There has been much written, discussed and argued about what cryptocurrencies like Bitcoin and Ether are worth. And there has been much nonsense, much superstition, and flawed analysis. Since we’re back in crypto winter, I feel it’s possible to write this without drowning in spam, spam by people trying to pump and dump some coin.
Let’s be clear on one thing first of all: There’s no lack of scarce assets. Just because Bitcoin is limited to a 21 million coin supply, does not imply any worth.
Secondly: History doesn’t have to mean anything, but it could, depending on what was driving the supply/demand dynamics in the past, and if that remains relevant going forward.
Usually, I think it’s fair to look at cash flow. If the box is expected to receive X millions, and spend Y millions, over the next Z months, we can start to build a model based on this. It doesn’t mean the model is perfect, and there’s always a lot of uncertainty with anything looking towards the future. But it’s something, something more than just fanatical belief.
But cryptocurrencies like Bitcoin and Ether don’t have cash flows as such. They’re not like a company looking to make a profit from its revenue.
So is it worth zero then? Could be. Any value attributed to it is purely down to manic speculation and gambling. This would certainly help explain the large swings and volatility observed over the last 10 years or so. And there’s nothing wrong with taking a trip to the casino every now and again.
But, playing the roulette isn’t really a serious investment case. It’s just a bit of fun with some spare cash.
A two part model
I believe we can view cryptocurrencies like Ether as a commodity. Calling them cryptocurrencies hence become a bit misleading, but anyway.
It’s a commodity that during some periods people find pretty to look at. They want to collect as much of it as possible, not to spend, just to look at. At other times people hate it, for whatever reason. Some of academic finance would argue this individual behavior, with regards to love vs hate, is uncorrelated, and in aggregate can be described as pure noise of some color. I think it’s a bit more complex, with lots of correlated behavior and group think. That’s why we get the level of volatility we get.
The above describes the first part of the model. It’s pure human emotion and we’re all along for the ride. Whenever there’s no utility or reason for buying the token, other than pure speculation, this part dominates. For most tokens today, this is the only part of the model that will ever dominate. Most tokens today are worthless and will never manage to trend toward anything but zero in the long run. If you were lucky with your timing you got in early and out at around the top. And after that, these tokens will slowly die and trend towards nothing. Till the next crypto summer, were they might, just might, get another chance to shine.
Across the wast number of top X tokens, the correlation is quite high. They go up and down much the same, even if people have widely different views on the potential of each of them. After the current crypto winter I think we’ll start to see this correlation break. It will start to break because the second part of the model will start to dominate more for some of these tokens. This part is the true utility value of these tokens.
If blockchains managed software, i.e., smart contracts, become genuinely useful to an ever increasing amount of real companies and real people, directly or indirectly, as part of their everyday actions, then the demand for Ether will rise and fall in accordance with economic activity.
What sort of economic activity? Depends on how integrated Ethereum becomes with various parts of the economy.
Let’s take a simple example: Assume a growing number of companies want to use stablecoins as part of their transactions. They prefer these over ‘old fiat’ because they represent programmable money, and give them lots of benefits due to this.
When there is lots of activity in the economy, we can expect business to be good, with more transactions between customers and suppliers. As Ether is needed somehow when making those transactions, demand for Ether would increase. Demand for Ether would hence have a positive correlation with overall economic activity.
Because the level of economic activity isn’t totally random, and comes with lots of momentum and lag, we can expect Ether volatility to reduce and it’s value to be less tied to pure speculation and more tied to what’s going on overall.
We can then start valuing Ether based on expected future economic activity, because we expect Ether demand to follow. We’d also need to take into consideration things like transaction efficiency. Due to technical solutions like Layer 2s and so on, the same amount of Ether would give us more bang for the buck, we’re getting a productivity gain. We would also expect, at least initially, different parts of the economy to be better integrated than others, which would skew the picture somewhat.
Is this a bullish take on Ether? No, it’s just a model. The inputs aren’t included. But I will predict that we’ll see an exponential increase in the amount of coupling between Ether and real world economic activity, and hence reduced volatility, due to the lag and momentum previously mentioned. This increased coupling comes because challenges with using blockchain managed software, like scalability, privacy, regulation, and sustainability are now at a ‘1 to 2 years away’ time horizon. The sustainability challenge, with Proof-of-Stake, is now expected to be deployed within months. Scalability, with ZK rollups, sharding, and related, is expected to be production ready the year after. That technology further plays a role in solving privacy. And regulators, in some form, are starting to give greater clarity, a crucial step towards greater economic integration.
For Ether and it’s value it all comes down to transaction fee volume and issuance. Those fees are burnt, hence removed from circulation. When things are not so hectic or good, less activity means less fee burning, with a growing supply instead.