Authors: Vincent Duchaine and Jennifer Kwiatkowski
Proprietary WealthUmbrella Trading View Indicator name:
- WU BTC Metcalfe Law Discount Indicator
Formulated by George Gilder around the network theory of Robert Metcalfe, what we call today the Metcalfe’s Law states that the value of a network is proportional to the square of the amount of network participants. This means that doubling the number of network members roughly quadruples the value of the network. A good example of this is the first company founded by one of my co-founder Robotiq.com. In 1999, he and his family created the real estate website duproprio.com, which later became the Canadian equivalent to Zillow.com. Their initial challenge was to actually have houses on their website because if you don’t have any houses for sale, nobody will be interested in visiting your site. On the other hand, if you don’t have anyone visiting your site, why would someone pay to put their house on it? It’s the chicken and egg problem.
They overcome this challenge by initially knocking on the door of everyone they could find with a “for sale” sign outside of their home, and offering to put their house on the website for free. With this initiative they were able to lock in some initial network participants. These houses attracted some buyers and houses were sold through the website. These successful sales encouraged new sellers to put their house on the website which spiraled into attracting more and more visitors up to the point where www.bytheowner.com became a giant in the province of Quebec in the early 2000 and a considerable player in the rest of Canada. This relationship between the number of sellers on the website and how many buyers and future sellers were attracted is a good example of the square effect of network participants on the value of a network described by Metcalfe.
We built an indicator around this concept in order to have a perspective of how healthy the current network valuation in dollars (Market cap) is in relation to the theoretical network value stated by the Metcalfe law. The value in itself means nothing, but the cyclical evolution through time of this value provides interesting information.
Our Metcalfe Law Discount Indicator gives a very different perspective of Bitcoin compared to those that look only at the economics of profit and loss (like the Kwiatkowski indicator does), since it is looking at the core health of a Network, i.e. the amount of active participants.
The computation of this index is not that straightforward as it accounts for several different phenomena (like lost supply, non active members, etc.), so we won't go into too much technical detail. What is important to note is that in order to make it constant in time we actually use the Z-Score of this index, which means that the indicator is expressed in terms of the amount of standard deviation. If you are not familiar with the Z-score, here is a good reference, but if you don’t want to become a Z-score expert, that’s ok too, here is how you should read our indicator.
A value of 0 represents a reading of the ratio of market cap to Metcalfe value that is exactly the expected average. This means a perfectly healthy value for the network, no discount, no premium. A reading in the positive means that the monetary value of the network is worth more than its historical network value. A reading in the negative means that we are currently trading at discount. If you know your stats, you know that a value under -3 or over 3 means is exceptional and statistically very uncommon. In other words, it’s a very good indication of a great discount or an enormous inflated value. Here are the historical values of this indicator for 2013-to 2020.
Most of the tops happen at values over 4 and most bottoms below -2. This indicator is interesting as it was able to flag very clearly the intermediate top in July 2019 during the small bull run we had between the 2017 and 2020 cycles. Many top indicators that look at the economics of Bitcoin investors miss this event, as this local top is not associated with a massively overstretched monetary valuation. This again underline the importance of using several different metrics when trying to anticipate Bitcoin next move.
The 2021-2022 top is also interesting. The real hyperinflation of the market cap over the network value derived from the Metcalfe law for that cycle happened in January 2021. This was just before Bitcoin hit 40K for the first time and suddenly dropped for a month or two.
However, the actual top of this cycle is a little later, when Bitcoin surpasses 60K. This, along with the previous example, shows the importance of using several indicators that each look at different aspects of the Bitcoin ecosystem as different phenomena in the price are often associated with different facets of the network’s health.
(P5 2022)
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