Practitioner's Brief: A Digital Currency Valuation Framework is Born
This article is based on the paper “Tokenomics: Dynamic Adoption and Valuation” by Lin William Cong, Ye Li, and Neng Wang.
This paper was originally published in March of this year; a revised draft was recently published on the CFA Institute Asia-Pacific Research Exchange (ARX).
Bitcoin supply is finite. Discussions about its price are seemingly endless, devouring the bulk of media attention broadly available for fintech innovations.
As far as how to value Bitcoin and other crypto currencies, the debate rages on.
A murderer’s row of experts has largely dismissed Bitcoin as not having any intrinsic value whatsoever; meanwhile, forward-thinking analysts and portfolio managers pioneering digital currency trading continue to wrestle with the task of assigning it, and others, a fair market value, beyond what buyers and sellers believe it to be at a moment in time.
Many in asset management view blockchain technology—a decentralized method of generating, storing, and distributing a record of rules and interactions (a “shared ledger”)—as having enormous potential, perhaps capable of disrupting business and finance just as dramatically as the Internet itself has.
Cracking open the blockchain-based “crypto” phenomena and homing in on the essentials, three scholars have taken a broad leap for the financial industry by providing the first dynamic asset-pricing model of digital coins on blockchain-based platforms.
Their paper, “Tokenomics: Dynamic Adoption and Valuation,” is the subject of this ARX Practitioner’s Brief.
The views expressed herein reflect those of the authors and do not represent the official views of CFA Institute or the author’s employer.
What's the investment issue?
Most sophisticated investors are taking a wait-and-see attitude when it comes to crypto currency. But more of them are anticipating future ramifications—and opportunities—to come. The burning question around “crypto” is the same one that surrounds public companies, commodities, and centrally issued fiat currency: how do we measure their worth?
Whatever term is employed (the authors use “tokens”), coins of the digital realm are still emerging as an asset class.
The pace of initial coin offerings has accelerated sharply, a boom for start-up financing (and for the to-do lists of regulators who warn of fertile ground for bad actors). In 2013, the coinmarketcap.com website listed 15 crypto currencies with a market capitalization of roughly $1.5 billion. As of September 2018, the website listed nearly 2,000 crypto currencies with a market capitalization of around $200 billion. More than 100 crypto funds have been launched since 2017, according to the Securities and Exchange Commission (which is tracking them and pushing them to register). One industry estimate has crypto fund assets at more than $2 billion. One of the largest such funds is BlockTower Capital, which raised $100 million for a discretionary trading strategy; it is now closed. This past spring, veteran endowment manager Mark Yusko launched a crypto fund for institutions.
To better understand how to value tokens, the authors wanted to create a dynamic model. They sought to incorporate dual, interconnected factors: (a) platform/network adoption and (b) the spillover effect of the perceived value of the token on the platform/network’s well-being.
The authors wondered whether these two factors might influence one another. Could simple, basic, actual token usage, tied to interactions on specific networks or platforms, produce a ripple effect?
How do the authors tackle this issue?
One can’t invent a token pricing formula without knowing what tokens inherently are—or, rather, what they do. So the authors first establish the singular role of tokens in the context of a blockchain platform.
Tokens, they state, intermediate peer-to-peer transactions on blockchain-based networks.
The fundamental productivity, or usefulness, of a given platform is the key building block in any token’s valuation, according to this study.
The authors wield hefty quantities of complex equations that are not easily put into plain English. Leaving them off to the side for the sake of succinct summarization, the math was produced in service of supporting a central thesis—the first of its kind—on precisely how tokens derive value: as an exchangeable asset, in limited supply, that users hold to get “transaction surplus available solely on the platform.”
That last part bears repeating. Linger for a moment on the notion of unique transactions; now we can begin to see the broad strokes of a pricing model that has as its anchor a set of identifiable forces to be measured.
The next step was to derive a token pricing formula (backed by heavy-duty math) that incorporated what the authors call “the user-base network effect.” That’s the circular feedback loop between a token’s valuation and its take-up, a chicken and egg conundrum for the fintech generation.
The authors underscore how token valuations are not only rooted in the viability of a technology platform but can, in and of themselves, potentially contribute to the developmental health of the platform—and thus derive some value. This can happen, the authors assert, in at least two instances.
First, at the start, the expected price appreciation makes tokens attractive to early users of a platform, allowing these users to capitalize on the future prospect of the platform and accelerating adoption, the virtuous cycle.
As with any new venture, though, the honeymoon phase can be fleeting; the platform technology evolves. It becomes less exciting, and more commonplace, as more users join in. Because of this inevitable maturation, the expected price appreciation diminishes.
Enter the second instance of how the token can assist in the development of a platform. It occurs by virtue of price fluctuation. A platform that lacks a form of token, by way of comparison, might see take-up wane if it starts to be perceived as unproductive or irrelevant. In this example, tokens might have helped stabilize the user base, or “moderate user-base volatility.”
“Flow utility from token holdings increases with the size of [the] user base,” the authors write.
Tokens, therefore, can be assigned a value commensurate with their ability to improve the welfare of the platform with which they are associated, whether by accelerating token adoption or reducing user-base volatility.
Token price movements are created, nonlinearly, to:
- platform productivity,
- users’ transaction needs, and
- platform size.
What are the implications for investors and investment professionals?
Based on the authors’ framework for assigning them value and borrowing a phrase from pop-rap pioneer MC Hammer, tokens are too legit to quit. They should be here to stay as a way to finance start-ups because they can facilitate fast adoption and further stoke advancements while also incentivizing early investors and contributors to enhance initial platform technology via the capital gains channel, explains one of the authors, Lin William Cong of the University of Chicago, writing in a separate article.
“Yet such benefits come at the expense of [the] entrepreneur’s ability to signal project type through token retention,” Cong says. A key regulatory implication, he added, is that initial coin offerings must be joined at the hip with the vesting of the entrepreneurs and developers.
“In terms of applications, we still understand very little about the role of tokens,” Cong concedes.
Competition among alternative crypto currencies is interesting and can be related to competition among platforms more broadly. And perhaps, once the current mania surrounding crypto currency speculation has abated, several promising innovations can finally get their deserved attention.
These include applications in auditing systems, financial market exchanges and clearing, and trade finance.
About the Author(s)
Rich is a veteran financial journalist who has written for numerous media outlets, including Reuters, ABC News, and Institutional Investor.