Utility Coin Valuation

Cryptocurrency valuation has been a hot topic since the earliest days of Bitcoin, and has only become more controversial with the introduction of tokens and ICO (Initial Coin Offerings). Some investors see ICOs and the resulting tokens as potential Ponzi schemes in the making, though others believe ICOs herald a new era in Venture Capital. So which is it?

As always, the truth is somewhere in between.

In my view, the controversy is largely due to a lack of agreed upon coin valuation models. These would be standards which consider specific factors of a coin offering and enable an easy, apples-to-apples comparison, untarnished by one’s emotions or beliefs. The primary challenge is that such models and methods have yet to be developed, an issue which will certainly be addressed as the coin economy matures.

In the meantime, I’ve tried to compile a model of my own. This is my attempt at coin valuation based on fundamentals. Consider it more of a brain dump than anything formal or extensively researched.

Let’s say that you’re invited to take part in an ICO by Amazing Diapers, a company which plans to offer premium diapers at 1 ADC (Amazing Diaper Coin) per pack. A pack of equivalent Pampers diapers is sold for \$30 USD. Does that mean that 1 ADC has a potential value of \$30 USD?

If 1 ADC entitles the owner to receive one pack of Amazing Diapers and equivalent diapers are sold for $30 USD, then you might think that’s obviously the value of the coin. The reality is a bit more complicated. Let’s consider that for a minute.

In order to buy Amazing Diapers, the crypto dad has to acquire an ADC coin in order to redeem it for the pack of diapers. ADC can be bought during the ICO or later on coin exchanges. In either case, cold hard fiat cash is exchanged for a coin which, in turn, is redeemed for a pack of Amazing Diapers. In other words, ADC are a special kind of currency, which makes them subject to so-called monetary theories and the famous Fisher equation for money supply. For our purposes, the Fisher equation could be written as follows:

$$Coins\ in\ circulation * Coin\ value = { Unit\ Value * Volume\ Sold }.$$

\(Unit Value * Volume\ Sold\) represents the total economic value of all coin transactions. When more transactions occur, the demand for a coin increases, driving up the value of all coins equally.

The formula can be rewritten to derive the value of single coin:

$$Coin Value = { Unit Value * Volume Sold \over Coins\ in\ circulation}.$$

Intuitively, this represents the idea of coin price equilibrium, a situation driven by the scarcity of ADC coins and the demand for Amazing Diapers. The more coins that are in circulation, the lower the price will be. At the same time, the more diapers that are sold (and the more ADC denominated transactions that take place), the more valuable the coins will be.

The relationship between volume and the coin’s value is linear, as you can see in the graph above. For the sake of the argument, we assume a 15% growth rate across arbitrary time intervals, but we could have picked any other growth rate we liked as the value is not relevant to our discussion. Irrespective of the growth rate, the coin value eventually approaches the perceived value of a pack of diapers—in our example, that’s $30 USD.

Let’s unpack this a bit more. Potential customers of the Amazing Diaper company need to obtain 1 ADC per pack. How likely are they to pay more than \$30/ADC if the perceived value (or market value) is \$30? Not very likely.

So what happens then?

There are a few possibilities:

• Sales volume drops (i.e. prospective Amazing Diaper customers switch to another brand of diapers)
• The issuer starts offering more Amazing Diapers per coin. This is akin to the process of deflation, or appreciation of a coin’s value.
• The coin issuer released more coins into the market. Depending on the volume of newly released coins, the coin may inflate (experience a drop in value) or stay the same.

The first option is not very interesting—in essence the system reaches a point of equilibrium, with the coin value capped at the value of the underlying good. The growth stops, capped by the equation \(Coins\ in\ circulation * Unit\ value\).

For continued growth, the issuer needs to enact one of the two remaining options: deflate the coin or issue more coins. It is remarkable that in either case the issuer begins to act as a monetary authority—the spitting image of the Federal Reserve—with all the associated power and responsibility.

The deflationary path leads to appreciation of the coin’s value. Indeed, one could now buy more diapers with a single coin, raising the value as potential diaper buyers will be willing to pay more for the coin. ICO investors and coin holders are clearly the beneficiaries of this scenario.

But in the final scenario—coin inflation—the issuer is the only beneficiary, leaving investors to twist in the fiscal winds.

Of course, releasing more coins into circulation obviously benefits the releasing party. Coins are sold to market participants for a profit, which is collected by the seller—in our case, that’s the coin issuer. Notice that ICO investors who held their coins see no benefit here and, in fact, may suffer if the coin’s value drops as a result of the additional supply.

An important takeaway from this discussion is the need for sound monetary policy management in order to achieve and sustain steady growth. If a one-time issuance of coins is not followed by active engagement with the resulting market on the part of the issuer, the coin’s growth potential is restricted.

Another takeaway, perhaps the most important of all, is that the success of the coin shifts the leverage away from investors to a coin’s issuers. Initially, when the transaction volume is small relative to the number of coins held by investors, there is little the issuer can do. However, the coins aren’t valuable yet either.

As time goes by and transaction volume grows, driving up the coin value, the issuer gains more and more control over the distribution of the wealth between themselves and their investors. Buyer, be aware!