate at which new coins are being generated, and will eventually decline to a negative number when no new coins are being created.

It is often useful to suggest that monetary supply inflation represents the amount of new investment which needs to be made into the Bitcoin economy in order for the price per coin to remain the same. For example, if 3000 coins are generated and the exchange rate is $230 per coin, then 3000*230 = $690,000 of new investment is needed to maintain a stable price.

In traditional economics it is usually taught that increasing monetary supply does not necessarily lead to a corresponding level of inflation because new money entering the system may stimulate economic activity to off-set the increased supply. That is also true here, although the mechanics are somewhat different.

Transactions

When analyzing a digital currency with a public blockchain you can see exactly how many transactions have taken are taking place, how large they are and how they are distributed. This gives offers wealth of information which is not available in traditional currency markets.

Number of transactions: The number of transactions which have occurred over a given period of time, usually one day, is a gross measure of economic activity.

Volume of transactions: The number of coins transacted during a 24 hour period gives additional information about the amount of economic activity. Various services also have charts for volume measured in various fiat currencies, as well as offering separate charts for exchange volume.

Number of transactions excluding popular addresses: Popular addresses are associated with exchanges and other large businesses using BTC. By excluding them an analyst may get a better idea of how active regular network users are in a given period of time.

Measuring Bitcoin Adoption

Perhaps the most important factor driving the value of BTC, other than speculation of course, is the number of users and how active those users are. Of course you can already get some idea of this by looking at the number and size of transactions, but digging deeper into the data can give you a much clearer picture. Here are some of the most important metrics to take into consideration:

Number of Unique Addresses Used Per day: Looking at the number of addresses which hold a balance of coins, or the total number of addresses that have been used, does not tell you much because many Bitcoiners will use more than one address. But by looking at the number of unique addresses which have been used in a particular day you can get a solid picture of changes in network use and therefore whether adoption rates are rising or falling. This stat is a combined measure of how many users there are and how active those users are.

Days Destroyed: This is a unique metric invented specifically for Bitcoin, which can be notoriously difficult to interpret. It can be used to give an indication of both the velocity of money and of user adoption. Here is how it works: If 10 coins are held at an address for 1 day, and then transferred to somebody else, then 10 (10*1)  Bitcoin days have been destroyed. The purpose behind creating this metric was to give a clearer picture of genuine economic activity than you would get from raw data on the number or volume of transactions. It is also used to measure the extent to which users are either hoarding or spending coins – a high figure for days destroyed means that coins are moving from savings into active circulation, whilst a fall would indicate that older coins are not being spent, many of which are likely to have been taken out of active circulation and left in longer term savings wallets. Spending may be said to be positive in the longer term as an indication of the growth in utility of the network and the health of the Bitcoin economy, but may drive down the price in the short term as many businesses sell instantly for fiat. On the other hand hoarding reduces the supply of coins on the market and can drive up price in the short term, but may be seen by some as a negative indicator of genuine user adoption. To complicate the picture, hoarding may also indicate that users anticipate future price rises.

Ratio of Trade Volume to Transaction Volume: Bitcoin has always been popular among speculators and investors, so the question always arises: to what extent is the volume of transactions being driven by traders and to what extent is it being driven by regular users. Days destroyed cannot tell you this as it may include coins being transferred from savings wallets to exchanges. The number of unique addresses can give you some idea, but once again it may include an uptick in activity among traders as they move money between different accounts. The ration of volume on major exchanges against the total volume across the whole network is therefore used to give a clearer picture; an increase in the ratio means that traders are having a proportionally larger impact on changes we may see in other metrics, whereas a decrease may indicate that changes are increasingly being driven by regular users.

Network Utility

Various data sets are available which give you some idea of changes in the quality of service being offered by the Bitcoin network to its users:

Average Confirmation Time: The average time it takes for a payment to be confirmed by miners. Increases in confirmation time may indicate deeper problems as well as negatively affecting user experience.

Absolute Cost Per Transaction: The amount it costs to make a transaction obviously affects utility and the ability to attract and retain users.

Percentage Cost Per Transaction: The cost of a transaction depends on the amount of data it uses. Although this is not directly connected to the value of a payment, there is some correlation. Many users may judge whether a transaction fee is fair based on its size as a percentage of the amount they are sending – so it it useful to consider the cost of transactions as a percentage of what is being sent as well as looking at its absolute value.

Network Health

Miners are essential to maintaining the Bitcoin network, so mining related data can be useful for assessing the health of the network and for providing advanced warning of any problems which may lie just over the horizon. Here are some of the most useful data sets for investors to look at.

Average Block Size: There is currently a cap on the maximum allowable block size, although a debate is raging on making changes to that cap so by the time you read this it may already have been changed. If the average block size approaches or reaches the limit then transaction fees may rise and payments may take longer to be confirmed.

Hash Rate: Hashes are the ‘proof of work’ calculations which secure the network. A high hashrate means that there is plenty of mining and a secure network. A significant and sudden drop in hash rate may have a short term impact on confirmation times and fees (making them rise) and if large enough may have implications for network security.

Network Deficit: At the moment the cost of mining is supported by the generation of new coins, but this coin generation will gradually decrease over time as described above. As this happens, fees will become more and more important to support the cost of mining and maintain the network. Eventually, the full cost of mining will need to be borne by users paying fees. The network deficit measures the difference between the cost of mining and the income generated by miners from fees, and may therefore be used to give an long term factor to forecast how well the network will be able to maintain itself through reductions in coin generation.

Data Sources:

The following websites provide a wide range of freely downloadable data and charts, including the metrics mentioned above and others:

  1. Blockchain.info: A block explorer which is perhaps the most popular source of data for the Bitcoin network. You can view charts online or download the data to your own computer.
  2. Quandl: Draws on a range of sources including Blockchain.info, and offers easy tools for importing the data into popular charting and analysis software tools.