Fundamental Value In Crypto; Bitcoin And Decred As Store Of Value Investments

Originally published on Seeking Alpha on 01/2019

Before I explain where fundamental value lies in crypto, I would like to reiterate the potential upside of cryptocurrencies as a whole. Many investors are not aware that cryptocurrencies can be an excellent addition to a traditional portfolio with equities and fixed income. Apollo Capital showed that a portfolio with 2% allocation to crypto significantly outperformed a traditional portfolio.

(Source: Apollo Capital)

Doors are opening for institutions to invest in crypto assets. Citigroup © and Goldman Sachs (GS) are setting up crypto trading desks; Fidelity established Fidelity Digital Asset Services to handle custody for cryptocurrencies; Intercontinental Exchange (ICE), parent company of the New York Stock Exchange, is launching a crypto exchange in February.

Here is an illustration of the potential market size for cryptocurrencies. The graph was created by MarketWatch in 2017. Bitcoin’s current market cap is $62 billion.

(Source: MarketWatch)

Categorizing Cryptocurrencies

Most of the cryptocurrencies can be grouped into 3 categories.

• Stable coin — Pegged to a fiat currency, usually USD. (Tether USDT-USD, True USD TUSD-USD, USCoin USD USDC-USD). The price of each stable coin always stays close to $1.
• Utility — Most cryptocurrencies currently reside in this category. They power blockchain operations. (Ethereum ETH-USD, Ripple XRP-USD, EOS EOS-USD, Stellar XLM-USD, Binance Coin BNB-USD)
• Store of Value — Cryptocurrencies that are designed to function as an alternative to gold. (Bitcoin BTC-USD, Decred DCR-USD, Litecoin LTC-USD)

Not all cryptocurrencies are worth investing. With the increase of institutional investment in cryptocurrencies, crypto with fundamental value will outperform. We need to understand how value is accrued in cryptocurrencies.

Why utility tokens are not good investments

Cryptocurrencies are not equities. Buying cryptocurrencies will give holders no stake in the future of the respective blockchain projects. For example, Ripple (XPR-USD) is used for instant cross-border money transfer. When a company in the USA wants to use xRapid to transfer payment to a business partner in Mexico, the money is converted to XRP in the process and is converted to Mexican peso when the transfer is completed. There is no reason for anyone to hold XRP, because holding XRP is not required to initiate a transaction on the Ripple network. When there is no fundamental reason to hold, there is no investment value.

Same applies to Ethereum (ETH-USD). ETH is used as gas to fuel smart contracts that are built on the decentralized application platform. Ethereum is extremely valuable as a platform, but because it doesn’t provide any compelling reason for investors to hold ETH, investment value is limited. A user who needs ETH to run smart contracts only needs to hold a small amount and can easily trade into ETH whenever he needs more.

When the technology of decentralized exchanges ((DEX)) matures, investors can easily trade in and out from cryptocurrencies without depositing into exchanges. As a result, utility tokens are not able to accrue any value and appreciate in price.

There is also an economical and mathematical explanation to why utility tokens do not have much investment value. The equation of economic exchange is M = PQ/V

• M is the size of the asset base, which is the market cap of the cryptocurrency.
• V is the velocity of the asset, which is the number of times the asset changes hand.
• PQ is price multiply by quantity, which is the size of the economy or the cryptocurrency network.

Utility tokens are designed to have high usage (high velocity), which discounts the market cap according to the equation.Burniske, partner at Placeholder VC, has done extensive analysis on this equation if you want to learn more.

However, utility tokens created by exchanges are different. Exchanges reward coin holders with a share of trading revenue, so traditional cash flow analysis can be applied to determine their intrinsic value. An example is Binance Coin created by Binance. It’s a great investment if Binance maintains its position as the top exchange, but I am not sure if it can hold its dominant market share amid the competition.

(Source: Hacked.com)

Investment opportunities in Store of Value cryptocurrencies

As crypto researcher Willy Woo indicated, utility is a red herring for investors. He pointed out that “the rise of ETH was NOT from utility. It was NOT from users buying ETH to get Gas to fuel smart contracts. It was from ICO token treasuries parking their funds in ETH as a store of value.” However, as the ICO market freezes in 2018, Ethereum loses its store of value properties. When institutional investors are looking for cryptocurrencies that are worth investing, they will invest in those that display store of value SoV properties that last.

The best candidate for SoV is Bitcoin because of its long history and wide recognition. Bitcoin was created more than 10 years ago, and the fact that it is still around despite regulatory restrictions and attacks indicates that it is almost impossible to destroy and will still be around in the foreseeable future. Almost every cryptocurrency has a Bitcoin trading pair, and it’s often the most liquid trading pair, leading people to be willing to hold Bitcoin much longer than utility coins. People will most likely park most of their money in Bitcoin and trade into utility tokens whenever they need to use a decentralized application. Value accrues as a result, and when more and more people accept Bitcoin as a SoV vehicle, it will potentially replace gold or silver in investors’ asset allocation.

Decred as a SoV investment

The second candidate is Decred (DCR-USD), which I covered in my previous article. Decred is perfect for investors who would like to diversify from Bitcoin. Decred is better than Bitcoin in all aspects, except for the long history of Bitcoin and its liquidity.

Decred’s governance mechanism is heavily underrated. Blockchain projects do not function like companies in regard to decision making. Companies can reach consensus easily by asking shareholders to vote, but blockchain projects are decentralized in nature. Blockchain is revolutionary because the technology creates trust without a third party. A true blockchain project will therefore lack a governing body to make decisions. As a result, it’s much more difficult for a blockchain project to reach consensus, and it almost always results in community conflicts. For example, Bitcoin miners who disagreed with Bitcoin core developers hard-forked Bitcoin and created Bitcoin Cash, splitting the Bitcoin community into two sides.

Foreseeing the criticality of governance, Decred embedded governance into the protocol when the cryptocurrency was created in 2016. Most of Decred’s major decisions are now being voted on the Politeia proposal platform. Stakeholders’ influence on the network is proportional to the amount of DCR held and staked. Besides voting rights, holders also receive around 12% annualized return on the DCR staked.

Besides that, governance also serves as a compelling reason for DCR holders to hold their coins, enhancing Decred’s store of value property. I would not be surprised if investors choose to invest in DCR instead of Bitcoin just because they want to have their voices heard and to participate in governance. As discussed above, the value of a cryptocurrency is heavily influenced by its velocity. DCR’s velocity is low because holders have incentives to hold their coins, which helps DCR to accrue value and appreciate in price. Decred has not positioned itself as a SoV coin, which provides an excellent opportunity for investors who realize the potential of Decred to invest early. The only concern with Decred is its relatively low liquidity. It’s a two-edged sword. On one hand, it helps price appreciation because there isn’t that much DCR available to buy. On the other hand, liquidity is essential for an instrument to function as a SoV. That said, I believe liquidity will come naturally when the market recognizes the value of Decred.

Risk

Investing in crypto is not for everyone. Although the potential upside is attractive, the market is highly volatile. The sector is also changing so rapidly that 5 of the top 10 cryptocurrencies in 2017 were no longer in the top 10 by the end of 2018.

The fundamental approach to value cryptocurrencies discussed in this article may not work practically, because the market is currently dominated by retail investors and it’s not clear whether current market participants invest based on fundamental factors.

There is also no widely accepted theory to value crypto assets, which contributes to the volatility. Burniske and other researchers have inspired several approaches to value crypto assets, but it will take some time for the market to accept quantitative valuation theories and let theories guide investment behaviors. 2019 is an interesting year to see if the increase in institutional investors will have an impact on crypto valuation.

Conclusion

With new infrastructures set up to trade and invest in cryptocurrencies, institutions will start exploring crypto investment opportunities. They will likely come to the same conclusion that utility tokens are not good investments because they change hands too often and thus do not accrue much value. Fundamental investors will most likely invest in cryptocurrencies that exhibit store of value properties. Within the SoV category, Bitcoin is the best investment, followed by Decred. Decred’s governance system has immense value because it helps all the stakeholders to reach consensus effectively and helps DCR to accrue value as a store of value instrument.