Assessing Store of Value in Utility Protocols

The Network Value of BTC

The move of bitcoin towards widespread adoption by existing financial institutions can’t be considered a good sign by bitcoin bulls. Although this represents bitcoin’s increasing legitimacy in investor’s eyes. Its inclusion in the bloomberg terminal and the launch of bitcoin futures in CBE and CBOE herald the burgeoning perception of bitcoin as a digital asset.

In a way, this represents bitcoin’s fall from grace as a digital currency. Its strengths, such as the blockchain technology, are re-implemented and re-envisioned by altcoins, while its weaknesses, such as the costly proof of work model and slow transaction times, are heavily criticized. This is coupled with proof from the recent hard forks that the bitcoin community lacks the political unity to implement major changes. The recent interest in altcoins, and the tendency for bitcoin to suddenly lose dominance as percentage of total market cap are signs of this.

This has significant theoretical implications on the price of an individual bitcoin. The world’s total available currency is valued at $90.4 trillion. Given 21 million bitcoin and the vision that bitcoin would universalize currency, this would value each individual bitcoin at $4.3 million. The world’s total above ground gold reserves are worth $7.7 trillion. If we consider that bitcoin would eventually be an asset class comparable to gold, this would value each individual bitcoin in the $366,667. Both represent considerable upside from bitcoin’s current value of $16,500

The first vision offers a clear endgame and mechanisms that ensure that it would reach the endpoint, rather than say, get 50% of the way there. The second vision is less clear. One does not know how much of the asset market bitcoin will capture, or its relative value compared to other globally traded assets such as gold and silver.

The Network Value of ETH

ETH, the Ethereum token, is an interesting case to explore because of its significant current network value and Ethereum’s potential as the ultimate utility protocol. Ethereum could serve as the backbone for processing smart contract operations for (hopefully) untold numbers of decentralised applications, DAOs, etc., and perhaps one day maybe even something like the fabled Ethereum Virtual Machine (EVM).

Ethereum’s developers understood that for Ethereum to fulfil its potential, the cost of using it as a smart-contract-executing utility must be as low as possible and must not depart at equilibrium from the actual cost of the computational resources consumed. To ensure this will be the case, they built the GAS mechanism into Ethereum to decouple the use of the network (and the cost thereof) from the value of the ETH token.

Each possible type of computing operation has a pre-defined GASCOST, measured in units of GAS. GAS may then be paid for using ETH (or another token or currency) based on the GASPRICE ‘exchange rate’, which is freely set among users and miners.

The Ethereum Homestead Documentation makes this all clear:

“Gas Price is how much Gas costs in terms of another currency or token like Ether. To stabilise the value of gas, the Gas Price is a floating value such that if the cost of tokens or currency fluctuates, the Gas Price changes to keep the same real value. The Gas Price is set by the equilibrium price of how much users are willing to spend, and how much processing nodes are willing to accept13.” (Ethereum Homestead Documentation Release 0.1, p49)

“Gas and ether are decoupled deliberately since units of gas align with computation units having a natural cost, while the price of ether generally fluctuates as a result of market forces. The two are mediated by a free market: the price of gas is actually decided by the miners, who can refuse to process a transaction with a lower gas price than their minimum limit.” (Ethereum Homestead Documentation Release 0.1, p68)

This is all logical in the sense that GAS, and by extension the ETH token itself, is a metering device meant to ensure correct economic allocation and remuneration of the network’s resources. In the long term, the GASPRICE (and through it the value of ETH) should therefore tend toward the actual marginal cost of computing resource on the network. It could not possibly be otherwise, since if the cost of running operations on the Ethereum blockchain became materially more expensive than the actual underlying cost of computing resources consumed by it, people would simply use another blockchain where that premium doesn’t exist (or fork to create a cheaper Ethereum network that has identical functionality and users at that moment)? Also, if the GASPRICE were to decouple sustainably from the actual computing cost of operations, then mining would be the only perfectly competitive industry in history to earn sustainably positive economic rent. There is no reason for this to be the case in an industry where capacity can be freely added and withdrawn and the market price freely set.

Since the value of ETH is decoupled from GAS and therefore from the volume of transactions on the Ethereum protocol, an ETH bull could argue that ETH tokens could have an arbitrarily high value without compromising the cost-efficiency of operations on the chain. But let’s first agree that because of the GASPRICE mechanism14 the volume of transactions on the ETH blockchain and the scale of its adoption are not transitive to a high ETH token value. This point is important as observers often erroneously assume that a high volume of network transaction volume driven by all of the different potential uses of the Ethereum protocol will necessarily give the ETH token high value.

Bringing it together

In the context of evaluating cryptoassets as money and in a world where value can be moved among protocols with little or no friction, a cryptoasset can be a monetary store of value without being most efficient for payments or a great means of payment without being a store of value. We can therefore look at the potential value of a cryptoasset’s monetary store of value function separately from its payments functionality. Monetary store of value functionality will likely be one or two orders of magnitude more valuable than means of payment functionality.

Payments are likely to be fragmented and transaction volumes shared across a range of sovereign digital currencies, off-chain payment systems, centralised payment systems and multiple non-sovereign cryptocurrencies, each with their respective strengths and weaknesses for specific payment instances. This, combined with the fact that payment functionality is analogous to utility protocols and will therefore be valued on a M = PQ/V basis, means that the means of payment value of any given cryptocurrency will be relatively low.

In contrast, the potential value of a winning monetary store of value protocol can be measured in relation to the total value of gold bullion and foreign reserves, suggesting a potential value in the USD 4.7 – 14.6 trillion range. If Bitcoin were to become that monetary store of value (and it currently appears to be the strongest contender by some margin), it could be worth USD 260,000 – 800,000 per BTC, i.e., 20 – 60x its current value. If one places a higher than ~5% chance of Bitcoin succeeding in this way, it is a rational and attractive investment for a long-term investor before considering other potential upsides stemming from payments and unit of account utility. Investing in other cryptoassets based on use cases other than monetary store of value appears less compelling.

Let’s be clear. This could all go substantially to zero for various reasons. Being ‘right’ in an investment with a high risk of failure but a highly positively-skewed distribution of potential outcomes is about getting the a priori probabilities right (as adjusted for new information as it arises) and getting position sizing right. Provided you accept that Bitcoin’s net expected value is positive, even marginally so, the right answer on position sizing isn’t zero. Nor of course is it 100% of assets. For those stuck at the step of whether or not to invest, the logical thing to do is to move past that point and focus on position sizing. If you’re more sceptical, invest less. If more confident, invest more. But even for the most sceptical, you might constructively ask yourself, why wouldn’t you invest USD 1? Well, rationally, you probably would. Now how about USD 2? Repeat until you get to your Bayesian optimal position size. Given the significant risk of loss, in most circumstances the correct answer is probably a long-term, buy-and-hold, unlevered investment of a low single-digit percentage of assets (at cost).