Rollercoaster memes aside, lets face it; bitcoins value methodology is still a black box. I’m not saying that there’s a question that bitcoin has value - of this there is no doubt in my mind. The question of course is what is this value? What should it be now? Is it undervalued or overvalued?
Although it occasionally experiences what some might call ‘price stability’, it’s clear to any observer that the price of bitcoin and other cryptocurrencies fluctuate. A lot. Comparing against any other asset class against any reasonable time frame shows a price volatility that stands out.
Now, the pundits wax lyrical about what currently drives crypto prices. Examples abound of all sorts of chart wizardry and/or novel fundamentals analysis involving new-fangled metrics around network stats and mining economics. I’m sure to some (limited) extent, these methods to establish value can be useful. But remembering how even a broken clock is right twice a day, I’m still skeptical that any of these valuation methods have proven to be consistently correct, even if sometimes they appear to be.
Let’s be honest with ourselves; any asset that is subject to multiple 100’s (or 1,000’s) of percentage points gains, followed by a 50-95% retracement in just the space of a few months, is clearly still undergoing price discovery. And i’m not just talking about the 2017-2018 bubble - this has happened several times now:
| Cycle Start | Base | Peak | Max. Gain | Pull Back |
|---|---|---|---|---|
| Jun 2011 | $0.95 | $32 | 3,370% | 94% |
| Jan 2012 | $2 | $7 | 250% | 49% |
| Apr 2013 | $13 | $260 | 1,900% | 83% |
| Nov 2013 | $200 | $1,242 | 521% | 88% |
| Nov 2017 | $750 | $19,777 | 2,537% | ??? |
It’s clear to me that these types of price movements are the fractal vacillations of a brand new asset class with the powder-keg combination of extremely high technological potential and little to no compatibility with existing mature valuation methodologies. As a result, as far as I have observed price action is dominated by the only applicable model: human fear and greed.
What else do we expect? There surely cannot be consensus on value when there isn’t even consensus yet on exactly what bitcoin (or other cryptocurrencies) actually is. Of course fear and greed becomes the default when nothing else we have fits this paradigm. Even the term ‘crypto-currency’ is a misnomer that 10 years after bitcoin’s launch still continues to constrain the mainstream financial press into assessing it as nothing more than an alternative / inferior currency. But who says bitcoin is competing with currencies? There are already several schools of thought on how to regard bitcoin as an asset class, with no consensus (ironically) as to which is most suitable. Consider these several common narratives :
bitcoin is a currency. Its value arises from comparing its market cap against the M1 money supply of other fiat currencies / countries.
bitcoin is a payment network. Its value arises from comparing its transaction volume against other payment networks like Visa.
bitcoin is digital gold. It’s value arises from sharing the convenient monetary properties of gold (portability, divisibility, fungibility, store of value) without the inconvenient ones (storage, transportation).
bitcoin is a capital-intensive utility. It’s value arises from the economic cost of securing the network through PoW mining.
bitcoin is a protocol. It’s value arises from being the missing piece of the decentralised internet; introducing digital scarcity in a world of digital abundance.
So which is it? Some or all of the above? None of them? One of the underlying issues is that there doesn’t yet seem to exist a suitable model for most analysts or investors to benchmark bitcoin or other proof-of-work coins against existing asset classes. It’s just not compatible with their frameworks, and as a result I think we’ve seen hesitation for most big funds to allocate some of their portfolios to this (relatively) new asset class, as crypto largely remains excluded from modern portfolio theory.
But that could be about to change…
The importance of Yield
Yield in investing describes, in essence, the income that an asset produces. Yield is typically considered separately to the price increase (capital gain) which is another method of making a return. In stocks/equities, the yield comes in the form of a regular (we hope) dividend paid to shareholders. In real estate, the yield is the rent you can charge. The yield is the interest you can make on your cash deposits, or the coupon on your bonds.
The income you can receive on a financial asset is a very important part of establishing the its value. It is the assets income, as well as the the probability/risk of receiving this income, that underpins most investment decisions of today’s financial markets. Essentially it is the one common anchor that helps asset managers benchmark different assets against each other, and establish a preference for how much of each they want to own. Even cash fits into this framework, and investors who choose to ‘not-invest’ by preferring cash over other higher-yielding investments are making just as much of an active investment decision as the most ruthless Wall Street wolves.
Bankers and investors often use the income generated by an asset to establish it’s price:
Person A: “I’ve got a magic machine here that will print $10 per week, forever. Wanna buy it for $25k?”
Person B: “Sounds good! That same $25k in my 1.5% savings account only makes me a little over $7 per week”
Person A: “… Did I mention that the machine breaks down 30% of the time?”
Person B: “No Deal! Too risky…”
Person A: “Ok, ok. How about I give it to you for $20k”
Person B: “Deal.”
Ok so I glossed over some technicalities here like compound interest, but you get the idea. As you can see, yield allow investors to better understand how they will be compensated for taking on various levels of risk, and thereby benchmark different assets against each other. This is price discovery in action.
Mining rewards are not yield
Proof-of-Work (PoW) blockchains such as bitcoin are fascinating because they align self-serving interests with shared interests. The mining community, by participating in the race to to solve the block solutions and enrich themselves, also secure the network and provide consensus and authority over the “true” history of transactions. Miners also receive demand-side rewards in the form of discretionary transaction fees.
But even though this is a financial return / income for miners, this is not the same thing as yield. For in the case of yield, investment returns should flow to the holder of the asset whereas mining rewards are essentially a return on the capital equipment used to provide the mining work. As such mining rewards are ‘earned’ exclusively these days by the owners of specialised facilities with millions of dollars of equipment. Gold investors know the difference between buying bullion and buying shares in gold miners, and while those mining shares might pay a dividend yield, it is not a yield being earned on the gold itself.
Gold, like bitcoin, doesn't earn a yield either (a common criticism of gold as an investment asset). This is probably why gold is frequently lumped together with other industrial ‘commodities’, even though industrial commodities (like iron or grain) have completely different valuation proposition: generally as inputs to value-adding processes, while gold for 6,000 years has been very differently regarded as a safe-haven, or store of value, or hedge against inflation. Gold is (mostly) a financial asset and doesn’t have (real) intrinsic value like industrial commodities, and yet is categorised in the same way - Why? Because it can’t be easily benchmarked against typical, yield-producing, financial assets such as bonds or equities. This I believe is the same problem suffered by bitcoin and other proof-of-work cryptocurrencies, and, given they don’t enjoy the 6,000 year history of gold valuation, why price discovery in crypto is still fraught with volatility as bulls battle bears in a relentless, algo-pumped, social-media amped, primal Battle Royale between greed and fear.
Staking is yield for crypto
People of course still invest in bitcoin and all of the other Proof-of-Work coins because of their expectation of price increases and capital gains. Same goes for fine art, vintage cars, unoccupied properties and so forth. But the types of investors who look for yield have largely had no palatable investment options in the crypto sphere.
That is, until now.
While Nakamoto-consensus and the Proof-of-work paradigm is responsible for kicking off the crypto currency industry, there are other alternatives for securing and maintaining blockchain integrity. The most popular alternative mechanism you may have heard of is called Proof-of-Stake (PoS). As I mentioned in my earlier post 5 Blockchain Industry Predictions for 2019 :
Unlike PoW chains (such as bitcoin), where these days mining rewards are exclusively the purview of specialised facilities… with PoS chains rewards become obtainable to anyone and everyone who owns coins. In such a scheme, the average Joe need only offer up his coins as a sort of collateral, and they can participate in the verification process needed to add new blocks to the chain. In this way, they can receive fresh new tokens as a ‘reward for being honest’, and they can do this while remaining in full possession of their funds; they don’t need to lend them elsewhere. In turn they can earn compounding interest.
We have our yield!
In this model, income flows to the holder of the asset and not to the owner of expensive mining equipment. So we have a form of crypto asset investment that is compatible with the existing mindset and methods of typical investors in financial assets. One caveat is that the yield itself is denominated in crypto, not fiat. Depending on how you look at this, it could be either an unwanted source of volatility, or a huge plus if the yield you were earning was also subject to capital gains (as well as the principal) without prejudice. It would be similar to if owning Apple shares meant receiving a fixed dividend not in dollars but in more Apple shares, except that Apple was contractually obliged to pay the shares every time (i.e. not discretionary) and it paid the same number of shares each year regardless of their rising (of falling) share price.
While Proof of Stake is not a new concept, the first generation PoS blockchains encountered various flaws that were unexpected and difficult to remedy retroactively (inc. so-called ‘weak subjectivity’, ‘long range attacks’, or ‘zero opportunity cost’ problems). It is only recently that relatively large projects are emerging that are deploying it successfully. Projects such as Tezos (live since 2018 Q3), Cardano (coming 2019), and Decred are all examples of well-designed Proof of Stake systems. Even Ethereum, the second largest PoW blockchain (at time of writing) is soon planning to switch over to PoS when it launches the network upgrade known as Constantinople.
FEBRUARY 2017
FEBRUARY 2019
Conclusions
Staking rewards are a big deal. For most investors, whether retail or institutional, they will be the first taste of yield in the crypto domain. My expectation is that as people begin to understand and experience investment yield in crypto, this will spark a new wave of interest in Proof of Stake blockchains. The main beneficiaries will likely be the new generation of PoS projects that make it very easy for non-technical users to stake or delegate their funds. For many of these projects, the staking rewards are just a by-product of their consensus design, with the main mission being a whole new blockchain ecosystem enabling new types of smart contracts and capabilities. Nevertheless, with a design built around Proof of Stake, the holders of the token may be more likely to hold on to their coins (taming volatility), more incentivised to participate in consensus (boosting decentralisation) and reduce the need for PoW mining, which is more energy-intensive.
The big prize, however, will be to bring cryptocurrencies a step closer towards being accepted as a serious investment asset class. By going beyond capital speculation, bringing mathematically enforced, predictable yields with no counter party risk, investors and institutions will finally be able to start wrapping their heads around how to price crypto properly. That means more disciplined valuation, better risk models, disciplined investment, and a higher readiness by big funds to deploy capital into crypto as part of established diversification strategies. I would expect price discovery to strengthen and volatility to decrease, even though many investors will still expect capital gains in addition to yield (perhaps like in real estate). Crypto capital markets will start to take form.
In an era when most investors are starved of yield, I see no good argument for why crypto yield will be any less legitimate than income-investing in any traditional asset class. Indeed, some investors may even prefer to take the additional risk of price volatility in exchange for mathematically-guaranteed payouts. The notion of a 0% default rate could become a very interesting proposition indeed when the next cycle of government debt crises begin to emerge. In any case, crypto-yield is an important development and it seems clear to me that Proof-of-Stake blockchain assets will continue their march into the world of traditional financial investing.
Andy
February 2019