Why PoS is Ethereum’s valuation game-changer
One of the most difficult questions to answer in the cryptocurrency market is how to value a token. While certain token economies are structured simpler than others and therefore easier to make back-of-the-napkin type of estimations, we still fall back to the demand/supply model for the most part. The mathematically inclined will use the MV=PQ framework, but terms such as V (velocity) is difficult to quantify. The V term is arguably even a more sensitive term in a crypto valuation than the WACC term in a traditional DCF. There are other emerging frameworks that I will discuss in other articles.
Coming from the traditional financial services space, we understand the lens of a traditional investor. Predictable cashflows lend itself to a much more easily “socially acceptable” valuation model. This is why moving to Proof of Stake is such an important step in Ethereum’s roadmap and growth.
DASH, one of the largest cryptocurrencies today gives us a glimpse into what a fully PoS-deployed network could look like, assuming similar economics. Today, ~20% of DASH’s total supply is being staked, for which the masternodes are being compensated ~7% per annum. Taking this to be a broad yardstick we can reasonably infer that a non-trivial double digit percentage of ETH will be staked.
There are two components to ETH’s fee model, (1) Staker inflation and (2) Gas fees.
Based on discussions in the community, the annual return of ETH staking is expected to be a function of the total amount staked. Refer to the table below — if 20% of all ETH is staked, then the expected staker interest is 2.7%. Once we add the fees earned from gas, the total annual return for a ETH staker is expected to be 4–6%, ceteris paribus. As the economy goes through its early years and demand and supply stabilizes, the actual amount of ETH staked will settle on a Nash equilibrium.
Once Ethereum moves to PoS fully post-Serenity in 2021, we can then begin to model the valuation through “old-school” discounted cashflow methods.
- Simply, Price (T) = Masternode reward (T+1) / ( Discount rate — growth rate)
To many of us in the cryptocurrency space, we know this almost intuitively. So what’s the big deal?
Because this represents the FIRST time a traditional investor can begin to understand cryptocurrencies, and an introduction to what “Masternode” and “Staking" means in financial lingo.
Users pay fees to use the Ethereum network. ETH owners (nodes) receive these fees as a dividend. It’s as simple as that, a decentralized world computer/AWS.
In the future, I expect the digital equivalent of REITs (real estate investment trusts) to appear for PoS coins. This allows professional managers to manage the complexity and uptime demands of running masternode(s). These CITs (crypto investment trusts) will allow large participation from dividend-seeking traditional investors. Given the non-trivial risk of running a CIT and risk premium necessary for investors to participate vis a vis other asset classes, I would imagine a steady state unlevered return to be in the 4–5% range annually as the Nash equilibrium. Even if the actual net return of the node after operational costs was only 3–4%, the share price may well fall below NAV to compensate, or conversely trade at a premium to reflect the potential of growth in ETH’s price itself.
Further, if banks one day were to begin levering up such structures , then 6–8% is reasonable. This is assuming an unchanged and benign global interest rate environment. Also I would imagine the risk premia to be very high initially, but compress over time as investors get more comfortable with it as a true dividend yielding asset class.
There are early iterations of companies offering a staking as a service model (SaaS), but most of them appear to be scams.
While PoW-coins (like Bitcoin) could theoretically also be turned into a CIT, it would be far more challenging for the management entity to continue to keep up with increasing CAPEX, specific PoW-issues such as algorithms becoming ASIC-resistant etc.
On a final note, this approach does not factor in any additional value derived from monetary premia, as a case can be reasonably made that ETH is not too dissimilar from BTC in that it may be treated as a valuable commodity, and thus held as a form of savings and sound money, and allocated within investment portfolios. Indeed, ETH is starting to behave as a UoA (Unit of Account) from the way people have been using the ETH unit (i.e. I just bought a Gods Unchained pack of cards for 0.12 ETH).
Special thanks to Richard Yan (Vite’s COO), Murad Mahmudov (@MustStopMurad) and Eric Conner (@econoar) for their valuable feedback for this piece!