Bridging value between TradFi and Crypto
A look into how valuation perspectives from the traditional finance world apply to crypto
Crypto FUD - Dude, where’s my ‘value’?
Last few months have seen an unraveling of crypto assets across the board starting with the Terra collapse and followed by bankruptcies at other major institutions including 3AC, Celsius, BlockFi and Voyager.
The total cryptocurrency market cap is down 55% since Jan 2022 - from $2.2trillion to $1trillion. (In the same period S&P500 is down 17% and the Nasdaq is down 25%)
Source: Coinmarketcap
This has understandably led to an environment of FUD or Fear, Uncertainty and Doubt.
As expected, many pundits from the TradFi world are reminding us that crypto has no intrinsic value.
“People may still want to buy them because they have extrinsic value ... people value things for personal reasons. But they don't have intrinsic value”
Andrew Bailey, Bank of England Governor
“Gold has underlying use value, You can use it to fill cavities. The underlying use value of a Bitcoin is to do ransomware or something like that”
Ben Bernanke, Former chair of the Federal Reserve
and
“I like investing in things that have valuable output, The value of companies is based on how they make great products. The value of crypto is just what some other person decides someone else will pay for it so not adding to society like other investments.”
All seem to asking the same question - Where’s the value??
So I thought it will be useful to apply TradFi perspectives of ascertaining ‘value’ to the crypto world.
TradFi - Valuation frameworks
Let’s look at the broad framework posited by NYU Prof Aswath Damodaran
If you define an investment as anything that you can buy and hold, with the intent of making money, every investment has to fall into at least one of these groupings
Cash generating Assets - e.g. Stocks, bonds etc.
Test: It has a stream of income / cashflows
Commodities - e.g. Oil, Cotton, lithium etc.
Test: Demanded as raw material to meet a fundamental need
Currencies - e.g. USD, EUR, gold etc.
Test: Its a medium of exchange, store of value and unit of account
Collectibles - e.g. Baseball cards, Art etc.
Test: Scarcity value or aesthetic value, emotional attachment
By the above logic an investment is an asset “only” if it has a stream of income/cashflows.
Why is that such a big deal?
Because of how we define ‘intrinsic value’ of an investment.
The premise of intrinsic value states how much an asset is worth can be derived by assessing the asset internally based on estimates of future cash flows, growth potential and risk. (The approach used is called DCF - Discounted Cashflow model)
For example, a company’s share price can be estimated by assessing the underlying fundamentals like revenue, margin profile, capex and working capital requirements.
This is not true for the other categories like commodities, currencies and collectibles.
So it follows that only assets can be valued… hang on then what happens to the rest?
All remaining buckets can only be ‘priced’
Source: Ashwath Damodaran blog
In other words, these categories (commodities, currencies and collectibles) derive value based on demand and supply dynamics.
For e.g.
Supply shocks in crude oil will push up prices globally
Demand for USD (seen as an inflation hedge / safe haven asset) has caused its value to appreciate against other currencies over last few months
Okay now based on this framework - let’s review the value proposition of the crypto universe
Crypto universe - Search for value
Let’s classify components and apply the tests
Blockchains: e.g Bitcoin, Ethereum, Solana
Apps on blockchains: Opensea, Uniswap. Immutable X
NFTs: e.g. Crypto Punks, Bored Apes
Blockchains:
Let’s first consider Bitcoin as an example. (Ethereum is a lot more complicated and may require its own post :)
Apply the tests
Does it have Cashflows or any income stream? - Nope - So not an Asset
Does it act as a raw material servicing a fundamental need like food, energy or shelter? - Nope - So not a Commodity
Is it a Medium of exchange / Store of value / Unit of account? - Well, its now proved to be a store of value
Does it have Scarcity and/or aesthetic value? - Yes, in the sense that total supply is fixed
When bitcoin started in 2008 - it was seen as a collectible. But I would argue, currently its much closer to a currency than a collectible
The Bitcoin narrative has pivoted a couple of times
Initially, it was positioned as a global currency - a potential replacement to the USD. Obviously, this narrative has not materialised. While it can be considered as a store of value. Its volatility means it cannot (atleast currently) become a medium of exchange or a unit of account (i.e. unless you are in El Salvador, no one is paying for coffee in bitcoin)
The narrative then shifted positioning bitcoin as an inflation hedge and uncorrelated asset class. This also has not eventuated as Bitcoin has acted as a risky asset moving with equities but with a higher beta as compared to Nasdaq.
So how do you value Bitcoin?
One things clear - it’s not an asset in the TradFi sense - so it cant be valued using cashflow models - since no cashflows.
It just means we might need to apply slightly different mental models.
But remember - just because some investment does not have ‘intrinsic value’ DOES NOT MEAN it has ‘no value’ and ‘no utility’
So what is Bitcoin’s utility and value?
Here is a view from BlockTower Capital’s Ari Paul
Just as gold, Bitcoin is permissionless and allows the bearer of the asset to convert it into any good or service anywhere in the world. To be sure this is nothing but a social convention, but so is gold as it carries no intrinsic value and generates no cash flow. Bitcoin’s key advantage over gold is its portability
If we think of Bitcoin as essentially a “Swiss bank” in your pocket then there is an objective way to value the economic worth of the crypto currency.
If we accept the offshore banking market as the proxy for the value of all assets that investors seek to protect from the arbitrary seizure of the state, then that market is currently estimated at approximately 35 Trillion dollars. Most of those assets are not just fiat cash and gold, but productive economic assets such as stocks and bonds, so a simple one for one comparison would not be accurate. Nevertheless if we accept the general valuation metric then Bitcoin which currently carries a market capitalization of less than one trillion dollars has plenty of fundamental upside. If we simply assign a 10% value of the offshore banking market to Bitcoin then the cryptocurrency has the potential to triple in the foreseeable future
Apps on blockchains
Consider apps on the blockchain. In this instance, we will look at apps on Ethereum.
Example includes - Uniswap, Opensea, Immutable X
Apply the tests
Does it have Cashflows or any income stream? - YES
Wait now what ?!
Yes, these are actually income-generating assets with a business model. They are much more amenable to traditional valuation models.
Ahh yes - this means these apps actually have ‘intrinsic value’
Below table reports the 1-day and 7-day average fees for the top three decentralised exchanges on Ethereum
Source: Cryptofees.info
What is Uniswap’s business model?
In simplified terms - It provides a platform for buying and selling tokens/coins and charges a fee on every transaction.
Here’s a chart with Uniswap’s monthly revenues for the past 12 months. A protocol would not generate c.$1.6bn in annual revenues if does not generate value for its users.
Like for any TradFi business - one can make assumptions about revenue, margin profile, capex and formulate an intrinsic value of the business using a cashflow model.
You can also apply relative valuation benchmarks. The business model for Uniswap is not unlike other tech firms which charge a clip on the volume/value of transactions that happens on their platform.
You could compare Uniswap’s Market Cap to Revenue ratio (13.0x) with other listed companies.
NFTs
Apply the tests
Do they have Cashflows or any income stream? - Nope - So not an Asset
Do they act as a raw material servicing a fundamental need like food, energy or shelter? - Nope - So not a Commodity
Are they a Medium of exchange / Store of value / Unit of account? - Nope - So not currency
Do they have Scarcity and or Aesthetic value or emotional attachment - Yes
So they are collectibles.
A collectible cannot be valued since it generates no cash flows but it can be priced, based upon how other people perceive its desirability and scarcity of the collectible.
But remember just because some investment does not have ‘intrinsic value’ DOES NOT MEAN it has ‘no value’ and ‘no utility’
How much you pay for them will depend upon different factors - what utility does it provide and more importantly what is the ‘signalling effect’ of a product. I have written about this before
Thorstein Veblen, famous sociologist and economist, coined the term ‘conspicuous consumption’ to mean the practice of purchasing luxury goods (or services) for the sake of signalling the buyer’s wealth in order to attain or maintain a certain social status. Generally associated with luxury goods like Ferrari, Rolex or Cartier.
Signalling effect might actually be much more pervasive as explained by Robin Hanson and Kevin Simler in their book The Elephant Brain.
Here’s a useful summary of the primary arguments from the book
Most of our everyday actions can be traced back to some form of signalling or status-seeking
Our brains deliberately hide this fact from us and others
From the perspective of everyday consumption and the motives that drive them, Messrs Hanson and Simler report below findings
Standard motive: To get useful stuff
Hidden motive: We care a lot about what the stuff we use make us look like and what ‘signal’ they send out to the world about us
In summary - while NFTs cannot have ‘intrinsic value’ as they have no cashflows they still have a lot of tangible value driven by human behavior and psychology.
Conclusion
So the blanket statement - crypto has no intrinsic value is false. Parts of the crypto ecosystem do have ‘intrinsic value’ within the narrow definition of the TradFi world.
Also - just because some investment does not have ‘intrinsic value’ DOES NOT MEAN it has ‘no value’ and ‘no utility’.
It just requires slightly different mental models to appreciate them.