Assessing the Health of Bitcoin

When investing in bitcoin as an asset, or companies that build on top of the Bitcoin network as part of an asset mix, we need some set of metrics with which to evaluate the progress of the investment thesis, and by extension, the health of the Bitcoin network.

It’s more than just a price on a chart; it’s an open-source network with millions of users, thousands of developers, hundreds of companies, and several ecosystems built on top of it. Most Wall Street analysts and retail investors haven’t actually used a bitcoin wallet, taken self-custody of the asset, sent it to others, and/or used it in various ecosystems, and yet doing so is very helpful for fundamental research.

Bitcoin means a lot of different things to a lot of different people. It enables portable savings, censorship-resistant global payments, and immutable data storage. If you’re an American or European investor in high quality stocks and bonds, and are not thinking about the Bitcoin network from the perspective of a Nigerian, Vietnamese, Argentinian, Lebanese, Russian, or Turkish middle-class saver for example, then you’ve not yet fundamentally analyzed the asset’s use case.

And on top of that, people assess the health of the network in multiple different ways. If Bitcoin doesn’t conform to what they want it to be, they might conclude that it’s not doing well. On the other hand, if Bitcoin fits exactly with what they want, then they might think it’s doing great even if there is plenty of frictions remaining to be solved.

Having spent a lot of time studying monetary history, as well as spending time in the startup/venture space around Bitcoin and studying the technical details of the protocol in recent years, I have a handful of key metrics that I personally look at when assessing the health of the Bitcoin network. This article walks through them and sees how the network is doing in terms of each one.

1) Market Capitalization and Liquidity

Some people say price doesn’t matter. “1 BTC = 1 BTC” is how they like to put it. It’s not bitcoin that is volatile; it’s that the world is volatile around bitcoin, man.

And there’s indeed some truth to that. Bitcoin has a fully diluted supply of 21 million bitcoin (technically 2.1 quadrillion sats, which are the smallest denomination of on-chain bitcoin), created and distributed in a pre-programmed decreasing pattern, produces blocks on average every ten minutes thanks to an automatic difficulty adjustment, and has operated with remarkable consistency since its inception with a higher uptime rate than Fedwire. I don’t know what the dollar supply will be next year, but I know what the bitcoin supply will be and can directly audit its exact supply at any time.

But price is an important signal. It doesn’t mean much on a day-to-day, week-to-week, or even year-to-year basis, but it certainly means something across several years. The Bitcoin network itself might be serving as a heartbeat of clockwork order in a world of chaos, but price is nonetheless a measure of its adoption. Bitcoin is competing in the global marketplace of monies now, against more than 160 different fiat currencies, gold, silver, and various other cryptocurrencies. As a store of value it’s also competing with non-monetary assets like equities and real estate or other things we can own with our limited resources.

It’s not really that the dollar is fluctuating in price around bitcoin as some proponents like to say. Bitcoin is the younger, more volatile, less liquid, smaller network compared to the dollar; it’s indeed the one fluctuating more in price. In some years, bitcoin holders can buy a lot more property, food, gold, copper, oil, S&P 500 shares, dollars, rupees, or whatever else compared to what they could buy in the prior year. In other years, they can buy a lot less. Bitcoin’s price is mainly what’s fluctuating on any given intermediate-term basis, and the fact that it fluctuates affects the purchasing power of the holders. So far, the fluctuations have aimed sharply up, meaning that a holder of bitcoin can buy a lot more than they could several years ago.

If price stagnates for a long time, that’s a piece of information. If that were to happen, we should reasonably ask why Bitcoin is failing to appeal to people. Is it not providing solutions to their problems? If not, why?

Fortunately, as the chart above shows, that has not been the case. Bitcoin’s price keeps making higher highs and higher lows, cycle after cycle. It’s one of the best-performing assets in history. And I would say it has held up rather well given the aggressive tightening of central bank balance sheets and the sharp rise in positive real rates over the past couple of years. Looking at on-chain indicators, its historic correlation with global broad money supply, and other factors, Bitcoin continues to enjoy long-term adoption and growth. But it must be monitored.

And then there’s liquidity. How much daily trading volume is happening on exchanges? How much transaction value is being sent around on-chain? Money is the most salable good. Liquidity is very important.

Bitcoin has been ranking very well in this metric too, with billions or tens of billions of dollars worth of daily trading volume against other currencies and assets, which puts it on par with Apple (AAPL) stock in terms of daily exchange liquidity. And unlike Apple where the vast majority of volume is on the Nasdaq exchange, bitcoins trade in many exchanges and currencies around the world including some peer-to-peer marketplaces. There are also billions of dollars worth of on-chain transfer volume in a given day.

A way to think about liquidity (and it’ll likely make you more bullish when you realize it), is that liquidity begets more liquidity. For money, that’s a big piece of what the network effect is.

When bitcoin had thousands of dollars worth of trading volume per day, someone couldn’t put a million dollars into it, even spread out over weeks, without drastically moving the price. It wasn’t a big and liquid enough market for them yet.

And then when bitcoin had millions of dollars worth of trading volume per day, someone couldn’t put a billion dollars into it, even spread out over weeks.

And now that bitcoin has billions of dollars of trading volume, there are trillion-dollar pools of capital that can’t put meaningful percentages into it; it’s still too small and illiquid for them. If they start putting a few hundred million dollars or a couple billions of dollars per day into it, that’s enough to tilt the supply/demand toward the buy side and seriously inflect the price upward. Since inception, the Bitcoin ecosystem has had to achieve certain levels of liquidity before it even gets on the radar of bigger pools of capital. It’s like leveling up.

So, who would buy bitcoin when it’s over $100k or $200k per coin? Entities that can’t really buy it until it’s that big, is who. And at $100,000 per bitcoin, each sat is worth a tenth of a cent.

Kind of like how the price of a 400 ounce gold “good delivery bar” doesn’t really matter for most people, the price of each full bitcoin (an arbitrary large unit) doesn’t really matter. What matters is overall network size and liquidity and functionality. And what matters is whether their share of the network is preserving or growing its purchasing power over the long run, or not.

Like any asset, bitcoin price is a function of supply and demand.

Supply is fixed, but portions of it can be in weak hands or strong hands at any given time. During bull markets, a lot of new people excitedly buy in, and some longer-term holders trim their exposure and sell to those new buyers. During bear markets, a lot of recent buyers sell out at a loss, and the more steadfast…