Invest Like the Best with Patrick O'Shaughnessy - Chris Burniske - How to Value a Cryptoasset - [Invest Like the Best, EP.62]

Starting point is 00:00:00 This episode of Invest Like the Best is brought to you by Paxos. I have personally interviewed Paxos's CEO, Chad Kaskarilla, on this podcast before, and I'm excited about how they're changing the crypto landscape. Whether you're a small fintech or a large financial institution, with Paxos crypto brokerage, you can offer your customers crypto buying, selling, transferring, and more, all with Paxos's easy to integrate APIs. Paxos takes care of everything in the back end from licensing and compliance to custody and exchange. You can start offering crypto to your customers within months. I've gotten a no Paxos over the years and have been personally impressed with their track record.

Starting point is 00:00:36 With clients that include PayPal, Venmo, Revolute, and Bank of America, they're the most trusted infrastructure provider for crypto and blockchain. I'm excited that more fintechs and banks are starting to offer crypto features, and Paxos crypto brokerage is the best way to get to market quickly and safely. To learn more, visit Paxos.com forward slash Patrick. That's Paxos.com forward slash. Patrick. Hello and welcome, everyone.

Starting point is 00:01:04 I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaunicey is a principal and portfolio manager at O'Shaunicee Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment

Starting point is 00:01:38 decisions. Clients of Ashonasi asset management may maintain positions in the securities discussed in this podcast. This episode is a continuation of the Hash Power series. It is the first of what we will call a Hash Power single, a series of conversations each with a single guest on a specific topic. In this case, my guest is Chris Berninski. The topic is crypto asset valuation. This conversation is loaded with information. I think you're going to love it. Like the Hash Power documentary, This episode and other hash power singles are brought to you by Fidelity Investments, a company that is constantly researching and experimenting with emerging technologies like crypto assets and blockchain to improve the lives of their customers. Fidelity provides a comprehensive set of products and services to individual investors, employers, and financial advisory firms. For more information, please visit Fidelity.com.

Starting point is 00:02:35 Before we get to Chris, a quick story. This morning, I spoke with a friend who sends part of his paycheck to his family in China. He used to do it this way. He'd send U.S. dollars from his bank to his father's bank for a fee of $40 on the U.S. side and more fees on the Chinese bank side. This process would take two to three business days at best, but often took longer because of random issues which my friend would then have to spend time sorting out as a middleman because the banks wouldn't communicate directly with one another. Then his father, who can't spend U.S. dollars in China, would have to physically walk to a bank and exchange the dollars for local currency, a process that would take three to four hours and incur another set of fees via an imperfect exchange rate, which eats some money. of the value. So at best, two days, a little bit of hassle later, my friend's family has the money. Now he does it differently. He takes U.S. dollars, buys Bitcoin or ether on an exchange like

Starting point is 00:03:23 GDax or Gemini, and sends the cryptocurrency to China. A few months ago, he could have sent it directly to his father, who could have then sold the Bitcoin on an exchange for local currency, but China shut down the exchanges. Well, my friend and God knows how many others quickly figured out a way around that. My friend is part of a large WeChat group of 500 people, which is the maximum number of people allowed in a chat group. We chat is similar to WhatsApp. The group is a way of trading cryptocurrency's OTC or over-the-counter off the exchanges. My friend posts the price at which he's willing to sell his Bitcoin for local currency and lots of others do as well, so there's an order book. He finds a price usually very close to the current Bitcoin price plus or minus half a percent,

Starting point is 00:04:03 at which a counterparty, who he usually doesn't know, is willing to buy his Bitcoin or Ether, and then they transact via a group leader. The group leader serves as a sort of trusted exchange party, almost like an escrow account, who takes a 0.1% cut of every transaction from both sides. It is in the group leader's interest to always act honestly, or he'd lose his little business. Next, the local Bitcoin buyer in China sends his local currency to my friend's father's AliPay account, which is Alibaba's version of Venmo, or his bank account, both of which settle instantly. The group leader delivers the Bitcoin to the buyer, and the process is done. This all takes about 30 minutes.

Starting point is 00:04:38 This process hasn't failed, even though China has shut down a key part of the original system. system, the exchanges. Even without the exchanges, an alternative sprung into existence quickly. Faster, easier, less hassle than the old way of doing it. I don't mean to read too much into this story, but the specific details and speed fascinate me. Here's a very simple action, send money to one's family member that creates a massive headache and takes forever under the old paradigm. Bitcoin or Ether, coupled with some ingenious use of other free technologies, fixes the problem and fixes it quickly. When Bitcoin launched, could we have envisioned this specific scenario? I think not. Now back to our guest, Chris recently published a book called

Starting point is 00:05:17 Crypto Assets, which is a must read for those interested in this field. Chris was at one point the only traditional buy-side analysts covering Bitcoin and is now a partner at a new crypto firm called Placeholder. Chris has developed new frameworks for evaluating and valuing cryptocurrencies, marrying techniques and ways of thinking from several different asset classes to assess this newest asset class. Chris prefers the term crypto assets because as you'll hear, several of these tokens aren't really currencies at all. We discussed the differences between cryptocurrencies, crypto commodities, and crypto tokens. We begin our conversation with a deep dive into the equation of exchange, which Chris has been using as a starting point for understanding utility value

Starting point is 00:05:55 of crypto assets. You can see all crypto-related conversations at investorfieldguide.com forward slash hash power. Now, please enjoy this great conversation with Chris Berninski. So Chris, this is going to be our deepest dive into nascent strategies. for actually valuing individual crypto assets. You've got a brand new book that's sitting in front of us that's out, I think literally today. I've read a ton of what you've written on the topic. And I think you are at one point we're the only kind of traditional byside analyst that was covering these things, trying to deal with them as you would deal with an equity.

Starting point is 00:06:41 So we'll start by your kind of overall method for evaluating cryptocurrencies. and then dive into what you think may be some of the ways that Wall Street, the broader world, will collectively decide our appropriate ways to think about underlying utility value of these things. Great. Thanks, Patrick. You know, since these are new assets, or we're dealing with a new asset class, we have to create new valuation methodologies. And the starting point within the equity space is discounted cash flow models. And the problem with protocols is they don't have business models. They don't have cash flows. They have incentive models that catalyze a community to pull together and provision a decentralized digital good or service. And so evaluating how the native asset that

Starting point is 00:07:35 incentivizes that economy to work is very different from a DCF. That said, it can all be boil down to a similar mindset in terms of going year by year and what are what are the demands for this asset and what is the economy that it supports look like now the native or the cornerstone model within the valuation is the equation of exchange so mv equals pq and we can get into let's get into detail okay so within classical monetarism mv equals pq is used to look at the money flow of a fiat currency within an economy. And so M refers to the size of the monetary base. And so with the U.S. dollar right now, it's around $4 trillion. V is the velocity. So how many times a dollar or a yen or a euro or whatever it may be turns over within a year? Right now, the U.S. dollar is in this

Starting point is 00:08:29 five to six range. P refers to the average price of basket of goods and Q to the quantity of that basket of goods. And so together, again, we have MV equals PQ. On the PQ side where we just ended, that multiplying together of the average price of baskets by the number of these baskets yields the economy of a nation. And on the MV side, you have the size of the monetary base of $4 trillion times of velocity of roughly $5, yields a value of $20 trillion, which is about what the U.S. GDP is. So, you know, that's how we set these things up. The question then becomes, okay, how does that make any sense within crypto assets? And this is where, as I said at the start, you can look at crypto assets and the protocols within which they operate as these mini economies, many economies that provision a good or two.

Starting point is 00:09:26 And so in the case of something like Filecoin, that is provisioning cloud storage. That is the good of that network. And so I can set up a very similar model to a DCF but using MV equals PQ. So I start off with my price per gigabyte, so dollar per gigabyte. I have to have a cost decline curve for that, which I base on historical cost decline curves of cloud storage or hard disk drives, whatever it may be. So that gives me my dollar per gigabyte in 2018, 2019, so on and so forth. I then have to figure out the quantity.

Starting point is 00:10:00 and that requires assessing the total addressable market of cloud storage. There's a lot of assumptions that go into that, but again, pulling together the information that's out there. And then the tricky part there is actually creating an S-curve based on the time the network launches, the time it'll hit 10% of its total penetration, and then the takeover time, which is basically the inflection of the S-curve from 10% to 90%. Because it's an adoption curve.

Starting point is 00:10:27 An adoption curve, exactly. And that adoption curve will tell me, you know, if I expect Filecoin to have this percent penetration, how many gigabytes will it have to be provisioning? And so at that point, in any given year, I can multiply the dollar per gigabyte in that year by the number of gigabytes provisioned to get a dollar value. And that is the economy of Filecoin in that year. That is the GDP of Filecoin. Now, I'm taking this equation, mv equals pq, if I want to solve for the size of the monetary base, M equals pq over V. So I have to take that economy and divide it by a velocity. And this is where things are going to start to get murkier, because we don't have a good basis or enough data to say, well, velocity of five makes sense or velocity of 10 or 20 or 100 makes sense. We have hypotheses about it, and we can base it on some of what we've seen with Bitcoin.

Starting point is 00:11:23 but stuff is to say it's a big assumption. And if we have an economy, say, a file coin that's turning over $100 billion a year, if that thing has a velocity of five, that means file coin itself needs to store $100 billion divided by $5 or $20 billion in that year in order to function within or allow that economy to function. So after all of that, we have gotten to the size of the necessary monetary base. And I divide the size of that monetary base by the number of tokens in the float to get the current utility value of a token in any given year. Now, that brings me to another part of this model, which is looking at, well, how many tokens are in the float. And that is a function of the total amount that has been issued at that point in time. But I need to subtract out

Starting point is 00:12:19 from what has been issued the percent that are purely being held at the store value because those have a velocity of zero and aren't available to this economy. And I also need to subtract out the percent that are being bonded by the node supporting the network. And not every network has that feature, but some do. Can you describe bonding in a little bit of detail? So bonding is going to have different manifestations depending on the network. But if you take something like proof of stake, which Ethereum may move from proof of work to proof of stake in Q1 of 2018. proof of stake requires you as a participant within the consensus process of Ethereum to bond a certain number.

Starting point is 00:12:57 And I think the last I heard it was going to be a thousand ether, which is a significant amount of money at today's prices, $300,000. And to bond that to be part of the consensus process. And then you're actually the assets that you have bonded proportional to the assets that the entire group of people participating in the consensus process, that dictates how frequently you basically are able to participate in the consensus process and earn a reward. Similar to how mining works. And so it's basically the idea with bonding is you get people to lock up a certain amount of their asset so that if they behave poorly, you slash that deposit.

Starting point is 00:13:38 And hence, you have an incentive to not be a bad actor, as opposed to Bitcoin, which is kind of saying, we assume you're bad actors all the time and we're going to continually punish you by making you exert work. And just really quickly, the motivation behind this, touch on how proof of work has become maybe less and less efficient in terms of the amount of just raw energy required to run proof of work in the network as the consensus mechanism and why kind of proof of stake, this bonding mechanism might represent a more efficient, or if it does represent a more efficient way of reaching consensus. Sure.

Starting point is 00:14:12 So to reiterate what I said at the end, from a broad perspective, with proof of work. The assumption there is everyone is a bad actor. And so I am going to force them to continually expend energy to participate in the consensus process. And the reason people think of it as inefficient is as the price of Bitcoin rises, there is actually a greater and greater incentive to participate in the proof of work process or to be one of those machines. And because of that, more and more and more people are becoming part of that proof of work process, which makes it more and more competitive, which means more and more electricity is being burned. And so actually, the individual machines themselves have become massively more efficient as we went from

Starting point is 00:15:02 CPU to GPU, small period with FPGAs, and then ASICs. But it's just the scale of Bitcoin's mining network has become massive. That is very different from the way in which a lot of these proof of stake systems will operate where I've heard someone call it virtual mining before, where you're not actually burning electricity to be part of the consensus process. You are staking your assets to say, hey, I'm a good actor, and I am putting down this deposit. And if I turn out to be a bad actor, then you can slash my deposit. And so it becomes a much more virtual consensus process, as opposed to this very hardcore expenditure of energy and expenses to support the network. That's really helpful kind of side train of thought.

Starting point is 00:15:48 So let's circle then back to why this is important, why the amount that's being bonded and also the amount that's just being held without transactions should be taken out of the float, back to the equation. Sure. So, for example, let's say 100 million tokens have been issued in total, but 60% of those are being held as a store value, which we believe given, some of the analysis I did with Coinbase is roughly accurate. It could be higher, but 60%. 60%. So 60 million in this hypothetical scenario is pulled out of the float. And then let's say 20% is bonded to be

Starting point is 00:16:23 part of this consensus process. That means only 20 million tokens are on the float. And all assets are priced at the margin and priced based on future utility. And so when this calculation of the current utility value of an asset really sets aside what is just held with the velocity of zero and says, you know, that is not continually being priced. That is basically just being held. What is being priced at the intersection of supply and demand at the bid and the ask is if you have a certain number of assets in the float that can incentivize or lubricate this economy within the MV equals PQ calculation, only those assets should be taken into consideration. So if I have, from the prior example, let's say 20 billion, or, yeah, is 20 billion in the monetary base that needs to be

Starting point is 00:17:14 stored, I would divide that 20 billion by the 20 million tokens that are in the float to get the current utility value of one of those tokens in that given year. Now, I have to do that with the way I've set it up into the future. And so then I can look at the current utility value of a token in 2025 and I can discount that back to the present at whatever discount rate I want to use. A very high one. A very high one, 30, 40, 50 percent to get, okay, this is a rational market price in 2017 based on the future utility value in 2025. That rational market price in 2017 hopefully has a certain percentage that is current utility

Starting point is 00:17:57 value, right, based on this whole calculation we've gone through. and then the premium above that, you could call it speculative value, but I can make the same argument for how stocks are priced and we don't call those speculative values. It's really just the expected utility value over current utility value. So let's use Bitcoin and maybe the fairly simple example of remittances as potentially the PQ side of this to really put some meat around this idea. And maybe we'll even do a few of these because I think it's complicated. And there are a lot of assumptions that go into this and changing velocity from four to seven makes obviously a huge difference in the outcome of the model. So let's use Bitcoin example and maybe walk through how you think about that entire equation for this hypothetical. Perfect.

Starting point is 00:18:41 So current remittances market, just to make the math easy, roughly $500 billion. It's a bit north of that. But roughly $500 billion, if we make an assumption using this adoption curve in a future state, Bitcoin is going to be facilitating 10% of that market. That means Bitcoin will be facilitating $50 billion of transactional volume in order to facilitate the remittances market. So that's the GDP in that case of Bitcoin for that one service that's providing. I then, so the monetary base necessary equals PQ divided by V, if I have an assumption about velocity of, say, five. That $50 billion economy divided by a velocity of five means Bitcoin needs to store $10 billion in order to allow that. Now, if it has

Starting point is 00:19:30 the velocity of 10 for that use case, it only needs to store $5 billion because basically you're getting twice as much value-carrying utility as you were with the velocity of five. And that's where, you know, we start to go down this rabbit hole of, well, how high could the velocity of these assets go? So let's talk about velocity. So maybe start with, I think you mentioned it earlier, but maybe start with like a recent history over the last 10 to 15 years of the velocity of the U.S. dollar money supply, and then talk about how you think about your assumption for that number for different crypto assets going forward. So I don't have the graph in front of me of velocity. I typically use the St. Louis Fed, but I know right before the 08-09 crisis,

Starting point is 00:20:15 we're around 10. And then we massively increase the size of the monetary base while the economy stayed roughly flat, and so velocity has been cut in half. And so I think right now velocity is for the US dollars around five. Now, when we look at Bitcoin historically, that aggregate velocity has been in this five to six range. And so, for example, to do that math, you know, right now Bitcoin is flirting with roughly a billion dollars a day in transactional volume. So that's not, that doesn't take into account exchange traded volume. That's just on-chain transaction volume within Bitcoin. economy. So a billion dollars daily, if Bitcoin were to do that every day for a year, that's

Starting point is 00:20:56 360 billion roughly in that year. And then, you know, Bitcoin right now is around 90 billion in network value, but you end up taking a weighted average for the whole year. And so let's say that weighted average actually turns out to be 60 billion because Bitcoin's inflected towards the late part of 2017. So that 360 billion in GDP divided by a, monetary base of 60 billion yields an aggregate velocity of Bitcoin of six. Now, that aggregate velocity is composed of smaller instances in which Bitcoin is used. So, for example, going back to this idea, 60% of Bitcoin is held just as a store of value, that has a velocity of zero. So 60% times 0 plus 40% times some mystery velocity needs to equal 6. And so doing the math, it ends up being

Starting point is 00:21:52 that means of exchange velocity would need to be 15. And that means of exchange velocity would need to be even higher if more assets are being held just as a store of value. So if we were to take it to 80% are being held as a store of value, then 20% times mystery velocity needs to equal 6. And so this is this is where we start to see the means of exchange velocities of these assets could be much higher than the aggregate velocity. So this is this this this all makes me think that the term cryptocurrency may actually be appropriate, right? With Bitcoin specifically, if the, if it's the equation of exchange and we're talking about a monetary base, effectively solving for the value of a monetary base to get like a utility value or an intrinsic value, however you

Starting point is 00:22:37 want to think about it, of something like Bitcoin. But maybe talk a little bit about your book's called Crypto Assets, not Cryptocurrencies. So talk about your impression of the different ways of categorizing these things. Are some currencies, are some commodities? Are they all just something completely different and new? How do you think about categorizing the different types? That's a really good question. And we specifically called the book Crypto Assets and not Cryptocurrencies for a reason. So, you know, right now the taxonomy that we're running with, which I have no doubt will change, given how early we are in this industry. The taxonomy is that crypto assets are composed of three verticals. So there's cryptocurrencies, crypto commodities, and crypto tokens. And the cryptocurrencies are

Starting point is 00:23:22 what people most commonly associate or confuse with the term crypto assets. And those are Bitcoin, Monero, Zcash, dash, light coin, ripple. And the definition of a currency is that it served as a universal means of exchange, store value, and unit of account. And so these cryptocurrencies, you know, that is their use case. And that actually starts to get a bit more abstract within the MV equals PQ calculation because of the pricing actually of the good. What is, like I struggle and other people struggle with this idea of, well, there's not really an explicit pricing of what it costs to send a remittance. And that's why you may have noticed when we're talking about the remittance example. I actually just kind of lump things into PQ. But so that's cryptocurrencies.

Starting point is 00:24:11 What is actually easier to grok for most people I've been finding are the crypto commodities. And so when I say crypto commodity, that is basically referring to this idea that in our physical world, we have physical commodities. So oil, wheat, natural gas, so on and so forth. And they power our physical world. But we increasingly live in a digital world. And so, this idea that we have digital commodities, compute power, storage, bandwidth, transcoding, re-encryption, all these different things, there's actually a price for that. It's hidden within the vertically integrated structures of the tech incumbents that we use today, but there is a price for that. And so what we see happening with crypto commodities, Ethereum being the most well-known one,

Starting point is 00:24:59 which provides access to this decentralized world computer, is this massive proliferation. of the disaggregation of our tech stacks and actually creating markets to price these crypto commodities on a 24-7 global basis, which could drive a lot of efficiencies. And then the third vertical, the crypto tokens, running with this analogy of, you know, in our physical world, we have physical currencies

Starting point is 00:25:25 and physical commodities that come together and form an economy, which produces finished goods and services, which the end user interfaces with, Cryptotokens are the end user-facing products. They are the things like Steam or Auger or Swarm City or whatever it may be that is pulling from a lot of this underlying cryptocurrency and crypto commodity infrastructure, much of which still needs to be built to provision this finished gooder service.

Starting point is 00:25:53 Could you describe Auger as one example, just to get a little deeper into a crypto token? Sure. So Auger is a prediction market. And basically what a prediction market allows you to do, is to put up something that you would like to bet on. And someone else can take the other side of that. Now, Auger and another similar crypto token nosus are setting this up so that it's an unstoppable form of this market. It's censorship resistant.

Starting point is 00:26:20 So you can end up wagering on anything, which certainly that can become very dark very quickly. But there are other more interesting things that we can wager on that, again, could drive efficiencies. I think that in the case of auger and nosis, this is something where because it is so consumer-facing, it needs to be very easy to use. And so with a lot of these crypto tokens, you're going to, I think, see them crossing a consumer adoption chasm before they get real utility value versus some of the cryptocurrencies and crypto commodities. I want to talk about this idea of censorship resistance.

Starting point is 00:26:56 Another way that this has been put in prior episodes where I've talked about cryptocurrencies is permissioned versus permissionless networks, that effectively the World Wide Web was permissionless. Anyone can, you know, start a website. You don't need to get some approval to do it. And I think that's another way of saying censorship resistant, meaning you can kind of do what you want on top of the network. How do you think about, and this could even come back to the investing side of something? You said this could get dark really quickly.

Starting point is 00:27:25 Like, let's say someone starts betting on someone's assassinated, the odds of someone's going to get assassinated or something, you know, horrible like that. How do you think about how that might affect the movement or the support of these things? Like that could happen, right? And after that, my guess is there would be a huge outcry to somehow shut this thing down. So to talk about the kind of pros and cons of this idea of censorship resistance. Censorship resistance. Well, on one hand, censorship resistance could lead to total chaos.

Starting point is 00:27:56 That's sort of where you were going with that example. On the other hand, you have more the libertarian side of things where we will self-organize, we will self-actuate and self-police ourselves. I think the reality actually falls in between. You know, a lot of these protocols, the vast majority of these protocols are being built by really well-intentioned, brilliant people that are working to decentralize the world's data, wealth, and power. and there are social protocols baked into the software that dictate the way in which people interface within it. And so myself, maybe being an optimist, my hope and also as an investor in the space, things I look for would be things that work towards enabling a censorship resistance that can be self-policed, I guess. And you look at, for example, the Bitcoin community,

Starting point is 00:28:49 super focused on censorship resistance, but within themselves, constantly policing each other all the time. People getting kicked out of the community, all kinds of political strife, really. And so my feeling with these systems is that if they're not serving for the good of humanity, then the masses will kind of come down on the protocol. And maybe it should be wiped out. It all depends on what that protocol is doing. So we've got one equation and a variable in that equation that we could solve for that could give us with all of the adjustments we talked about, sort of what the price should be today.

Starting point is 00:29:24 This would be the same as an equity analyst, building a discounted cash flow model, comparing what they think the intrinsic value of the business is to the market's current price. Whatever that gap is, is the opportunity, long or short. So talk about that gap specifically as you're seeing it today. So I don't know how many of these kind of independent valuations that you've done. but what's the what's the dispersion or the standard deviation of the if you've got like a stack chart or something where I don't know 10% of its utility 90% speculation I'm making that number up how different is that pie chart for cryptocurrencies today and kind of roughly how much

Starting point is 00:30:03 is in your estimation utility or discounted utility value versus just total speculation so right now, a lot of these assets, the majority, are composed of more expectation than current utility value. And you can think of it as very similar to, you know, when a newly issued stock hits the market and trades at a pricey PE or pricey price to sales. I mean, and look at Amazon. It continues to trade, I think, above 200 times earnings. And this is what makes a market, as people disagreeing about these different ratios and how something should be price. based on future expectations. To your question about, you know, the standard deviation or how are all these things shaping up,

Starting point is 00:30:47 I haven't gone through and valued every single asset. It's actually not what I have to do as a venture capitalist. I just have to make sure that the assets that I am choosing to invest in have some reasonable basis of what I have to believe for this to turn out to be a good investment in 10 years. So I'm actually always boiling these things down to the physical reality of how many machines have to be connected to the network or how many users? And is it 100 trillion or is it one million? Because you know, there's a big difference there. That said, I fully expect this to happen, this idea of a lot more sell-side research, a lot more by-side analysts covering these assets. Something I've been

Starting point is 00:31:27 heartened to see is since I open-source the general framework, I've started to see other teams, the actual crypto-acet teams, use the framework, create their own inputs and include it as part of their SAF or sale documents to explicitly show people what their assumptions are and why they're pricing this asset. And so my goal is, you know, as a community, we can find some way to create, you know, say for the top 100 crypto assets, these models that rise to the top based on what people feel are the most reasonable assumptions. That's a good way to transition into other emerging ways of valuing these things. One of the things I kind of wondered aloud at the end of hash power was what will be like the price to earnings ratio or the price to sales.

Starting point is 00:32:09 ratio of these things. So is there anything like that that's being proposed or people are talking about what are some of the other emerging ways of valuing these things like a common ratio, like a PE ratio? So full credit goes to Willy Wu, who I always give credit to for this because he is the first person who tweeted out the idea because everything in crypto happens on Twitter, right? But it's this idea, what's called an NVT ratio. So network value to transaction volume ratio. And what that ratio is, is you take the any given day's network value, which is synonymous with market cap, but I use network value because these aren't companies, these are networks. So you take any given day's network value and you divide it by that day's transaction volume. And so if you take

Starting point is 00:32:59 something like Bitcoin, right now, network value roughly at 90 billion, daily transaction volume at 1 billion, 90 divided by 1 yields a ratio of 90. Historically, with Bitcoin, we've seen that it likes to base at around 50. And then everyone's still trying to work out what exactly happens in times when the market really heats up and speculation goes to the roof. There are a few interesting things that happen. There's certainly a period after the bubble burst where this ratio goes really high because the price of the asset is still relatively inflated, but everyone has gotten scared and they're not really moving their assets. So your denominator gets small, even though the new number. is still rather quite big. It appears that right before the pop, the bad pop, not the good pop,

Starting point is 00:33:47 right before things collapse, this ratio can soften a bit. And the best way to explain that is actually some of Bitcoin's transaction volume can be shuttling Bitcoin between exchanges for arbitraudence plays. And so as things are really heating up in a speculative fashion, you actually have more people shuttling their Bitcoin between exchanges, which, including. the transaction volume, but not really from a means of exchange use case for goods and services and economy, more to support FX volumes. And so this is just a ratio that we have pulled together and we're tracking for Bitcoin. I would love to see someone do it again for the top 100 crypto assets. I've been working with a couple of professors to pull together the data set necessary to do this.

Starting point is 00:34:33 it's a heavy lift because you actually need to sync a node to all the networks and pull blockchain level data and parse it. But again, inevitably something that will happen. It's just we have to find the right people with the right appetite and resources in order to do it. I want to just dig into this billion dollar a day idea of on-chain transactions to have you explain what that means, what the difference is with someone that's saying going on to Coinbase and if I go on to Coinbase and buy $10,000 worth of Bitcoin, how does that impact that one billion? number because I think the question I get all the time is what are the underlying use cases here? What's it actually being used for? Maybe remittances is one example that are literally on-chain transactions, not me buying it at Coinbase. So maybe talk a little bit about that difference.

Starting point is 00:35:19 There's a big difference between transaction volumes and trading volumes. And so transaction volumes are, as you're alluding to, on-chain volumes, which are basically moving amounts of Bitcoin using Bitcoin's blockchain directly, getting cleared and settled within the chain. Now, what a lot of people think of as Bitcoin volumes are actually trading volumes. And that is within the isolated liquidity pools that we call exchanges, so GDAX, BitStamp, and these guys. And that's just matching a bid and an ask within an exchange is order books. And a lot of that volume never even hits the chain. It's within that isolated liquidity pool. Where it would hit the chain is if at a certain point an exchange has had enough Bitcoin go off its

Starting point is 00:36:09 exchange that it needs to net out the books or people just individual users are sending from their GDAX account to their BitStamp account, then in order to move that Bitcoin from one address to another, the exchanges actually have to, or one exchange has to send another exchange the necessary amount of Bitcoin. The third thing that'll go on is within some merchant service platforms. So, for example, if I'm a Coinbase customer and I send Bitcoin to a Coinbase merchant, that also doesn't have to hit Bitcoin's blockchain. It can stay within Coinbase.

Starting point is 00:36:46 So when I did a bunch of work with Coinbase in late 2015 and into 2016, we basically did something where we knew from some of Coinbase's numbers in this publicly in the paper, we just said, okay, Coinbase is within its platform, at least at that time, transaction volumes were about 5% of what we were seeing on chain. So we just multiplied on-chain transaction volume by 1.05 to calibrate for that. Really, we should probably multiply by something like 1.2 or 1.3 to take an account some of the other platforms. And I'm sure all these numbers have changed. Changed a lot.

Starting point is 00:37:20 So another interesting one that I've seen in terms of valuing or evaluating these things, and this probably bridges nicely into venture capital or the venture capital way of thinking about, like you said, a 10-year investment horizon versus a speculative, you know, trading horizon, which is the quality of the underlying community and developers. So is there any, are there any formulas or methods that are emerging for how to think about the impact of the team on the, on the value of the network? So there's a gentleman named Nick Carter, who's making a name for himself on Twitter right now. And he, actually did a master's thesis under the sponsorship of ARC when I was here with the University of

Starting point is 00:38:01 Edinburgh quantifying different forms of governance and looking at different ratios. For example, within equities, there's the Tobin ratio, I think it is. Tobin's Q, yeah. Yeah, Tobin's Q. And looking at are there analogies from that into the cryptospace? And I don't think anyone has really formalized that. Nick took the best stab at it thus far. and I think he'll continue a lot of that work. But right now it's still a very qualitative measure. So if you're thinking about a 10-year horizon instead of a much nearer term horizon, which I think is what a lot of people are thinking about when it comes to buying and selling

Starting point is 00:38:39 different crypto assets, what are the key variables that matter, or maybe those variables that matter more on a much longer horizon than on a shorter horizon? So there's, I mean, definitely a starting point is always technology. What are the tech chops of the developers behind? on this protocol and are they trying to make a breakthrough in distributed systems that people have been trying to do for the last 20 years or is there a much more achievable roadmap and how qualified are they to do so? Now interestingly technology is kind of table stakes because these are open source systems and I can download all the source code and spend it my own network and basically

Starting point is 00:39:17 I've recreated everything at no cost which then takes us into the next investigation which is one of governance. All of this conversation and activity we've seen around forks really comes down to governance. And if you are not properly governing your community, which takes into account things like what is the asset distribution? What is the participation process in software updates? Who is getting the majority of the new assets that are being issued? All these kinds of things. If these teams don't have a fair approach to governance, then they can actually easily be forked. and you can actually see a lot of value start to accrue to a competing protocol simply because they are better governing the members of their community.

Starting point is 00:39:59 So that's a really key, if not the most key component of long term, is this a team that I can put my dollars behind? And that's very similar with a venture capital approach of, okay, bet on the team. And then the third one that I spend a lot of time looking into is the crypto-economics, is the projected graph for this token based on all the assumptions I have, one that goes up into the right, or is it one that stalls out and actually goes down into the right? And, you know, that starts to become a balance of the adoption curve, so the growth of the unit economics, mashing up against the cost decline curve of the service being provided, the inflation rate of the

Starting point is 00:40:40 crypto asset, all these things come together so that, you know, sometimes you have really weird-looking current utility value charts. And so that's why, you know, I go through this exercise. It's almost like this investing opportunity, if it is an opportunity, is if we could somehow bet on the GDP, if I could make an investment in the GDP growth of cloud storage, of an individual country, but instead of a country, it's a contained network. Like I can make, I can make a bet on the value of a network over the long term. In that vein, how do you think about when you're thinking about, when you're thinking about,

Starting point is 00:41:15 a network, whether or not centralization or decentralization is appropriate for that thing. So you've mentioned cloud storage several times. Those are obviously popular because it's a clear, it's a clear use case. How do you think about evaluating whether or not something is just better off centralized? What does it take for you to say, no, that that's something that belongs in a decentralized network instead? Well, I would say it always comes down to is the service that it's providing in some way better being decentralized and centralized. Because, for example, we take cloud storage. I don't think that all files will ultimately be stored in a decentralized network.

Starting point is 00:41:55 I think that some files are better suited to being stored in a decentralized network, and some files are better being stored in a centralized network. So what is the competitive advantage? And so this is where we get into some of the things we talked about before, right, in terms of being uncensurable, but also uptime. If you look at Bitcoin's network from an uptime perspective, Bitcoin, for all its flaws and as much as people complain, it doesn't go down. You know, it's supported by tens of thousands of machines all around the world, independently running this code, independently verifying and settling transactions. That is much more robust, much more anti-fragile in the way in which it grows and unfolds than a verticalized infrastructure like AWS or Visa or whatever.

Starting point is 00:42:41 may be. So sensitive resistance, resiliency just generally as a technology system, there's also a case to be made in some cases for a performance edge. So you take something like Filecoin. They actually think that they can provision files more quickly than AWS because there can emerge these local biases. If I am storing my files in New York, then the farmers, the people storing files around me are likely to be able to provision that file to me much more quickly if they're in a nearby vicinity. And that allows massive scaling, but with local biases in a way that centralized operators cannot. What are some of the, this always seems to happen in any interesting field that a lot of the discussion coalesces around a couple key examples. So like right now it's

Starting point is 00:43:33 Filecoin. Like everyone seems to be talking about Filecoin. And for good reason, I think it's the biggest, the biggest ICO. It's a big protocol innovation. It's a big one. So it's good that we're talking about it. What are some of the other, I guess, potential or in-development networks that you are excited about, that you think are some of the most important projects, maybe a few that everyone isn't as focused on as something like Filecoin?

Starting point is 00:43:56 I can go with the underdog that doesn't get enough love. And that would be Steam, actually. So Steam was launched, I believe it was 2016, although it feels much longer ago. And Steam you can think of as the marriage of medium and Reddit, but incentivized with a token. And they came out, they had a hyperinflationary monetary policy, they fixed that, they've hard forked 19 times, they've changed lots of things. But similar to Bitcoin, say what you like about Steam, it's there, it works, people are using it, and it is proving out its resiliency. And what I like about Steam is roughly two-thirds of the block reward goes to authors of content. Roughly one-six goes to curator, so people that are actually upvoting, downvoting,

Starting point is 00:44:42 and helping surface the best content. And then a remainder goes to witnesses and people that stake can get interest. So there's a really finessed monetary policy and way in which value is distributed going forward within the Steam Network, which I think is great. And it's using a consensus model called delegated proof of stake, which sort of, as you asked before, it's decentralized enough. Some people would say, oh, that's too close to being a centralized system, but it's decentralized enough to allow Steam to function in this global manner.

Starting point is 00:45:17 So that's one, and people can go and check out Steam if they like and look at the content and all of that. So real quick, just so I understand, so I always try to, maybe this is a naive framework, but think about each token that this is like a matchmaking service, that you can spend the token to get something. That could be a transaction fee to send Bitcoin. It could be an ether to have access to this kind of global computer, a file coin to store something. And then there are ways of earning it. So you've already talked about earning it, which is create content, curate content, secure the network. How do you spend it? So what's the idea behind right now, if I want to go

Starting point is 00:45:52 read a medium post by you, I don't have to pay anything. So in this model, do people have to buy steam to then spend it to access content? What's the other side of the marketplace? So there are a few sides to this marketplace, but one of the most common ones is basically you can exert more influence on the network, the more steam that you have. So let's say in the future, you're an advertiser. And you want to exert a lot of influence on the network. You can actually do that based on the amount of steam you have and push content higher to the top. So you're actually paying to get some content to the top. And that gives you leverage within this system. But it's very explicit leverage. It's not sort of in the shadows. It's very clear what's going on. which allows people to trust the content more. And what about just like an average person? I want to go read something that's, is it published in the Steam network? Like, how does that all work? So you as a reader, as a consumer, don't have to pay anything.

Starting point is 00:46:47 But the way that Steam, at least in the last time that I went through it, the way that Steam allows you as a publisher to get content on there, you actually have to pay for the bandwidth. Got it. And you're more paying with it by the fact that you have Steam, the amount of basically material that you can put through the Steam network is proportional to the amount of Steam tokens that you have. All right.

Starting point is 00:47:10 So let's do another one, another maybe overlooked project that you think is appropriate for a blockchain-based network. So really like the Aragon team. I don't know anything about Aragon. Okay. So Aragon, I believe they did their crowd sale in May. They're a team that goes a long ways back, actually, in the crypto space. They worked on a company called Stampery, which was,

Starting point is 00:47:32 stamping material within Bitcoin's blockchain and using it as this monument of immutability. And what Aragon does, it's an ERC20 token, so it runs on top of Ethereum, whereas Steamits its own full stack. And the best way to say it in a sentence is it's decentralized Delaware on a blockchain in terms of it provides a framework for organizations to manage, well, first to register, but then to manage their cap table, to pay out employees if they need to, to be very transparent about where funds are being held, how funds are being used. So a number of components, and this is constantly expanding as it's under development, but, you know, could very easily see it becoming a bit like a stamp of approval, just like Veracine works on the web. This ICO or this token project runs their funds and administers things using Aragon. And then as we get farther out in the future and this whole idea of decentralized autonomous organizations and codifying much of what we see in existing organizations and running it transparently on a blockchain, that's more the direction that Aragon is going in the future.

Starting point is 00:48:43 Really interesting. How do you think about, I'll say holistically, so for decentralized networks in general, and then when evaluating individual nascent networks, how do you think about and categorize existential risks? So what are the things that in your mind could, and usually the answer is there's no thing that could completely destroy the whole idea, that the technology is not going anywhere. But maybe you have an idea on this topic. So existential risks, what are they and how do you think about them? Well, so it's going to vary crypto asset by crypto asset. But just for ease of example, we can run with Bitcoin. So Bitcoin's capital base right now is supported by half a million to a billion dollars of machinery.

Starting point is 00:49:23 and you can do that calculation by just looking at the hash rate of Bitcoin and dividing that hash rate by the average hash rate of your average machine. I think the latest ant miner is 14 terra hash. And you get the number of machines that need to be connected to the network. It's somewhere between 2 to 400,000 and then the average price of these machines is $2,000. That's a lot of money, but it's not that much money if I'm a nation state. So then it becomes, okay, well, I could basically try and, rebuild a whole network and I and I have the funds to do it but what becomes a limiting factor is

Starting point is 00:49:59 actually that Bitcoin is secured by custom hardware A6 and the production capacity of A6 is not that great. So for you to actually try and rebuild the whole Bitcoin network would be a painfully laborious process. You would probably want to set up your own fabrication facility and just quietly be producing your own A6 and then hope that you know over time no one is going to notice that you're amassing this massive amount of hash power, you just turn it all on immediately. There are lots of scenarios, ways this could play out. But at the end state, let's say someone is 51% attacking Bitcoin, and they have the majority of the hash rate. At that point, the core developers can release a software update, which everyone's going to be incentivized to move on quickly, that changes the

Starting point is 00:50:44 proof of work from Schaft 256 to something else and basically obviates the existing ASIC base. So then all this work has basically gone into doing something that at that point is obsolete. So that's one avenue of attack. I can go through a number of different avenues of attack. There's the regulatory attack. Basically just... You're going to jail and you're going to jail and you're on it. Yeah. And, and killing all the fiat on ramps. That's, that's something that people talk about a lot, like China did. And sure, that could happen in one nation or another nation or maybe there's a conglomerate of nations. But what we've been finding is that it's a bit this game of whackamol, regulatory arbitrage, one nation wax crypto, and the nation next door to raise their hand. They're like, hey, you guys can

Starting point is 00:51:29 come here. And so because these are supernational protocols, getting supernational collaboration from nations on how to handle them, it, I mean, it would be pretty amazing. So, and even then there would be, I mean, again, I'm going deep down a hypothetical scenario and I can play devil's advocate within myself. But that's another one. I think, you know, really probably the one that seems most plausible to me is that you end up kidnapping all the core people within the space, be they, the developers, some of the miners and that community. And you basically, I don't know, hold them hostage until everyone shuts down the network or I don't want to get morbid here. But there is sort of that side. And so this is where Belagie wrote a great post on sort of the

Starting point is 00:52:15 different forms of centralization and decentralization and how to look at those to better understand and investigate the resilience of these networks. Such fascinating, interesting stuff. As you think about, and I know, of course, your orientation is more towards 10 years or a very long holding period, so volatility of the price doesn't really matter all that much to you. It's a buying opportunity. It's a buying opportunity. As you think about, though, that kind of movement, is it fair to say that, the equation that we started this whole conversation with sort of forms a base below which, you know, the entire speculative portion of the stack could collapse to nothing, but that that

Starting point is 00:52:55 utility base would kind of be the floor or does the collapse of the speculation itself affect the underlying utility base? It's another way of saying, could these go to zero if there's a 90% crash? So I think of it exactly as you said initially, the former example where basically the market price of these assets is a certain component of current utility value, and then the excess above that is the discounted expected utility value based on discounting a future utility value back to the present. And so that current utility value is the price floor. Now, I can imagine scenarios where it trades beneath that, just as stocks can trade below book. It's hard for me to see that persisting for long if, if,

Starting point is 00:53:45 the network is truly providing value to the world. And, you know, we have this very clear understanding of the supply side, and, you know, demand is there or growing. Now, the way in which these assets could start to fall more and more in value in this sort of doomsday scenario is if we go back to what I was talking about, the percentage in the float, if more of your store of value holders capitulate, I'm out, you know, and I'm not going back in and there's no hands that come back, then you will actually have more tokens in the float, an increasing number of tokens in the float. And so that actually will drop the price of the token

Starting point is 00:54:25 more, but it will ultimately find this equilibrium price, you know, where you've got the really strong hands holding, the people who have bonded, and this economy is still ticking along, still using this asset, because the economy is not dependent so much on the price of the asset. If you think of something like Ether, and people are working on this, but Ether is working to dissociate the price per Ether from the actual cost to use the network. And it needs to do that because just because the price of Ether is going up doesn't mean the network should get more expensive to use. It just means I actually need fewer units or fewer smaller fraction of Ether to use the network.

Starting point is 00:55:05 And so therefore the expense stays stable. And that's why I'm not overly concerned. I know there are some massive crashes. coming, but so long as we're not diluting ourselves about the actual utility of these networks and these assets and what we're building, which I don't believe we are by any means, you know, long run will be just fine. Last two questions. The first is around velocity.

Starting point is 00:55:25 It's where we started. It's a really important variable in evaluating the value of one of these networks. Is there a scenario in which velocity just gets so high that these things are moving so much that it kind of permanently affects and depresses the value of these things. Like what's kind of the worst case scenario from an investor standpoint? We want velocity to be lower. And are there ways that people are thinking about artificially reducing velocity or something like that so that the M that you're solving for here

Starting point is 00:55:56 doesn't need to be, say, just a couple hundred million dollars or something? So there are all kinds of scenarios, right, in ways in which we can see velocity progressing. If velocity is infinity, then M, equals pq divided by infinity implies your monetary base needs to be zero. And that's just a theoretical example. I would say, you know, this is where building in mechanisms to the actual consensus process that require people to bond, not only for this value component, but also reputational. Like if you're going to participate, you should bond in there. There are protections against civil

Starting point is 00:56:32 attacks where I can replicate my identity and actually become a threat to the network. It becomes much harder to do that if I have to stake $300,000 each time I want to replicate a node on the network. So, you know, we are seeing people build that bonding in. I do expect this asset class to be a new store of value on a global basis. And right now it's serving as a disaster hedge against global macroeconomic dislocations. But in the future, I won't use Filecoin, but let's say Gallum for GPU flops and rendering and machine learning out goes, if that's being used on a massive basis and very stably sort of growing in its use, maybe that becomes a reserve commodity in a sense.

Starting point is 00:57:16 Maybe we have these new massive protocols that, yes, have this utility, but have become stable and massive enough to the point where they're becoming a reserve asset of sorts. Last question. Has you most interested in terms of, you know, I've read all your own posts, and obviously your views have evolved as you continue to look through this. And when you were valuing Bitcoin using remittances, you mentioned in your post on crypto asset valuation, that there are some assumptions that you got wrong. So you're learning on the fly just like everybody else is.

Starting point is 00:57:46 What, as you think about valuing these things, has you kind of most interested? What's the frontier for you, the thing that you are most actively investigating that maybe you don't know yet? Well, you know, we've talked about them a lot, and it's formalizing our understanding of velocity, formalizing our understanding of discount rate.

Starting point is 00:58:03 Discount rate within equities is the weighted average cost of capital. And we have formulas for doing that. For me right now with crypto assets, I'm basically saying this is three to five times riskier than what I would use for risky equity. But I don't have a mathematical basis for that. As an investor, I can say, well, this is how much I expect to get compensated. This is what I need. Yeah, 30% cagger for 10 years is significant return.

Starting point is 00:58:28 Yeah. But we don't have a formal basis for that. And then related to all of this is really the psychology of how these assets are going to play with the masses as they gain broader adoption. But, you know, someone is going to win a Nobel Prize on this stuff. We saw Black Shoals. It may not be me. There may be multiple Nobel prizes that get won. I just want some crypto people to win Nobel prizes 10, 20 years out. Well, this has been really, really informative.

Starting point is 00:58:56 I've learned a ton in this hour. Thank you so much for your time. Thank you, Patrick. Hey everyone, Patrick here again. To find more episodes of Invest like the Best, go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfield guide.com forward slash book club. After you sign up, we'll receive a full investor curriculum right away and then three to four

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Invest Like the Best with Patrick O'Shaughnessy - Chris Burniske - How to Value a Cryptoasset - [Invest Like the Best, EP.62]

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