Crypto asset valuation

The fundamental questions that need to be answered here are: How can crypto assets be defined? Can they be considered as assets? If so, do they fall under traditional asset classes or do they represent an entirely new asset class? And finally, what are the different types of crypto assets? Crypto assets are digital assets recorded on a distributed ledger usually blockchain.

They derive their name from the cryptographic security mechanisms used within dis- tributed ledgers. Cryptography is used to verify transactions and secure the network without the intervention of a central party EY, Therefore, the terms crypto asset and token are used as interchangeable synonyms in this work.

Some authors also dis- tinguish between tokens and coins, stating that a coin is built in its own blockchain protocol e. Bitcoin or Ethereum and a token is implemented on top of another block- chain protocol, for example all ERC tokens are implemented on the Ethereum block- chain Koenig, , p. However, for the purpose of this thesis this distinction is not necessary, and both terms are used as equivalents of the term crypto asset.

Generally speaking, an asset is defined as something that has a monetary value costs, book value, market value or residual value , and that an entity purchases, owns, bene- fits from or has use of, in generating income.

An asset can be physical cash, machin- ery, inventory, land and building… or non-physical patents, account receivables, stocks, bonds, goodwill…. Furthermore, assets are characterized by being convertible into cash BusinessDictionary, n. Since crypto assets clearly fulfil all these definition criteria, they can be considered as assets. The question whether crypto assets represent a new asset class is not that simple.

As already outlined, crypto assets have very different financial characteristics compared to other asset classes such as stocks or bonds. They are based on DLT which is not the case for traditional asset classes. Usually an investor in crypto assets receives tokens that can be sent, received, and earned through the participation in the DLT or blockchain.

The price of a token depends on the supply and demand on so called crypto exchanges such as Coinbase, Binance or Bit- finex. This outstanding raise was accompanied by low correlations to other asset classes. The spectrum of crypto investors is quite broad, ranging from tech-savvy teenagers, high-net worth pro- fessionals to even highly sophisticated hedge fonds and institutions.

Especially more and more institutional investments are expected to enter the crypto space Horsley, All these specifications are tempting to consider crypto assets as a completely new asset class. However, from a legal and regulatory perspective they are not treated in a uniform way. While some nations such as China strictly prohibited the trading of crypto assets, others are welcoming them as a legitimate investment.

Many regulators try to put them into legal classifications of existing laws. In the USA for example, it currently depends on the nature of a token weather it is legally treated as a security, commodity or anything else. In that frame- work, tokens that are developed by a single, centralized entity such as a corporation might be considered as securities. These tokens have to meet all the SEC requirements for securities.

Other tokens, that are for example, backed by an underlying commodity, might be considered as a commodity under the supervision U. Tokens that do not fall under these defini- tions are considered as utility tokens and stay unaffected by regulation. All in all, it can be said that the regulators do not per se consider crypto assets as an entirely new asset class, but rather categorize them within existing frameworks according to their nature.

However, this is does not lead to the conclusion that crypto assets cannot be seen as a distinct asset class. Regulatory steps towards crypto assets are still at the beginning and the future will show how they will be treated by the law makers.

It can be assumed that a well-balanced regulation of the crypto market will strengthen the legitimacy of crypto assets as a new asset class since more people will feel more comfortable to invest their money in crypto assets. For now, they could be described as a new asset class in the nascent stage. As the law makers noticed correctly, there are various types of crypto assets, also re- ferred to as tokens, which will be explained in the following.

Utility tokens provide the user future access to a good or service, which in most cases, have yet to be developed. A utility token might be best compared to a gift card or software license, for example. Ethereum is the best-known example of a utility token. Ethereum provides the platform to create smart contracts code that can execute transactions automatically.

Augur, for instance, is a decentralized prediction mar- ket built on top of Ethereum where users can place bets on outcomes, like which team will win the World Cup, and be compensated for being right. A security token also equity token has similar characteristics to traditional securities such as equities stocks. Not so many security tokens have been issued so far, but many experts in the crypto space expect an increasing popularity of security tokens especially equity tokens in the near future.

Many altcoins such as Litecoin and Bitcoin Cash are variants forks of Bitcoin, with modifications to the original open-sourced protocol to enable new features. Other cryptocurrencies such as Ripple created their own block- chain Cong, et al.

Finally, there are asset backed tokens also referred to as crypto commodities that represent a claim to an underlying asset e. It enables micro shares of assets such as 0. Tether, for example, is an asset backed token since every Tether is backed by 1 US Dollar. The IOTA network can be used among others for secured data transmission. For some, Bitcoin, the crypto asset with by far the highest market cap, is valueless comparing the crypto market with the tulip ma- nia in the 17th century in the Netherlands.

So how valuable is it really? The true value of Bitcoin is probably somewhere between the two extreme perceptions. What is the fundamental value of an asset in general? And how do crypto assets derive their value? Wikipedia defines the fundamental value of an asset as follows: In finance, fundamental value also: intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value which is influenced by market conditions such as a recession or a speculative bubble.

It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present value. First of all, it is important to note that the fundamental value of an asset and the market value, which is reflected by the market price, need to be distinguished.

The market price is very often driven by psychological factors. Especially in the crypto space many in- vestors make decisions based on the behavior of other market participants, rather than hard analysis. All these factors are part of the extrinsic value of an asset and need to be excluded from a fundamental value analysis. Furthermore, it is important to determine from what perspective it is looked at the value of a crypto asset. There are basically two motivations of inves- tors that buy tokens.

There are buyers who purchase a token in order to get access to the future utility of the token. Generally speaking, the value of a token is based on a combination of the purpose of the token and the underlying rights the holder has. For cryptocurrencies value is derived from strong features as a medium of exchange, store of value and unit of account. The value of a utility token is mainly derived from its usa- bility. For cryptocurrencies as well as utility tokens also, network effects play an important role which means the bigger the network gets the higher the value.

Whereas the value of security tokens can be compared to the value of securities such as stocks that derive their value from future cash flow expectations. Conceptual framework: Valuation techniques of crypto assets The valuation of crypto assets is about determining the fundamental value of the asset regardless of the current market price. This helps to get a feeling for whether a token is over- or undervalued.

It is comparable to fundamental analysis of traditional financial assets such as stocks. In traditional fundamental analysis for stocks financial reports help to calculate the value of a stock. This does not work for crypto assets anymore and new valuation techniques need to be developed in order to assess the monetary value of crypto assets. A number of authors and leading thinkers in the crypto space have written about the valuation of crypto assets and have developed a wide range of valuation techniques that will be presented in the following pages.

However, research is still its infancy as crypto assets themselves and it will take a few years until highly sophisticated and val- idated valuation models for this emerging asset class will be available. Historically, this is comparable to the development of valuation techniques for stocks which have been established decades after the first stock trading.

While Dutch East India Co became the first company to offer its shares on a public exchange in the early s, it was not until the 20th century that a comprehensive framework for calculating the fundamental value of equity securities was developed Evans, In general, there are two approaches of how to value a token or any other traditional asset class: absolute and relative valuation models. Absolute valuation models attempt to determine the absolute fundamental value, often referred to as the intrinsic value, for an asset.

In traditional finance the absolute value of equities is usually calculated based on future returns that the investor expects to receive from holding the asset. A very common absolute model is the discounted cash flow model DCF Henry, et al. When it comes to absolute valuation models for crypto assets market sizing techniques, especially the Equation of Exchange based on the Quantity Theory of Money, has gotten the most traction in the market.

But also, the asset rotation theory and the cost of production approach can help to estimate an ab- solute value for a crypto asset and therefore fall under the category of absolute valua- tion techniques.

The underlying idea of relative valuation models is that similar assets should be sold at similar prices. Relative valuation is usually conducted by calculating ratios. There are currently no specific accounting or disclosure rules for cryptocurrency assets, so businesses classify them as indefinite-lived intangible assets similar to intellectual property such as trademarks.

Companies must review the value of such assets at least once a year and write it down if it drops below the purchase price. If the value rises, companies can only record a gain when they sell the asset, not if they continue holding it. Companies and accountants want the FASB to adopt fair-value accounting instead, which would allow them to recognize losses and gains immediately and treat digital assets as financial assets.

The FASB on Wednesday said fair-value accounting best captures the economics of crypto assets and determined the method would be a requirement rather than an option for companies. Buesser said. Ethereum is the second-largest cryptocurrency by market cap. The accounting standard-setter in December started researching whether to establish new regulations, and in May it added a crypto project to its technical agenda that sets its rule-making priorities.

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At the time, no investment company thought cryptocurrencies were a lucrative investment. What are the Challenges of Valuing Cryptocurrencies? Valuing crypto assets is challenging. For a start, valuation approaches in the traditional financial markets cannot be applied in valuing crypto assets. Besides, there is a lack of a precise conventional method for valuing crypto assets. Some of the challenges of valuing crypto assets include: SolidProof Cryptocurrencies and blockchain networks that they are built on are not companies.

Crypto assets are a medium of exchange independent of any bank or central authority. Without any apparent cash inflows, it becomes complicated to establish the precise value of crypto assets. Lack of financial records makes it hard to establish the precise value of crypto assets. Most cryptocurrencies have been in existence for less than five years and are still developing. Crypto assets are decentralized ; thus, financial records are not kept by any central authority. This makes valuation challenging.

Some factors to consider when valuing crypto assets are: Utility The value of crypto assets is mostly affected by its utility. The higher the utility, the higher the crypto asset attracts much value. For instance, Ether has a high-value thanks to its utility on the Ethereum blockchain used to develop smart contracts.

ETH is needed for anyone of the Ethereum blockchain to execute commands and develop applications. Perceived Value The perceived value of crypto assets also drives the relative value of cryptocurrency. Demand and Supply Demand and supply directly affect the value of crypto assets.

Introduction was a landmark year for crypto assets, such as Bitcoin or Ethereum. Millions of people entered the new market around the world. The extremely high increase was characterized by low correlation with other financial assets. Even though crypto assets are still in an early and immature stage of their existence, many leading investors and thinkers in the crypto space consider them as a new asset class.

Obviously, these extreme price fluctuations do not necessarily reflect the underlying value of a crypto asset. The price is rather driven by hype and even market manipulation. This leads to the question: If the price does not represent the value, what is the fundamental value of a crypto asset? And how could this value be calculated? In the traditional financial world, fun- damental analysis based on financial statements is used to evaluate stocks of a com- pany. Since there are no financial statements for crypto assets new valuation tech- niques need to be developed, that comply with the different features of this emerging asset class.

Objective and approach of the thesis This thesis aims at elaborating fundamental valuation techniques for crypto assets. Since research in this field is still at the very beginning this work intends to provide investors, financial analysts, token issuers, researchers or crypto enthusiasts a frame- work of how to determine the fundamental value of this emerging asset class.

To do so, three main research questions are formulated: 1. How can the fundamental value of crypto assets be determined? Which valuation techniques can be applied to the different token types? What is the fundamental value of the IOTA token? In order to answer the questions, the thesis will progress in the following manner: First, the reader will be introduced to distributed ledger technology DLT and blockchain, which represent the underlying technology of crypto assets.

It will be elaborated to what extent crypto assets can be considered as a new asset class and how crypto assets can be classified into different types. The terminological part will end up with a discussion of the fundamental value of this new asset class. The main body of the thesis consists of two parts, a theoretical conceptual and a practical applicational part. The theoretical part aims to collect and evaluate all current valuation methods for crypto assets. At some points the current models will also be further developed.

This part also discusses limi- tations of each model and elaborates the applicability of each model to the different token types. The conceptual framework is based on a profound literature review. The discussion of the models is also inspired by experts from the crypto space, especially from members of the Block- chain Research Accelerator BRA who assisted this master thesis.

The second part of the main body comprises a case application of one valuation model, namely the Equation of Exchange, to the IOTA token. First, the general purpose, the underlying technology, the history as well as the token design of IOTA will be presented. In the second step the fundamental value will be calculated based on an in-depth Excel analysis which can be found in the appendices Appendix 1. The input parameters are based on forecasts of market research firms, expert opinions from members of the BRA and personal assumptions.

Three different scenarios of market penetration of the IOTA token will be conducted which results in a lower and upper bound of a present fundamental value of the IOTA token. The conceptual part ends up with a discussion of the results and limitations as well as the risks related to the IOTA project.

The conclusion will be summing up the key findings of this thesis by referring to the above research questions. It also comprises a discussion of the limitations as well as a future outlook of the research topic. Terminology and definitions The rise of the crypto ecosystem created a lot of new terminologies that are very often not clearly defined in literature. Nearly everyone has already heard of terms such as blockchain or Bitcoin, but only a few people are able to explain them and their underly- ing technology in a simple and comprehensible way.

This section explains briefly the basic terms that are relevant for this thesis and the general understanding of the topic. By reading it the reader should be able to grasp the meaning of terms such as distributed ledger technology, block- chain, crypto assets and the fundamental value.

The World Bank defines distributed ledger technology, short DLT, as a new and fast- evolving approach to record and share data across multiple ledgers, which each have the exact same data records. You can think of DLT as just a distributed database that eliminates the control over the ledgers by one central entity World Bank, , p. There exists, at any point in time, only one version of the ledger and each network participant owns a full and up-to-date copy of the entire ledger World Bank, , p.

The following graph Figure 2 illustrates the general functioning of DLT compared to centralized ledgers: Abbildung in dieser Leseprobe nicht enthalten Figure 2: Illustration of centralized ledger left and distributed ledger right Source: World Bank, , p. In the distributed ledger each node in a P2P network owns a full and up-to-date copy of the entire ledger. Every proposed local addition to the ledger by a network participant is communicated across the network to all nodes.

Nodes col- lectively validate the addition through a cryptographic consensus mechanism. After val- idation is confirmed, the new addition is added to all ledgers to ensure data consistency across the entire network World Bank, , p.

DLT shows significant advantages over centralized ledger systems. As already men- tioned it removes the need for an intermediary or central authority. This can translate into lower costs, better scalability and faster time to market. Since all members have a full copy of the distributed ledger, DLT also provide greater transparency, immutability and easier auditability than traditional systems. These digital contracts are automatically executed once certain conditions are satisfied, for example invoices that are paid automatically once a shipment arrives.

Furthermore, DLT is considered as more resilient against cyber- attacks because of its distributed nature World Bank, , p. It should also be emphasized that DLT is not one single, well-defined technology. In- stead, every DLT that exists differs in its design and functionality depending on its pur- pose. Blockchain is the first and by far the most common type of DLT. The first application of DLT, more specifically blockchain, was the cryptocurrency Bitcoin.

The Bitcoin blockchain was designed with the specific intention of creating a digital currency that is free from central control and anonymizes the identities of its network participant World Bank, , p. Due to limitations of the Bitcoin protocol, such as limited scalability and high transaction fees, a bunch of other DLT networks such as Ethereum, Ripple or IOTA were developed in the last years.

Even though DLT has been closely linked to digital currencies, various other DLT and blockchain applications exist or are under development. There is a particularly strong interest in DLT in the financial sector: at the time of publication, at least half of the top 30 banks are engaging in blockchain proofs of concepts. DLT could disrupt the way stocks are issued and traded, and in the long term potentially replace existing trading platforms.

Other typical sectors that are exploring DLT solutions are trade and commerce, agriculture, govern- ance, healthcare and humanitarian aid World Bank, , p. The fundamental questions that need to be answered here are: How can crypto assets be defined? Can they be considered as assets? If so, do they fall under traditional asset classes or do they represent an entirely new asset class?

And finally, what are the different types of crypto assets? Crypto assets are digital assets recorded on a distributed ledger usually blockchain. They derive their name from the cryptographic security mechanisms used within dis- tributed ledgers. Cryptography is used to verify transactions and secure the network without the intervention of a central party EY, Therefore, the terms crypto asset and token are used as interchangeable synonyms in this work. Some authors also dis- tinguish between tokens and coins, stating that a coin is built in its own blockchain protocol e.

Bitcoin or Ethereum and a token is implemented on top of another block- chain protocol, for example all ERC tokens are implemented on the Ethereum block- chain Koenig, , p. However, for the purpose of this thesis this distinction is not necessary, and both terms are used as equivalents of the term crypto asset.

Generally speaking, an asset is defined as something that has a monetary value costs, book value, market value or residual value , and that an entity purchases, owns, bene- fits from or has use of, in generating income. An asset can be physical cash, machin- ery, inventory, land and building… or non-physical patents, account receivables, stocks, bonds, goodwill….

Furthermore, assets are characterized by being convertible into cash BusinessDictionary, n. Since crypto assets clearly fulfil all these definition criteria, they can be considered as assets. The question whether crypto assets represent a new asset class is not that simple. As already outlined, crypto assets have very different financial characteristics compared to other asset classes such as stocks or bonds. They are based on DLT which is not the case for traditional asset classes.

Usually an investor in crypto assets receives tokens that can be sent, received, and earned through the participation in the DLT or blockchain. The price of a token depends on the supply and demand on so called crypto exchanges such as Coinbase, Binance or Bit- finex. This outstanding raise was accompanied by low correlations to other asset classes. The spectrum of crypto investors is quite broad, ranging from tech-savvy teenagers, high-net worth pro- fessionals to even highly sophisticated hedge fonds and institutions.

Especially more and more institutional investments are expected to enter the crypto space Horsley, All these specifications are tempting to consider crypto assets as a completely new asset class. However, from a legal and regulatory perspective they are not treated in a uniform way. While some nations such as China strictly prohibited the trading of crypto assets, others are welcoming them as a legitimate investment.