How Do You Value a Cryptocurrency? | Chris Burniske on Cryptoeconomics and Financial Models



what's up everybody welcome to another episode of hidden forces with me Dmytryk of feena's today I speak with Kris Pearn Eskie Kris is a co-founder of placeholder' a New York venture firm that specializes in crypto assets prior to placeholder Kris pioneered arc invests next generation internet strategy leading the firm to become the first public fund manager to invest in Bitcoin transitioning to focus exclusively on crypto assets paving the way for Wall Street to recognize it as a new asset class his commentary has been featured on national media outlets including The Wall Street Journal the New York Times Fortune and Forbes in this episode we blow the roof off of crypto economics exploring a model for valuing this new asset class amid the enthusiasm and excitement of Wall Street and the general public what are the most useful ways to think about crypto assets like Bitcoin and etherium how do we differentiate between the different currencies dabs and tokens how do you judge the merits of a white paper the seriousness of the dev team and the enthusiasm of early adopters how important is governance volatility and supply schedules as early indicators of the future success or failure of a crypto venture this is the most ambitious episode I have produced yet on distributed letter technologies and their economic applications at times the conversation veers into the abstract realm of financial theory balancing mathematical variables in equations that can be hard to follow in one particular part starting shortly after the 21 minute mark and going for about 15 minutes we tackle the topic of money velocity and its effect on the price of any given crypto acid using the quantity theory of money otherwise known as the equation of exchange a macroeconomic theory from the 19th century that was put into algebra by the economist Irving Fisher in the early 20th if you feel lost at any point don't worry this is the only part of the conversation where we rely on mathematics and algebra rest of the discussion is easier to follow and very rewarding for anyone who has been frustrated by the lack of information around how to value this emerging asset class I highly recommend you stick it through as always you can join our email list by visiting the show's website at hidden forces pod com if you listen to hidden forces on your iPhone or Android make sure to subscribe if you like the show write us a review and if you want a sneak peek into how each episode is made or for special storylines total pictures and questions then like us on Facebook and follow us on twitter and instagram at hidden forces pot and now let's get right to this week's conversation Chris pernitskiy welcome to hidden forces thanks for having me it's a pleasure having you on I mentioned to you that I had your other half Gill Lauria on from the cell side you are the first are you really I mean like are you the first by sight analysts who have covered this space you have the reputation back in 2014 and 2015 it was only me on the buy side for our audience for those listening in who don't know what a buy side analysts is or what the buy side is can you give them just a quick sort of summary of that the way to think of it is the buy side within the Financial Services is really the one managing the money directly so the asset managers making the buys and sells managing portfolios whatever it may be and so being an analyst working on the buy side meant I was advising a portfolio manager who was managing assets for Ark investment management's clients the firm owns out at the time on the sell side you really have the service provider so Southside research is a common vertical within the sell side and that's where Gil Luria is one of the first sell side analysts in the crypto space so in fact Gil what I think was the only one that came on this show where we talked about the financial aspects of crypto currencies and we really dealt with the the supply side a lot in dealing with it sort of viewing it as a commodity and sort of what are the how do we determine value based on some of the supply-side dynamics but for the most part we've covered this entirely from a technological standpoint the underlying technology and the use cases and besides all the other stuff we cover on the show you've written the best book I've found by far that attempts to put a financial framework around the cryptocurrency industry and in fact this term I'm using as well as actually confusing so you actually do a good job of creating a taxonomy in the book and we're gonna try to stick to your terminology if I mess up its I hope you can correct me so that the audience doesn't get confused but you break this down along three lines you have crypto currencies crypto commodities and crypto tokens and those are all part of crypto assets so why don't we start there and then we can sort of pick apart and ask questions as we go through sure and thank you for that one of the most important things to get across when I'm using the term crypto assets is to broaden the conversation beyond currencies if we stick to thinking of the thousand plus crypto assets that are out there right now as strictly currencies then it will take us down a bunch of dead-end conversations and arguments because a currency is a pretty specific use case within our world and per the definition a currency should serve as a means of exchange store value and unit of account and a lot of crypto assets out there are not specifically focused on serving those three use cases on a global role they're attacking other use cases so that then brings us to okay what are those other use cases so pulling back to this word crypto assets that is the word I use and increasingly the industry is using to describe this asset class as a whole that stands up on its own against stocks or bonds or real estate or precious metals or whatever it may be now within that crypto asset asset class there are verticals just like there are verticals within the equities asset class or the bond asset class or whatever it may be and so those verticals include crypto currencies which we've just gone over the ones specifically focused on being the mean means of exchange store value unit account those include things like Bitcoin litecoin Z cash Mon arrow ripple so on and so forth just to start to jump in there but what about the fact that in practical terms bitcoin is not of great medium of exchange it does that matter is we simply in the taxonomy is is simply the theoretical framework is such that you can use it technically as a means of exchange and therefore it qualifies that's a great point and I would say that when you look at the different cryptocurrencies some of which I mentioned different ones of them specialize or are strong in different areas so while they can all perform this Universal suite of services Bitcoin for example is really good at being a store value because of its disinflationary going on deflationary supply schedule but that very same supply schedule actually makes it a somewhat poor means of exchange right now it's a mediocre unit of account within the crypto ecosystem specifically and a poor unit of account outside of the crypto ecosystem and so this is where we start to see trade-offs and it's also important to realize these are open source software's just because Bitcoin is one way today early in 2018 doesn't mean it's gonna be that way in 2019 or 2020 or 2025 they can change so that's also very important because your entire analysis here is based on an operational framework – that is conditioned by the open source nature of the protocols you're dealing with and that adds a certain parameters expectations assumptions and also a layer of complexity and you know because you're gaming out what it's going to look like it's interesting what you said there about Bitcoin being a poor means of exchange as a result of its supply schedule is that what you think is or maybe you were saying that it's a good store of value because of its supply schedule how much of it is the supply schedule and how much of it simply is the sort of adoption of it and the sort of the intangible belief structure of the community that is investing in it and the network effect and everything else well I would say that many of those factors you just mentioned have been born from the supply schedule excitement around being able to adhere to a very fixed monetary policy and govern that monetary policy in a decentralized manner that's very powerful right and that has built everything around it now I should be clear around Bitcoin as a medium of exchange I think someday it could get to the point where it becomes a very widely used medium of exchange and I would argue it's quite important Bitcoin get to that point it's just right now given its massive popularity Bitcoin in some ways has become a victim of its own success right too many people want to use it that has made transaction fees high which is something if you're in the industry you're probably sick of hearing about by now and so the Bitcoin developers are working on solutions scaling solutions to bring transaction costs down so again it's going back to this idea that these are open source software protocols and thus they can change over time is really important for understanding just if a crypt asset is not good at doing one thing now doesn't mean that will forever be the case so I do want to move over to cryptical mutters in crypto tokens but before I do I want to pause it with something that will circle back to and that is what would happen if you were able to solve the scalability problem within Bitcoin how that would affect its price given some of the other work you've done so let's continue on with crypto commodities sure crypto commodities were really kicked off by aetherium which is another crypto asset that some people may have heard of and the reason I use the term crypto commodities is because when I look at the physical world and I look at many commodities exchanges like the CME I can trade different derivatives products on physical commodities like bananas natural gas oil wheat whatever it may be and those commodities those physical commodities are building blocks to our world and so it makes sense that I be able to accurately price them and trade them not only on prices of today but three months from now within the crypto space we are seeing the birth of many digital commodities markets that are just as important as our physical commodity markets so to make that more concrete that's things like cloud storage right gigabytes of computer space or bandwidth access the internet or compute like GPU flops or just logic like what a theorem provides but the point here being that we are seeing the birth of markets to price digital commodities just as we've had markets to price commodities for many decades now and this feels like an inevitable trend and so we look at different assets out there beyond a theorem you have assets like file coin so you can basically bring your computer to the network so you download the software connect your computer the network and you start storing other people's files and getting paid for doing so just like you bring your car to the uber network and you get paid for driving people around I'm giving them overrides so that's file coin there's things like Gollum which is GPU so graphical processing unit flops so you could connect your gaming machine or maybe even your Tesla which has an Nvidia drive px in it and your Tesla can actually be crunching through machine learning algorithms or rendering graphics as part of this global GPU flop network so you can start to piece together how abstract but also all encompassing the idea of a crypto commodity or digital commodity can be just to kind of further that point about it being a commodity you're agnostic about where you're getting the commodity from it's just the same as gold or oil it doesn't matter whether it's coming from one refinery or another it's oil and similar sort of concept here which is that if you're gonna want a provision or distribute file storage or computation out to some distributed application you can create a basic framework for pricing that whether you're buying it from one or another because you're buying storage yes and there's a price for that yes and the market will set the price inevitably of the dollar per gigabyte say of cloud storage what's the key here what has been unlocked and this is has been inspired by Bitcoin right this whole lineage of crypto assets has been inspired by Bitcoin if we think of what Bitcoin did it issued a scarce asset and governed this distributed set of actors to provision some resource in exchange for that scarce asset so with Bitcoin it was minting new Bitcoin in exchange for clearing and settling Bitcoin transactions and the security around that process with something like file coin just to stick with that asset as an example you are minting new file coin and doling out that file coin in exchange for computers coming to the network and files and so the same logical leap can be applied to most any digital service or resource that you can think of so now let's talk about distributing cryptical mutters encrypted tokens because for the cryptocurrencies for me that's a very obvious difference between those in the commodities because the cryptocurrencies you're just basically it's an accounting ledger whereas the crypt of commodities there's some level of smart contract going on there there's some level of if now if this then that computation with the commodities correct for many of them yes okay from my own curiosity what would be an example of something where that isn't the case so within the crypto commodity right well I think of some of the protocols that will provision crypto commodities will be pretty thin in functionality so for example file coin again right that's a pretty thin protocol they're using a new consensus called proof of space-time and there is a lot I shouldn't under sell how much engineering has gone into file coins protocol but it's more to emphasize that some of the functionality or just the service being provided by a crypto commodity is a pretty straightforward service and that's what allows it to become a all present building block right right and so if we go back to this idea of the taxonomy of cryptocurrencies crypto commodities and crypto tokens I really see the cryptocurrencies and crypto commodity as being building blocks these ubiquitous protocols that provision these digital resources and so to use the physical world as an example again within our physical economies we have currencies that pay for the exchange of commodities and commodities that form the raw building blocks for finished goods and services and so in the crypto world using that same analogy we have crypto currencies and crypto commodities coming together to build the base layers upon which we can build more consumer-facing applications or DAPs distributed applications and so this is where you're starting to see things like prediction markets right or things like err gone for governance or even steam which is kind of like reddit and medium had a baby and added an incentive layer to it so those crypto tokens are really the consumer-facing finished digital goods and services that rely upon the infrastructure built beneath them and the value proposition there the value they're adding is more complicated to value also because the fact that it there's more that goes into it it isn't this yes in a layer as you're describing yes and the farthest off right this is sort of the dream of the crypto space consumers using all of these distributed applications without necessarily having to know or worry about anything that's going on beneath them right just like when I swipe a credit card I don't have to know how the whole merchant banking backend of credit card systems works what are some of the most exciting distributed applications you've seen out there you mentioned file coin you mentioned Gollum mm-hmm these are not fully function well this certainly Gollum is not right I mean there's right there are issues around how these distribute applications can function given the scalability concerns on the underlying protocol which also gets us into questions of proof of work proof of stake and what some of the developer communities and some of these particularly theorem are trying to do in order to solve that problem I don't know how you want to tackle that that was like a whole collision collision of question we can go we can either go down the scalability thought trail or we can go down okay what are some of the more exciting use cases that we're seeing let's do this we'll circle back into the scalability later so let's talk about the most exciting use cases given the constraints that we face today and reasonable expectations I would say one of the consumer facing projects that caught most people's attention in the last couple of months would be crypto kitties and so crypto kitties being a you could argue 1/4 vertical with encrypt assets you could call them crypto collectibles but it's this idea that you can have non fungible digital assets so a unique single digital asset that I can't trade for any other digital asset because it's unique just like people find certain baseball cards to be uni course four coins or artwork or whatever it may be but there was a marketplace created for these rare digital cats and they were provably unique and rare and therefore that scarcity creates value right and there are descriptions and all that kind of stuff the application was so popular quickly clogged a theorems Network because we're in the early days of these technologies of scaling but again that's a good sign a theorem there was a victim of its own success because crypto kitties put to use a theorems platform to create this end user DAP so I think that's a good example there are other examples out there like Leroy and which is a decentralized Twitter you can access it using toshi which is an app that coinbase puts out so just like we have web browsers like Safari or Chrome or whatever it may be to explore the web there are browsers like Toshi which are dap so distributed application browsers so that you can browse all of these use cases that are being built and used them with cryptocurrency with crypto commodities and those kinds of things how important is portability and the application being built in a modular fashion so that it could be platform agnostic to you and looking at distributed applications to invest in well that's a deep question and a very important one so just to rephrase this idea that a distributed application could be built to run on top of aetherium but it could also run on top of a theorem classic or Definity or iOS or whatever it may be there's any number of sort of these multi-purpose general compute platforms and even rootstock which has been built on top of Bitcoin provides a virtual machine very similar to what etherion provides I would argue that increasingly we're going to see distributed applications at the very least need to have a back-up plan right let's say a theorem goes down god forbid what is the immediate back-up plan because all of these daps can't be reliant on a single point of failure and whether that means they run on two chain simultaneously is to be seen it's not free to do that right you have to continually keep your application in sync on these two separate chains which is not only lift from the engineering perspective but also just cost you have to pay to use these chains well what about just having the optionality to switch to something let's say something better comes along with something that people didn't foresee the ability to switch to a different platform so that's been done and that can continue to be done so for example storsch which you could think of it as a competitor to file coin they switched from running on top of Bitcoin I think they're running on top of counterparty which was a smart contracting solution on top of Bitcoin they switch from that to etherium and so the basic thinking is you replicate State which is effectively if you were to take a snapshot of where all of the users and all of the data and every yeah a snapshot is the best way to sum it up and replicate that snapshot onto another chain and then start that chain running again from there so you can port to a different chain it's just not a fun or easy process right so there's something else that is important to note here while we're talking and that is that all of these the tokens the commodities and the currencies the cryptocurrencies crypto commodities and crypto tokens are all invested mm-hmm you can invest in all of these and you can speculate in all of these so that brings us to some really great work that you did using the equation of exchange which I want to get into as we think about valuing these currencies and in terms of like speculating and determining value I have to tell you something I mean I'm not most of them ton of shows here that our financial my background is in that area I've never had to think about this equation in this manner and that forced me to deconstruct it in ways that I only had a few days to do like I told you I started working on reading your work this weekend and so I preface that in case I sort of say anything that sounds incoherent please correct me but let's go down this route first of all why don't you explain this to our audience what this equation is what it and let's and I'll do my best as we move along to try to interject where I can to provide some clarity and how you use it in structuring and understanding and trying to value the current and future utility utility value of these currencies and commodities and tokens yes I'll start by saying while I have been an advocate for using the equation of exchange within value encrypt assets that we're still very early days in terms of valuing these things and having a grasp on how everything work so I don't want listeners to think well this is all said and done this is how to value these crypto assets you know this is a Greenfield territory and I'm not necessarily right but you make me feel better because I do want to feel comfortable spitballing you with you yes it's pitfall so the equation of exchange is M V equals PQ so M being the monetary base and we're just gonna use a traditional economy and fiat currency to set this up so M being the monetary base say of the US dollar which is you know four or five trillion dollars right now that's the amount of money the Federal Reserve has generated that's a reflection of its balance sheet which is the liability structure yes the amount of US dollars in the float the bending on if you're looking at and 0 M 1 M 2 it's all different but we're just going to stay generalized idea of M V is the velocity so the number of times a currency will change hands in the air so if I pass you one US dollar that's a velocity of 1 you pass it back to me for another good or service velocity of 2 and you count those over a year u.s. dollars velocity right now is around 5 and then on the other side of the equation the P Q you have P which is the average price of a basket of goods and Q is the quantity of goods and so when you multiply those two together P times Q that's typically a representation of the GDP the gross domestic product of a nation and so when you have the monetary base taking the US dollar a say four trillion turning over at a velocity of five that means 20 trillion has changed hands in that year and lo and behold the US economy is it's approaching 20 trillion and so this is how those two sides of the equation match now to translate that to the crypto world we can think of each one of these crypto assets as supporting their own native economy and in so that's a very good point yeah that's been the most useful one of the most useful analogies I've come up with to really sort of think through these things and I've done it it's not a sole effort I should call out to joel Manero and brad Burnham to my partners who have helped me think through this a lot but within this economy there is a digital girder service that is being provided at price P and so let's use another example let's just use a mesh network for Internet connectivity so there's $1 per gigabyte of Internet connectivity that's P and there's a quantity of gigabytes provisioned by that network over any given year and to project out this size of that economy for 2018 2019 2020 I have to project out the price the average price charged by that network for that gigabyte of connectivity each year which is relatively simple to do in the context of other technology modeling where you have a cost of Klein curve and you drag that out over an extended period the queue is harder because queue is representative of the adoption of this network and it should look like an s-curve a technology adoption s-curve and so to figure out the quantity of gigabytes provisioned by a mesh network I would have to look at ok what's the total addressable market of gigabytes provisioned for Internet connectivity what subset of that is suitable to a mesh network and then what is this specific mesh networks penetration within this target market but when I have those two variables with lots of assumption that goes into them multiplying P times Q will give me the annual say GDP of that crypto asset when I have that side of the equation done that's the monetary expression of the size of the addressable market that's the monetary expression of the size of the economy P times Q for a crypto asset in any given year can be thought of as the GDP of that crypto asset in that year but for you the total addressable market is a subset of the actual total economy yes but then there is a penetration percentage within that addressable market for a specific crypto say I got it so it kind of goes total addressable market then percentage that's even suitable given the constraints of this crypto network and then the actual percent penetration into that but to be clear what you're basically trying to identify is what is the sort of ceiling that I can hit in terms of the total size of that I can penetrate that's the starting point that's the very starting point but then to get to an actual Q for any given crypto network I have to boil down okay this is the max what is the percent penetration into that max I expect in 2018 2019 2020 so on so it's really to get the gigabytes the gigabytes of network or Internet connectivity provisioned if I have the gigabytes and I multiply that by dollars per gigabyte I get a dollar value which represents the GDP of that crypto network than that given year now if I'm solving for or if I want to figure out the necessary price of this crypto asset I really need to solve for the monetary base necessary and so on the other side of the equation we have M V so if I divide both sides by velocity I get monetary base equals P Q which we've already solved for divided by V and so this is where we need to do a lot more research and unengaged and more research with professors but a lot more research on the natural velocity the resting velocities of these crypt assets it might be too early I've backed out for Bitcoin as a means of exchange its velocity is roughly 15 in aggregate Bitcoin expresses a velocity any given the air of five or six so there's even nuances to how we calculate velocity but before we fall down that rabbit hole just to finish this idea you divide a economy a crypto economy of size PQ by the velocity of the asset in that economy in that year and you get a necessary monetary base to support and that economy to get the necessary price of a given crypto asset you need to divide that monetary base by the number of crypto assets and the float so let's say ten million or a hundred million or whatever it might be to get $1 per token of current utility value for that crypto asset in that year okay let's focus on the variable of velocity for a second because this is something that people don't intuitively grasp which is that as velocity Rises the monetary value of a given crypto asset or token can drop assuming money velocity I mean money supply it remains constant and the quantity of goods provisioned by the use of that particular token doesn't rise can you talk about that a little bit and let's see if we can play around with this variable and help make sense of it for our audience okay velocity is a tricky one and it continues to trip me up to this day if we go back to this idea that we're solving for the size of the monetary base the higher velocity goes actually the smaller the monetary base needs to be to support a equal-sized economy so let's say just to use examples if the economy is worth $100 and the velocity is 1 or 2 then the monetary base needs to be 50 in order to support that economy but if the velocity is 10 the monetary base only needs to be 10 in order to support that economy same sized economy different velocities smaller monetary support the price level is another way to support yeah although we didn't get all the way to market prices but we'll loop back to that maybe at the end so this idea of velocity is confusing right because it's saying ok the more this asset changes hands the more in some ways it's used the lower the value of the monetary base actually needs to be and so to pick that apart because it's missing a few components to really help people understand the dynamics if we go back to a crypto asset within its crypto network supporting this economy then that asset within that protocol is serving as a currency just within that protocol and so as a currency it's facilitating the exchange for the resource that's provisioned by that network but it's also storing value and so when I try and figure out the velocity of different crypto assets I end up doing a weighted average based on how that crypt asset is being used so if you take something like Bitcoin and we see an expressed velocity of roughly 6 any given year for all Bitcoin outstanding now that 6 is composed of a certain percentage of Bitcoin that was just held with the velocity of 0 and another percentage of Bitcoin that was actually used that was actually in the float circulating as a means of exchange so okay we have bitcoins hybrid velocity of 6 from some work I did with coinbase a couple years back we estimated roughly 60% of users are using Bitcoin as a store value so that's 60 percent times a velocity of 0 which leaves 40% times some means of exchange velocity has to equal 6 so 40% times 15 equals 6 which reveals to us the means of exchange velocity of Bitcoin is actually 15 and so this is where it's important to decompose for any given crypto asset how much of it is going to be held either as a store value or as part of the consensus mechanism that gets into staking and those kinds of things so how much of it is going to be held versus how much of it is going to be circulating the percent of the asset that is circulating could have a very high velocity and if that velocity goes too high it could unwind the value of the capacitor is this balance of say 60 percent can be held as a store value 40 percent can circulate at a relatively high velocity and the crypto asset can still retain value because of that high Vlasta so it would be fair to say that when you're looking at an ideal store value an ideal crypto asset to invest in if you want to protect the value of your money or to grow it over time you want to have a propensity for hoarding in the asset itself that can help to offset the potentially high levels of velocity that would come with having a digital asset that could be used let's say as fuel if you're talking about something that's being used for fight like file coin for example there's a balance between the store of value guys and the means of exchange guys the store of value guys are continuing to hold the asset because they expect it to be used on a greater scale as a means of exchange going forward and the means of exchange guys continue to use it because on this given date it provides a better service than anything else competitively out there so it is a balance because if 100 percent is hoarded and there's no actual means of exchange turn over to the asset then it could become the house of cards right but the way in which you sum it up does strike at at the balance is another way to put this that M times V is a measure of an expression of availability so if you have a lot of the coin is steak let's say your algorithm incentivizes a large percentage of the monetary base to be outside of the float that leaves a smaller amount to be available and so that can drive that puts downward pressure on the price now we're getting mixed up here because we're talking about relative values it makes the currency more valuable given assuming other variables having to do with the velocity for the float itself so to take what you're saying and put it into math because you are onto a correct point here if we go back to calculating the rational market price for a crypto asset we went through that process of calculating PQ dividing it by a V to get a necessary monetary base when I then divide the monetary base by a certain number of tokens outstanding the number of tokens I use or crypto assets I use are only the crypto assets that are in Flo so if 60% of crypto assets are bonded and being held those aren't in the float so there's actually fewer cryptid assets in the float and therefore the value per crypto asset is greater now just to tie this sort of all in a bow people need to remember market prices are based on expectations of future values so this is why when we started this conversation I was talking about projecting this outside of 2025 calculating the value the utility value of a token in 2025 and then discounting that value back to the present right to get a rational market price today so just to be clear also these are theoretical frameworks that we're using to try to work this out in our head but there are so many assumptions as is so complex so I don't want to give our audience the idea that somehow we're talking about nice and neat equations here that we can figure out the value of Bitcoin and all yours is overpriced or it's a mean or whatever it's very very messy these days super-early lots of assumptions not even totally I I guess I feel some pressure because I have really advocated for MV equals P Q and a fair number people look to me for crypto valuations stuff and I do spend a lot of time doing it but we're all novices in the space we're all trying to figure it out so let's move past that because I've heard this sensibility and brains of my audience enough let's move into some of the other aspects and ways of valuing cryptocurrencies so I've got a few over it not here one of them though is the white paper right which is like super important and I'm curious how important that is to you one too and how important it is given the fact that at least in my experience having tried to evaluate white papers and having sought out experts even the foremost authorities have been able to find have hesitated to give a definitive opinion on whether or not this is going to work if there's so many other aspects because market adoption ultimately is so important and viability and proof-of-concept how important is the white paper to you in the equation of valuing and evaluating something how do you go about doing that and yeah that's my question well it really depends on the white paper in terms of how many details the white paper gives I from those details even start to piece together some kind of model on what the future value of this crypto asset will be that said I really use the white paper as a gut check on the seriousness of this team because I and maybe this is too old-school of me but if you go back to bitcoins original white paper it was a pretty short white paper it doesn't discuss the market opportunity it just focuses on how the protocol is going to work and so it's a pretty austere clean to the point white paper and that's because a white paper should cover the technical aspects there can be you know a associated one pager or a specific paper on the crypto economics I understand combining together protocol mechanisms and crypto economics because both are really important but what I don't like to see is white papers that start with the the market opportunity and how much this tokens going to appreciate and how all investors that buy and now are going to get rich right yeah that again that that is an immediate red flag for me so I guess to back up even more when I'm approaching any project approaching it from technology crypto economics and governance which is slightly different from how we phrase it in the book the book we go into a bit more detail on things but just for your listeners to chunk it into those things I think that investigating any project from those three angles should be enough that said my crimp token omits you're talking about some of the stuff we've talked about before the utility the supply schedule everything and even are the incentives strong enough to get people to bring their laptop to the file coins these are open source which is an yeah if I'm only making three cents a year I'm probably not going to be incentive so that brings us to the question of the developer community tonight and how important that is now that's I mean obviously it's super important it's much easier to evaluate the qualifications of a developer community for a platform like aetherium which is established but for something that's brand new let's say how do you do that and how you do it overall frequently developers that are launching new projects they have track records right it may not be in LinkedIn hopefully it's on github right and the other projects they've worked on and so that's really a merit-based track record there's also the social aspect to crypto it used to be that this community was pretty small and it wasn't that everyone knew everyone but you were only a leap at most – away from people certainly with 2017 and now into 2018 the space is growing really quickly and so some of that familiarity is falling by the wayside that said I would always go back to you know what are the priors of the developers and how accountable are they to this project if you can't even figure out who the developers are or they're shady links into who they are and you can't really confirm their identity then there's no accountability to the project and so I think point number one is making sure there's accountability and then point number two okay what are the proof points what are the priors that prove to me this developer team will be able to launch this protocol because it's easy to talk about these distributed systems it's really hard to build them so you mentioned governance as well let's talk about that because that is a huge thing I think it's under discussed and underappreciated because this is an open-source you're talking entirely about blockchain based protocols here yeah all this our conversation and these are open source protocols that are being used so talk to me about the importance of governance and how you evaluate that governance is the third part in what I mentioned a little bit ago of Technology crypto economics and governance and so we've done a decent job of covering technology and crypto economics and the reason that's important to start with is technology's table stakes for this network to even work crypto economics is table stakes for bringing actors to the show what do you mean table stakes table stakes as in if you don't have good technology you don't stand a chance in this space I just end it with that expression1 yes yes and crypto economics is the same thing the third variable that is defensible is governance and to emphasize why this is the point if we think of blockchains as open data layers and that are coordinating all of these actors around a particular asset or resource then as an open data layer you can copy the code and the data layer you can copy that whole protocol replicate it and spin up your an entirely new protocol which is a fork and so that's like taking Facebook replicating the whole user graph all of your data within it and spinning it up on a separate set of servers which Facebook doesn't own and now you and I own and if Facebook has not governed their community well and there's this easy forking mechanism to spin up the exact same service over here with slightly different incentives or maybe I have control of my data over Facebook having control over my data if Facebook hasn't governed their community well then you could get a flood of defectors right that come over to this new protocol and so this is where these crypto networks need proper governance need fair governance where their constituents feel loyal and feel committed to stick with this protocol because otherwise that protocol could get forked to death and basically commoditized in the way that I just described it's a very very good point so that's up in some ways there are pros and their cons to this right to having open source the pro is one that you just identified there which is that let's say the community of developers are not filling the promise or people aren't happy about it it's very easy to just for a renegade group to fork and create their own version but you could also have a sort of malevolent form of anarchy sort of mob rule and you have all these Forks and you don't really have any major progress in reading your book my sense was that you think universally speaking open source approaches to building distributed databases and applications distributed consensus is the only ideal way but the best way to go about doing this why do you feel that way well the history of information technology has taught us too ever bet against open and I mentioned Joel maneger earlier but this is something Joel and I talk about a lot and he's really stuck in my brain and that is it doesn't matter what platform you look at but probably the most important recent one was the Internet there were a bunch of private intranets and a lot of the incumbents like the telcos wanted to create their walled gardens where people could connect to one another and they put out brutal campaigns you couldn't possibly trust the open Internet why would you let anyone wander around out there they're gonna get infected with all kinds of viruses and see all kinds of nasty things so on and so forth and now intranet still marginally exists to this day they do provide utility to the world but not nearly as much as Internet's and the same goes for proprietary software versus open source software private cloud versus public cloud all kinds of examples and so for me having learned those lessons and grown up a millennial it just feels so obvious to me that you should never bet against open is it an important point to differentiate between open source and walled garden in this case driving with AOL was a wall yeah yeah so I guess I should be more precise open source is typically referring to the way in which code is currently available and not owned by anyone and can be built upon yeah so that's open code development versus walled garden or proprietary code development which would be more like Microsoft say but then there's also just open networks vers closed networks which isn't necessarily open source per se as much as an open network anyone can join it anyone can become a machine on it versus a closed network where you know you have to have an ID and get through the bouncer at the door I was bringing it up because there's this one particular protocol that we focused on early I don't know if you're familiar with it it's called hash graph mm-hmm it is patented mm-hmm and they have not released a public ledger yet and I'm not privy sort of to all the details about how they're gonna do it but I think it's an interesting thing to look at and I'm considering it and thinking about it like for example Apple had a very controlled approach to how they built their ecosystem but you could argue that they provided a tremendous amount of value as a result of how they did that so it's just an interesting thing as I look at the problem of scalability and trying to solve like what is the problem we're looking to solve and so anyway that's why that's why I mentioned hmm you raise a good point with Apple and it's kind of this idea of sometimes the most decentralized forms of governance are not the most efficient forms of governance so there are trade-offs there you know a dictator can move quickly and very literally break things in which in the short term is more efficient for what he's specific or she specifically wants to get done versus you know maybe a really decentralized democracy that plies along in this painstaking manner but make sure to take into account everyone's opinion I would say to contextualize the idea of open even more and the importance of what's going on here requires a little bit of a walk through the history of information technology and if we go to first there was really the hardware era say the 40s 50s 60s ruled by IBM and those were all verticalized systems where IBM controlled the whole stack starting from the hardware then in 1971 about comes the microprocessor from Intel that is a standard open unit of hardware really and that starts to commoditize hardware and on top of that the software industry explodes software industry famously gets consolidated by Microsoft right which can put more CDs on more shelves than anyone else and so they have distribution and they also have lock in proprietary contracts with the hardware providers low and behold what starts to unlock the software industry is it's the open source movement for software creation but also distribution of information in the form of the web and so you start to commoditize the software industry and you give explosion to the web industry which is really a data industry and so now place all the firm I'm a partner at we would argue that we're in the data era of value creation where hardware and software have largely been commoditized they still produce industries but they're not where the fattest margins are the fattest margins are with the data aggregators like Facebook Amazon Netflix Google and we are seeing a consolidation of the web around those data aggregators now just as the microprocessor did and just as Linux and the web did the only way to compete against consolidating incumbents is to actually release a service that makes the very monetization model of the prior generation obsolete and that's by making that service free so we made hardware effectively free we made software effectively free now block chains make data effectively free because the very way in which a blockchain operates and the network on top of it relies is that the data be shared and open and free amongst all nodes that connect to the network right which is the public ledger which is the public ledger let's talk about something else we went and like kind of geeked out a little bit there on the on the sort of tech this would actually be considered at geeking out what I'm about to do right now but it'll be more on the financial side so I was thinking about volatility and I was thinking about the effect of having all these different little micro economies where they're tokens are tradable and the potential volatility that could be caused and the effect that it could have on the underlying business models of companies that are using it so let's say you're an airline and you're using a software a distributed application that's built on top of you know a blockchain or whatever and it's using a particular type of token and that token is analogous to oil you know the way that oil is used or jet fuel or whatever but let's say that in this universe of all these relative tokens and relative commodities and crypto currencies investors decided to pile into that because they see a really good opportunity for an appreciation that could drive up the price of that underlying token which could negatively impact the business model of this business that's using it I was just thinking about that I don't know if you think about that at all and definitely that's a great point and there's a couple of ways to approach it so on one hand you're right that if price appreciation of the crypto asset makes the actual underlying utility of the crypt asset more and more expensive then I would argue that's a bad crypt economic model there are some crypto assets out there with that model and they have reasons for doing that but what is much more scalable certainly is sort of this two tiered model which aetherium has implemented where you have a exchange rate for ether which is set by you know these global 24/7 exchanges but then you have an exchange rate from ether into something called gas and gas is what you need to use to pay for logic to run within a theory ins world computer and so you can actually using this model you can change the exchange rate of ether to gas so that you have to pay fewer ether four units of gas as the price of ether goes up what then happens is the dollar value of using the network can remain the same even though the price of ether itself is going up it decouples the store value component becomes a utility company s and so that's important that's also important bringing us back to the question of velocity because if you're gonna have a utility aspect to your network that's gonna demand higher amounts of velocity it's gonna generate higher velocity that's gonna decrease the price did I make a mistake by even venturing back into this conversation Chris should I just sort of voided it entirely well just to wrap it up again because I can see it's on your mind it there's a bunch of levers here right so if say the percentage of the asset being held is decreasing at the same time that the velocity of the means of exchange guys is increasing then that's a recipe for a vicious unless that's a double whammy yeah and value now if velocity is going up and people are saying hey this networks being used more look at all of this transaction volume in exchange for the good or service then maybe that velocity going up can also attract more investors which are actually holding a greater and greater percentage of the crypto asset and so they're become these variables I would say over time we will see these networks trend towards equilibrium and there are different theories on how cleanly or messily a crypto Network will operate at equilibrium one other point to emphasize going back to volatility if you have a fixed supply asset base something like Bitcoin which will ultimately converge upon 21 million units that asset should be inherently more volatile than something that you can modulate the supply because the supply is fixed and so price will fluctuate around it so it's a supply rule versus a price rule where say you fix price to keep that very stable and modulate supply which is effectively what the gold standard was right and even fiat currencies today they're backed by these central banks which are making these very small decisions around the Fed Funds rate in order to control the supply of money within the economy to influence the way in which the volatility of a fiat currency and really the economy as a whole they're targeted and inflation rate works so the central bank system and fiat currencies has become very call it sophisticated but opaque over time crypto as it currently stands the monetary policies are pretty rudimentary but they're totally transparent and so we can continue to iterate and iterate on these monetary policies to optimize for specific use cases and I would say we're just in the earliest days of doing that so this may be a little premature but and this kind of touches again back on money velocity because money velocities drop since the crisis even though the supply of the monetary base is expanded and that's a reflection of the large outstanding private levels of not dead know the velocity specifically has drops because of how much the monetary base is expended if we go back to the equation right if PQ has remained roughly flat it's right a little but that is divided now if we divide by M by a bigger monetary base the velocity can actually be less in order to serve the economy because you have more US dollars to services you're saying that the drop in velocity I mean the the expansion of the monetary base pushed down the but I'm saying that let's say you had zero debt in the economy and you expanded the monetary base you could have hyperinflation which means your velocity would go off the charts so what I'm saying is that you're the drop in velocity is a reflection of the the gravitational pull of the debt in the economy which is creating an artificial demand for staking for holding for hoarding the currency mm-hmm does that make sense so I was bringing that up in the context of thinking of what would be the consequence of introducing liabilities and fixed income securities within the context of cryptocurrencies that's wait now we're going against that is down the rabbit hey just out is also a very good question so we can we don't have to go down that rabbit let's go another more practical rabbit hole here so the futures market now we're going down all these different financial derivatives market you know holes or whatever they call so the futures market recently the CFTC and the CBOE launched cash-settled futures derivatives contracts and products on Bitcoin what has the influence of that bin what have you seen what do you think it'll be going forward and is it problematic in your view that these are cash-settled would it be ideal to see more sort of physical settled contracts first order I would say this is great we need more hooks into the traditional financial system more ways for capital market investors to get access to crypto assets and still to this day a lot of retail and institutional investors don't know how to get access or maybe even can't get access to Bitcoin let alone other crypto sets and so vehicles like futures or ETFs or mutual funds or whatever it may be they basically take any given crypto so let's just use Bitcoin for now and they fit it into this neat wrapper that plays nicely with all the other infrastructure that's been created around the financial services space and so that's great and we've seen with things like oil through the 80s that as the open interest the amount of interest in futures contracts as that grows it can actually increase the liquidity of the underlying asset which in that case was oil in this case would be Bitcoin so as more institutional investors get comfortable with Bitcoin futures maybe over time they get comfortable with Bitcoin itself and so it's a funnel that's polling more and more people into Bitcoin so that's the first point that I would emphasize the second in terms of cash settled versus in-kind I think someday we will have in-kind it's just another leap right because then you're talking about delivery of Bitcoin and what is delivery of Bitcoin look like and how do you make sure it's secure and a big one here is just custody directly holding an asset that a lot of people are still trying to wrap their heads around in terms of its classification its regulatory status who custody at all those kinds of things that just right now for a lot of institutions just getting exposure and cash settling is all that that's the thing it's so interesting right I'm sure that you're not the first person that's thought of this perverse sort of idea that you're investing you're not in really investing in the asset class you're speculating on top of a speculation you're trying to introduce an asset into your portfolio but you're not actually getting exposure to it well you are getting exposure to it you're just not directly holding the underlying but well I would say that's true if in a physical settled futures market but in a cash-settled futures market aren't you simply just using it as a proxy for making bets with other people that you could use a ping-pong ball to do the same thing my point being you are using a proxy and I would say you're always better off having autonomy over the asset that you hold right if I owned a claim on one Bitcoin I feel less secure than holding the actual private key that can move that Bitcoin directly so I understand your point there but I would say this is still important for getting people to dip their toes in the water and just start to get exposure all right now one last point there because you do bring something up that is a little amusing I would say that securitizing crypto assets with traditional financial instruments and I say this actually having spent you know about a year plus of my life having worked on similar projects it's a bit of a bastardization well of course it's very ironic yeah you're taking a native asset that can be transacted globally 24/7 loafie and you're wrapping it inside this legacy architecture vehicle this old wrapper and I think that might have been the point you're emphasizing yeah no it's interesting but it also speaks to the issue of that ultimately all that has to do or much of it has to do not just with familiarity and comfort and regulations in the financial industry but also with these scalability issues and that's related or relevant in the case of exchanges and the challenges that exchanges have and sort of all the transactions that happen on exchanges that don't actually happen on chain and all these interesting aspects of this ecosystem that we can't possibly get into Chris because we don't have the time and I don't have the brainpower today but I'm gonna I'm gonna get there Chris cuz I'm gonna get your back on so two more things before I get you off one of them has to do with government regulations we'll get there we'll end on that but I also noticed that you used a lot of Modern Portfolio theory in your book and Gaussian distributions and is that something that you do you work off Modern Portfolio Theory when you think about allocating portfolios for clients because and I say that because you know there has been a move among some you know fund managers away from those models and towards more complex ways of viewing stock moving some prices so I'm curious about that I should be clear that my role in the crypto asset industry has changed a lot over the years so my first three years from mid 2014 to mid 2017 was at our investment management which is a public fund manager much more involved say day-to-day in portfolio construction I'm now partner and co-founder of a firm called placeholder which is a venture capital firm that specializes in decentralized information networks incentivize with the token and so now my my job is much less about day-to-day portfolio construction I still have to think about okay we're making this investment in this new team what are the ramifications for doing that in the context of the broader portfolio and but I'm I don't focus on things like volatility or absolute returns or the Sharpe ratio or let all that kind of stuff as much as I used to that said I think that the reason I highlight Modern Portfolio theory or have highlighted it so much in the past is to contextualize what's going on with this asset class for people coming from the traditional financial industry because bitcoins place in a portfolio is very value add just from a Modern Portfolio Theory perspective you don't have to even believe necessarily in the long-term prospects of the technology or the developers or the community or any of that if you just look at the fact that most crypto assets are near zero correlated with other assets that you hold in your portfolio then that near zero correlation of returns means you can add in many instances we've seen this in the data you could add say one percent of Bitcoin to your portfolio so you swap out say one percent stocks into Bitcoin and there have been many periods where that actually decreases the volatility overall of the portfolio which blows people's minds right because you're adding this super risky volatile asset but you're actually decreasing the volatility overall the portfolio and that's because of you know the very tenants of modern portfolio theory and then on the other side that can also increase the absolute returns so not only have you increased the returns you've decreased the volatility of the overall portfolio and that's what every investor looks for so that's why I just use modern portfolio theory to contextualize things we did a show on volatility it was episode 5 and our guest Christopher Cole used this analogy he called it adding Dennis Rodman to your portfolio because when you look at how the Bulls played when they had Dennis Rodman there were all these sort of intangibles and it would show up in the portfolio yeah it would be like short of the performance of the team last question is regulations and government action because this is a huge unknown and I don't think we're out of the woods by any measure whatsoever I know that Wall Street super happy they have the financial products and everything else but I'm not at all sort of convinced that we're past the point where governments are not going to all of a sudden turned back in the other direction and regulate the out of this or you know shut things down or whatever like we've seen in China obviously Chinese different country but how do you evaluate the risk of that and you know what would be some of the signals you would look for to raise your alarm bells on mm-hmm first things first you mentioned China China has been a case in point that what any single nation state does does not necessarily break kryptos back if you go to the end of 2016 the Chinese yuan accounted for over 95 percent of Bitcoin trading volume January of 2017 is when the People's Bank of China came out and effectively started banning Bitcoin trading it was a slow rollout but you ended 2017 with less than 5% of global trading volume for Bitcoin happening through the Chinese yuan and nonetheless Bitcoin rallied 15 20 X in 2017 so I use all of that to remind people that it was the Bitcoin spaces worst fear that the Chinese government do something regarding Bitcoin at the end of 2016 that happened at the start of 2017 and then Bitcoin rallied 20x through the year so we've seen time and again with this space that any single nation state regulating or clamping down on crypto really aggressively actually just leads to this game of whack-a-mole where activity goes elsewhere so that's point number one true but that's capital flight so point being it does have a negative impact on the value of the currency within the borders or than the boundaries of the country in some senses yes or it certainly reduces access to that crypto asset which is a shame but in China right now if you wanted to let's say you have a million dollars worth of Bitcoin can you get it in China if you have the right VPN a virtual private network the right VPN to basically fool the Great Firewall of China that you are not based in China right and so you're accessing G Dax or it bit or bitstamp or whatever it may be from the Philippines oh how would you convert that into yuan if you were to access whatever exchange you would then need one of the fiat currencies or other currencies that that exchange deals with so you wouldn't necessarily I see what you said you're saying that the exchanges would assume that you're coming in from a foreign country that you're using you're setting up a fake Bao okay so you're basically yeah okay fine fine right definitely definitely not the retail customers no an economical choice but going back to regulation even though I painted this picture of crypto we'll survive no matter what I have been reassured to see how actually US regulators by and large are dealing with this the Securities and Exchange Commission SEC through 2017 was increasingly active and communicative in how it's approaching the space they said things like the Dow the famous Fiasco of summer of 2016 that was clearly a security they said other of these assets can be securities they did in one of their memos point out that Bitcoin and ether are likely not securities and so they've been starting to say paint the boundaries of what's out there I think more regulatory and enforcement action will be put into place in in 2018 so we'll see more of that and rightfully so I think there has been a fair amount of bad behavior in 2017 but most of all what I want to emphasize is that I'm encouraged that regulators are working with industry there's people like coin center-right advocating for crypto there's people like me and others in the industry that meet and talk with regulators consistently and I just hope that those channels of communication remain open because right now I'm optimistic about things I do think that there's good reason to be optimistic for something like Bitcoin for example because it is a store of value and it's not currently competing for a transaction volume also there's a challenge in terms of the IRS and filing your tires that's a huge tax – that's a gun well there's and that's the thing there's so many regulators just in the u.s. let alone globally like transacting in a cryptocurrency one of the biggest if not the biggest sort of head went against it is the fact that you have to reconcile those transactions to pay taxes I might be wrong but that was just my thought on that the other thing is what happens if we get to a point where there is a distributed letter technology or a blockchain or something that can actually issue you know loans like large amounts of loans that I just don't know at that point you know like you're talking about a huge threat to the banking system and I still think we're in uncharted waters but Chris listen man this was a great conversation I sure hope that I didn't sound too uninformed when we went through that whole morass of like 20 minutes me too but I did this was at least a painful learning process and I I'm gonna make a point to study hard and think about all the stuff we discussed and covered again in the future for our audience well thanks for having me I hope you can come back on in their future sounds good thank you very much okay and that was my episode with Chris Byrne iski I want to thank Chris for being on my program today's episode was produced by me and edited by still another call out for more episodes you can check out our website at hidden forces pod com join the conversation through facebook twitter and instagram at hidden forces pod or send me an email @ DK at hidden forces pod calm thanks for listening see you next week

6 thoughts on “How Do You Value a Cryptocurrency? | Chris Burniske on Cryptoeconomics and Financial Models”

  1. One of the best conversation on crypto I heard.
    Still the main question kind of remains unanswered. How do you determine if a cryptocurrency is overvalued or undervalued?
    Making the point of m*v=p*q only makes sense when you actually have an economy substratum for the crypto application, which is very seldom the case in these days…

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