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Crypto projects have the potential to create significant value for users, but value accrual is equally important
Crypto-assets are not made equal, it is important not to generalise them as a collective
Non-value capture crypto-assets like bitcoin arguably benefit from widespread adoption and long-term value is associated with gaining a monetary premium
Productive crypto-assets like Sushi can be valued similarly to equities since investors can benefit commensurately from the growth of the network
From value creation to value accrual
In Part II of The Snowball Crypto Thesis, I explained how the emergence of open-source blockchain technology has resulted in innovations in multiple verticals such as finance, gaming and the creator economy.
Disintermediated products allow users to share in a larger portion of the value pie since these decentralised platforms typically run on code and require much less overhead expenses compared to a company. As a result, should these products gain the critical mass of product-market fit, it should result in massive value creation for users and consumers. However, value creation alone does not make a crypto project investable - investors in crypto-assets must derive some value from owning the coins and tokens.
This concept should not be unfamiliar to investors. For instance, a company like Uber creates value for drivers and riders via their ride-hailing and food delivery offerings, which enables users to earn an income. Uber also creates value for consumers in the form of the convenience of being able to call a ride from anywhere at any time, as well as an increased variety of food offerings available just on one app. However, if Uber fails to turn a profit and generate cash flows while empowering consumers, drivers and riders, investors might not see any return on investment. This is because the value captured by Uber (and thus its investors) might not be commensurate with the value that they create.
This brings us to the trillion-dollar question - which crypto project will create massive value and will simultaneously be able to capture a commensurate amount of that value?
To answer this question, we need to be able to distinguish the various types of crypto-assets, which might be confusing if one is just starting to learn about crypto. The mainstream media also often paints crypto-assets with the same brush, with large-cap networks like Bitcoin and Ethereum basking in the limelight, with the occasional mention of headline-grabbing names like Dogecoin. This often leads people to think of crypto-assets as a collective group of funny money that trades on the internet.
Source: u/mavensbot Magic Internet Money: Bitcoin Wizard
In the next segment, I will classify crypto-assets into two main buckets and attempt to briefly explain the nature of value created and captured by these assets. The naming conventions and ideologies behind the following segment are inspired by this interesting paper by Placeholder.vc, a venture capital firm that invests in open blockchain networks and Web3 services. I highly suggest giving the paper a read for a more granular understanding of various crypto-assets and their valuations.
Source: ARK Invest - Bitcoin: Ringing The Bell For A New Asset Class
Non-value capture crypto-assets (Cryptocommodities/currencies)
These are non-productive, non-cashflow generating assets that do not have intrinsic value per se. Examples of such crypto-assets are bitcoin and its many forks or variations such as Bitcoin Cash, Litecoin etc.
These crypto-assets are mainly used as a medium of exchange (eg. payments, P2P transfers), or as utility tokens on their respective networks to pay for transaction fees. In addition, these assets display characteristics (eg. verifiable scarcity, fixed disinflationary monetary policy) that make them conceptually similar to traditional stores of value (SOVs) such as gold and other precious metals. By extension, their lack of intrinsic value should not preclude such crypto-assets from being investable and deserving of an allocation to a diversified portfolio (just look at gold and silver).
SOVs are very much social constructs - gold will only retain value over time if society agrees that it is valuable and adopts it as an SOV. Furthermore, the most widely adopted SOV assets command a monetary premium over other commodities and currencies. For instance, in the precious metals space, gold is the most valuable precious metal asset by market capitalisation despite silver having more industrial use cases and platinum being rarer.
I believe the same principles should hold true for digital assets vying for SOV status. In the digital asset space, bitcoin retains its monetary premium, being the most valuable crypto-asset by market capitalisation even though the Litecoin and Bitcoin Cash networks boast higher transaction speeds and cheaper transaction costs.
Source: Bitinfo, CAA 29 June 2021
If I could hazard a guess as to why this is the case, I would think that bitcoin's dominance can be attributed to it having the highest adoption amongst other non-value capture crypto-assets. The above chart shows the number of active addresses of different blockchain networks. The number of active addresses on the Bitcoin network (in blue), clearly trumps its forks - Litecoin (red) and Bitcoin Cash (orange).
This makes sense given how network effects play out - users of a network beget even more users. In fact, the growth of the Bitcoin network is still roughly tracking that of the early days of the internet (~118% CAGR over the past decade).
This leads me to believe that the only non-value capture crypto-assets that could have long-term value appreciation would be those that can achieve a monetary premium, which is closely linked to the adoption of the asset. At the moment, Bitcoin is currently benefitting from its first-mover advantage and strong brand name, but it would be interesting to see if credible competitors can emerge to compete for SOV status.
Value-capture crypto-assets (Cryptocapital)
As the label suggests, cryptocapital assets are productive and capture value from their underlying networks. Other than capital gain, investors of these assets could earn a yield from inflationary block rewards or transaction fees generated by the network.
Therefore, if the network is expected to generate value into the future, and all or part of the value created is captured by token holders, we can potentially obtain fair value estimates by summing the discounted value flows captured by the token. Alternatively, we can adopt a multiple-based approach on the protocol’s network revenue or earnings to obtain a fair price per token/coin.
Source: Bankless, John Todaro
For instance, SushiSwap is a decentralised exchange (DEX) built on the Ethereum network. Its use case is very much like a traditional centralised exchange - Traders can buy and sell multiple cryptocurrency pairs on SushiSwap and are charged a 30 bps trading fee for each trade. SushiSwap token stakers receive a portion of the platform revenue - 5 bps of the total fees are distributed to them as rewards. Therefore, Sushi token investors stand to benefit from rising trading volumes on the SushiSwap DApp. With some form of volume, growth and take rate assumptions, the exercise of valuing the SushiSwap token would not be dissimilar to valuing a centralised crypto/securities exchange like CoinBase or NASDAQ.
What’s most fascinating here is the business model innovation enabled by blockchain technology. In the standard value creation pie, the value created by a business is shared between the user of the product or service, the company’s overheads (board of directors, management, staff, taxes), and shareholders.
However, for value capture crypto-assets, the protocol providing the service on the blockchain has little to no overhead and all value creation is shared between service users and investors, which are not mutually exclusive groups. In fact, users of the service are economically incentivised to be vested in the success of the protocol and promote its adoption. Moreover, since there is no elaborate “cost structure” involved, margins should be mathematically higher for value-capture crypto-assets than for similar equity-structured businesses.
Granted, most of these protocols are still in their early stages and face various technical and competitive risks. Other aspects of tokenomics also come into play when assessing investability, such as the token's monetary policy, vesting schedule and incentive structures. However, should these proof of concepts turn out to be viable business models that achieve a critical mass of adoption, I can see a scenario where value-capture digital assets command a higher valuation over equity-structured comparables.
If you have read the previous posts in chronological order, I made the case for wider adoption of bitcoin (Part I), which might spur investors to look further out the risk curve to discover a plethora of crypto use cases (Part II).
Upon ascertaining the market opportunity in a particular vertical, investors might come to realise that different crypto-assets are not made equal. Using familiar valuation frameworks, the case can certainly be made for value-capture tokens which generate cash flow to be potentially worthwhile investments.
In my next article, I will talk about the historical risk-return profiles of various crypto assets, as well as risk management frameworks when thinking about allocating to the crypto space.
Thanks for reading,
Disclaimer: This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/The Snowball do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such.
Cover photo source: Xavi Cabrera on Unsplash
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