A deductive valuation framework for cryptocurrencies | by Alexander Liegl | Medium


Foresight in an immature market


This essay is a thought experiment to understand which types of tokens (interchangeable with “cryptocurrencies”) can and cannot accrue value. The conclusion it draws is that only tokens that are competitively superior current or future stores of value have a fundamental reason to capture a non-zero share of the economic value generated by their underlying decentralized protocols. Any token that is a competitively inferior store of value has no fundamental relationship between its price and the economic value generated by its protocol. In order to give a rigorous and exhaustive argument, this essay is structured as a deductive proof. This axiomatic approach is meant to produce a rigorous framework for logically deducing why, how, and where future returns on investment capital will be lost and made in the captivatingly paradigmatic cryptocurrency markets.

Premise 1

Centralized protocols (companies) capture some of the economic value they create by charging a type of fee, tax, interest, or rent.

A centralized protocol accrues economic value by taking some type of a cut of the economic activity it directly enables. A platform is a type of centralized protocol. The Apple AppStore platform is an incredible business because it takes a 30% cut from every app using its platform. Despite the massive haircut, applications continue to flock to the AppStore simply because its competitive advantages produce unparalleled positive expected value. As such, the relationship between the economic value the AppStore creates and the way in which it captures a share of that value is straightforward: it takes an equilibrium fee high enough to maximize its profits but low enough so it does not cause applications to jump ship. Generally speaking, any type of centralized protocol, company, or platform has some means of participating in the economic value it creates for end consumers. Theoretically, its pricing is a Nash equilibrium between maximizing its own profits and maximizing consumer surplus. While in practice it varies, the objective is fairly clear: centralized protocols capture some of the economic value they create; tautologically, the value-capture mechanism is to charge customers a type of fee, tax, interest, or rent.

Premise 2

Generally, the notional amount of economic value a centralized protocol captures is proportional to the notional amount of economic value it creates.

Straightforward. If the AppStore creates more economic value now (say $200) instead of last year (say $100) and keeps its haircut at 30%, then it captures more economic value now ($60) than last year ($30).

Premise 3

Investors purchase centralized protocol tokens (e.g. equity shares) with the expectation of profit due to the protocol creating increasing economic value and the token price appreciating because it captures some of that value.

Also straightforward. Say, for sake of simplicity, that Apple’s entire business were the AppStore and that there are 100 tokens one can buy, with each token giving one the right for 1/100th of the economic value captured by the AppStore. Hence, the token should double in price if the value the AppStore captures doubles (see Premise 2). Of course, there are other factors that determine token prices over time, including a speculative premium or discount. But, the principle generally holds: investors purchase tokens (e.g. equity shares) if they believe the protocol is going to do better (than the market predicts) in future and can profit by selling their tokens at a higher price than the one at which they bought them. Since the only utilities such tokens produce is a cash-flow from profit participation (e.g. dividends) and an increase in token price (e.g. capital appreciation), then, by definition, investors purchase them with the objective of scoring a profit.

Premise 4

Any token that provides some means of profit participation is effectively a type of equity and hence will be classified a security.

Tokens that do enable profit participation are tacitly described as productive assets. There are different types of productive tokens, but, they generally can be seen as variants of typical stockholder equity. Therefore: (1) the token will likely see regulation of some form in the short- or long-term; or (2) the token has no legal obligation to actually honor their productivity (e.g. BNB only reflects its intended purpose as long as Binance honors this — suing Binance, if they stop honoring it, is practically infeasible).

Regarding the United States’ SEC, the Howey Test dictates that if there is an expectation of profit, then the underlying is a security. According to Premise 3, investors purchase value-capturing tokens with the expectation of profit. Thus, any such token is a security and will be regulated as such. Note that “work” tokens like REP, inherently necessary for their unique consensus models, seem to be an exception. However, every market on Augur constitutes a type of financial market and thus, equally, falls into bucket (1) above.

This premise is not a red herring. Enforcement and regulating agencies are currently taking a surprisingly lenient approach towards the cryptocurrency markets. However, wise market participants know that the SEC and similar agencies are simply taking their time to map out the system. They won’t shoot the messenger, but they will shoot those making their fortunes off of non-traditional structures inside their regulatory purview. The market, currently, heavily underestimates long-term government crackdown and regulation risk. This risk is reflexively reinforcing because it is directly proportional to the cryptocurrency industry’s own success. Minor battles might have been won in the past, but the real war has yet to be fought.

Premise 5

A decentralized protocol captures none of the economic value it creates.

A decentralized protocol (loosely interchangeable with “blockchain”) is disintermediating by definition. Apple is the intermediary of the AppStore: it collects a 30% cut of the revenue that applications make by using the AppStore platform. A decentralized version of the AppStore would remove Apple, the intermediary, and forego the 30% cut. No matter how much economic value the decentralized protocol (or, by extension, platform) creates, the fact that it is decentralized prohibits it from ever directly participating in that economic value creation. Independently, as will be shown in later premises, value can still accrue to a specific type of token.

Premise 6

A decentralized protocol offers some service that is consumed by consumers and provided by providers.

Take, for example, Filecoin. At a high level, Filecoin provides a file storage service: clients can store their data in a decentralized and encrypted manner and miners can use their excess storage capacities to get paid. Clients need to buy Filecoin to use the service, spending those on the miners to store their data. Miners can then sell or keep (“HODL”) their Filecoin as they see fit. Generally, it is arguably correct that every decentralized protocol offers some service by two or more sets of participants that establish the network.

Premise 7

For tokens of decentralized protocols, there are two sets of token users: (1) speculators that buy and hold the token (i.e. remove token supply); (2) protocol service consumers and providers (e.g. Filecoin clients and miners).

Speculators buy and hold tokens, arguably with the prospect of profiting from an increase in their price (buy low, sell high). Prices rise if demand outstrips supply. Hence, if there are more tokens bought by speculators than tokens sold by the rest of the market, then the token price should increase. One could, alternatively, think of this as speculators removing more of the token supply than sellers are adding to it. Theoretically, as long as removal is larger than addition, then the price should rise proportionally.

Protocol service consumers and providers are the actual adopters and users of the decentralized protocol’s service. Protocol consumers buy the token in order to spend it to consume the service provided by the protocol providers. Protocol providers accept the token in return for the service provided and then either keep the token or sell it for whatever other currency allows them to keep the lights on and the beer cool (e.g. USD, BTC). A simple outline of the chain of events is: (i) consumer buys token in exchange for a different currency; (ii) consumer consumes protocol service by spending the token; (iii) service provider receives the token from the consumer for providing the protocol service; (iv) service provider keeps or sells the token in exchange for a different currency.

Premise 8

Consumption and provision of the service causes insignificant token holding time, thus removes the token from total supply for an insignificant time, and thus has negligible influence on token price.

Abstracting away all other reasons for why to hold the token, the actual chain of events as outlined in Premise 7 from (i) to (iv) should result in an insignificant amount of time that tokens are removed from the existing supply. Since it is established that removal from supply results in upwards price pressure, an insignificant time of removal from supply should result in insignificant upwards price pressure. On one hand, the protocol service consumer only buys the token when they want to use the service. No one stockpiles gasoline before going on long road trips; gasoline is provisioned “just in time” as one buys it only when needed. On the other hand, the protocol service provider only holds the token when receiving it from the consumer, and sells it immediately thereafter. A protocol might have time (or velocity) sinks that act as a way to expand the supply removal time (e.g. miners need to hold the token 24 hours after receiving it from the consumer before they can sell it). However, as the protocol usage grows the significance of those sinks should fade proportionally. They are pointless because they introduce superfluous friction that will be priced into the service, thereby making it less attractive to consumers.

Tangential to the “Velocity Problem,” the pure act of consuming and providing the service should result in insignificant supply removal time and thus insignificant upwards price pressure. Note that, because insignificant supply removal time is not equal to *zero* supply removal time, the increased usage of the protocol should result in a marginal upwards price pressure. However, as an extension of the “Velocity Problem,” this effect should be negated by increased token velocity. One can conclude that, objectively, the actual adoption or usage of the protocol should result in insignificant supply removal time and hence insignificant effect on token price. As long as a protocol has non-zero usage its price will also be non-zero; zero is its asymptote.

Premise 9

Only speculators have a meaningful impact on token price.

Since it is established in Premise 7 that token price is constituted by two different sets of users — speculators and protocol service consumers and providers — and that the latter has insignificant impact, it follows that only the former can have meaningful impact.

Premise 10

Since only speculators have a meaningful impact on price according to Premise 9, there are only two ways by which its price can increase over time: either (a), an increasing number of speculators buy and hold the token (thereby removing supply); or (b), the token is a better store of value (retention of purchasing power) than existing alternatives. In the case of (b), both speculators and protocol service consumers and providers gain utility just from holding the token (i.e. thereby removing supply; speculators get utility from storing value in the token besides profiting off of higher prices in future).

Option (a) is arguably a type of Ponzi scheme. The token price can only increase if an increasing number of speculators come in to buy and hold the token, thus providing upwards price pressure. The number of speculators (or the quantity they buy) has to perpetually increase in order to keep the price going up and to the right. This is unsustainable as both history and logic confirm: there is only a finite number of possible buyers (hyperbolically speaking, the world population) and, empirically, every acknowledged Ponzi scheme has eventually collapsed. Even worse, these speculators (mostly) are unaware of participating in a Ponzi scheme variant in the first place. Erroneously, they believe that there is a fundamental relationship between token price and the economic value the underlying decentralized protocol creates. But since that relationship is null, they are only speculating on more speculators coming into the token than when they bought in. It’s the definition of unintentional gambling; the only causal factor being price, not fundamentals.

Option (b) is equally worrisome. What would cause a protocol consumer or provider to hold the token even when not buying it to spend it and consume the service or when receiving it for providing the service and selling it immediately thereafter (and thus substantially expand supply removal time)? Only if the token is a competitively superior store of value relative to existing alternatives (e.g. BTC or USD). More precisely, one could sharpen the task to being a competitively superior “non-sovereign monetary store of value.” Consequently, fiat is out of the race and only BTC and similar self-appointed cryptocurrency contenders (e.g. ETH, XMR, ZEC, etc.) and physical commodities (e.g. gold) remain. If the token is a competitively inferior alternative to existing ones, neither speculators nor protocol service consumers and providers have any incentive to hold it besides for their specific reasons (delusional speculation or usage of the protocol service). They will use the token for their own intentions, but will, immediately afterwards, exchange it for a competitively superior store of value.

Premise 11

Non-sovereign monetary stores of value abstract away all reasons causing fiat currency fragmentation.

What is a non-sovereign monetary store of value? Something “non-sovereign” is independent from any form of government. Something “monetary” is of or relating to money or the mechanisms by which it is supplied to and circulates in the economy. Something that is a “store of value” retains, or attempts to retain, purchasing power in future for its users.

The key variable is “non-sovereign,” which forces one to abstract away any reasons that cause the current market share distribution of fiat (or sovereign) stores of value (currencies, e.g. USD, EUR, JPY). Fiat currency fragmentation, generally speaking, is due to factors like physical borders, governments, central banks, armies, and so forth. These entities, more or less, bind populations to specific fiat currencies given their physical location. As long as there are nation-states demarcated by physical borders, fiat currencies will maintain their fragmentation. Even with sovereign fragmentation, the status quo is a fiat currency distribution heavily skewed towards the US Dollar. As a substantiating data point, USD owns 43.8% of global foreign exchange market turnover, followed by EUR with 15.7% and JPY with 10.8%. A non-sovereign cryptocurrency has none of the constraints that its fiat colleagues suffer from. It is entirely indivisible — a single liquid entity that knows no nation-state borders or coercive enforcement agencies. Its cosmopolitanism is directly proportional to that of the internet (and, perhaps, even more so given recent and future hardware developments).

Premise 12

The distribution of non-sovereign monetary stores of value converges to a power law.

What is the distribution of non-sovereign monetary stores of value if they abstract away all reasons causing the fragmentation of fiat currencies? Certainly a point of contention, but arguably non-sovereign monetary stores of value compete solely on liquidity. The most liquid one will win and take the market for itself with very little or zero left for second place, third place, and so forth. A store of value is simply the best asset to save in and exchange in future. It is the one with the highest liquidity and salability, the most widespread adoption, the lowest volatility, and the strongest robustness to internal and external risks.

Cryptocurrencies, currently, satisfy none of these requirements. However, some are significantly better positioned than others to satisfy those requirements in future and, thus, win the market. Why is it a winner-takes-all or -most market, i.e. a power law distribution? History shows that, over long enough time periods, money that develops in the free market (as opposed to state decree, legal tender, and national borders) converges in a power law type manner, where less liquid monies collapse into more liquid monies (cf. Mises et al). Definitionally, a store of value is a subset of money. By transitivity, competing stores of value will also converge into a power law distribution. For this reason, there will be a winner-takes-all or -most market of non-sovereign monetary stores of value.

Deductive conclusion

A token can only accrue value if it is a competitively superior non-sovereign monetary store of value. Conversely, any token that is a competitively inferior non-sovereign monetary store of value cannot accrue any value.

The natural consequence of the premises above is that every token competes in one massive power law distribution for the title of *dominant* non-sovereign monetary store of value (the precise term introduced by John Pfeffer). If it does not win this rat race (or comes to a close second or third place), its market share will, effectively, be zero. It is established above that there are two sets of token users: (1) speculators that (unknowingly) are participating in an unsustainable Ponzi scheme variant; (2) protocol service consumers and providers that create a supply removal time too insignificant for their participation to have any meaningful impact on token price. Neither set will create a way in which the token price can actually reflect the economic value created by the protocol because that cannot be true by definition. Also, neither set will provide a sustainable way to increase the token price, since Ponzi schemes are bound to collapse and actual protocol usage has negligible effect (and might even be antithetical to price appreciation, cf. “Velocity Problem” above). The only reason the token will see extended (or, theoretically, infinite) supply removal time, and hence upwards price pressure, is if it is a competitively superior non-sovereign monetary store of value.

The fate of the others

Problematically, this catapults every token into direct competition with existing and vastly superior alternatives, e.g. Bitcoin. In the long-run, if the token wants to maintain non-zero value, it will have to beat Bitcoin or be a close second or third place (in case it turns out the market is winner-takes-most, not winner-takes-all).

What happens to tokens that will not be the first, second, or third place non-sovereign monetary stores of value? They will be a pure medium of exchange: an unavoidable source of friction necessary to maintain an independent blockchain and consensus model. Protocol services will still be “rendered” in this valueless exchange token, however the actual pricing of the service will be done in terms of the dominant non-sovereign monetary store of value. The valueless token will be reduced to a status of facilitator and nothing more. And no, a pure medium of exchange doesn’t warrant a premium or value per se. This point has been argued before by Vitalik Buterin somewhat diplomatically and by Daniel Krawisz of the Nakamoto Institute somewhat aggressively.

While any token with non-zero usage will have a non-zero price (as insignificant supply removal time does not equal zero supply removal time), it will have its price converge towards a zero-asymptote. Any capital currently or previously invested in those tokens will be transformed into consumer surplus and fatter wallets for early, cashed-out token speculators. The former will see technological progress similar to TCP/IP; the latter will see more zeros in their USD-denominated bank accounts if they sold their tokens early enough. It will be a Schumpeterian tote bag that ushered in a new era of open-source technology via an act of unprecedented, yet inadvertent, altruism. Investors should brace themselves to write-off these unintentional donations as tax deductions.

Productive equity-like tokens, e.g. REP, can theoretically capture non-zero value but face strong regulatory uncertainty for now and in future. More importantly, they suffer from the fact that decentralized protocols can only succeed if they disintermediate value capture. To be a better alternative than a centralized counterpart, the productive token’s decentralized protocol must take less or zero rent. Thus, they will naturally capture less value than shares in a centralized company; they are a competitively inferior model of economic value capture.

Only the very few cryptocurrencies that are competitively superior non-sovereign monetary stores of value will be able to accrue any value at all, and therefore have a fundamental relationship between their price and the economic value created by their underlying protocol. Any current cryptocurrency should be priced in terms of the total addressable market of the global non-sovereign monetary store of value and its probability of winning that market. For example, Ether currently has some true fundamental value — albeit a fraction of its current market cap — because some do use it as a store of value and view it as competitively superior to BTC, USD, etc. In the future, there might be some that have similar conviction in Filecoin or Tezos or what not because, for them, they offer a better way to use, retain, and compound purchasing power. This means that as long as those hard-core holders of last resort remain, the lower bound for any of these cryptocurrencies is non-zero. However, due to the nature of the markets and prospects outlined above, the currently best positioned prospect to win, arguably Bitcoin, will create a return on capital many orders of magnitude higher.

The opportunity

Where will investors find attractive return profiles with less capital destruction risk? Along the lines of the infamous McKinsey-mantra “mutually exclusive, collectively exhaustive,” altcoins need to minimize their overlap with Bitcoin’s value-proposition in order to maximize their chances of value-accretion and, put bluntly, survival. Currently, privacy coins are the main opportunity of how investors can differentiate themselves from the Bitcoin juggernaut while preserving its ethos. Fungibility, and by extension privacy, is a binary. Conversely, fungibility is not a spectrum: a coin either is or isn’t fungible, it can’t be a “little” fungible. Bitcoin currently does not satisfy the binary of fungibility and hence enables an unprecedented opportunity for privacy coins. Binaries allow for independent markets and, thus, privacy coins are a way of riding the Bitcoin wave while reducing direct competition. It might change in future. It might be that Bitcoin somehow becomes totally fungible and satisfies the privacy binary. But from a probabilistic investing perspective, diversifying into high-potential privacy coins (XMR, GRIN, ZEC) may generate similar returns on invested capital as Bitcoin, as long as Bitcoin falls short of becoming fully fungible and private.

Smart contract platforms also come to mind, but their prospects seem less attractive. They face increasing commoditization and the microeconomic inevitability that low barriers-to-entry drives return on investment towards the opportunity cost of capital. Smart contracts will and do require escrow for the duration of the contract, which acts as a type of velocity sink. However, above it is shown that any type of velocity sink has negligible effect on value accrual and can even be counter-productive to user adoption.

The currently dominant investment portfolio is long Bitcoin and privacy coins, complemented by smaller positions in potential non-sovereign monetary store of value contenders like ETH and DCR. Prospectively, future use-cases will emerge that are binary and non-overlapping with Bitcoin, such that the native tokens can carve out their own share of the global store of value market.

Technological progress has always been easier to invent than predict. Author optimism is, therefore, based on the prospect that current and future industry participants will revolutionize our world with the technology incepted by Satoshi Nakamoto in 2008. Historically speaking, humans have an acute sense of how best to converge on technological paradigms that usher in new eras of unprecedented socio-economic prosperity. Bitcoin is a catalyst to revolutionize the global financial systems and start another chapter in humanity’s technological and economic progress.

Thank you to Nic Carter, John Loeber, and Su Zhu for their feedback.