It’s been a whipsaw week for bitcoin and other digital currencies, leaving investors struggling to decipher bitcoin’s true value.
A single bitcoin traded at $3,560 on Friday afternoon. Trade has been characteristically volatile. The digital currency experienced two drops of more than 30% over the past three months, thought it is up 250% year to date.
Dan Davies, senior research adviser at Frontline Analysts, argued there’s no point in attempting to value bitcoin as if it were just another type of security.
“It’s not a security with some intrinsic value, rather it’s a currency that in the long term is governed by an exchange rate driven by trade or volume of transactions,” Davies said.
The fact that a significant proportion of bitcoins is hoarded or held for investment doesn’t disqualify it from being a currency, according to Davies. But the BTC/USD
BTCUSD, -1.49%
exchange rate is entirely determined by speculative portfolio capital flows right now, he said, leaving it difficult to assign fair value.
Read: One bitcoin-linked fund has lost half its value in just 2 weeks
Viewing bitcoin as a currency makes it possible, at least in theory, to come up with a long-term exchange rate by using the quantity theory of money. The formula is: MV = PT, where money supply multiplied by its velocity equals the price level multiplied by the transaction volume.
Since both price and transaction volume is expressed in U.S. dollars, the price of bitcoin would be 1/BTCUSD, Davies said.
In this case, bitcoin’s supply is fixed at 21 million and money velocity for normal currencies is usually at around 10, according to Davies. So, the long-term fundamental value of bitcoin equals the long-term value of transactions that will be carried out in bitcoin divided by 210 million (21 million bitcoins multiplied by velocity).
The hardest value to plug into this formula is the transaction volume. If, for example, bitcoin was used primarily for global trade in illicit drugs, the figure would be around $120 billion, which is an estimate the U.N. used in 2014.
“I used that number a few years ago, but we would have to come up with a different estimate, as bitcoin is clearly used for things other than illicit drugs now,” Davies said.
Davies declined to offer an updated number, saying he needed to do more research.
But doubling that transaction volume number to $240 billion, for example, and dividing by 210 million produces a value of $1,142, around a third of the current exchange rate of $3,569.
That isn’t far from an estimate that Mohamed El-Erian, chief economic adviser at Allianz Global Investors, recently suggested as a fair value for bitcoin.
In an interview with CNBC, El-Erian said the fair price should be about half or a third of what it is now.
El-Erian argued the currency will only survive as a peer-to-peer means of payment and governments won’t allow mass adoption.
Read: Bitcoin needs to be worth $1,000,000 to be a legitimate currency
But on the way to figuring out fair value, whereever that may lie, analysts do concede that the crypto’s improving relevancy is a factor.
“The fact that bitcoin has increased its relevance over the past several years and the number of people and businesses using it is increasing suggests that we should update our assumptions about its viability,” Davies said, adding “though I still would not trade, nor invest in it as I cannot predict capital flows in and out of bitcoin.”