Today’s we are going to tackle an important question … a very sane question … what ARE you really investing in when you buy a Bitcoin or any of these other cryptocurrencies? And … are all of these coins created equal?

I think this is important because people are rushing into crypto, without understanding … thinking they are buying something like a stock … and it very much isn’t.

Very good article in Coindesk’s 2017 year in review series, titled 2018’s challenge: What Are Crypto Assets Really Worth?

A question which goes hand-in-hand with What Are You Really Buying.

It is fascinating and telling to me, that this question gets almost no coverage AT ALL, in the mainstream crypto press … a sure sign of the frothiness of this market … but it is a topic that is being discussed at great length among serious investment managers and Wall Street trading desks.

Quote from the article:

“This is quite unlike the behavior of some traditional assets, such as stocks, which have very well defined value characteristics (dividends and price appreciation, arising out of expectations of future cash flows generated by a firm). In contrast, the value characteristics of crypto assets are very hard to define, let alone standardize for a valuation framework.”

“It is possible to create an immensely successful platform or protocol enabled by a token, where the value accrues to the users instead of the token holders.”

Let’s break this down … most important point here is:

99 times out of 100, you are not buying ownership in a company when you buy these cryptocurrencies. In fact, in many case, there may not even be a company. These are open source software projects. So there is no expectation or promise that if that particular crypto project is wildly successful, that any of that value will go to the token holders.

So, what are you buying? And how do you value it?

New tokens are brought to market in something known as an ICO, or Initial Coin Offering … but unlike an IPO with stocks, again, you are not getting shares of the company or underlying project … this is just a crowd-funding model. Participants in the ICO are essentially donating money to the project because they believe in it. And instead of a price break and a cool t-shirt, like you get with a Kickstarter or IndieGoGo project, you get tokens. And bragging rights, if it turns out one day to be a big success.

And why would you want those tokens? You might ask … To understand, let’s start at the beginning …

You have to understand the beginnings of cryptocurrency … it was started by a group of libertarian thinkers who wanted an alternative, decentralized, trustless form of value transfer. In other words, this was and is, at it’s core, a social movement as well as a technological one. In the beginning, the vision was that there were no centralized banks, brokers, governments or even companies controlling any of this. It was a system that required no middleman.

Rather than companies, think of each of these block chain projects as a “distributed Internet tribe” who come together around some idea or interest, formally known as decentralized autonomous organizations (DAO) which, unlike companies who have one legal entity and lots of employees to deliver the good or service … DAO’s have no central legal entity and no employees. So the entire system is built around group consensus.

And these tokens provide that central mechanism, that grants access to the network and incentivizes work to be done amongst all the disparate players.

So, when these projects launched to create this brave new world, the original contributors were funding projects they believed in, and would like to use.

So an ICO is really just a fancy Kickstarter project. But instead of the promise to deliver the drone or book or new cooler that keeps your beer at a perfect 42 degrees for a solid week, IF they are successful … and many aren’t … the ICO is the promise to provide access to the new browser, social media platform, blockchain version of Upwork or whatever it is … and, again it is just a promise because most of these ICOs don’t exist yet. They are an idea being crowd-funded.

With me so far?

So, fast forward to 2017, when the price of these tokens, starts shooting up and a bunch of people who have no idea what they really represent start buying them.

As an investor, the big questions is … If these tokens represent access to a given network or application … how do they have value? Because, as a true investor, with no interest in having access to or participating in the underlying project, what value do these things have. Especially when most of them convey no ownership rights.

There was a paper floating around Wall Street trading desks recently, by John Pfeffer, a former KKR partner… His valuation model was the first I have seen to make a point that seemed obvious to me … I will link to it in the show notes. But let me try to give you a simple way of thinking about the conclusion.

So basically, in his model, and in my way of thinking as well, for the moment, you have two different types of tokens. You have utility tokens and money tokens.

I’ll spare you the mathematical model he uses to support the conclusion …but it is that utility tokens will, at equilibrium, have almost no value above and beyond the computing power and resources required to maintain them. So, I found an excellent analogy for these types of tokens in ‘A Gentle Introduction to digital tokens by Antony Lewis (again linked in the notes).

These tokens are similar to a ticket to a sporting event. The equilibrium price arrived at in Pfeffer’s paper is like face value of the ticket. But, that price can be driven up and down in the secondary market by scarcity and sentiment. If the team is really good and seats are totally sold out, scalpers may get many multiples of the face value. If the team is bad, there are plenty of tickets available and they sell for less than face value.

So, in that model, the price of a token on the open market should be some reflection of the consensus about the future success and failure of the project amongst those who want access to it. What happens when investors pour in, especially uninformed investors, is you have something like multiple layers of scalpers on super bowl tickets. Before long, people are buying to turn around and sell to the next greater fool. Which is what a bubble really is. And face value and any relationship of the current price to it is totally lost.

But the key point, under this valuation model is, when the music stops, 99% of these utility tokens will have failed and even the ones that are very successful, will have little intrinsic value.

Now, an alternative analysis exists for monetary coins. And, in Pfeffer’s paper, in particular the monetary token that wins the battle to become the new de facto store of value, i.e. the digital version of gold. In that case, the price at equilibrium is not driven by sentiment but strictly scarcity.

One thing I forgot to mention is that one of the unique characteristics of tokens is that, unlike fiat currencies, there is a finite number of each. The number of Bitcoin is the number of Bitcoin … ever. No central bank can just keep printing more.

So, if you have a finite number of coins, 21 million, which are today worth $247B, and you have literally trillions of dollars of gold and off-shore cash trying to find a new home, because Bitcoin is a better store of value than gold, then there is some inherent value in the token itself, above and beyond what is required to maintain the token.

Which is one of many reasons I stay away from alt-coins and ICOs. Basically, you have to know you are playing a game of musical chairs in which you are buying in hopes of selling to the next greater fool.

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