Arguably the most interesting financial trend of 2017 is the spreading of cryptocurrencies, especially in the Ethereum ecosystem. With the ICO boom of this year, a lot of different business models have been connected to tokens or blockchains of their own. This brings up several questions in the mind value-conscious investors, as given the special properties of these coins, and especially considering the various distribution and usage schemes of the tokens, valuing them is tricky, to say the least.
Whether or not we are in a bubble currently is a layered question, as we are definitely in a huge speculative wave that will end badly for several coins, but the segment is in the early phase of adoption, and the market as a whole will likely multiply in the coming years.
As I concluded in my comparison with the Dot-Com bubble, selective investing in the ICO-boom is vital for long-term investors. To make things more complicated, traditional valuation models generally fail with cryptocurrencies, because of the hybrid stock-commodity properties of them and the novelty of the technology, coupled with the questions regarding the future usage patterns.
Is it possible to set up a framework to analyze all the different business models and value the connected coins? Or is it possible to, at least, determine hard guidelines to follow when selecting the coins to hold or forget? I will answer that question below and in the coming second part of the article.
Where is the Value Coming From?
For a traditional analyst, the most interesting question is the source of the value of the tokens. There are several crucial hurdles to clear for a token to be considered valuable on the long-run. Why? Firstly, because as opposed to stocks, holding a token doesn’t give you ownership in the company conducting the ICO, thus the success of the company doesn’t directly increase the value of the coin.
Also, the fact that the blockchain technology and all the main patents and methods are freely available to the public means that an infinite number of tokens and blockchains can be created with no legal hurdle, possibly making the competition fierce, decimating demand for the services behind the token and in turn the token itself.
Another problem with the current ICOs is that even if the idea behind the company is valid, and the demand for the token is organic (we will get back to this soon), there is no guarantee that the execution of the idea won’t be obsolete in a matter of months, let alone years. This is one of the main reasons that a lot of Dot-Com companies failed; it’s nice to be a revolutionary player, but more often than not, markets are ruled by the second or third generation of companies that annihilate the pioneers of a technology, leaving only the nostalgy behind.
Non-Ownership Sources of Value
Of course, besides ownership (which is non-existent in most of the current models) there are several ways that the token can acquire value. The most important, in my opinion, is the organic demand for them, that, together with the inherently limited supply can create an imbalance between demand and supply, driving the price of the “digital commodity” higher.
For the holders of the tokens, a lot of projects also deploy some kind of fixed or variable “rent” or “dividend” (yikes). I am, maybe too much so, skeptical regarding these premiums, as they present an extra cost somewhere in the ecosystem that will create immense incentives to create cheaper “rent-free” alternatives for the given business. So, the existence of such a system, while it might be intriguing, in my opinion, could be the exact reason why that the business will fail. But there is a catch; if a model is strong enough to survive and dominate a, sometimes completely new niche, it could be able to sustain these premiums and give a huge boost to the value of the token. But what will set these winners apart from the rest?
To answer that question, we have to note that both of the above sources of value are based strongly on the network effects. This, sometimes elusive, term is used to describe why in some industries the winner takes all (or at least most of the profits), and some companies enjoy a “natural” monopolistic position.
Think Facebook for social networks, Microsoft for OSs, or a landline phone company in the past. Adding more users to such networks not only decreases the cost of operation per user but actually increases the utility that all (yes, this is a huge simplification here, you geeks out there) users enjoy through the network. Translating that to products according to this great summary:
A product displays positive network effects when more usage of the product by any user increases the product’s value for other users (and sometimes all users)
This makes these networks multiple times more valuable than other ecosystems that don’t sport sustainable network effects. Understanding these effects is very important for judging the future demand for blockchain applications and tokens, and not only because it’s a widely used buzzword in whitepapers, sometimes to blur and ridicule any and every concern regarding the business model. But before we take a closer look at network effects, let’s see the logic behind my valuation approach.
The Logic of Determining The Value of Applications and Tokens
We have to stress that this is only a basic filter, but one that has great heuristical value to move forward in the analysis. According to Fortune:
Jeff Garzik, a leading figure in the blockchain community who runs a consultancy called Bloq, sees ICOs as “transformative” but remains wary. “Ninety-nine percent of these ICOs will be garbage,” he says. “It’s like penny stocks but with less regulation.”
While the 99% might be a bit rough, it is safe to say that most of the current ICOs will end up left behind, while the survivors will multiply several times in value and create the infrastructure for a new crop of businesses that will thrive in the blossoming industry. Still, investors’ primary job in such a nascent segment is to efficiently filter out obvious and less obvious scams, losers, and laggards. For that, the first step is to really understand what’s driving the revolution in the first place.
The Most Important Advantages of the Blockchain Technology
In order to create a framework for valuing cryptocurrencies, we have to be, at least vaguely, aware of the current and possible use cases of the technology. The novelty of the tech makes this very hard and in some cases impossible, but if we keep track of the main advantages of the blockchain we can identify projects and business models that are built upon the real strength of the technology rather than on the hype.
- Permanent and verified transaction records
- Simplified databases and tracking functionalities
- Lower transaction costs and times
- Security of a decentralized and redundant system
- Peer-to-peer transmissions
- Smart-contract logic: rule-based business models and ecosystems
Matching these virtues with the business models is only the first step; while you can identify potential winners, aligning with the strength of the technology doesn’t mean that a venture will be a long-term winner, not to mention the exact “valuation” of the token. These advantages will also take effect in several different levels of the economy, from private, limited user-base blockchains to global transformational systems that might be used by the majority of the citizens of the world. You can see a model of adoption with examples below from the great article of Marco Iansiti and Karim Lakhani.
The Adoption Cycle’s Role in Valuing Cryptocurrencies and Blockchain Applications
While that sounds chilling and revolutionary, there is an investment problem here; even if you went back to the 80’s with the knowledge about Google, you couldn’t have directly invested in the company, as not only the founders of the firm were in kindergarten, the infrastructure that the business was based was non-existent. So are we in the 80’s of the blockchain technology? Well, in a way yes, global transformational adoption will likely take at least another decade. That said, my gut feeling is that this adoption cycle, although it will resemble the Internet’s will provide huge surprises; both positive and negative ones.
The Looming Coin-Regulation Storm
It’s hard to overstate the regulatory hurdles that the segment will soon face. The ICOs legal framework is shaky, to say the least, and somehow regulators will try to curb the boom and divert in into a more traditional direction. And in a lot of ways, that would be good for investors as well. A more regulated market would be beneficial in avoiding scams, while letting the currently left-out investors participate in the rise of the new industry.
For the current crop of coins, this is probably the biggest risks out there, as whole ICOs could be deemed illegal, leaving holders of the tokens out in the cold, or facing an uncertain transition into another legal framework that would likely push the value of the ventures and the tokens down.
In the next part of the article, I will take a look at this and other risks that blockchains and systems built upon them face. I will also set-up actionable guidelines to weigh the advantages and the risks of certain applications and cryptocurrencies while forecasting the actual demand for the service and the attached token. To make it more robust, I will integrate some of the traditional valuation methods as well.