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Valuation of Crypto and its Important Concepts.

December/22/2021

Crypto Assets and Valuation

Crypto assets are relatively very new entrant into the asset class and there is no organized method to value a crypto asset.

Crypto assets are digital assets and can be used for either of the below purposes

  1. Store of value
  2. Medium of exchange
  3. As a commodity for the base protocol architecture which the token is a part

The value of a crypto asset depends up on a) Token type b) Use case of the tokens.

There are different types of tokens such as, tokens which represent a project cash flow and derive value from those cash flows, tokens which give ownership rights in a project and there are other utility tokens as well.

Valuation methods are completely different for each type of tokens.

Before moving on to the different models of valuations of Crypto assets /Crypto tokens / Crypto currencies, lets understand some important concepts.

What is a crypto token?

A crypto token is a virtual currency and it represent a tradable crypto asset or it can represent a utility of a block chain protocol. These tokens can be used for its intended utility or for exchange of value or store of value by the holder of the token.

What is a protocol?

A protocol is a general set of rules and in block chain, a protocol establishes the basic structure of the distributed database which allows the secure transfer of digital value and data. The first token issued in the block chain technology is the Bitcoin and it is nothing but a collection of bitcoin protocols which allows safe exchange of digital money. Protocols allow crypto currencies to spread across the network of full & partial nodes with no central authority.

The major contribution of Bitcoin protocol was the creation of a digital money which can be traded and spent without the issue of double spend (Double spend is the possibility of purchasing a crypto currency which was already spend and it is worthless now, just like purchasing a ticket from a black market and when we approach for entry, it is already used). Subsequent to the Bitcoin white paper, there were many advancements in crypto protocols with multiple functions and there are many crypto currencies came up with their own protocols.

One such major protocol was Ethereum protocol which is designed around a smart contract which means, contracts / agreements which automatically executes if the pre conditions / criteria is satisfied. Now, there are multiple protocols with in the Ethereum block chain architecture which decentralized many financial products like insurance, lending etc. and automated the underlying agreements using smart contract protocol. There are many smart contract protocols other than Ethereum protocol also developed over the time in the block chain universe.

What is NFT?

Non fungible tokens are a unique digital asset which are not replaceable with other digital assets. Fungible tokens are replaceable with another token which is identical to it. E.g., Bitcoin, Ether etc. One Bitcoin can be exchanged for another Bitcoin as they have same value, every fiat currency also works in this way. But NFTs are not crypto currencies like Bitcoin & Ether, but they are based on protocols which guarantee ownership of an asset. Most NFTs are Ethereum based tokens and gives digital title to assets such as real estate assets, art works, music etc. Each token is different from other ownership tokens and is non fungible in nature.

Who are Block chain Validators?

A blockchain validator is someone who is responsible for verifying transactions on a blockchain. Once transactions are verified, they are added to the distributed ledger. In proof of work (PoW) systems like Bitcoin, validators, also known as miners, solve complex computational math problems in order to win the right to verify transactions and receive rewards for the “work.” In proof of stake (PoS) systems like Avalanche, validators are given rewards as long as they stake the network’s token (AVAX) and correctly participate in the network. This mechanism helps secure the network by imposing the need to lock up value in the network in order to participate in the consensus decisions.

How will one value these multi variety of crypto assets? each one is different from other crypto assets, which may seem similar but will be completely different on protocols, utility, token type etc.

Valuing a Crypto Asset

Generally, the value of a crypto asset is the function of the below three elements / process.

  1. Economic Value creation b) Supply of Token c) Risk factors.

The total universe of expected Fair market capitalization of the crypto asset is computed and it is adjusted to the number of tokens available to arrive at the expected fair price of a token. Finally, the risk associated with the tokens such as technology risk, security risks, regulatory risks are adjusted to arrive at a final risk adjusted value.

Some of the valuation experiments are as follows

  1. A) Valuing block chain protocol tokens: – The base protocol tokens like Bitcoin, Ethereum are very difficult to value because each tokens has multiple usage and it fulfill different functions. The protocol tokens have a floor value or intrinsic value unlike a fiat currency. The intrinsic value is derived from the transaction cost economy that the protocol supports. For example, a user in a block chain pays transaction costs to a validator and the present value of the future transaction costs act as a base line for valuation.

The floor Value of a Token based on Proof of stake protocols is the function of minimum transaction cost and minimum yield the validators accept and the floor value of tokens based on proof of work protocols is based on the minimum demand for the asset.

  1. B) Valuing crypto currencies as a store of value: – A token which is used as a store of value is valued similar to a safe heaven commodity like gold and this method is flawed by its over dependence on the belief that supply derives value which is often untrue.
  2. C) Valuing Application layer tokens: – These tokens rely on the basic infrastructure of another block chain and usually possess less store of value characteristics and hence not valued as a store of value token and it not even valued as a currency since a currency’s value is depended on its velocity and if we apply that model, these application layer tokens may fetch zero value which is also not correct. So, the common practice is to value these tokens according to the economic value generated by the basic project if the economic model (tokenomics) of the token has strong economic link with the value generated by the project.
  3. D) Valuation of Security Tokens: – These tokens are direct parallels of traditional assets and confer the same entitlement to the cash flow and assets. They are valued in the same way as the traditional securities are valued.
  4. F) Valuation of Tokenized Assets: – The example of tokenized assets are tokenized version of real estate or financial assets etc. They have the same value as the underlying assets such real estate and financial assets. The major point is to adjust the values for the platform risk.
  5. G) Valuation of NFTs: – These tokens are very difficult to value since they gives ownership rights on assets whose values are highly subjective and individual centric (for example an art work can be valued by an individual at millions of dollars but others may value it based on its basic paper and paint which will give a completely different value)
  6. H) Valuation of Stable coins: – The stable coins are also crypto currencies which are not mined but peg its value to some group of underlying assets. These are valued equal to the value of underlying currency or commodity they replicate.

Supply of tokens and Risk Adjustments

The fair market capitalization arrived at using any of the above methods needs to be adjusted to the supply of tokens and the inherent risk associated with the tokens. The various risks associated with platform such as a) Regulatory risk b) Security risk c) Technology risk etc. are adjusted to arrive at a fair value of the tokens.

Conclusion

These are some experimental methods applied to value a token / crypto asset and the experimentation is still going on to arrive at a stable model which link the value created in the decentralized economy with the value of tokens (tokenomics).

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