Pricing a CryptoCurrency

pricing a cryptocurrency

Cryptocurrencies have been getting a lot of attention lately. With increasing capitalizations of the major currencies in circulation now (like Bitcoin, Ether, Litecoin etc.), investors are increasingly looking at making these currencies a part of their portfolios. Since retail investors can also invest in these currencies without restriction, understanding how these currencies are valued becomes crucial.
The value/price of a currency is based on the demand for the currency, the supply of the currency and risks associated with the currency.

Demand of the Currency

A cryptocurrency is generally a token which is issued around an operation which happens in the background. The demand for the currency is essentially the value which can be generated through the operation backing it up.

To arrive at this value, we need to start by identifying the major use cases of the currency. The next step is to quantify these use cases with regards to the value for customers they can potentially generate. Taking an example of the Bitcoin, one major use case was that Bitcoins can be used to transfer money abroad at a significantly lower cost and time. To calculate the value of this use case, we can estimate the total amount of money which gets transferred internationally around the world. We can then add a haircut on it to take into account that some countries do not allow Bitcoins and also that only some customers might migrate to this solution. This final value will constitute the demand for the Bitcoin for this use case.

Values for all major uses cases of a currency are calculated and added to arrive at a final value of demand for the currency. A small premium might be given to a generic coin like the Bitcoin which may have a large number of other not-as-big use cases.


pricing bitcoin


Supply of the Currency

Most cryptocurrencies tend to have a limit on their lifetime supply. For example, the Bitcoin has a limited supply quantity of 21 million coins.

The Risk Factor

Now that we have calculated the present demand and potential supply of the currency, we need to assess the risks in the future. Some major risks may include the following:

Regulatory Risk: Currencies like the Bitcoin which target a big and systemically important use case like international money transfers have significant regulatory risk attached to them. Different countries will have different regulations to deal with such coins. These regulations will determine how much of the potential value of the currency can be realized.

Utility Risk: A cryptocurrency is as valuable as the utility of the operation behind it. Use cases which are not sustainable and have a high risk of substitution add utility risk to the cryptocurrency’s value.

Platform Risk: The Blockchain is an evolving technology. Different Blockchains face different challenges and these might affect a currency built on it to achieve its potential value. For example, the Bitcoin Blockchain is facing problems of scalability and security. Hard forks (major changes) are being suggested to counter these problems. This has caused the Bitcoin community to divide and is causing problems in the Blockchain.

Security Risk: Blockchains face security risks both from outside and the inside. Hackers & interested parties may try to attack and alter the working of the Blockchain. Also within a Blockchain, some stakeholders like miners might try to collude and gain control of the Blockchain for their own benefit. The Bitcoin Blockchain has been facing a security issues. Some Bitcoin exchanges got hacked. Also there is a risk of miners colluding as a majority of miners are centralized in China.

Execution Risk: A coin may have a good plan backing it. But can the plan be executed? This is particularly important in the case of Initial Coin Offerings, when most coins raise funding with a prototype or just a whitepaper about them. The team behind the coin issue plays a big role in the assessment of execution risks.

These risks need to be included in the price of a cryptocurrency. A discount factor can be applied to the fundamental value of the currency to account for these risks.

To summarise, the price of a cryptocurrency is the following:

Price of Cryptocurrency = (Demand of Currency / Supply of Currency)*Risk Factor

13 comments:

  1. Good article, so what's the answer? Whats its relative value, is it overbought?

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    Replies
    1. It depends on the currency and the use cases of the blockchain application behind the same...

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  2. Good analysis, Manish. Do you have quantifiable figures to price the coin? We already have the supply figure. Perhaps transactions volume can be used as demand (http://www.marketwatch.com/story/is-bitcoin-in-a-bubble-this-metric-suggests-theres-more-room-to-grow-2017-06-08) and standard deviation be used as risk. Perhaps an econometrics model (multiple regression) can be utilized to price the coin using the variables mentioned above. But how to put everything together into the pricing model is another story.

    A.S.

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    Replies
    1. Using a regression is interesting though it would be more of a technical analysis of the Bitcoin price. We know the capped supply of Bitcoins. Also we know the main uses cases of the bitcoin (i.e. international transfers, alternate investment). We need to quantify the value of these use cases and simply divide it by the supply to arrive at a "fundamental value" for the Bitcoin.

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  3. Please let me know if you want to develop this deeper and if you need any assistance that I might be able to help. I have graduate degree in both Economics (MA) and Finance (MBA) and experience in data management and quantitative/financial/simulation modeling.

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    Replies
    1. Sure, connect with me on Linkedin and we could chat about what we can do https://www.linkedin.com/in/mhada

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  4. Alright, i read the article, overall is an article that hasn't answered the question with your title "Pricing Cryptocurrency", If you're going to use that title, then the reader would expect to find the answer in your writing and findings, that wasn't the case here.

    In order to qualify for such answer, anyone needs to understand demand and supply first, also some business experience in the past, not necessarily successful venture, since failure is a very good teacher, is needed.

    I personally think, you never ran any business in the past, or held any managerial positions in any company, your assessment was based from a consumer standpoint and was more of an excerpt of multiple news glued together without a real order to it, or a descending order to current events in the world of virtual currency.

    In order to achieve a complete analysis and evaluate value or the need for virtual currency, you would have had to enter this world at least around the 3rd year since the birth of Bitcoin and by that i mean, owning it, trading it, purchasing it, selling it, buying things with it and eventually lose some of it to scams that were born because of it.

    In order to achieve that knowledge and qualify as an analyst, one needs to study its past and present, having a blog and a computer is not sufficient, but a mere attempt to get some feed back, and that,.. you got from me.

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    Replies
    1. Thank you for the feedback. You make some interesting comments. Yes, I do agree that to value something, you need to understand it thoroughly. What I have written is a broad framework of how analysis needs to be done. Besides, investing into something and then figuring out its value is not advisable in my view. However, I do want to thank you for taking time out and writing some interesting feedback for the post!

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  5. Hi Manish,

    Well done.

    This is a good article that provides a framework for further analysis.

    Can you provide more details on the statement, "The Bitcoin Blockchain has been facing a security issues". My understanding is that the Bitcoin blockchain itself is hacker proof, but it's the online storage of bitcoin private keys that's a security risk.

    Thanks.

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    Replies
    1. That is correct. Storage of private keys poses the biggest security threat.

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  6. Good article thanks for sharing this interesting article it may be useful.

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  8. Some truly interesting info, well written and loosely user genial.

    ReplyDelete

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