One Way to Value a Cryptocurrency

2021 June 23 Twitter See all posts


A conservative method using traditional macroeconomic thinking.

Basis of Demand for Crypto

Supply and demand determine the price of any asset. Crypto assets are no different. The price level of Ether, the currency for Ethereum, will be analyzed using this type of analysis. Any other crypto protocol could be subject to the same methods.

Possible demand sources:

  1. Bullish Speculators
  2. Purchasing Ether for use in transactions (gas fees)
  3. Purchasing Ether to pay for real-world goods and services
  4. Investors buying Ether to stake

Possible supply sources:

  1. Bearish speculators
  2. Block rewards (Miners and stakers earn newly minted Ether to maintain the network)
  3. Selling Ether received for real-world goods
  4. Stakers selling their Ether

The balance of these factors determines the price at any given time.

Modeling Cryptocurrencies as Currency

Making Assumptions

Speculation on cryptocurrencies like Bitcoin or Ether has a "collectible" quality to it. There is no direct return on holding cryptocurrency. It is comparable to having cash under your mattress or a baseball card in the attic. The conservative method is to assume that speculation in these currencies will diminish as they mature.

The conservative basis for valuation is using only the demand for Ether for paying transactions. Price volatility could prevent the adoption of cryptocurrencies for regular purchases. Purchases using assets, like fiat-backed stablecoins, on Ethereum, with fees paid in Ether, may be more appealing.

It is rational to speculate that the number of transactions on Ethereum will grow, increasing demand for the currency. Buying at a time of lower demand and selling at a time of higher demand could be profitable. As Ethereum matures, the rationale for this type of speculation will decrease.

There is already a large amount of Ether locked up in staking contracts. Because there are diminishing returns as the total Ether locked up for staking increases, demand for Ether for staking will decline in the long term.

I am assuming that Ether has similarities to other currencies and that the Ethereum ecosystem is an economic unit.

Defining a Model

Macroeconomics has a model to define the relationship between the supply of currency, currency holding time, goods and services produced, and prices. One version of the equation is:

  MV = PQ

  M = Currency Supply
  V = Velocity of Money
  P = Price Level
  Q = Quantity of Goods and services

Qualitative comparisons using this equation are easy to do. We can ask questions like "What happens if currency supply is constant, velocity is constant, and new upgrades increase the quantity of goods and services produced?" If M and V are constant, P would have to decrease as Q increased. As the price level falls, one Ether can purchase more than before. You can buy more computing on the chain or convert it for more dollars. A buyer pays more dollars because they can buy more goods and services on Ethereum than before.

Velocity plays a part in this equation because currency is not a good in itself but a medium of exchange. In our sources of supply and demand, each item has an opposite. Etheruem burns Ether for transaction fees, but miners or stakers earn fees and block rewards for running the network. Even if currency supply is constant, increasing velocity raises price levels (inflation, lower buying power) because currency is actively involved in the economic flow instead of being stuffed in a mattress. Money supply can decrease with inflation if increasing velocity means money is coming from underneath mattresses and buying goods.

Expanding the Framework

A bullish Ether speculator hopes to see the scenario where M and V are constant while Q increases. EIP 1559 will stop the currency supply from growing once implemented. All the holders maintain the same level of HODL, so velocity does not increase. Ethereum upgrades increase the gas limit. New applications increase Q. Each Ether becomes more valuable as the price level falls.

MV = P↓Q↑

Alter the assumptions above, if desired. Include purchases of goods and services in a larger Q. Lower V to model more HODLing.

We now have a framework to model assumptions about adoption and impact on the price level. Trying to input actual numbers may not provide accuracy, but comparisons can be beneficial. If you expect to 10x your investment, you know that demand for Ether for fees, goods, and services will have to be at least 10x, but probably more to make up for increases in currency supply and profit takers that increase velocity. Because blockchains like Ethereum are open state, it would be possible to download all transaction data and make a stab at how V, M, and Q are changing over time.

Investment Implications

Velocity is a Big Question Mark

Proponents tout Ether as "programmable money." It is possible to increase the velocity of currency dramatically with this technology. Transactions that take days or weeks in the analog world take seconds on Ethereum. Modeling this is uncharted territory.

Ether Min/Max Valuation Model

Ethereum can currently process roughly 25 transactions per second (TPS). Implementing the Ethereum 2.0 roadmap could increase this to 100,000 TPS. 4000x increase. That takes care of Q. Assume Ether supply increased 5% in that period. Currently, one year of fees is less than 10% of the total Ether supply. Velocity in the US dollar has varied over time, but roughly six turnovers per year is a decent baseline. Assume velocity increases to match the US dollar. If you plug all the numbers in, Ether might see a 60x increase in purchasing power. We solve for 1/P to get our multiple because purchasing power increases and P decreases.

MV = PQ
1/P = Q/MV
1/P = 4000/(1.05 * 60) = 63

There is also an assumption that each additional transaction will keep generating the same amount of value, close to perfect elasticity. Perfect elasticity may not be unreasonable if applications make Ethereum transactions more valuable. This valuation plus the surrounding ecosystem would be a pretty big chunk of global GDP or probably about the size of the S+P 500. Built into the assumption of perfect elasticity is that a sizeable portion of commerce will run on Ethereum.

For our minimum case, assume that Ethereum reaches 100,000 TPS. Assume velocity increases to 365 turnovers. Programmable money! Plugging in the numbers gives us a valuation increase of 5%. Ether's price already reflects ETH 2.0 improvements. If demand for those transactions does not appear, then Ether is overvalued.

MV = PQ
1/P = Q/MV
1/P = 4000/(1.05 * 3650) = 1.04

Blue Sky Mentality

There are rough analogs in economies going through a boom with small increases in the money supply. Price levels decreased 2%-3%/year from 1870-1890 in the United States. New technologies like railroads, steel, and factories increased Q while M grew modestly because of the gold standard. What you could buy with a dollar nearly doubled in the period. If you had invested in an index of the stock market in 1870, your dollar was worth 5x more in 1890. Companies building factories, railroads, and steel mills increased in value much faster than purchasing power.

There is no reason to think a rapidly growing economy like Ethereum won't see similar results. The applications built on Ethereum that drive demand for Ether to pay fees will be more valuable than any price increase in currency. The rate of return can be eye-popping for a new protocol, but the base is small. All crypto assets together are roughly one Apple Inc. Our 60x max for Ether would make it worth a third of the S+P 500. Huge, but only a fraction of the global public equity market. As protocols mature, the value creation shifts rapidly to the applications built on the protocol. HODLing a mature protocol's currency could lead to lower returns than betting on future applications. If these applications never come, then you might as well be holding beanie babies or baseball cards. There will be no utility basis for valuing the currency.