The Question of Valuing Blockchains (How do to *what*?!) #defi #dopefi

A common lament on Internet forums is how a particular token/blockchain is “undervalued”. What is this this based on? What does it mean?

Let me assure you, at this point, no one really knows. The vast majority of the notion is simply emotional responses based on little analysis, technical or otherwise.

As I have done previously, I will be responding to the content of a more seasoned financial services professional, as I did in this post.

This time I will be responding to the keynote address in this EY Global Blockchain Summit 2021 | 20 May | Day 3.

It starts about 3:30.

There’s a lot of great stuff here. One of the key things to pick up on is how confusing and different some of the concepts that are associated with Decentralized Finance and true blockchain (decentralized) technology actually is.

To directly get at the question asked near the end of the presentation: HOW does one get value out of blockchain technology? Simply put, you invest in it. You buy tokens. You buy some of the digital real estate, call it your own, and put it to work.

If those tokens are smart tokens, they can accrue value through their utility. That’s it. You buy in. You gain value. You sell. You win.

It’s the same game as before, just the underlying rules are bit more complex (and can change, or might be immutable).

To be very honest, this is a complex subject. The more you know, the better decisions you can make. Let’s cover some basics and build on ’em.

INVESTING vs SPECULATING

In the presentation this question is raised as something that Wall Street firms themselves need to work to more firmly delineate, shall we say. What business are they in? Is it speculating? Or investing? What are the risk/reward thresholds that define the two? Have they become completely blurred?

David Trainer, in his presentation, notes how this relate to the loss in the ability for regular folks (“retail investors”) to trust the system, as it were. The informational disparities and differences in *returns* have become so vast, we end up with WallStreetBros and GameStop stocks (and now AMC since I began writing this). Pay disparities between CEO’s and workers have gone a-kilter, the percentage of the U.S. economy “sucked up” by financial services firm is big and growing, valuations provided to the public are often designed to help insiders, etc.

He covers a lot of this from a very sympathetic stance. Which is fine, as it’s coming from someone who knows and lived it, and things often look much less malicious over coffee and donuts.

As someone who deals a lot with the politics of this (and spent years doing bankruptcy consulting picking up the pieces after the crash he mentions, and later ones), it’s interesting to see some of the same data that gets others very angry presented in an “is it good or bad, who knows” manner. Let me assure Mr. Trainer, and others — the reason *WHY* I’m personally so excited about Decentralized Finance is because it offers a solution (or at least the possibility of improvement) to the ENTIRE finance situation.

The deep and long anger at the financial sector has metastasized into hate for many, and it’s not going back beyond “deep suspicion” for most. People don’t trust Wall Street, and I doubt they will ever again. But they need a place to grow they value of the money they have earned. Hence, once folks overcome the fear of the new and techy (I repeat myself…), I think Decentralized Finance will sour.

I would argue that UNI, like 1Inch (1INCH), Compound (COMP), Secret (SeFi), and other governance tokens for decentralized trading/investment platforms are all INVESTMENT TOKENS.

So enough about that politics stuff, let’s get on to the fun.

COMPUTER SCIENCE meets ACCOUNTING

In regards to valuing blockchains, one needs to realize the difference between valuing companies and valuing blockchains is *in the code*. The code is king. The code is law. These are entirely different beasts (valuing companies vs. blockchains) and need different ways to pin them down and study them.

I would argue that Ethereum (ETH) is an INVESTMENT blockchains. It has smart contracts, it has (will have 2.0) staking, it has utility to be used to pay for (settle) transactions. Valuing an investment blockchains looks at it’s ability to generate value by the act of HODL’ing itself, essentially. Even if the underlying token never *itself* gains in value, it can generate income. Staking, liquidity pools, farming, these are all the actions of investment blockchains.

I would argue that DOGE (for example, more later) is a SPECULATION blockchain. It has little development. No plans for expansion. Tokenomics (discussed below) that go against long term holding (inflating with no staking to offset it). No utility outside of speculation.

So those are two, fundamental, ways to start segregating blockchains for further value analysis.

Note also: these are fairly subjective notions. Everyone who invests wants to see their investment gain in value. But those with more experience know that things which rise at “unnatural” speeds will also likely fall in the same manner. That’s, subjectively, the difference here. Rational vs. irrational gains/losses, and what one is hoping to find and the level of risk one is willing to take on.

Before we go further, let’s try and reach a general consensus about what comes next. First up, NO ONE KNOWS HOW TO DO THIS STUFF precisely. It is very much still an art, based on code and data.

Back to the Impossible Question

As I start to get into some of the complexities for “HOWTO: Value a Blockchain” you’ll find that there are lots of factors that could influence the value, some that unquestionably do, some that might in certain circumstances, and some that can pull the rug out from under the whole market in an instant.

In such an environment, ANYONE who claims to have the total and correct answer will quickly be exposed as being wrong.

Also note: There are LOTS OF INTERNET RESOURCES ON THIS. Some good, some bad, some safe, some malicious. Some are paid shills, some are objective analysts. It’s a wild west *in that side of the Arena* as well.

Do your own research (DYOR), as they say. Do you own research into researchers (DYORIR), I would add. Watch the watchers. Read some code. Smart Contracts are actually fairly easy to read. Others less so, but they are still honest about what they do. Gain some knowledge and you’ll find your feet start to feel on slightly more solid ground.

Danger zones become clearer, and the actual risks involved crystalize. The aids in the next step (still the first one, ‘natch).

But the huge question remains: HOW DO WE PUT A VALUE ON A BLOCKCHAIN?

Here we are going to discuss four main dimensions that we can use to determine what we think the value *should be* versus what *it is*. This is at the core of any prediction. The four main factors as I see them.

  1. TOKENOMICS
    • “the study of how cryptocurrencies work within the broader ecosystem. This includes such things like token distribution as well as how they can be used to incentivize positive behaviour [sic] in the network.”
    • How many tokens are in circulation? How many have been minted? How many can be? Is there a max supply? Are there burns? What’s the inflation rate? How long until max cap is reached? Diluted value? Developer share? Investor share? Investor vesting schedule? Fully diluted value? Again, there are many variables, but for this metric, they are usually calculable and should be public for any token you wish to invest in. If you can’t find them, alarm bells should be going off.
    • It can be a daunting calculation, but any reputable token should have a section describing all of these variables directly. Another level of complexity: many of these are variables *within the tokens themselves* and can be changed with governance votes or new development work. ETH moving to ETH 2.0 is very good and highly visible example of this. ETH 2.0 has wildly different tokenomics than ETH, and will lead, over time, to likely different valuation for the token and blockchain (they might even diverge, as less number of tokens are worth more per token, but the overall value of the blockchain itself drops as the number of tokens decreases with burn).
    • Example: BTC has a total max cap of 21 Million BTC. 18.72 million BTC have been mined. Every four years or so (210,000 blocks at about 10 minutes each), the BTC protocol “halves” the number of BTC produced with each new block. This immediately cuts in the half the new “supply” for the market. Supply drops, demand stays the same, prices start to climb. This has happened with each halving, and will likely happen until all BTC have been mined. These “tokenomics” are UNIQUE TO BITCOIN. Every blockchain has their own and needs to be evaluated ON THE CODE ITSELF.
  2. MEMETICS/ZEITGEIST/SOCIAL CACHE/GOODWILL (pick your term)
    • With the rise (and fall?) of Doge, it’s impossible to ignore how “marketing” affects the price of fungible tokens. “Pump and Dump” schemes for “meme tokens” or “shit coins” have been an unquestionable part of the growing cryptocurrency landscape. If would be foolish to ignore how many tweets or tiktoks or whamboozzies are posted about a particular token when that works are a proxy for *latent demand*.
    • Example: BTC has HUGE memetic cache. It is *the* cryptocurrency. BTC is the 100% level on this metric. This could be measured with traditional polling tactics.
    • Danger: Fads are fickle. The “next big thing” is always around the corner. Currently cryptocurrency is a very niche (demographically) market. Finding ways to reach out to the rest of humanity is something many projects don’t even realize is a huge problem they have no idea how to solve. Projects that directly address this shortfall will likely gain more value over time given dedicated, effective marketing efforts. Many tokens do the same thing, at similar levels of cost/efficiency. Marketing will likely make the difference on who gains the most market share (valued at roughly ~$400,000,000,000,000).
  3. DEVELOPMENT TEAM
    • Cryptocurrency is the melding of Accounting and Computer Science. When looking AT THE CODE to determine a valuation, one would be foolish to ignore the people developing, producing and supporting it. There is very little “perfect” computer code in the world. Economics is a social science. Pretty much any codebase can and should be improved over time. Does the cryptocurrency you are investing in even *have a development team*? Do they have a funding method outside their own tokens? Do they have economists or theorists gaming things out? Can they survive a bear market? Does that matter to the value of the token? Decentralization changes and modifies a lot of these questions, but it doesn’t make them go away.
    • Considering the utter and complete ease with which one can launch a new token on various platform, this point becomes very, very important to making sure your investments are sound enough to have a chance of blossoming.
    • Example #1: Doge had no active development team when it took off. It was started as a joke copy of BTC, but without the max cap supply. It looks like they quickly slapped together a new release in February, but not much going on there. Could that change from billionaires tweets? Sure. Is it likely to? Probably not. (note: this is changing with the renewed interest in the token.
    • Example #2: SafeMoon/Elon/Dog/C*M/P*SSY/ etc. Soooo many of these copy and paste tokens have materialized it’s hard to keep track. I won’t go into their genesis and background on this post, but it’s a whole thing now. Watch out. Read the contracts! Alarm bells should go off anything that requires you to change the slippage to 10%+ on a Dex for a trade to complete!!
    • QUICK NOTE ABOUT GITHUB! If, as someone who wants to evaluate the value of blockchains, one is not familiar with (and has an account on) Github, I can only say it is INTEGRAL to the cryptocurrency ecosystem and understanding how and why is important. Which is to say…this is mostly where you will be READING THE CODE. Similar to the “blockchain explorers”, it’s important to remember and take advantage of the fact that the CODE IS OPEN SOURCE. If you can’t read the computer code that defines the project, you probably don’t want to give them your money. (note: that’s a link to bitcoin’s code, which you can read as much of as you would like).
    • Danger: If Github goes down or goes bad…most of the companies in the world and internet (especially crypto) will fall to pieces soon after. It’s a curiously centralized point of failure for the ecosystem, and I’m not sure to what degree this vulnerability has been addressed.
  4. INSTITUTIONAL SUPPORT
    • Can you buy and sell the token for fiat on an exchange? Fiat liquidity is really the whole game here. Outside of that, all of this is little more than the “gold” one has collected in Diablo or Ultima or Wizardry (or any of a million other games where you collect gems or gil). And even many of those you can sell on Ebay or the like. If you can’t turn it into real money because there is no institutional support, what have you? (note: if you can, we’re good to go here)
    • This also goes for investing. Large financial firms looking at holding BTC until all of it is mined are not concerned about the petty lifetimes of mortals. This affects how the prices will move, long term, for all those tokens and networks that gain/lose to big money support.
    • Understand also how Decentralized Exchanges can, to some degree, make the previous point moot. As long as ETH can be sold for fiat, any token that can be exchanged for it *has some value*. This is the same for BNB (BSC), ATOM, MATIC, SCRT, ALGO, ADA and all the other Decentralized Layer 1 core tokens in production.
    • But BIG MONEY matters. We are, generally, talking about the move from a Centralized Financial system to a Decentralized one. Until the BIG MONEY finds it safe, and more profitable to do so, it will always be the “side-chain”.

So, where does this leave us?

Let’s look at a few more example to try and start to get at the VERY REAL COMPLEXITY IN VALUING BLOCKCHAINS.

Again, if you’ve read to this point, and thought this would be an easy endeavor to try and get “right”…well, let’s do a few example to illustrate how many of variables can change and to what degree they can change. Again, cryptocurrency investment is, at the moment, an inherently risky endeavor. Understanding some of those risks is the fundamental to understanding how to value the blockchains themselves,

EXAMPLE #1: UNISWAP (UNI)

Uniswap is governance token (protocol) for the Uniswap decentralized exchange web application. That’s it. That’s all it “does”. Investing in the token is investing in the power to guide the application.

  1. TOKENOMICS
    • Are you ready for this? You were told there would be math…
The Tokenomics are daunting

So, we have a billion to start, many are given away, the rest will be distrubuted over the next four years. Each segment has varying needs/desire to hold/dump the token, and so each “tranche” could affect the short term valuation with dumping, and the long term valuation with overall inflation. After the four years, a “normal” 2% inflation rate is pegged and…one assumes…governance will determine the future after that.

How much is 1% of that worth? How about 10%? 51%? The questions here are NOT EASY AND NO ONE KNOWS. What I’m trying to get at here is what are some of the right questions to ask. Where does the value come from? The answer here for UNI is direct: CONTROL. How much is that control of the protocol Uniswap *worth*? As we are talking about crypto, real answers to this question are there in the real world: we let the market decide. What *should* it be worth? A much harder question.

What people *do* need to understand is *WHAT THE TOKENS REPRESENT*. It changes. They all have their own code.

But wait, there’s more. Uniswap is a *protocol*. You actually use it to make money.

You can use Uniswap to create “liquidity pools” that others can then access to swap any tokens in a permissionless and trustless way. The person/entity that owns the tokens in the swap pool gets the “fees” that are paid to the protocol. This is about .3% per swap. UNI had a daily volume of about $1,000,000,000 on June 1, 2021. That’s $300,000,000 in fees. Per day. UNI is the *governing token* of the platform, it doesn’t get the fees but it can direct where some of them go.

So…basic idea…you own 10% of the tokens in swap pool, that pools generates $100 worth of fees, you get $10. Very straightforward.

UNI, the token, *is not involved in any of this*. The fees to swap and enter/exit pools are all paid in ETH. UNI itself is used to govern (vote on) how the platform *itself* works.

So…the idea is that *INVESTORS ARE THE BOARD OF DIRECTORS*.

This is where the ideas around a “company” or “generating value” start to get wonky. The concept that replaces it is the DAO. The Decentralized Autonomous Organization.

Anyone can use Uniswap to generate value be creating or contributing to pools. But in order to have some degree of control over the Uniswap protocol itself, one must invest in the governing token, UNI. Anyone can do so. Anyone who does so can then vote on governance proposals.

How much is that worth in six months? In four years? Still a great and difficult question, but at least we now know what we are talking about when it comes to the question of “what does this token represent/do?”. Now that we have the right context, the question becomes more rational. How much is it going to be worth to own 1% (or 10% or 51%) of the control of Uniswap and then maintain that control over time?

2. MEMETICS

Uniswap is actually quite strong here, but name recognition outside the core crypto crowd is probably closer to 0% than 10%. This is a VERY relative scale. When one understands that BTC is at 100% on the memetics scale and really does *nothing* that another clone couldn’t do, we need to understand how much “sentiment” matters when discussing the notion of “value”.

3. DEV TEAM

New versions coming out. Active Github repo. 100% on this metric.

4. INSTITUTIONAL SUPPORT

Being built on ETH provides some stability on this end. However, I haven’t done the research on who keeps the website up and operating. Or other infrastructure to make the governance tokens be able to do anything. An effective valuation service would do this research and incorporate it into projections (and update it as risks change, as happens with 3) DEV TEAM changes.

EXAMPLE #2: DOGE (DOGE)

  1. TOKENOMICS

Doge was started as a joke “meme” coin in 2013. It has no max supply (unlike BTC). It has an inflation rate of (I think) like 5,000,000,000 doge/yr. There is no staking, no way to hedge the inflation. There is no max supply. There is no inherent utility, no smart contracts. The idea is that one can ride the price “to the moon”.

This is an inherently SPECULATIVE asset. Indeed, an entire class of entire speculatory assets grew up in the shadow of Doge. Various other dogs and animal names, celebrities, anti-celebrities. Once it started to become clear how *easy* it was to release a new smart contract (i.e. the code that defines a token) onto both Ethereum (ERC-20) and on the Binance Smart Chain (BEP-20), meme coins skyrocketed in popularity, for a time.

2. MEMETICS

Very strong, to a point. However, when memetics is your biggest strength, it is a certain vulnerability. Doge hit the wall when Elon called it a “hustle” on Saturday Night Live. Since then, it has lost it’s luster and that inflation rate means folks need to pour a few hundred million dollars into it each month to maintain the price levels it currently enjoys. This is unlikely, long term.

There are other meme coins with wildly different tokenomics. Things like auto-burn, reflection (all holders get coins with each transaction), auto-liquidity adds (each transaction adds some liquidity, with the hope of it always being available). The rabbit hole here gets deep very quick. One should note, however, that the founder of Ethereum, Vitalik Buterin put a pretty good stop to a common meme coin marketing tactic, which seems to nip the nascent fad in the bud.

He was a billionaire at the time, so I guess it’s, unfortunately, another example of billionaires moving crypto markets. In this case, however, he did move billions of dollars toward Indian Covid relief efforts, which is incredibly Canadian of him.

Regardless, May 2021 was Meme Coin Month, and any who follow crypto can’t really deny it.

3. DEV TEAM

Is there one?

4 INSTITUIONAL SUPPORT

This one changes dramatically since I started writing this piece. Coinbase is now listing Doge, which, as any CB listing does, provides a high degree of liquidity. Essentially the highest, as going from USD to DOGE and back is now at the cost of CB transactions (.5% for the first $10k/mo), which is about as cheap as you’ll find for a straight speculative asset..

How do you value ENTIRELY SPECULATIVE ASSETS? I have no idea on this one. I tend to avoid these with anything beyond play money. They are the true gambles of the crypto space. BYOR, Buyer Beware. Also…rug pulls exist.

I may have to write more on this concept of rug pulls as the basic deceptive concept is quite simple but it can take many forms. This is why, again, READING THE CODE is so terribly important when understanding how to value a blockchain. Is there a development team? Does it have institutional support? Even *asking* these question will generally steer one away from shit coins as investment vehicles. Speculators…tend not to even care.

EXAMPLE #3: ATOM (ATOM)

  1. TOKENOMICS

No max supply. Inflation rate at 7-20% based on overall staking % on blockchain. Governance token for Cosmos Hub. No other (current) utility. Curiously, ATOM was one of the first “natural inflation” tokens I became interested in. It’s different than something like ALGO, which is offering time-sensitive rewards, for ATOM, the inflation is built into the protocol as a means to encourage staking. Staked coins earn new tokens at a rate higher than the inflation rate, unstaked tokens earn nothing. Staked tokens are “locked” for 21 days, so it takes three weeks to make staked tokens liquid again.

Tokens are staked (delegated) with validators who mine the next blocks. This is a Proof of Stake network. You’ll find this structure (staking, delegators, validators) to be VERY COMMON in proof of stake blockchains because…well…

Let’s talk about the Cosmos-SDK. This is an interesting case and I’ve been following a bit more closely than other projects over the bull run. Currently I think of ATOM (more the Cosmos-SDK) as a bit like the Linux of crypto. A bold claim, to be sure. I know, most of cryptocurrency is open source, but ATOM (Interchain Foundation) is building and giving out the tools to build more Layer 1 blockchains. Like, just *giving them away*. Because of this focus on the building the tools to build blockchains instead of just building and promoting one single, Cosmos (ATOM) itself has lagged while the ecosystem it hopes to support has grown. However, those efforts have now paid off and a module that allows “Inter-blockchain Communication” (IBC as a protocol) has been incorporated into a new of production chains.

There’s going to be a big fight in a court one day over the tagline “Internet of Blockchains”, as this is an issue many chains are trying to solve. What curious is how many of them rely on *the same code base* in order to achieve that goal. (note the “forked from”)

In addition, ATOM is about to launch their native DEX (the Gravity Dex), where ATOM is the transaction paying token and “core pair”. This expansion of utility for an existing token is only possible with an active development team and some degree on external institutional support.

2. MEMETICS

This is where ATOM tends to fail somewhere miserably. The decentralized organizational structure of the various foundations make a coherent brand or visions somewhat problematic. This is a common problem is blockchain projects and the correct solution clear. Traditional marketing firm? Volunteers on twitter and 4chan(!) and Telegram and Reddit? How to reach out when you have a good project and good tech but no central authority to declare a marketing budget or follow through, along with clunky governance, is a problem this project has not yet appeared to solve.

NOTE: Much larger “market cap” chains don’t even have these issues yet, as they have yet to enact on-chain governance. In this sense ATOM is dealing with issues that are at least one major software version ahead of many other chains (i.e. ADA governance goes live next week 2021/6/15 for holders of at least 500 tokens. The shitshow that follows should be fun to watch).

3. DEVELOPMENT TEAM

When your development team is writing the software that other teams rely on, you are in good shape on this. By building the tools that build the thing, one tends to develop a large stable of people able to do the thing.

4. INSTITUTIONAL SUPPORT

This is a mixed bag for ATOM. While the core ATOM token is on most exchanges, many other Cosmos-SDK projects have not had the same success. Some of this has to do with the complexity of the tokens (staking, I would assume) and shared wallets). Which means that as the core token of a hub where most of the others aren’t connected to centralized exchanges, the utility of being that center decreases. Hence the absolute necessity for a native Dex.

EXAMPLE #4: PancakeSwap (CAKE)

You know what, I’m going to stop here. An anonymous dev team running a forked version of a modded blockchain on largely “centralized” infrastructure that has already shown some vulnerabunnyability yet still seems to be doing several billions of dollars worth of swaps each week and underlies something like 167,000 token swap pairs valued at wtf knows what.

If your risk meters aren’t as high as the APY’s shown on their interface, you haven’t been reading the code. 😉

If your returns don’t match, move along. If you have to set your slippage to 10+% to complete a swap, is this really what you want to be trading in? All good questions to ask oneself as the food-themed Dexes beckon.

The Biggest Threat of All

So that’s a lot of stuff to think about. But NONE of that really gets at the overarching question and threat to measuring and anticipating the future value of any particular blockchain or cryptocurrency.

IMHO, the biggest threat or factor in valuing blockchains is government regulation. In the past couple months, we have seen various news coming out of China (and a reduction in the BTC hashrate as well) and various news out of India regarding negative attitudes towards allowing citizens access to this global marketplace while also accessing their state banking systems. Those 3,000,000,000+ humans drive a lot of the demand for global cryptocurrencies. Or don’t, as the case may be.

In order to correctly value what a blockchain “should” or “will” be worth, a team is most likely going to need experts on local politics in all the major economies and accurately anticipate/assess regulatory threats six months to several years ahead of time. ALL OF THEM. This is a daunting task, to understate it dramatically.

Wrapping it up

Well, that went on a lot longer than I had anticipated. Feel free to ask any questions you may have or correct any mistakes I may have made.

I think the larger point here is that the work of doing the legwork to value what a blockchain *should be* is REAL WORK. It’s going to be part of that “institutional support” that grow up around the ecosystem. Right now it’s near impossible to tell the real work from the Pump’NDump charlatans, and often not worth the effort to try.

Regardless of all that, however, rest assured that gaining knowledge about a new area of technological advancement will have real dividends, as the next generation will learn all this stuff by default.

Cheers all, happy staking!

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