Considering the flood of cryptocurrencies on the market in the last years, this commentary tries to examine economic viability of blockchain protocols and cryptocurrencies that are based on them. After the speculative phase of cryptocurrency trade that we are currently witnessing, a sobering will follow and a great portion of current protocols and currencies shall be useless and without value.
What determines the value of blockchain protocols and the cryptocurrencies that are based on them? For the purpose of valuation, cryptocurrencies can be segmented into at least three groups:
- a cryptocurrency having means of payment and a store of value fuction,
- a cryptocurrency with a utility value
- a cryptocurrency backed by yield or assets.
Below, cryptocurrencies are discussed that perform the function of a means of payment or a store of value as well as currencies with utility value. Cryptocurrencies, which are backed by yield or assets, are not interesting for the purpose of this article from the viewpoint of determining factors that influence their valuation, as they can be captured by classical approaches of asset valuation. In conclusion I attempt to establish the factors of blockchain protocol value on which many cryptocurrencies are based.
Cryptocurrencies as a means of payment
Bitcoin is the most recognisable of all means of payment cryptocurrencies. Its usefulness and value are measured according to three properties that every currency should have: means of payment, store of value and unit of value. Despite the fact that Bitcoin has all three properties in theory, in practice there is a problem with the means of payment property, as Bitcoin is rarely actually used in exchange of goods and services, mostly because of its volatility, long transaction confirmation times and because the technology is still foreign to average users.
If we were to approach the valuation of a digital currency such as Bitcoin professionally, we would first examine its fundamentals, such as the growth of the number of transactions as well as new users and merchants supporting this digital currency. We observe that there is a large discrepancy between the fundamentals and the market price, the reason probably being that the prices are rising as a result of user speculations due to the current growth momentum of prices and not so much due to expectations that Bitcoin will substitute classical “fiat” money in everyday transactions.
Precisely this is the key to answering whether digital currencies such as Bitcoin have value or not. The best-known academic in the field of company valuation, Aswath Damodaran, has a similar opinion. In his latest blog he criticizes that the current trend among users of digital currencies is discussion about their prices instead of talk about the technology as such, and finding solutions for quicker adoption. However, in his analysis he agrees that the price could be justifiable on the market if it reflected the expectation that future advancement of the technology shall enable actual growth of transactions and number of users. Even if we measured this in several more (and not less) years, I believe that it would not really impact the actual valuation of currencies such as Bitcoin, as the outcome is pretty much binary — it may succeed and increase its worth substantially or it may not succeed and nothing will become of it.
A store of value as a powerful use case
Despite the fact that the most recognizable cryptocurrency, Bitcoin, has new currencies breathing down its neck today, many people are using Bitcoin as an alternative to gold — as a store of value. The two have some similar properties: limited production and not under control of countries. The difference being that Bitcoin is much easier to transfer and much more accessible than gold. What gives additional value to Bitcoin’s store of value function is its low or almost non-existent correlation with real economy, which attracts asset managers who are seeking safe haven assets during time of financial crises. This is also partially confirmed by the fact that there is already a billion and a half dollars worth of exchange volume carried out daily with Bitcoin, which surpasses the exchange of the largest gold fund.
If Bitcoin is becoming important as a store of value (or safe haven during high volatility on financial markets) and is not going to evolve into a currency to be used as a means of payment, then it is hard to claim that it is overinflated.
Cryptocurrencies with a utility value
Now let us take a look at where value drivers of digital currencies with utility value are hiding. These currencies have a utility value only inside the protocol that clearly defines the rules of the game and the relationships between the protocol users. Such currency has utility value, which means in practice that it can be spent for a service or earned by performing a task within the system. These digital currencies could therefore be called “service money”.
What are these types of currencies, that have become the most popular in so called ICOs (initial coin offerings) really about? It’s basically the issue of tokens or units of value, in which value is created “out of thin air” and is essentially based on the expectations of investors or users, that the team will successfully build a protocol that operates according to the conceived principle (exchange of tokens for the service) and attract users. The issued tokens are a type of fuel that runs the protocol or the platform and the first investors at the same time become the first users of the platform on the side of demand for a certain service.
Essentially, this is the generation of a micro-economy or local market, similar to platforms already surrounding us in everyday life (Airbnb, Uber, Facebook). If we caricature what such a “fund raising” business model would look like in a real economy, it would be similar to a crowd of individuals in a crowd-funding project giving a certain amount of money to an environmental planner, who would use it to build all the required infrastructure for farming as well as determine the laws and rules for effective exchange of produce, whereas the exchange would only be possible in a currency, issued in advance. Once the “farming protocol” was built and useful for growing vegetables, the farmers with free resources would be included in it and produce and sell produce to the “investors” from the initial phase of crowd-funding, and later also to interested buyers of vegetables. Since the platform for exchange of vegetables would be open, all who could produce vegetables and all who would need to buy those vegetables would be able to cooperate. What is more, the roles could be completely interchangeable: a consumer could simultaneously be a producer, as in the Uber or Airbnb examples. A so called networking effect and increased dynamics take place in this process, and the micro-economy suddenly gains value as a currency that was initially generated “out of thin air”.
The last example may not be the most representative for blockchain protocols and platforms, as blockchain protocols are unlimited in the sense of the number of included producers. In the previous example this would mean that at the establishment of this type of micro-economy, the land would be unlimited. This does not mean however that the demand and supply are unlimited. If we wanted to evaluate the value of a cryptocurrency that operates upon such protocols, in an extreme case its value would correspond to the size of the global vegetables market if all producers of the world were included in the platform. This is, of course, only an extreme example, but I wish to demonstrate that the value of the currency and consequently the protocol correspond to the potential value of exchange for a certain service.
Use case of cryptocurrencies with a utility value
This brings us back to the key question of how much this type of digital “service” currency is worth and how does this reflect on the cryptocurrency market today. Despite the fact that a great number of currencies are emerging to attack this platform area, only some of them actually manage to create added value on the market. The most expanded field is cloud data storage. The principle is that anybody can share free space on a hard drive of their computer, where anonymous individuals upload encrypted data if needed. Anybody can provide “hosting” for cloud data storage, an industry controlled by only a few global companies. This way the unused resources of individuals are used and they are rewarded in cryptocurrency, the payment of which is carried out automatically according to the rules of the protocol, determined in advance, without control by intermediaries. And the best part of this: blockchain enables individuals to have low friction access to markets that were inaccessible to them before, and the contribution of individuals is transparently recorded in a decentralised register. Accordingly an automatic payment in accordance with rules determined in advance, is carried out, without any intermediaries.
Value drivers of blockchain protocols
Let us take a look at the relationship between the cryptocurrency and the blockchain protocol. Blockchain is a foundation technology for the operation of protocols, based on which people can exchange value units in the form of cryptocurrencies. Various applications and networks for the exchange of services, mentioned above, are designed based on these protocols. It must be mentioned that the architecture of application itself is designed as a protocol with its own currency and rules of exchange. So we can have a structure, as in the case of Ethereum, where we have a native protocol with its own currency and an unlimited multitude of “subprotocols”, again with their own currencies, often called “AppToken”.
When evaluating the market value of a certain cryptocurrency, we are actually indirectly also evaluating the protocol, on which the currency is based, as the protocol is only worth something if activity present. The value of such a protocol is equal to the product of cryptocurrency market value, determined by demand and supply and the velocity of currency, determined by the number of users and their activity. When talking about demand and currency velocity, we must have in mind the actual demand and currency transactions due to its use and not due to speculations about the growth of the price (e.g. a vast number of stock market transactions, carried out by speculators, does not represent true value yet).
MVp = MVc * Vc
- MVp = protocol value,
- MVc= value of cryptocurrency, designed on the protocol,
- Vc = velocity or frequency of cryptocurrency exchange.
In the case of Etherum it would be reasonable to claim that the value of the native protocol depends on the value of “subprotocols”. However, the value of the native protocol does not grow linearly with the addition of “subprotocols”, due to a positive feedback loop. The success of certain subprotocols has a multiplicative effect on the native protocol, as this attracts new developers, thus increasing the probability of success for new applications, which acts to attract additional users. This is a classical network effect, in which we can claim that the value of the native protocol as a potential function of the product of subprotocol values.
MVn = (Σ MVp )^m
- MVn = native protocol value
- MVp= subprotocol value
- m > 1.
(Non-)ownership of the protocol
It is interesting to take a look at the view that an economist would develop in the above example of fund raising and issuing of a currency: if, in the first phase of crowd-funding, individuals contribute the capital at the beginning of protocol or platform building, do they own the platform? Is the token, when first issued, nothing more than a share, representing ownership of a certain asset and future yield related to it? But this is not the case.
A built protocol cannot be owned by anyone, similarly to the TCP/IP protocol, used for communication between electronic devices, or the HTTP method for transfer of information via the World Wide Web. The blockchain protocol is run by a number of computers around the world and they are rewarded for their contribution of computer operations in a cyptocurrency. The protocol thus “operates on its own”, according to the rules that were set in advance, if only it is designed well enough, that it is used for a certain activity, which creates value and attracts miners. The protocol ownership in this case becomes irrelevant — it is owned by everyone and at the same time by no one. The yield per token (let us say in the form of a dividend) is no longer a variable in this business model, as the protocol does not work on the principle of profit and its distribution to investors. This means that within the protocol, the currency or token is only a receivable or certificate, enabling exchange on the market.
“Helicopter money” and inflation effects
In past years, the blockchain community has become extremely innovative and creative and has introduced a number of currencies with utility value, where currency issuance is present through time and from the protocol side. This does not only apply to currencies with a utility value, as a similar method of money issuing is also applied to currencies that are used for payment functions, such as Bitcoin. The protocol thus recognizes the contribution of an individual in the system and accordingly rewards them by issuing new money. The concept of this type of money printing is similar to so called “helicopter money” in today’s monetary system, the difference being that the new issuing of money is directed towards users, for which a contribution in the system can be measured. In this case a service of the individual is paid from the protocol side and not from the side of other participants on the other side of the market, who want to exchange services. The role of an individual in this case can be quite general, but it is crucial that it serves the entire network: in most cases this is a function of confirming miner transactions based on the “proof-of-work” concept, but the issues can also be more general, such as management, supervision or voting about key network issues.
The described model, in which the emission of a certain cyptocurrency increases over time, lead us to the question — what inflation effects does this have on the currency value? In the case of the blockchain protocol, distributing an additional emission of currencies to the people who are rewarded for their contribution does not necessarily bring negative inflation effects for the user who only holds this currency (and does not earn additional units). In the case of an increasing activity on the protocol (increased exchange of services and growth of users) the network effect can actually offsets the inflation effects.
Since a blockchain protocol is a well thought out system of relationships between different participants, a new economics field called cryptoeconomics was established for this purpose. Cryptoeconomics is a combination of cryptography, economics and game theory, that tries to establish a decentralized network of individuals which is robust and develops through time by including new participants, despite the potential attempts of individuals to abuse the system. Individuals can be included in various roles in the system, and the protocol is set in such a manner that these individuals are rewarded or punished according to their completion of tasks. This means that there is a symmetry or a so called “incentive discentive model” — beside receiving a reward for a successfully completed role, an individual can also be punished by having its staked cryptocurrency “burned”. Whenever possible, the protocol evaluates an individual’s contribution independently and rewards or punishes them accordingly; when the protocol does not have this ability, this decision is left to the market.
Blockchain protocols therefore operate by the “skin in the game” principle, which means that no one can endanger other participants within the network without endangering themselves as well. In today’s models of corporative management, especially in the monetary sector, the lack of “skin in the game” decision makers is actually the main problem contributing to moral hazards in banking and consequently to ever more likely financial crises. Blockchain is not all about an independent and decentralized monetary system, but a technology and a new economic field that uses incentives to establish networks in which interactions between stakeholders are set with the final goal of fairly rewarded individuals and a higher network value.
The objective of this article is to try to analyse the economic protocols of blockchain protocols and the cryptocurrencies based upon them as well as to determine their value drivers. The fact remains that in the past year or two we have witnessed a categorization of cryptocurrencies that can be divided into currencies with the function of means of payment or store of value and currencies with utility value. The latter are making us enthusiastic from the viewpoint of new economic models and new approaches to their valuation. The networks generated on the basis of blockchain protocols shall replace classic “pipeline” companies in many industries and the concept of ownership and central entities shall be replaced by the concept of stakeholders and a well thought out decentralized system in which individuals co-create the value of the network.
Disclaimer: though this article has a positive connotation in relation to cryptocurrencies and blockchain protocols, this does not mean that the author is not worried about the current valuations of many cryptocurrencies and the low criteria of investors when financing crypto start-ups. Many anomalies are present on the market and markets behave irrationally, which is the result of revolutionary technology and associated euphoria and its exploitation.