Finding a floor in cryptoasset valuation

As noted, cryptoassets tend to extreme reflexivity which “is driven by uncertainty and confusion around the early-stage technology, virality of communication mechanisms, lack of standardized valuation frameworks, regulatory paranoia, and majority retail participation”.

The last two months have embodied one of these reflexive tailspins. What’s been particularly unnerving is that this price decline has been accompanied by, on balance, good news for the ecosystem.

In terms of crypto’s price and newsflow decoupling, the particular moment I think back to was when the market failed to respond to news that Nomura and Ledger were planning a custody JV (May 15th). Since then there have been other positive developments, the most encouraging being 1) Coinbase and Ledger’s development of institutional custody, 2) the SEC speech which argued that ETH is no longer a security 3) the revelation that Mt Gox is unlikely to liquidate all holdings 4) clarity over Tether and 5) large ecosystem funds announced by Binance and Huobi.

This decoupling of price and news-flow is obviously a bad sign about supply and demand and we can dissect how the narrative has changed for the different categories of crypto owners.

  • For retail, the run up late last year was fueled in part by “get rich quick” mania which is now, given 2018 returns, is a distant memory. Google trends corroborate this decline in interest. It’s likely that real world use cases will be needed to resuscitate this.
  • For the crypto funds, the focus of incremental investing has been on early stage projects, some of which still have the potential to produce venture-style returns, so this hasn’t been much support to the liquid token universe yet, though we are probably getting close to that point.
  • Early adopters, were only really able to hodl if they took a very long term bullish view and that means most are still hodling. Very much still in the money, but I would think unlikely to be adding much more exposure.

The groups outlined above are the existing closed capital circle that has already committed to cryptoassets which have experienced a huge wealth shock and much of that capital has left.

Looking forward from here, following the 70% decline (gulp) since January 7th, the risk-reward has clearly been reset. In this tailspin, reflexive selling has been the dominant flow. The most important question now is “at what price point will “value buying” take over?”

One of the drivers of the extreme volatility in cryptoassets is the lack of standardized valuation metrics, which give investors confidence and a framework to accumulate assets whose values have been depressed.

A number of attempts have been made to define valuation for cryptoassets, but it remains theoretical. The most accepted is MV = PQ, but at this nascent stage for crypto economies it’s impossible to measure V, so it becomes more of a projection of how a crypto economy might look. A different approach was made using black scholes which is interesting at this point in the life cycle, as it takes account for the potentially exponential market opportunity, but again handicapping the probability for success is highly subjective. Metcalfe’s Law for network valuation has also been applied to crypto.

The floor in valuation may come from signaling of this new value-seeking flow. On this note, I found both Mohamed El-Erian comments and the news about Steve Cohen’s investment in Autonomous Partners to be encouraging. These are respected finance figures putting down a flag that we are reaching a point of value. This narrative is also coinciding with significant developments on the custody side which will allow institutional investors to allocate.

Another indicator to watch for a floor would be de-correlation. Currently, correlations between cryptoassets have been running as high as 80%. This is a clear sign that the market is in liquidation mode as we know that the technical quality of the assets and their potential vary wildly.

Not wanting to get into project/asset specifics, but Bitcoin is also reaching its marginal cost of production (though this varies significantly) which has historically been a lower bound for commodity markets. One could also comfortably ascribe a lower bound value to Ethereum and other established projects using Metcalfe’s Law for network value, where community activity is rampant.

The price decline of the last 6 months has been accompanied by a collapse in sentiment and as we know this can overshoot. What has been created — early stage decentralized and immutable stores of value, trustless P2P mediums for exchange, flexible smart contracts, a web stack and applications — is clearly extremely valuable as more and more economic activity happens in a digital format. This isn’t just about technology, it is a generational shift around the concepts of ownership & barter, a symptom of a more globalized economy and the evolution away from centralized third parties.

It is fair to argue that the technology in it’s existing state isn’t scalable to reach its full potential, but the narrative and perception around this can change quickly. Cryptoassets are often characterized by naysayers in the media as chronically overvalued, but there are other assets that could be equally leveled with that criticism. The total liquid universe of crypto assets is 20% cheaper than VISA’s market cap and just one intended use case is simple medium of exchange; cyclically adjusted PE ratios put US equities at their most overvalued since the tech bubble; there are $7tr of negative yielding bonds.

Technology has tended to come in waves and there are a number of exciting new projects on the horizon. On the development side, the trend is much more positive. Higher quality teams have committed to the space and are working diligently and leveraging each other’s work to apply distributed ledger technology into the mainstream. This may end up first being applied in digital items, security tokens, gaming, social media or virtual reality. Looking further out, the disruption of more traditional industries is highly probable, if not inevitable.

Written by

Partner @ Distributed Global

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