Prophets

Finding Value in Cryptocurrencies

What matters to a long-term investor is the share of the global economy this money will represent over the next few decades.

The 2017 boom in cryptocurrency prices has focused attention once again on valuations. 1  Most of the analysis is either too optimistic or too pessimistic. The former tries to put a hard value for profitable buying and selling decisions on a complex network of ideas just beginning to evolve. The latter asserts that no valuation is possible.

Labeling something too uncertain to value is foolish. The more volatile a price is, the more profit there is in having a value, the more risk there is in not having a value, and the more error you can tolerate in your valuation. If the price of something never changes, its value is irrelevant. But if the price of something oscillates wildly, it's too volatile not to value. Valuation sets your portfolio allocation, given neutral opinion. Having a value -- even an incorrect one -- protects you from bubbles and panics, as well as from fear and greed. Moreover it causes you to buy when prices are low and sell when prices are high to maintain portfolio allocation. 2

Market capitalization of cryptocurrencies is about 0.1 percent of global wealth. But what matters to a long-term investor is the share of the global economy that cryptocurrency value will represent over the next few decades. 3

There are zero-value stories. Cryptocurrencies could be extinguished by government actions, or have intractable technical problems. The technology could be incorporated into existing currencies and payment systems. With no barriers to entry, people might keep introducing new currencies at lower and lower values. Everyone might decide it's foolish to accept worthless tokens for real goods and services. 4

There are moderate-value stories as well. Payment processing revenues run at about 3 percent of global value added, and cryptocurrencies could add significantly to the value in applications including micropayments and smart contracts, or where specific types of privacy are important, including some discouraged or illegal-but-tolerated activities. On the other hand, cryptocurrencies compete in part by being cheaper 5 .

Say cryptocurrencies grab 10 percent of payment processing revenues at 10 percent of current prices but three times the market size. That suggests about 0.1 percent portfolio allocation to the sector, about current cap weight. You can play with the numbers, but in my experience you generally come up with allocations between 0.1 percent and 1 percent, and valuations near current levels to 10 times that.

True believers read the preceding paragraph as akin to treating the internet as an email provider. Most of the value in the net today is from things unimagined in 1995. All human activities have transactional elements: we earn trust, repay loyalty and reciprocate affection -- but not with or for money. A company can be thought of as a fenced-off place for economic activity that is not mediated by money. Workers do not buy their desks and computers and sell their product to other workers -- non-market procedures are used to organize work.

All these things could potentially benefit from properly designed ledgers to balance out like with like, as opposed to a single universal money that defines the value of everything. Rules of exchange vary for different relationships. Some people need “soft” money that is easy to obtain but uncertain in value, others prefer hard money. For some purposes you want money that pays high interest, for others low or negative interest. Some transactions require ledgers that are not money-like at all. And these describe only existing transactions and organizations, the future could hold entirely new types.

While it's possible to imagine the end of traditional money and finance, I don't consider that plausible. Money and businesses have existed for millennia, and should last another decade or two. 6  And not all of the value of cryptocurrency-inspired activity is captured by the currencies themselves. The currency value to the total might be around the fraction of the economy represented by financial firms today, call it 20 percent. When I play around with high-value stories, I get allocations from about 1 percent to 5 percent, with valuations 10 to 50 times current levels.

I considered this in 2012 and picked 2 percent allocation. I have mostly been a seller since that initial purchase, as prices have been mostly rising. I rethink the allocation regularly, but have not changed it in five years.

I'm a technophile and an optimist, so I suspect most people will prefer lower allocations. I claim no special expertise in evaluating stories or estimating numbers. But you should have a number. Cryptocurrencies are too volatile not to value.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

  1. Valuation is a story plus numbers. A story without numbers is an anecdote. Numbers without a story make you the bad example in a Nassim Taleb book.

  2. There is an important caveat. If you maintain a non-zero valuation on something that does in fact go to zero, it can consume your entire portfolio. You may never have more than (say) 5 percent of your portfolio allocated to it at any one time, but as it falls in price, you keep adding dollars without limit. So wise investors couple any valuation with a stop-loss, a maximum amount they are willing to lose if the true value turns out to be zero. Similarly if the price of the thing keeps going up, wise investors a point at which they will admit their valuation was too low, and accept the market's valuation instead.

  3. It isn't necessary that existing cryptocurrencies thrive, any more than in 1995 it was important to buy the internet companies that are big in 2017 (most of them had not yet been founded). What was important was to have the correct amount of exposure to the internet sector, and to stay diversified so you picked up the winners (and the losers) as they came to market.

  4. Actually, all those objections, especially the first and last, could apply to government fiat-currencies as well, but that's a topic for another day. I also note that in 1995, those same arguments were used to justify minimal valuations of internet financial prospects. Despite all the ups and downs of the Internet sector, investors who maintained any reasonable constant exposure had higher returns and less volatility than investors who passively accepted whatever internet exposure was included in the S&P 500, or who had zero or 100 percent internet exposure.

  5. About 20 percent of the cost today and competition from existing processors, other cryptocurrencies and other innovations should push revenues down further.

  6. The Internet was a tremendous innovation, yet it represents only 3 percent to 6 percent of the global economy.

To contact the author of this story:
Aaron Brown at aaron.brown@aqr.com

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net

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