Crypto Primer: Valuing cryptocurrencies
Cryptocurrencies are a new type of asset, and there is no agreement yet in the market on how to value them. The valuation varies greatly depending on the token type and the dominant use case for the token.
Cryptocurrencies may be used as a store of value, a medium of exchange, and as a commodity fuelling the economy of the protocol. Some tokens derive their value directly from the cashflows of a project, and others confer ownership. The valuation approaches will be entirely different for these different token types.
Valuing blockchain protocol tokens
The original cryptocurrencies – the native tokens of blockchain protocols such as Bitcoin, Ethereum, Polkadot, and so on – are the hardest token type to value because of the novel nature of these assets. These protocol tokens fulfil multiple functions and can derive value from multiple sources.
First of all, protocol tokens – unlike fiat currencies – do have an intrinsic value that provides a floor to the valuation. This is derived from the transaction cost economy that the protocol supports. As users of the blockchain pay the validators for transaction costs, the present value of future transaction costs provides a base line. Proof-of-stake protocols are worth a minimum of the transaction cost volume times a factor determined by the minimum yield that validators accept. For proof-of-work protocols, the floor value is much lower as the transaction cost economy translates into simply a minimum demand for the asset when valued as a currency.
Valuing cryptocurrencies on the basis of the market capitalisation required to support the demand for payments in the token is akin to valuing fiat currencies. The estimated volume of payments made with the cryptocurrency divided by the velocity of the currency provides the monetary base required to support the token functioning as a medium of exchange. Velocity on the other hand is linked to the token’s acceptance as a reliable store of value. As with fiat currencies, a lack of confidence in the currency leads to extreme velocity i.e., hyperinflation, and a loss of value.
Valuing cryptocurrencies as stores of value is similar to valuing safe haven commodities such as gold, and it is based on modelling the supply as well as the demand. Valuation models such as “stock-to-flow” have been proposed for bitcoin to mirror models for scarce commodities. The weakness of these models is that it assumes that supply is the driver of value. This does not hold true for bitcoin or gold, as the price of safe-haven assets is more often driven by changes in demand. Supply trends are an important factor, but they only provide part of the answer. When demand is stable, supply becomes the driver. However, in times of economic upheaval, the demand for safe-haven assets is the primary driver of value. In the case of bitcoin, and cryptocurrencies in general currently, the demand trends arising from the institutionalisation of crypto assets are a stronger driver than supply.
The above values are additive, because tokens that are, for example, held as safe-haven assets are not simultaneously used in day-to-day transactions.
From fair market capitalisation to fair price
The supply models of cryptocurrencies also make an important difference to value. The above valuation approaches determine the estimated market capitalisation, which is then divided by the token supply to calculate the fair value estimated for the price.
Different supply models will translate the same market capitalisation into different price estimates. The protocol’s “monetary policy” for issuing and destroying tokens and the caps and mechanisms for these need to be considered.
Supply overhang from vesting schedules, or from foundations associated with the protocol holding large volumes of tokens that they may sell in the market at any time, also need to be considered.
Finally, the demand for the token, and the available liquid supply, is also influenced by the token’s acceptance as collateral, for example in decentralised finance applications.
The difficulties in determining an absolute fair value for cryptocurrencies include not just developing the right model and using the right approach, but they also include estimating the parameters and forecasting the business volumes. The high uncertainty around future business volumes and around the determinants (such as technology) of how the aggregate volume will be divided across the various protocols mean that reverse and relative valuation techniques are often used.
In a reverse valuation the question asked is what assumptions are required to justify the prevailing price, and then how reasonable these assumptions are.
Relative valuation can compare metrics across protocols to pinpoint the relatively undervalued tokens, or it can compare changes over time to a key metric underpinning the valuation of the protocol. An example is observing the network effect and relating it to how much change in value a certain amount of change in the user base would translate into.
Relative valuations are weak indicators, because they say nothing about the starting point (e.g. if a token was massively overvalued to start with, or the price has anticipated the growth in business volume, then the observed growth would not necessarily translate into a price change). Meanwhile comparing the valuation of different protocols is only valid if all the relevant factors are considered, and picking out one metric to compare can lead to flawed conclusions. Nonetheless, relative valuations can provide important and useful insights.
Valuing application layer tokens
Despite enthusiastic claims to the contrary by projects, especially during the ICO boom, application layer tokens that rely on the infrastructure of another blockchain do not possess strong store-of-value characteristics and are extremely unlikely to have much value as store-of value-assets.
As a result, the suggestion that they have value as a “utility token” to be used in the economy of the application is also flawed. Valuation as a currency in the protocol economy depends on the velocity of the token. Tokens that are not readily held as stores of value will experience extreme velocity, which means their value can tend to zero when assessed on this basis.
However, these projects are basically new business models: decentralised versions of private corporations. The projects generate economic value, and if the economic model for the token (tokenomics) has a link to the value generated by the project (such as project revenues used to buy tokens in the open market), the token can be valued accordingly. The valuation would be based on the traditional step of estimating the total economic value generated by the platform, and then translating this into token value according to the tokenomics model of the project.
These models are varied and experimentation is going on to arrive at stable models that link the value created in the decentralised economy to the token value.
Other types of crypto assets
Security tokens are a direct parallel to traditional assets as they confer direct entitlement to cashflows and the assets of a business. They are valued in the same way traditional securities are valued.
Stablecoins should have a stable value equal to the currency or commodity they replicate, barring flaws in the replication methodology.
Tokenized assets (such as the tokenized version of Tesla shares, or tokenized real estate) have exactly the same value as the underlying asset, barring any platform risks.
There is not much to say about valuing NFTs such as collectibles or digital art, because the value of these is in the eye of the beholder.
Beyond the usual uncertainty around the size of the opportunity and the success of the project, there are additional risks to consider for crypto assets when making valuation assessments.
There is risk with the technology, in particular security risk. For large, long-established protocols this risk may be negligible, however, it needs to be assessed. Smart contract risk for assets and applications built on top of other protocols is particularly relevant to consider.
In the case of tokenized assets or assets that can only be owned via a token, regulatory restrictions on ownership and trading of tokens in major jurisdictions can lead to a supply/demand imbalance that persistently keeps the price away from fair value.
Key to remember
The crypto asset universe encompasses a variety of economic models which call for different valuation approaches, and most cryptocurrencies derive their value from multiple sources.
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