Dear all,
I presume that most of you here are invested in cryptocurrencies, including Smart Contract platforms designed to service dApps amongst other things. I am of course referring to the likes of Ethereum, Cardano, EOS, and the many others.
I also presume that, amongst the many reasons why cryptocurrencies are exciting to you, the one reason you care most about is their potential to rise in value. As markets develop and adoption spreads, the value of the coins is expected to boom.
No surprise, I am here for the exact same reasons... although some key questions do often scratch my mind:
- How are we supposed to value these coins?
- What would "success" or global adoption mean for their price?
- Does high usage automatically translate into high valuation?
To be honest, it has not been so clear to me.
Reading between the lines, these questions seem to be vastly ignored by most of the community and this is a real issue. Most market participants are young and/or unexperienced with regards to how financial markets work. This is fine so long that we can still get a good grasp of what investing in such and that project actually means.
Is anyone sure that increased adoption of a given coin will make us profit from it as coin holders and, if so, how? Are we only taking a view on adoption/use of a certain Blockchain technology we believe in, or is there a second layer of risk related to whether wide adoption would actually lead to much higher valuation of a given coin? Since we're all used to the stock market, our intuition would be to say "Yes, obviously!". Except that a cryptocurrency is not a stock.
Through this post I would like to encourage collective thinking and debate as I attempt to bring some clarity to these issues. My knowledge is surely not complete and so please feel free to add or correct me wherever is necessary. I am invested in quite a few projects myself, and I am thrilled, but I want to retain a critical mind and get answers. There should not be any taboo in questioning how it will all work, so please feel free to upvote as you see fit so that we get maximum audience. Also, make no mistake: if institutional investors cannot get a reasonable understanding of how these ecosystems should be valued, then they will NEVER come to the party in mass. So let's get on with it!
As mentioned, cryptocurrencies are completely different from regular company stocks. This is not a problem in itself, except that it emphasizes further the need to understand their new concept.
The value proposition of a stock in today's traditional economic system is as follows:
"A single share of a company represents a small, but real, ownership stake in a corporation. One stock's percentage of ownership is determined by dividing it by the total number of shares outstanding. While there are different types of stocks, stock ownership generally entitles the owner to corporate voting rights and to any dividends paid." (source: https://www.fool.com/investing/2018/05/13/the-definitive-guide-how-to-value-a-stock.aspx)
This means that stockholders are entitled to extract a share of the profits made by the company. This, in turn, incentivises stockholders to maximise profits. This broadly means that the company is on a mission: the mission to make as much money as possible for its stockholders.
Now, let's look at cryptocurrencies which are a completely different animal. Wikipedia states:
"A cryptocurrency (or crypto currency) is a digital asset designed to work as a medium of exchange that uses strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets."
They are a medium of exchange then, and hence should be primarily correlated to supply and demand as opposed to the profits generated by the business ongoing. There is actually no profit per se in a Blockchain's economic system, and this is why we can avoid the heavy syphoning of value by stockholders.
Let's now look at various use cases of crypto platforms:
1) Cryptocurrencies used as a payment system such as Bitcoin: This one is pretty straightforward, if you can or should pay for goods and services with such currency, and if it proves to be a better form of money vs other means available, then demand will increase and make the price of the coin go up. The same applies to the "store of value" concept, if people see such coin as a store of value, then demand goes up and price goes up.
2) Cryptocurrencies used as Smart contracts platforms: here, the coin is necessary to use the network's capacity to process transactions. This can be the case for dApps, or for other activity related to tokenising, tracking and/or trading certain assets. It is to be noted that dApps would require, as far as I can tell, a lot more transactions per second than such other activities. Think of Facebook for instance, which processes more than 50,000 transactions per second with their centralized server.
In the first case, it is relatively easy to see why such successfully adopted currency and/or store of value would massively increase in price versus current valuations. If Bitcoin was globally adopted, it could reach a price in the area of USD 1m vs. USD 7k right now for instance. This case is clear.
In the second case, focused on Smart Contracts, I am inclined to think that the value of the coin would be primarily correlated to the need to hold some to spend it on network usage (e.g. to pay the fee associated with doing a transaction on the Ethereum platform). As we know, most platforms currently have limited capacity, meaning that any widely used dApps would congest an entire network instantly (see what happened with cryptokitties). Ethereum currently processes about 15 transactions per second when EOS has reached about 4,000 transactions per second, but this is still small compared to what is required if we want multiple, globally used dApps to operate on these systems one day.
This is why Smart Contract platforms are working on scalability, and it has been claimed that the goal is to reach 1 million transactions per second or more in the future through the use of various new technologies including side chains.
Here comes my dilema: if progress in scalability takes us from few thousands transactions per second right now to millions per second in a few years, I guess it means we can go to 10 or 20 million transactions per second not so long after that. Side chains and other piece of innovation will help for sure.
And here is the problem, what would happen to the fee you have to pay to the network the moment usage, even if huge/global, represents a small fraction of the platform's capacity?
These platforms operate in different ways. Let's use EOS as an exemple this time, holding 1% of the EOS tokens gives you access to 1% of the platform's ressources. As long as the ressources are scarce, you have to keep on buying the EOS token to satisfy your needs and that makes the price go up. But what if the ressources aren't that scare anymore in 5-10 years from now? What if Facebook wants to build on EOS, needs capacity for 50,000 transactions per second and this only represents 1, 2 or 3% of the network's capability at the time? It means they would "only" have to buy an equal amount of these tokens in the market. Not such a great price pusher for such huge project, no? Ethereum and Cardano work in a different way, but the problem remains broadly the same as far as I can tell.
One can then ask, are we going to see the value of these platforms go down as scalability goes up despite high nominal usage? How do you value a highly scalable Smart Contracts platform that is only used for this purpose? Honestly, I don't know and this is why I am here to share a concern and discuss it. This is what the above logic might lead us to believe to be honest.
In any case, we would also have to consider other forms of usage such as fund raising activity, either via ICOs where new platforms would have to buy tokens to operate on a given Blockchain or Airdrops whereby token holders receive tokens of new projects for free to create a network effect. This is definitely valuable, but ICO activity might slow down and not every project needs to be airdropped. This cannot be seen as the driving force behind the value of a Smart Contract platform in my opinion. Nor should we count on these to be used as a currency for everyday payments (which would be a clear driving force for upward valuation from here, as discussed).
So where does that take us? Imagine Cardano in 5 to 10 years from now, what could it be?
- a nice, solid, globally used platform
- processing 800,000 transactions per second
- able to handle 4,000,000 transactions per second thanks to sidechains
- but not be used as a currency for day-to-day payments since, let's say, Bitcoin already does that
What would the market value of the platform be then? Setting aside "sentiment" which would make these platforms more or less valuable depending on market shape; I am talking about intrinsic value here. Would users pay a fee for the system? Sure. But what would it be? What valuation would it entail? You could have a very solid platform, used on a global scale, but worth USD 10bn looking at the fees being paid to use it!?
What do you do then? You keep the fees at a higher level than necessary to support higher valuations? Not possible, someone would fork the code and offer a lower fee. OK, so you limit the scaling progress to a given number of transactions per second to match usage? Not possible either, the code would be forked and used by any non-profit organisation to use its full capacity.
So here are my thoughts guys, please show me the way now :) and, of course, please feel free to correct any misunderstanding I may have. We just cannot take ignorance or hope as an answer.
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