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What does JPMorgan Private Bank think of Bitcoin

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Can the value of the Bitcoin network grow according to Metcalfe's Law? We'll see.

There are network effects in any multilateral system.

The magic of network effects allows the value generated within the system to grow exponentially. With the help of modern science and technology, the fermentation vacuum period of network effect has been shortened repeatedly.

Network effects, an important value building block within the Bitcoin system, have not been discussed in detail before. This paper, from the Private Department of JPMorgan Chase, analyzes and discusses the value of Bitcoin and whether it can surpass gold as a better store of value from the perspective of network effects. Rhythm Blockbeats has translated the original:

"What makes an immature asset like Bitcoin a serious contender in a strategic portfolio? That's how we should understand the investment opportunity."

In the course of Bitcoin's rapid rise (in price and social discourse), we've all been forced to learn and understand the asset, and to try to understand the hard 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 point of view, Bitcoin should be classified as a crypto asset (a store of value) rather than a cryptocurrency; The design of the web (transactions are too slow) makes it impossible as a daily medium of exchange. That said, our goal in this article is not to introduce readers to the complex network and breakthrough technical specifications behind Bitcoin. Instead, from an investor's perspective, we aim to:

- Focus on the value of the Bitcoin network's growth. While the likelihood of widespread adoption is uncertain, Bitcoin's ultimate success, like that of a social network, depends on the growth of users on the network. Institutional money management firms have been increasing their holdings amid the bitcoin frenzy. These key investors have helped Bitcoin mature and become a landmark of the dotcom boom.

- Discuss the impact on suitable investors. It is still the early days of Bitcoin development and the age of speculation. At this stage, the right investor might allocate a small portion of their portfolio to bitcoin, akin to investing in a call option that is likely to be underwater. As the network expands, we may see the potential for Bitcoin to serve as a store of value in portfolios, similar to gold, but in a transformative, easier to accumulate and trade form.

Bitcoin is like gold, but its store of value features keep coming up

While Bitcoin may not have a bright future as a cryptocurrency, it can serve as an asset store of value that shares key characteristics with gold. First, its control is decentralized. The issuance and control of Bitcoin is not influenced by any entity, institution or government. The same is true of gold. In times of heightened economic or political uncertainty, this decentralised control is an important reason gold can act as a safe haven -- and Bitcoin will eventually do the same. Second, like gold, the supply of bitcoin is limited; It will never exceed 21 million Bitcoins. Unlike gold, however, Bitcoin is much more volatile.

So far, bitcoin's price hasn't acted like gold's. Volatility is very different: 72% for Bitcoin and 14% for gold. While gold has become almost as volatile as stocks, bitcoin is in a class of its own. Moreover, when other financial assets fluctuate, so does gold, but in the opposite direction. Gold usually rises in value during stock market corrections. Bitcoin's price does not follow a regular pattern, sometimes uncorrelated with other financial assets and sometimes in step 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 golden qualities all the more remarkable?

Like social networks, bitcoin's value depends on the number of its users

For Bitcoin to truly challenge gold as a strategic portfolio allocator, its "base of believers" needs to grow -- a key to transforming it from an immature asset of today to a global store of value of tomorrow.

In the wake of the COVID-19, Bitcoin's legion of believers continues to expand -- the year-on-year growth rate of Bitcoin wallets increased from 27% in mid-2020 to 50% by March 31, 2021. What's more, institutional investors are also increasingly believing in bitcoin -- a milestone in the "adoption" of crypto assets, since institutional capital tends to be "sticky." In a 2020 survey of nearly 400 U.S. institutional investors, 27 percent of respondents had some exposure to digital assets, up from 22 percent in 2019. (Their top three reasons for investing in crypto assets are their low correlation with other assets, their innovative technology, and the upside potential of crypto assets.) Since the survey was conducted (June 2020), the operations of money management firms have indicated a surge in interest in crypto assets, as well as an increase in crypto-related content in S&P 500 company financial filings, leading some to speculate that institutions will adopt more crypto assets in the middle of 2021.

Institutional investor participation is increasing

Image credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; March 31, 2021

As the Bitcoin network grows, the durability and value of crypto assets are expected to increase. It's similar to what we've seen with networks like Facebook. If there's only one person on the network, it's worthless. If there are 100 people, it will have some value, but if there are billions of people in the network, it will be very valuable.

Metcalfe network effect

Research on network effects was initiated by Robert Metcalfe (co-founder of Ethernet) in the early 1980s and standardized in 1993. His analysis is based on the premise that the value of a network is greater than the actual number of users in its network, thanks to the power of "links". As the number of users increases linearly, the number of series in the network and its value increase exponentially. That is, if there are 100 users in the network, then the value of the network is 100^2 = 10,000, not just 100. But that number may be overly optimistic, since 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 by Yoo, Christopher S., "Network Effects in Action" (2020). Faculty Scholarship at Penn Law. 2236.& NBSP;

Metcalfe's Law helps us understand why Facebook is now a nearly $1 trillion company. By correlating historical monthly active users to the price of shares outstanding from 2014 to 2020, we can estimate Facebook's historical stock price as a function of n^1.7 (the original ratio is n^2) using "generalized Metcalfe's law". In other words, 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 implies that the total value of FB 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, or $273 per share at the end of the year). The model suggests that a 10% increase in the number of active users translates into a 17% increase in Facebook's value since 2014.

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

Image credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; December 31, 2020

However, the index is not static over the life of the Facebook stock, and the value generated by each marginal user has changed as Facebook has matured and innovated. Early on, investors may have been skeptical that the network would ever reach maturity, and they would not have paid for the potential value that users would bring - as reflected in the below-average Metcalfe index in early 2010. However, the index rose rapidly in mid-2010 and eventually leveled off as the network became more and more likely to mature, suggesting that the eventual additional users did not add that much incremental value.

As the network matures, the impact of new users on Facebook's prices is declining

Image credit: Bloomberg Finance L.P,J.P. Morgan Private Bank; December 31, 2020

The evolution of Facebook and the networked value captured by Metcalfe's Law are instructive when considering Bitcoin. We're not using Facebook as a metaphor and using Metcalfe's Law to get an imprecise target price. And we can't ignore the fact that Facebook's 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 every dimension, with only 70 million bitcoin wallets and less than 1% of global adoption; This means that the incremental impact of new users on prices (i.e., their index) is still rising. Moreover, based on the current price of Bitcoin, the generalized Metcalfe's law index value is N ^1.54. The index shows that Bitcoin investors are valuing Bitcoin in line with Metcalfe's Law, yet the price is deviating.

The number of bitcoin wallets is part of its price function

Image credit: Blockchain.com, Bloomberg Finance L.P., J.P. Morgan Private Bank; March 31, 2021

There is no denying that there are still many unknowns about the future of Bitcoin. For example, what might be the impact of government regulation? Until we know who, and how, will regulate bitcoin and other crypto assets, it's hard to discern the impact on the development of the web. If rules are put in place to protect investors, they can ultimately contribute to a better and more durable network. Of course, Bitcoin is not without its competitors. There are now more than 4,000 crypto assets. We expect to end up with only one or a few winners. Each survivor will represent a specific track and will have a different mission. That said, it could be trade, store of value, or on-chain application platforms. Bitcoin's first-mover advantage -- roughly half of the crypto market capitalization as of April 2021 -- may prove to be its best bet as digital gold.

What does this mean for investors?

In our view, Bitcoin has reached a key milestone on the road to widespread adoption, with institutional investors increasingly confident in the web. Because bitcoin's price remains highly volatile and its correlation with other mainstream assets has not been consistent, small allocations are possible for some investors. Imagine that if Bitcoin is widely adopted, your investment might earn several times over, or if it doesn't work out, your investment is just an underwater option.

Bitcoin's inconsistent correlations made it suitable for only a small number of configurations in its early days

Image credit: Bloomberg Finance L.P., J.P. Morgan Private Bank. The indices include: Gold Index, US Dollar Index, S&P 500 Growth Index, IEF Index (7-10 Year US Treasury Index); April 23, 2021

Ultimately, if and when Bitcoin matures, we expect it to look more like gold. At that stage, Bitcoin would be suitable for portfolio strategies that allocate large amounts of money to gold. But we're not there yet.

In order to let the currency across from as a "call" to consider to the threshold of the strategic investment portfolio, we need to see its volatility tends to be stable in the future, when other mainstream asset price volatility, fluctuations in the price of the currency is no longer so far, this ability makes the currency assets from other encryption, become the final winner.