This question is keeping me busy for quite a while now. As with regular investing, diversification is the only free way of reducing risk and, despite what a lot of people tell you, this in no different in the bitcoin universe. Litecoin, often cited as being the silver to bitcoin’s gold, is an obvious candidate for diversification. But if I look at some of the characteristics from a traditional investor perspective I have to conclude that at this point in time litecoin is likely to represent the gold.
First, litecoin has already solved its scalability issue, while bitcoin developers and miners are still debating on how to proceed. And that debate is pretty ugly at times. In August we get a so-called soft fork which could then turn into a hard fork. I’ll leave the technicalities out, but basically you could have two kinds of bitcoin by the end of the year. Within the regular investing universe this would surely lead to an ‘uncertainty discount’ in the price of bitcoin.
Second, since the scalability uncertainty was removed, transactions made with litecoin are currently cheaper and faster than transactions made with bitcoin.
Third, while litecoin is often referred to as ‘chickun’, because chickens don’t fly that well, or just as boring, this is mostly a virtue and hardly a vice. As a reminder, the realized volatility of bitcoin is over 60% in recent months, almost six(!) times higher than that of equities.
So this brings me back to my question; Why is litecoin’s market cap so ‘small’? Perhaps because bitcoin’s market cap of USD 40 billion is just way too high. For example, because this soft fork thing is not properly reflected.
But if we take the USD 2500 bitcoin price as a given, finding an answer becomes harder. Currently, there are 3.14 times more litecoins than bitcoins in circulation. If both were ‘equally’ priced, litecoin should be worth USD 796. Obviously bitcoin has the market leader advantage. It’s bigger, generates more transactions and offers more places to spend your digital money. But how much is that worth? Looking at the equity market, my guess is that a market leader can earn a 25-30% valuation premium compared to its competitors. But lets play it safe and suppose bitcoin has a 50% ‘leadership premium’. That pushes litecoin’s ‘fair value’ (a bold phrase since we are discussing the valuation of an ‘altcoin’, something that wasn’t around just a few years ago) to just under USD 400. However, the current valuation should include the litecoin advantages over bitcoin as mentioned above. These could fade if the bitcoin community manages to keep things together and solves the scalability issue in an orderly manner, but this not yet the case. Hence, in this case litecoin’s value should be north of USD 400, ten times its current price.
I’m probably wrong about many things here. For instance, the 50% discount is derived using examples from the equity market, and may not apply to cryptocurrencies as well. In addition, investors could see a massive gap between bitcoin’s and litecoin’s future, which is resembled in the price. Perhaps there is no need for a digital silver when we can all buy digital gold. Still, the sheer size of the valuation gap underpins my notion that it deserves a spot in a multi-cryptocurrency porfolio, and not just from a diversification perspective.