What is the Best Metric for Comparing Cryptocurrencies?By Kyle Torpey
Over the past few weeks, there has been a lot of coverage of a report from Bitwise Asset Management, which suggested that 95% of global cryptocurrency trading volume reported on sites like CoinMarketCap is fake.
Although it has long been known that cryptocurrency exchange data should not be trusted, the Bitwise report has been a good reminder that a lot of the metrics used to compare cryptocurrencies in general are suspect.
So what data should people be looking at when comparing cryptocurrencies?
The Importance of Liquidity
In the competition going on between various cryptocurrencies on the market, the ultimate goal is to become a viable form of money with real-world utility. This means the cryptocurrency needs a sufficient level of liquidity (in addition to the other properties of money), which should lead to a relatively stable valuation.
People need to be able to move in and out of the cryptocurrency without causing wild fluctuations in the price. A liquid money is also a more useful money, as it generally means there are many other people who are willing to accept the cryptocurrency in large quantities. Liquidity helps users avoid issues such as slippage and potential loss of value while holding the asset.
As early bitcoin investor Trace Mayer has pointed out in the past, many altcoins would not be able to handle millions of dollars worth of selling pressure without sending the price to zero.
In terms of cryptocurrency specifically, a more liquid form of programmable money is preferable for financial smart contracts, such as Abra’s crypto collateralized contracts. It’s possible that these new financial systems built on top of base cryptocurrency networks can bring tremendous amounts of liquidity to cryptocurrencies in the coming years.
The advantages of a liquid cryptocurrency over an illiquid or less liquid cryptocurrency create additional network effects around the most liquid cryptocurrency, which in turn creates a sort of feedback loop where some liquidity leads to more liquidity.
Price volatility effectively measures a cryptocurrency’s ability to do its job as a stable, trusted store of value. For the most part, increased levels of trust and stabilization appear to come through a combination of time and the network not breaking.
As more people are willing to trust an asset, there should also be an increase in the number of people willing to trade for it, which has the side effect of improving price stability.
As we pointed out earlier this year, bitcoin’s volatility has trended downwards over its ten years of existence, as the asset has become more liquid and the network effects around it have continued to grow.
The standard deviation of daily returns over a certain period of time is generally used to measure cryptocurrency price volatility. In the chart below, we’re specifically referring to the 180-day volatility of daily returns, according to Coin Metrics.
Combining Price Volatility, Liquidity, and Other Factors
While price volatility may be one of the best data points for measuring a cryptocurrency’s usefulness as money, it should not be used in isolation. Like pretty much every other data point in the cryptocurrency market, this one can also be gamed.
When looking at price volatility, other attributes, such as the levels of centralization found in the cryptocurrency network, should also be considered. The best example here would be something like Tether (USDT). While the USDT token is able to keep a stable value, it’s also completely centralized behind one company. It wouldn’t make any sense to compare Tether to something like Bitcoin.
Other data points like exchange volume and on-chain transaction volume should also be checked. A cryptocurrency could have low levels of volatility over the short term combined with low transaction volume. Once someone decides to make a large buy or sell order, those volatility numbers could skyrocket.
When a cryptocurrency has more trading and transaction volume, it becomes less likely that large transfers of funds will have a heavy impact on the price. In this way, volume can be viewed as a sort of check on the credibility of a particular cryptocurrency’s price stability.
For example, dogecoin is currently closing in on bitcoin’s 180-day volatility of daily returns, but it only has a little over a hundreth of the trading volume of bitcoin, according to OpenMarketCap.
It should be noted that this article is only referring to cryptocurrencies rather than crypto assets more generally, which could potentially have alternative sources of fundamental value.
As we’ve written in the past, altcoins in general tend to be heavily correlated to bitcoin, albeit with a higher degree of volatility. For this reason, a recent report found that ether could outperform bitcoin over the short term if the market turned bullish.
Of course, on-chain transaction volume may become less relevant as off-chain protocols, such as the Lightning Network, become more popular and privacy is improved for on-chain transactions. Still, the overall conclusion is that none of these factors should be taken in isolation, and a combination of price volatility, exchange volume, and on-chain transaction volume should be useful for comparing different cryptocurrencies in terms of their utility as money.