J.P. Morgan Private Bank understands the investment opportunity of Bitcoin this way

This article is from BlockBeats, with the original title: 《How JPMorgan Private Bank Views Bitcoin》
Authors: Thomas V. Kennedy, Stephanie Roth, both from JPMorgan Private Bank; Translation: BlockBeats.

Any multi-party system has network effects.

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

As an important value component within the Bitcoin system, network effects have not been discussed in detail before. This article, from JPMorgan Private Bank, analyzes and discusses Bitcoin's value from the perspective of network effects and whether it can surpass gold as a superior store of value. BlockBeats has translated the original text:

"What can make Bitcoin, an immature asset, a strong competitor in a strategic portfolio? We should understand this investment opportunity in this way."

In the rapid rise of Bitcoin (in terms of price and social discussion), we are all being forced to learn and understand this asset better, trying to comprehend various challenges: What is Bitcoin? How does it work? What is blockchain? What does Bitcoin mean for investors in the short and long term?

From our perspective, Bitcoin should be classified as a crypto asset (a store of value) rather than a cryptocurrency; the design of the network (transaction speed is too slow) makes it unsuitable as a medium for daily transactions. In other words, the goal of this article is not to introduce readers to the complex networks and groundbreaking technical specifications behind Bitcoin. Instead, we aim to:

• Focus on discussing the value of Bitcoin network growth. While the likelihood of widespread adoption of Bitcoin is uncertain, its ultimate success, like that of social networks, depends on user growth within the network. In the Bitcoin frenzy, institutional asset management companies are continuously increasing their holdings. These key investors are driving the maturation of Bitcoin and becoming milestones representing network prosperity.

• Discuss the implications for suitable investors. We are still in the early and speculative stages of Bitcoin's development. At this stage, suitable investors may allocate a small portion of their portfolios to Bitcoin, similar to investing in call options that are likely underwater. As the network expands, we may see Bitcoin potentially serve as a store of value in portfolios, akin to gold, but in a transformative and more easily accumulated and traded form.

Bitcoin is like gold, but its store of value characteristics are still emerging

While Bitcoin may not have a bright future as a cryptocurrency, it can serve as a store of value asset, sharing key characteristics with gold. First, its control is decentralized. The issuance and control of Bitcoin are not influenced by any entity, institution, or government. The same is true for gold. During times of economic or political uncertainty, this decentralized control is a significant reason why gold can serve as a safe-haven asset—Bitcoin will ultimately play this role as well. Secondly, like gold, Bitcoin has a limited supply; it will never exceed 21 million Bitcoins. However, unlike gold, Bitcoin's volatility is much greater.

So far, Bitcoin's price movements have not mirrored those of gold. The volatility difference is significant: Bitcoin is at 72%, while gold is at 14%. While gold's volatility has nearly aligned with that of stocks, Bitcoin's volatility stands apart. Moreover, when other financial assets experience volatility, gold tends to move in the opposite direction. Typically, during stock pullbacks, gold's value rises. Bitcoin's price changes are erratic, sometimes showing no correlation with other financial assets and at other times moving in sync with growth stocks. While Bitcoin's performance today may not resemble gold's, it does not mean it won't in the future. So, what can make these gold-like characteristics more pronounced?

Like social networks, Bitcoin's value depends on its user base

For Bitcoin to truly challenge gold's position in strategic portfolio allocation, its "faithful base" needs to continue growing—this is key to transforming Bitcoin from today's immature asset into a future global store of value.

After the COVID-19 pandemic, Bitcoin's "army of believers" has been expanding—year-on-year growth in Bitcoin wallets increased from 27% in mid-2020 to 50% by March 31, 2021. More importantly, institutional investors are increasingly believing in Bitcoin—this is a milestone for the "adoption" of a crypto asset, as institutional capital tends to be "sticky." A survey conducted in 2020 among nearly 400 U.S. institutional investors found that 27% of respondents had some exposure to digital assets, up from 22% in 2019. (Their top three reasons for investing in crypto assets are: low correlation with other assets, innovative technology, and potential for growth in crypto assets). Since that survey (June 2020), asset management companies have shown a surge in interest in crypto assets, and mentions of crypto-related content in S&P 500 company earnings reports have increased, leading some to speculate that institutions will adopt crypto assets more in 2021.

Institutional investor participation is increasing

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

As the Bitcoin network develops, the persistence and value expectations of crypto assets will also increase. This is similar to the development we have seen with networks like Facebook. If there is only one person on the network, it will be worthless. If there are 100 people, it will have some value, but with billions of people on the network, its value will be immense.

Metcalfe's Law of Network Effects

The study of network effects was initiated by Robert Metcalfe (co-founder of Ethernet) in the early 1980s and was formalized in 1993. His analysis is based on the premise that the value of a network is greater than the actual number of users in that network, thanks to the power of "connections." As the number of users grows linearly, the number of connections in the network and its value grow exponentially. In other words, if there are 100 users in the network, the network's value is 100^2 = 10,000, not just 100. However, this number may be overly optimistic, as not all nodes can connect with each other, so the model has been adjusted.

The value of the network grows exponentially with its number of users

Image source: Yoo, Christopher S., "Network Effects in Action" (2020). Faculty Scholarship at Penn Law. 2236.

Metcalfe's Law helps us understand why Facebook is now a company valued at nearly $1 trillion. From 2014 to 2020, if we correlate historical monthly active users with circulating stock prices, we can estimate Facebook's historical stock price using the "Generalized Metcalfe's Law" function of n^1.7 (the original ratio being n^2). In other words, the stock price can be expressed as a function of the number of active users. For example, as of December 31, 2020, the number of monthly active users was 2.8 billion; this means FB's total value is approximately 2.8^1.7, or $725 billion in market capitalization, which translates to about $255 per share (very close to the actual market cap of $778 billion at the end of the year, or $273 per share). This model indicates that since 2014, a 10% increase in the number of active users would translate into a 17% increase in Facebook's value.

Facebook's stock price can be estimated based on its user count

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

However, throughout the lifecycle of Facebook's stock, this index has not remained constant; as Facebook has matured and continued to innovate, the value generated by each marginal user has changed. In the early days, investors may have doubted whether the network could reach maturity, and they would not pay for the potential value brought by users—this was reflected in the below-average Metcalfe index in early 2010. However, as the likelihood of the network entering maturity increased, the index rose sharply in mid-2010 and eventually stabilized, indicating that additional users did not add as much incremental value.

As the network matures, the impact of new users on Facebook's price is decreasing

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

When considering Bitcoin, the evolution of Facebook and the network value captured by Metcalfe's Law are very instructive. We are not using Facebook as a metaphor and applying Metcalfe's Law to obtain an imprecise target price. We also do not overlook the fact that Facebook's network can be monetized more easily through advertising. This analogy demonstrates the power of a mature network. Today, from various dimensions, the Bitcoin network is still immature, with only 70 million Bitcoin wallets and a global adoption rate of less than 1%; this means the incremental impact of new users on price (i.e., its index) is still increasing. Additionally, based on the current Bitcoin price, the generalized Metcalfe's Law index value is n^1.54. This index indicates that Bitcoin investors' valuations align with Metcalfe's Law, although the price has diverged.

The number of Bitcoin wallets is part of its price function

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

Undeniably, there are still many unknowns about the future of Bitcoin. For example, what kind of impact might government regulation have? Before we know who will regulate Bitcoin and other crypto assets and how, it is difficult to discern its impact on network development. If regulations are established to protect investors, then ultimately these regulations could contribute to building a more ideal and sustainable network. Of course, Bitcoin is not without competitors. There are currently over 4,000 crypto assets. We expect that ultimately only one or a few winners will remain. Each survivor will represent a specific track and have different missions. This could be a competition for trade, store of value, or on-chain application platforms. Bitcoin's first-mover advantage (as of April 2021, Bitcoin's market cap accounted for about half of the total crypto market cap) may become its best guarantee as digital gold.

What does this mean for investors?

In our view, Bitcoin has reached a critical milestone on the path to widespread adoption, with institutional investors increasingly confident in the network. Given that Bitcoin's price remains highly volatile and its correlation with other mainstream assets has been inconsistent, some investors may consider small allocations. Imagine if Bitcoin were widely adopted; your investment could multiply several times, or if Bitcoin fails, your investment would merely be an underwater option.

Bitcoin's inconsistent correlation makes it suitable for only small allocations in the early stages

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

Ultimately, if Bitcoin matures, we expect it to resemble gold more closely. At that stage, Bitcoin will be suitable for portfolio strategies that allocate significant funds to gold. But we are not there yet.

For Bitcoin to cross the threshold from being a "considerable call option" to a strategic portfolio asset, we need to see its volatility stabilize in the future, and when the prices of other mainstream assets fluctuate, Bitcoin's price fluctuations should no longer be so extreme. This will allow Bitcoin to stand out from other crypto assets and become the ultimate winner.