Cypherpunks in Sportcoats: The Fundamental Value of Cryptocurrencies and Blockchains

Gene Hoffman and Misha Graboi

June 8, 2022

In the not too distant past, a pack of the uninformed chanted “Blockchain not Bitcoin!” This was “proof of no IQ,” as a secure decentralized database, a blockchain, requires an incentive to compensate farmers/miners to validate transactions for third parties. Blockchains need cryptocurrency and cryptocurrencies need blockchain.

Cryptocurrencies do have a value, and they can be valued using traditional economic tools. The model we’ve created takes into account three core elements of blockchain technology: The Trilemma + Security Budget + Real-World application.

The Blockchain Trilemma

A blockchain can be any two of: secure, decentralized, or fast (high transactions per second). Choosing security and decentralization, and eschewing speed, creates a scarce resource – measured either as transactions per second or transactions per year.

Most can agree that some amount of the existing flows of money, equity, debt, and other assets will shift to blockchains. They will do so to get faster final settlement, fewer intermediaries, tighter spreads, and 24-hour cross-market, cross-border trading. The Internet of Markets™ will change the world as profoundly as the introduction of the web and the browser.

Security Budget

Incentive is critical to maintaining a necessary security budget.

What is a security budget, you may ask? It is the amount of money spent to incentivize farmers/miners to continue validating transactions over a period of time - usually expressed in years. If $1 trillion worth of money and assets is moving over a blockchain per year, one might want a 2% security budget of $2 billion dollars. An attacker should face prohibitive costs to effectively 51% attack a blockchain – in this example, it would cost an attacker at least two billion dollars to attempt their first double spend transaction.

Blockchain and cryptocurrency are inextricably, and functionally, linked. It is at the nexus of this limited transaction block space and huge potential for transactions that the market will establish transaction fees, which can be thought of as a critical component of the security budget. Yes, some fees may move to Layer 2 for lower value transactions, but the clearing ability and broad connectivity of a dominant Layer 1 chain should mean there is significant demand for block space there as well.

The Value Of Transactions

We believe you can use traditional financial tools to value a blockchain and its coin based on this market share capture. Some portion of the roughly $1 trillion in fees paid globally each year to just move money (securities trading, debt, other assets, and blockchain-enabled applications such as NFTs only increase this market size assumption) are going to be moving to a handful or less of dominant Layer 1 blockchains. Transaction fees may need to be lower to lure users from the traditional rails, though there are arguments the other way as blockchains enable new types of security and trustlessness.

A high-functioning blockchain must have a solid security budget and that budget requires a robust fee market on Layer 1. That fee market creates fee pressure to move lower value transactions to various Layer 2 solutions like Lightning and ZK-rollups. We posit that, by volume of transactions, 80% to 90% will migrate to Layer 2 over the medium-term. However, we believe that Layer 1 transactions will likely have an aggregate face value of 80% to 90% of the total value being processed each year, as higher value transactions and Layer 2 settlement transactions are routed to the Layer 1 chain.

Real-World Utility

At minimum, a cryptocurrency represents a ‘ticket’ for future access to scarce and highly coveted block space, because transaction fees have to be paid in the chain’s cryptocurrency.

In a mature, well-architected chain, the presence of transaction fees and the fact that coins are the only ‘tickets’ tradable for fiat that allow access to transaction blocks means that there is a connection to a minimum coin value – not to speculation that somehow the blockchain’s coin will be adopted as a quasi-fiat currency, but to actual economic value generated by the demand to secure and transact on chain. In many places, especially in places like the Global South, secure payments and asset transfers that require little or no trust and are available both locally and cross border are a new set of functionality.

Most of the assumptions needed to provide a valuation are familiar to any analyst modeling a business or industry–market size, market share, adoption, pricing, etc. – which give a baseline estimate of the economic value of the blockchain itself. To translate this to a coin price, one additional estimate must be made, and that is the velocity at which coins are paid to block validators in the form of transaction fees. A mature blockchain will likely have alternative uses and incentives for participants to hold that cryptocurrency (e.g. lending, future belief of transaction fee growth, defi options, etc.), and an estimate must be made about this propensity to hold vs. selling coins to transactors for block access. While this introduces a currency-like supply and demand function into the analysis (we tried to find ways to remove this assumption and could not), it is fundamentally linked at its core to the economic value generated via transaction fees. This is because at any given point, a decision must be made by coin holders to sell their “tickets” to transaction block access, or to hold their coins for some other purpose which, presumably, they view has a value at least equal to (if not higher than) a decision to sell today

In this model, the fiat price of transaction fees is fixed, but the number of coins this fee represents is defined by transaction fee velocity1. A chain generating an aggregate of $1bn of transaction fees annually, with a yearly transaction fee velocity of 1, implies an aggregate coin value of $1bn, for example. If the propensity to hold is higher, and velocity lower, coin value will increase, as the amount paid in fiat for transaction block access will represent a smaller proportion of overall coins (and vice-versa if velocity is higher). Over time, as chain applications proliferate, we would expect the propensity to hold to generally increase and velocity to decrease. A small additional step, dividing this aggregate coin price by the number of coins in circulation at a given point in time (often defined by the protocol, though estimates of burned coins, coins off the market, or other permanent coin losses may need to be factored in), will give the price of a single coin.

Towards a Model

Those who say cryptocurrency or Bitcoin have no value are wrong. They have at least the value of their utility to be used in future blocks to securely transfer money and assets, and to keep assets safe by not being transferred in the first place. Blockchains likely create and capture more value than just transfers, as an NFT is economically more valuable than simply its ability to be transacted. DeFi solutions like Chia Offers create trading opportunities that could not exist with previous financial technology. Storing value is a legitimate use case for those who want certainty around inflation and issuance of monies. Indeed, as with many emerging technologies, there are likely to be economically valuable uses of blockchains that have not even been thought of yet.

With this insight and valuation model on how to value a blockchain based on transaction demand and coin velocity, one can reasonably arrive at a valuation of a coin in a mature chain. Applying something like a required rate of return of 50% annually, one can work backwards to today’s coin price simply driven by market share capture of a blockchain, one’s best guess of how much volume moves to Layer 2, and one’s estimate of annual coin velocity. By way of example, ETH transaction fee velocity over the past 12 months has been a little above 2.5% (per Messari data).

In our version of this model we used the following assumptions to value the XCH:

  • In 10 years a gross payments fee market of approximately $900bn (data extracted from a McKinsey study2) worldwide, this excludes other potential mature chain transaction demand like NFT and securities trading and focuses only on the payments market
  • Blockchains get about 30% of this market in 10 years
  • Fees fall by about 30% as blockchains are adopted
  • Due to network effects, there will be significant concentration in winning Layer 1 chains, each of 4 winning chains takes 25% of the blockchain market share
  • Approximately 20% of a chain’s fees will be on Layer 1, with the vast majority (80%) migrating to layer 2 solutions–however, transactions on Layer 1 will tend to be quite large in fiat terms
  • At 30 TPS, this implies approximately $10 per transaction for large size transactions, which is quite reasonable relative to many other payment systems and compares well with the market fees historically seen in Bitcoin and Ethereum
  • Transaction Block Velocity is approximately 2.5%, which is what was seen in Ethereum over the last 12 months. This may prove to be high in a mature chain with many uses.
  • We believe a relatively conservative required rate of return for an early-stage (but deployed and operating) block chain project is about 50% per annum to compensate investors for risk around future assumptions

Per our emission schedule, there will be about 39.5mn Chia coins outstanding in 10 years. This implies an aggregate price of Chia in 10 years of about $380bn, or a per-coin price of about $9,700. Discounting this back at our assumed blockchain required rate of return for 10 years, which reflects both industry and Chia-specific risks, yields a value today of about $168 per coin.

As Niels Bohr (and not Yogi Berra) said, “prediction is difficult, especially if it’s about the future.” We think our assumptions are reasonable, and conservative, and our capital cost estimate captures our risk. However, reasonable minds may differ, so we invite you to try this model out with your own estimates.

  1. Note in this case, transaction fee velocity only means the speed at which coins are paid to block validators as transaction fees, defined as total transaction fees paid in coins per time period / average coins outstanding during that time period. Trading among holders is not relevant to the analysis. 

  2. Derived by removing interest revenue from the $2tn in payments fees annually, per the McKinsey 2021 Payments Report