Fundamental analysis for cryptocurrency is not as simple as it is for fiat currencies and is still an evolving field.
While currencies like the US Dollar, the euro or the British Pound are highly influenced by economic and financial data from the relevant country, cryptocurrencies like bitcoin are borderless, are not restricted to a particular country and are built in an entirely different way.
What is Fundamental Analysis?
Fundamental analysis seeks to assess the value of an asset based on the drivers of supply and demand. Given bitcoin’s fixed supply, fundamental analysis is mainly focused on various factors of demand.
Because there is no centralised entity in control of bitcoin, there are no regular data releases or speeches that have any bearing on its price while with traditional currencies, a figure from a central bank like the Federal Reserve or a worse than expected data reading often move the forex markets.
Cryptocurrency analysts are still figuring out how fundamental analysis for bitcoin and altcoins should be done. One idea is to use Metcalfe’s law to assess the value of cryptocurrencies, since they are a blockchain network and Metcalfe’s law states:
“The effect of a telecommunications network is proportional to the square of the number of connected users of the system.”
As more users join a network, the more valuable it becomes and this is demonstrated by the growth of Bitcoin over the years. With dozens of users, the price of one bitcoin was a few dollars, then as bitcoin became more popular the price started to rise into double digits and eventually into the hundreds. At present, with an estimated 50 million cryptocurrency users worldwide, the price of bitcoin is in the thousands.
The key metrics to assess the demand for bitcoin include the number of transactions, median value of transactions, number of unique addresses, fees earned by miners, merchant adoption, social metrics and trading activity.
These demand drivers have been manipulated to produce various fundamental indicators for bitcoin. For example, the Network Value to Transactions (NVT) ratio acts like a price-earnings ratio for a stock, where the network value is divided by the USD value of transactions on the network to give a sense of whether the cryptocurrency is under- or over-valued based on economic activity (as proxied by the USD value of transactions).
The Market Value to Realised Value (MVRV) ratio takes a similar approach, dividing the network value by realised value (which accounts for at which time and price coins were bought or sold to give an indication of the balance between long-term investors and short-term speculators). If market value deviates too much from realised value, it suggests bitcoin is over- or under-valued.
While you can easily find a calendar outlining major events for national currencies like the US Dollar, identifying events that will affect the price of bitcoin is often difficult to do. Macroeconomic shocks, such as the Cypriot bail-in in 2013, often affect the price of bitcoin. Moreover, events that are related to regulating cryptocurrency, especially in large economies such as the US or China, can also have a significant effect on the price of bitcoin and other cryptocurrencies.
Demand can also be affected by technical considerations. For example, if there were a catastrophic bug in Bitcoin that allowed for infinite inflation (which has happened before but was successfully fixed) and an adversary were able to exploit the protocol, the value of bitcoin would fall dramatically. Therefore, it is worth noting that because of the technical nature of cryptocurrencies, it is important to remain up to speed on the protocol and technology side of things. Some examples of how technical factors affect the price are when bitcoin exchanges get hacked or there is an exploit discovered in the protocol, which would both prompt a negative reaction.
Turning to the supply side, cryptocurrencies like bitcoin are fixed in supply and are relatively supply inelastic, meaning that as the price rises, the supply response is fairly muted as new units are created at a rate of 12.5 BTC per block (on average every ten minutes). Since this schedule is pre-programmed, there is no way of introducing supply at a higher rate than 12.5 BTC per block.
Because of the fixed supply, the fundamental analysis of bitcoin mainly focuses on demand drivers. Nevertheless, one key aspect of fundamental analysis for bitcoin relates to the block reward halving, where many analysts maintain that the halving of the block reward has a positive effect on the price (based on the limited historical data).
Another supply side factor relates to miners; if you can estimate the average cost of mining one bitcoin, then this is likely the floor for the bitcoin price. In fact, this study demonstrates that the price of bitcoin closely follows the marginal cost of production.
Also, miners tend to liquidate their bitcoin holdings during or just after high price volatility. The transparent nature of the Bitcoin blockchain means that you can try to analyse addresses with high balances to get an indication of a short-term increase in the available supply, which can originate from miners or whales.
How does fundamental analysis for bitcoin and cryptocurrencies differ to that of traditional assets like currencies and stocks?
There are a few main differences:
- Cryptocurrencies are not tied to any particular country or company. Therefore, there is no centralised or regular data releases or speeches that can affect BTC unlike the USD, EUR and GBP.
- Cryptocurrencies are often valued using Metcalfe’s law of the quantity theory of money.
- You can assess the level of demand for cryptocurrencies by looking at the number of transactions, the media transaction value, the number of unique addresses, the fees earned by miners, merchant adoption, social metrics and trading activity. Demand drivers also include macroeconomic shocks, which can from time-to-time influence the price of bitcoin, as well as regulatory announcements in large economies.
- Supply-side analysis includes assessing the supply schedule, block reward halvings and estimating the average cost of mining one bitcoin.
One area where there is no difference in fundamental analysis of cryptocurrency and traditional assets is that this type of analysis should not be used in isolation. Be sure to use technical and sentiment analysis to reinforce the fundamentals. Fundamental analysis is typically more reliable on longer timeframes, while on shorter timeframes you may want to use technical analysis for an entry into a trade.
Check out our Trading Resources page for more information on the fundamental analysis of cryptocurrency.