How I value cryptocurrencies

A short essay on coins (Cryptocurrencies)

Unavoidably, we all had some contact in the last few months with the sudden surge of cryptocurrencies. Maybe you even have already jumped on the bandwagon and realised some easy gains (or hard losses).

The ones who got further interested will have discovered that there are many alternatives to Bitcoin, many with doubtful credibility. To only note two coins with certainly interesting names but probably no value: the meme-based Dogecoin, which had a surreal market cap of USD +2bn for a brief moment or the Insanecoin, which is what you probably become if you invest.

However, some currencies claim to create some real value. Examples thereof could be Ether from Ethereum, which is busy creating smart contracts or Ripple, which promises to become a key player in facilitating payment services for financial institutions, other businesses, and individuals. Currently though, these products are still in a first development phase.

Instead of writing about its current primary function, which seems to be a global (unregulated) casino game, I am much more interested in finding some real value behind the hype. The first time I really got interested in Bitcoins was in 2015 when I wrote a short essay about the future regulation of Bitcoin. I have been following the trends closely and felt that with the popularity of the topic the coverage should be better framed by certain news outlets. I will shortly explain two key functions of the coins and elaborate which advantages or disadvantages they have compared to the traditional services.

Payment Transactions

A functional payment system needs to be commonly accepted, to have sufficient liquidity and most importantly, it has to be trusted by the majority of the users. Bitcoin was originally created as a payment system and therefore the first payment was made to order a pizza (which would be worth $ 136 Mio. today). This example rises already the first problem with using any cryptocurrencies currently available as a payment system: price stability. Due to the high illiquidity of many cryptocurrencies prices vary within an hour or even minutes more than 10%-50%. To buy a beer in bitcoin at 20:00 on Friday, 07.12.17 for 6 euros would have already cost you almost 7 euros by midnight, and this is the most liquid currency so far.

The second problem is the transaction cost. Momentarily, “miners”, which deliver the computing power for the transactions, get rewarded by newly created coins or a fee deducted from the transaction. The current cost per transaction can be up to 30 USD and also Ethers fee has been soaring. I am fairly sure users will not be ready to pay that amount in the long run. This will increase the illiquidity further. Even though some businesses or even governments are officially accepting bitcoins (mainly as a marketing gig) there is yet no evidence that it is actually commonly used for product and service payments.

Initial Coin Offerings (ICO)

It has been very interesting to observe some ICOs over the past year. More than USD 4.5bn have been raised by major ICOs in 2017. Most of them are blockchain based tech start-ups, with varying credibility. ICOs are barely regulated at the moment and therefore can be quickly executed and are significantly cheaper than traditional means of raising money.

However, I ask myself, what is in it for the investor/coin buyer after he purchased some newly created coins. After some initial research on how to value coins, I only found vague explanations. This ambiguity, I discovered, comes through the many uses and yet unclear purpose of the “coins”. To analyse the value of a “coin” clear characteristics of the currency at hand have to be determined.

If the coin is structured as a substitute to equity (such as shares) the value becomes clearer. The investment could benefit from a sort of “dividends”, which could be payed out as additional coins or real (fiat) money. However, if these characteristics apply, it will be categorized as security in many jurisdictions and therefore more rigorous regulations will apply. The US already enacted some guidelines specifically for ICOs. Even though there are still many legal uncertainties also in the US and I am confident many jurisdictions will follow soon. This will decrease the advantages of ICOs significantly.

I see three criteria how the coins can entail some underlying value. Firstly, the firm which succeeded in his initial aspiration buys back the tokens at the higher price. The coin functions than in as security with debt and equity elements (tokenised security). Again, there is a high likelihood that this kind of use of the coin will be regulated in the near future because it entails security characteristics.

Secondly, I can identify some value if the coin is actually used in the service created by the start-up (utility token). For example, Ethereum built a whole network around its cryptocurrency Ether. Ether is an important part to use Ethereums services such as the smart contracts or self-executing investment funds. Therefore, it might be that a steady demand will arise. However, there are far more examples where the coin does not add any value to the underlying service. The most recent example could be the KodakCoin. They created a blockchain based copyrights management platform which solves a current struggle for many photographers. They will be paid for their royalties in KodakCoins, their new cryptocurrency. However, Kodak gives no clarity where exactly and if this coin can be used in exchange for services or goods. It is hard to see how this adds any additional value in comparison to pay them in traditional currencies like USD or EUR.

The third reasonable application for funding through ICOs could be for non-profit investments or organisations. NPOs can reduce costs for raising funds and investors do not speculate on any future financial value but rather a social or ecological value. Through smart contracts they could even incentivise the NPO to reach certain goals and then automatically release further donations. I am sure there many more scenarios how NPOs could profit through ICO funding or other blockchain-based technologies.

Most coins today however, have no pay-out or dividend scheme at offering. There I fail to see how the value of a currency is connected to the success of the issuing company. Many indicators given by the countless coin investor portals such as founders credibility, mission or issue to be solved by the start-up, supply of coins and transparency seem arbitrary to me. These indicators do not show how the value created by the firm (even if successful) will transfer to investors.

My verdict…

 In conclusion, I do not see the current craze on cryptocurrencies as justified. In my view, many investors do not understand the fundamental values of these coins and therefore the current gains will be only short term. China and South Korea will only be the tip of the iceberg in banning or regulating cryptocurrencies. As soon as the heat on the markets cools down and the first investors will lose (real) money regulators will wake-up and introduce tightened regulations. However, some aspects bear some real opportunities which only a few participants incorporated. In these cases, the underlying new technologies and services are the real value driver. Hence, they should be able to weather future currency storms.