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.
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.
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
