Valuing Cryptocurrency

Valuing Cryptocurrency

At the time of writing, the market cap for the top ten Cryptocurrencies is $487 billion. However, the vast majority of people don’t use cryptocurrencies in their lives. If nobody is using them, what drives their value? Seemingly, somebody pulled the market cap out of thin air. But who? And how is this possible?

To answer these questions, we have to establish the meaning of value first. I believe something is valuable if, and only if, it has the “ability to fulfill someone’s desire.”

How does something satisfy your appetite? There are two ways: directly and indirectly. The former is when you can use something to address a need, and the latter is when you can exchange something for another thing, that you can then use; you can enjoy the ownership of a house either by living in it or by renting it out in exchange for money which you can then use.

This possibility of exchange has created indirect value. As a result, when people say value, they are often thinking of a market price. Some claim that commodities such as gold have an intrinsic value, but the statement only means there is a market for gold. If you are not the person planning to use gold, a nugget of the precious metal is only useful in the sense that you can exchange it for something beneficial to you. In gold’s case, this is true because there is a well-established market for it; you can readily sell your gold to the market and get paid in cash, which you can use to buy anything that is for sale. (On the other hand, if you are living in a society without a gold market, by definition, you cannot exchange gold for what you want.) Hence, even when you do not want something for yourself, it is valuable if there is a market for it.

For most fiat currencies, the market is the whole country, or more; USD is used not only within the US but also for the substantial amount of international trade. This acceptance is not the case for cryptocurrencies. Even if I accept cryptocurrency as payment, few other markets accept cryptocurrencies. Practically most cryptocurrency transactions happen within cryptocurrency exchanges. In this regard, cryptocurrencies are closer to gold than a currency. In other words, cryptocurrencies have more indirect value than direct value. This phenomenon will continue if the demand for a cryptocurrency’s intrinsic value does not increase.

What’s the intrinsic value of a cryptocurrency? The value of a cryptocurrency is the right to use its blockchain. (There may be an exception to this rule, however, for the sake of this post, I will focus on general cases.) In other words, the amount of cryptocurrency that I own is related to my ability to use a blockchain. For example, the more Bitcoin I have, the more I can add to another account, and pay more transaction fees to make my transfer faster. The blockchain enabling these activities is close to immutable. Also, the chain is freely accessible anytime, anywhere, as long as you have the account address and its passcode. The ability to add numbers to the accounts on this blockchain is the feature and the intrinsic value of owning Bitcoin.

However, the indirectly formed value is also significant. If there is no market for Bitcoin, the value of the coin, which nobody is willing to pay for, becomes 0. A currency without a value can no longer perform as a store of value nor a medium of exchange.

From the perspective of financial value, the market cap of a cryptocurrency is the theoretical maximum value of the blockchain per block (a blockchain’s routine agreement schedule): 1. Given that a cryptocurrency is the only accepted payment to use its blockchain. 2. The total value of payable cryptocurrency per block is less or equal to the whole circulation of the cryptocurrency. 3. Therefore, the most you can pay for the blockchain per block is the market cap of its cryptocurrency. In other words, the blockchain’s maximum processable value per block.

How does the price of a cryptocurrency is formed? In summary, that is driven by the amount of capital trading a limited amount of cryptocurrency. People to see the direct value of cryptocurrency will use the value of the blockchain as a rule. For them, the price X of a cryptocurrency must be lower than the value they can get by using the cryptocurrency. By the law of demand and supply, as the need for the blockchain increases, Y will get closer to X. For an investor, it is ideal if you can invest in a cryptocurrency where you expect its blockchain to have massive demand, but X is low. Nobody can predict or calculate X or Y, but the expectation forms the price of a cryptocurrency.

However, I wonder how many people know or consider the above when they invest in cryptocurrency. There are many crypto-millionaires due to the sudden growth in the cryptocurrency market cap; the bubble can burst if there is no direct value as its foundation. On the other hand, if there is no sufficient market cap, maintainers of the blockchain, engineers, and miners, will leave for the more profitable project. If the price is too high, users will abandon the blockchain. To solve this chicken and egg problem, we need to have many useful blockchains that can drive a massive demand from the market. People will learn what makes a valuable blockchain from the success cases and create a better judgment. Then, this market will evolve from a wall street of imaginary companies to innovators building the next step of our civilization.