Re: BTC/Crypto-Playing Jenga With The Ouroboros.

I’ve been an outspoken critic of the lack of intellectual rigor when it comes to Crypto valuations and how it’s easy to conflate real value with yet another product of the Liquidity Lottery.

This thread delves a little deeper on these issues, buttressed by similar thoughts from JPM’s Michael Cembalest, for whom I have the deepest respect as an independent thinker. I borrow some exhibits from Cembalest’s recent piece entitled “The Maltese Falcoin.”

I’ve opined often that the endless Liquidity Lottery of the last several decades has led to serious conflation errors.

In the world of Crypto, there are basically 2 categories of assets. Category 1 = Pure “stores-of-value” where perceived value is in “the eye of the beholder” based on notions of scarcity/collectability. BTC and NFTs fall into Category 1.

Category 2 includes the huge swath of “incentive tokens” like ETH and other DeFi tokens that represent currency within their respective ecosystems.

Category 1 is really impossible to value fundamentally. BTC “stock-to-flow models” give the illusion of modeling, but it’s pretty silly to base valuation on artificially inelastic supply without providing a fundamental framework for why there should be demand in the first place.

Category 2 is arguably more interesting, because at first blush there seems to be real economic value embedded in the tokens required by the ecosystem’s mandate; in other words, there is a “use case” beyond just speculation.

Recently, some folks have attempted a DCF analysis on ETH. While I applaud the effort, these models are built upon a “Jenga Tower” of assumptions with very wobbly foundations. I explained this to my son the other day:

Any DCF can be summarized as follows:

CASHFLOW (CF), by definition, underlies DCF analysis. So where does CF come from? Any business or project derives CF by taking REVENUES first and subtracting out Costs of Goods Sold (COGS), Operating Expenditures (OPEX) and Capital expenditures (CAPEX).

To build out a financial model, you project out every line item and ultimately end up with CFs for every interval in the forecast period and then assume a Terminal Value at the end.

Selecting an appropriate Weighted Average Cost of Capital (WACC) or Discount Rate is also critical for discounting those CFs to the present.

The problem with Category 2 DCF valuation models is that the REVENUE foundation upon which everything else rests is a CIRCULAR REFERENCE that already assumes a starting value to the very token you’re trying to value! This is what I dub the “Ouroboros Effect”:

This DCF analysis for ETH has been making the rounds:

I am not even going to quibble with growth assumptions or the dubious “comps analyses” of other absurdly priced assets or question what the WACC is (I don’t even see it mentioned).

Let’s go right to the foundational question in this ETH valuation model: WHAT ARE REVENUES BASED ON?

Answer: Gas fees that are paid in ETH! Doesn’t that presume a starting valuation for ETH already? Isn’t that exactly like trying to value Company XYZ whose revenues are based upon payments in XYZ stock?

But where did the INITIAL VALUE originate from? This reminds me of the question: “Where did the Universe come from?” Answer: “The Big Bang.” Follow-up question: “Where did the Big Bang come from?”

While I don’t have a cosmological answer to the “Big Bang” question, I posit that the answer to the analogous origin question for Crypto is: THE LIQUIDITY LOTTERY.

In other words, decades of endless liquidity have charged up multiple “Inflation Capacitors,” of which Crypto is just one:

I argue that both categories of Crypto Assets derive their primary values from the Liquidity Lottery as opposed to anything fundamental and lasting.

Therefore, the imminent END to the Liquidity Lottery may spell serious risks to Crypto speculators who are conflating value with a temporarily charged “Inflation Capacitor.”

Incidentally, Crypto may be the "Inflation Capacitor" with possibly the HIGHEST sensitivity to rising rates given the lack of real CFs:

There is no arguing that Crypto is the “flavor du jour” among VCs and that they have poured tons of capital into the space. What remains to be seen is what happens to that capital as the Liquidity Lottery ENDS.

It’s not hard to see the libertarian allure of BTC as a hedge against "central banking serfdom” and endlessly expanding balance sheets (leading to endless winners of the Liquidity Lottery -- including BTC).

However, the last several decades of “Fed puts” have lulled people to complacency, and I think the ultimate “rug-pull” of this decade could be the disappearance of the “Fed put”/endless balance sheet expansion:

Many argue that widespread “institutional adoption” has legitimized the asset class, and that it is here to stay. Perhaps, but at what price levels?

It takes more than just adoption to be a “store of value.” Cembalest has 3 requirements: a) mass adoption, b) its volatility settles down to other store-of-value volatility levels, c) it goes up or at least remains stable when there are systemic or inflationary risks.

BTC fails both (b) and (c). Note that outside of a few outliers like MSTR’s Saylor, there are few “store-of-value” investors that would exchange USD stability for BTC hyper-volatility.

Of course, no Crypto discussion is complete without obligatory “Metcalfe’s Law” references:

However, as Cembalest states: “[Metcalfe’s Law] has proven to be a useful tool in assessing valuation differences ACROSS crypto-currencies at a point in time, but less useful in assessing or predicting absolute PRICE LEVELS.”

To Cembalest’s point, I hear this line of reasoning often: “BTC settled more transaction volume than Visa last year without a trusted intermediary. Isn’t that settlement layer worth something?”

But I ask back: “Why should value accrual occur to a token with no ability to REPATRIATE those disintermediated rents via real EXTRINSICALLY derived CFs from outside the ecosystem (and not based upon the tokens themselves)?"

While disintermediation risk for traditional payments players is real, could this be another example of technology bringing about “profitless prosperity” – “profitless” to both disruptor and disrupted and “prosperity” to the consumer?

Cembalest, however, even questions the extent of the disintermediation threat. With “only 1% of remittances” sent via crypto globally, remittance costs have been declining long before the advent of crypto:

Furthermore, because any remittance disintermediation would more likely use stablecoins whose gas fees (dependent on computational complexity) are lower than NFTs or DeFi tokens, "stablecoin use looks like a rather weak valuation pillar for cryptocurrency.”

The last point I want to make is the differentiation between COMPANIES that can successfully leverage BLOCKCHAIN LEDGER TECHNOLOGY (BLT) vs. the Cryptocurrencies themselves as the crucibles of lasting value in this tech revolution.

Web3’s value proposition seems to rest upon PERMISSIONLESS BLOCKCHAINS which require Cryptos that not only rest upon dubious valuation foundations but also impose unsustainable externalities:

There is no free lunch. Cembalest: “Many DeFi advocates anticipate a future world of peer-to-peer uncollateralized lending on blockchains, allowing crypto holders to lend and cut out fees charged by banks for credit scoring, monitoring and payment. Good luck with that.”

Like the other author, Cembalest paints a scenario where PERMISSIONED/PRIVATE BLOCKCHAINS that don’t require the Crypto “Ouroboros Effect” to reward miners for verifying transactions.

He cites a real-world example: “JP Morgan built a repo system on a blockchain with more than $200 billion in transactions cleared to date.”

In this case, one can argue that JPM has widened its own moat without requiring ANY miraculously levitating Cryptos.

“As a result, adoption of a permissioned, private blockchain using internally created stablecoins does not imply or result in increased value for any token anywhere… blockchain adoption often has nothing to do with crypto valuations.”

With that, I end this treatise and welcome comment and respectful debate as always.