ERC20 Tokens: Valuation and the Future of Tokenized Assets
Let’s take a trip back in time before the crypto boom. Almost a decade ago, Bitcoin kicked-off the tech revolution by releasing blockchain, cryptocurrency, and all their transformative potential into the digital wild. The project single-handedly breathed life into a vision of a world beyond just tangles of centralized systems and intermediaries. And while Bitcoin easily stuck to cyberpunks and anarchists, it lacked utility aside from holding value. Ethereum tackled this problem head-on, reworking the purpose of cryptocurrency to power applications built on them, creating what’s now called the ‘ERC20’ standard. Short for “Ethereum Request for Comments”, ERC20 isn’t so much a new technology or software like its underlying blockchain. Rather, it’s a protocol or set of rules that tie together the hundreds upon thousands of different tokens floating around. These tokens are called ERC20 tokens — each with their own project, governance, functions, and utility properties — which retain the ability to trade and hold value, just like conventional cryptocurrency like Ether and Bitcoin.
Interoperability is what created the vibrant Ethereum token trading ecosystem we now know today. Without uniformity, a separate exchange protocol would have to develop for each possible token pair and its intricacies. Token A and token B might be compatible, but what about token B and token C? As a result, as the number of distinct tokens would rise, the complexity of ensuring tradability exponentially would increase as well. The ERC20 format solves this problem through similar names, functions, and arguments to ensure compatibility across the board. Beyond the obvious benefits for developers and exchanges, standardization means less risk, better liquidity, more options, and a better experience for ETH traders overall. You can support your favorite projects, from distributed storage to healthcare solutions, across the countless exchanges that support Ethereum-based tokens.
The valuation game
Now that we’re established a baseline for what ERC20 tokens are, how do we value them? In other words, what determines the prices at which we buy and sell tokens? There are countless factors like adoption curve, utility value, and end-market fundamentals which we can factor into valuation. Yet, it’s important to note that crypto markets are extremely new with a limited amount of data regarding behavior, returns, and correlations. Which brings us to the question, what about existing methodologies? Unlike traditional assets like stocks, bonds, or real estate, many cryptocurrencies don’t have recurring cashflows (money going in and out) or dividend payments (distribution of profits to shareholders). Commonly used formulas for valuation are somewhat obsolete, complicating their intrinsic value.
But as the crypto market evolves, there have been attempts to alter existing methodologies, i.e. Chris Burniske and Joel Monegro’s theory of crypto as small emerging economies. By likening crypto to the currency of a new country, similarities emerge regarding future value. Ashley Lannquist gives a short summary which captures this valuation framework succinctly:
For a crypto asset, the consensus protocol is like a country’s constitution, the community is similar to a constituency (miners are supply-side, users the demand-side), the core devs are like an executive branch who execute code once approved by the community, tokens are similar to an internal currency, and investors underwrite the currency and invest according to relative attractiveness versus other currencies and investments.
Thus, it’s incredibly important to look for solid governance (teams), steady productivity (development), good monetary policy (token supply), among other factors. And as crypto develops, there’s immense opportunity for economists to further develop indicators and indexes that can drive better, more holistic frameworks. Until then, it’s key to use qualitative and quantitative analysis to determine value, meaning that research of the token and the corresponding project is key. Some tokens here today may not even exist tomorrow. So, here are some select resources that you can read to develop your knowledge on crypto valuation (many were plucked from Ashley Lannquist’s source list, so take a good look at her analysis!):
- Alex Evans, “On Value, Velocity and Monetary Theory”
- Ashley Lannquist, “Today’s Crypto Asset Valuation Frameworks”
- Brett Winton, “How to Value a Crypto-Asset — A Model”
- Chris Burniske, “Cryptoasset Valuations”
- Chris Burniske and Joel Monegro, “Placeholder Thesis Summary”
- Johnny Antos and Reuben McCreanor, “An Efficient-Markets Valuation Framework for Cryptoassets using Black-Scholes Option Theory”
- Phil Glazer, “Valuation Models for Cryptocurrencies”
- Vitalik Buterin, “A signaling theory model of cryptocurrency issuance and value”
- Kyle Samani, “The Blockchain Token Velocity Problem”
- Kyle Samani, “Understanding Token Velocity”
- Dr. Warren Weber, “The Quantity Theory of Money for Tokens”
Tokenized assets to bridge the real and digital
The beauty of the Ethereum ‘world computer’ means just about any logic can fit into an ERC20 token. Security tokens that represent traditional assets in a crypto format can be just as capable as utility tokens that run dApps. This is why The Ocean is especially excited about projects that aim to put both liquid and illiquid financial assets on the Ethereum blockchain, like Trust Token, Harbor, Polymath, and Digix. For most of the world, it’s hard to buy or trade stocks or bonds. Multiple parties involve cumbersome trading agreements with enormous systems overhead. Plus, they rely on trusted participants and not everyone has access to the same speed and execution that stock exchanges do.
By putting financial assets in token form, we can remove the complexity and cost of working with expensive exchanges. In fact, any compliant exchange that extends ERC20 support can offer traditional financial asset tokens. This can mean better execution, lower fees, an accelerated trading timeline, a larger investor base, and thus — a healthy democratization of the traditional financial market, our endgame at The Ocean.
But tokenizing is not without complications. Just like traditional financial markets, there is still a certain degree of trust required to marry a physical asset like gold and a digital asset like a token. Projects need to ensure real-world assets exist and are kept safe. In the real world, there are countless bodies and laws which protect investors. But how do you know who to trust and which projects to support in crypto? This is where regulation kicks in to provide the safety and security that traditional exchanges normally provide. Come back next week to explore what compliance means for the future of crypto and The Ocean.
__________________________
Have any topics you’d like us to explore? Mention us on Twitter, and we’ll do our best to create interesting, relevant content for you.
