A CREDO TAX PLANNING STRATEGY SOLUTION
CRYPTOCURRENCY AND DIGITAL ASSETS: Understanding Digital Assets and the Applicable Valuation Framework and Techniques
Digital Assets, including cryptocurrencies, are progressively more becoming a focus of conjecture and investment. Digital Asset acceptance and use is succeeding at a faster pace. Regulators are on the lookout on how to keep up with changes in the digital asset landscape while not stifling advancement. This whitepaper discusses comprehensive considerations with respect to defining and valuing digital assets for various purposes, primarily financial reporting.
When it comes to literacy, advisors are usually challenged with the valuation methodology for crypto assets. New valuation methodologies need to be adopted such as daily active users or network access because there’s no way to discount cash flows for crypto assets. Simply put, the old models like price-to-earnings ratios, discounted cash flows or the capital asset pricing model do not apply when it comes to valuing crypto assets.
Majority of advisors are competent on valuation methodology for traditional assets such as stocks, bonds and real estate. These asset classes have their own distinctive characteristics (thus the constant deliberation on how to best value them).
Understanding how technology and digital breadth adds value to a company and make it worth more than its tangible parts is a way to understanding how a complete digital asset could preserve its value even without those tangible aspects.
The Value of Digital Assets
Fiat currencies ground rules are based on their utility as stores of value, units of measurement, and as a means of exchange. Majority of cryptocurrencies have comparable characteristics, but because most of the trading are based on approximation, they are considered as an asset class where technical analysis has an absolute supremacy. Technologists and academics are continuously exploring the actual fundaments of cryptocurrencies.
The value of most cryptocurrencies can be based on the network’s size that is participating in their primary blockchain. According to a report published by Goldman Sachs, the free-float market capitalization of key cryptocurrencies that includes bitcoin, ethereum, bitcoin cash, litecoin, and XRP, is in fact correlated to the size of the network. The network size and the mathematical principle called the Metcalfe’s law (which states that any network’s value is the square of its number of participants) can be used to identify which of the said tokens are worth. This means that the true and relevant methods of measuring the network’s size must be identified. Similar to price-to-book and price-to-earnings ratios not being able to convey the entire story about the values of the current stock market leaders, we also need to identify the right metrics that would reveal the size of a cryptocurrency’s underlying network.
The Key Metrics
There are several metrics that can be used to determine the value of digital assets.
These metrics provide information about the activity across a blockchain (transaction count over a set period, or the total value of transactions over that period, active addresses, hashrates and fees paid.
These metrics give insights about the principle behind cryptocurrency, the technology that it uses, its use cases and the tokens’ supply and distribution plan.
These metrics give us information about the market capitalization of the asset, its volume and liquidity.
Why Valuing Digital Assets Matters
While there’s no industry standard yet on how digital assets should be valued, taxed, and be transferred to the next generations, it is crucial for trust officers and estate attorneys to make decisions on digital assets. Despite a good understanding of various valuation techniques behind digital assets of some advisors, they are still diffident to embrace them. Financial advisors are often challenged in assessing actually cryptocurrencies as real money since given their volatility, many are still not confident that they are in actuality a store of value. However, many still believe in the technology and that’s where investors are more comfortable putting their investment dollars in.
How Are Digital Assets Classified in the Accounting Framework?
The crypto’s binary-coded surface is a complex thing that many businesses and executives are realizing how intricate it is to account for it, which accounting standards to apply, and what it really means for the accounting team. As there’s not much guidance specific about digital assets and cryptocurrency accounting, the story should begin with the identification of how exactly to classify these assets on the balance sheet. It can’t be classified as cash, cash equivalents, or a possible type of foreign currency since such should be accepted as a legal tender and backed by a government. Similarly, cash equivalents must stand for investments that are readily exchangeable to cash or have a near maturity that results in irrelevant risk to the value.
The reality is, accounting for digital assets as an investment or financial instrument is yet another swing and miss. So this leaves us with companies classifying them as an intangible asset. Though this still isn’t a great fit, it’s the best that is available based on the current standards based on the following definition. Digital assets lack physical substance and are indefinite-lived (no prescribed life). Companies begin with recording digital assets at their acquisition cost and therefore subject to annual and trigger-based impairment tests.
Accounting outcomes can be hard for some to understand how digital assets should be accounted for because of the their constant unpredictability and the fact that the impairment model for indefinite-lived tangible assets allows a write-down in value but no write-up for increases.
Even a single day’s major decline in a digital asset’s value could merit a trigger-based impairment test and a possible impairment charge. In contrast to some financial instruments, the impairment structure for intangible assets is not an other-than-temporary-impairment model.
Impairment Tests on Digital Assets
The applicable guidance in ASC 350 is followed in impairment tests. This deals with looking at the asset’s fair value and comparing it to its carrying value. A less fair value means you have to write it down and take an impairment charge. However, you cannot pull through any value for preceding impairment charges taken under current U.S. GAAP. Alternatively, you would only identify any upside as a gain upon the sale of the intangible asset, and that’s only applicable in cases where the sale price exceeds the adjusted carrying value.
What’s the Future of Digital Asset Accounting
It is safe to believe that regulators will standardize the applicable regulation at some point, specifically as these assets are becoming popular. Maybe that will require moving to a fair value model, a carve-out classification of a financial instrument, or even a completely new asset class. There are companies who are accepting digital currencies in exchange for goods and services (bringing into the fold the ASC 606 rev rec framework. In this scenario, the crypto is classified as a non-cash consideration from the customer and accounted for as such.
Proceed with Vigilance
When investing in digital or crypto assets, you should always weigh its pros and cons as they are another financial asset that can be further diversified and from which you can possible have some serious gains.
Though the accounting can be disorganized and the significant instability only intensifies the mess on the financial statements, it is advisable to proceed with vigilance and consult Credo CFOs & CPAs for additional insights and consultation.
The Future of Blockchain
“In the next five to 10 years, you could see a financial system where all assets and liabilities are native to a blockchain, with all transactions natively happening on chain. So what you’re doing today in the physical world, you just do digitally, creating huge efficiencies. And that can be debt issuances, securitization, loan origination; essentially you’ll have a digital financial markets ecosystem, the options are pretty vast.”
– Matthew McDermott, MD Goldman Sachs, Head of Digital Assets
Overview of Blockchain
- Blockchain is a form of shared database that varies from the usual database with the way that it stores information. Blockchains store data in blocks that are then linked together via cryptography.
- New data are entered into a fresh block as new data comes in. And once the block is filled with data, it is then chained onto the prior block making the data chained together in sequential order.
- Diverse types of information can be stored on a blockchain. It is most commonly used as a ledger for transactions.
- In the case of Bitcoin, blockchain is used in a decentralized approach to make sure that no single person or group has control. All users are collectively given the power to retain control.
- In Bitcoin’s case, blockchain is used in a decentralized way so that no single person or group has control—rather, all users collectively retain control.
- Decentralized blockchains are absolute making the data entered irreversible. When it comes to Bitcoin, the transactions are permanently recorded and viewable to anyone.
- The concept of blockchain predated its first prevalent application in use which is Bitcoin in 2009. Since then, blockchain use set off thru the creation of different cryptocurrencies, decentralized finance (DeFi) applications, non-fungible tokens (NFTs), and smart contracts.
How Does Blockchain Work?
Blockchain’s purpose is to allow the recording and distribution of digital information (but not edit it). Thus, blockchain is the foundation for indisputable ledgers, or records of transactions that cannot be altered, deleted, or destroyed. This is the reason why blockchains are also called distributed ledger technology (DLT).
The goal of blockchain is to allow digital information to be recorded and distributed, but not edited. In this way, a blockchain is the foundation for indisputable ledgers, or records of transactions that cannot be altered, deleted, or destroyed. This is why blockchains are also known as a distributed ledger technology (DLT).
Where is Blockchain Used?
There are currently more than 10,000 other cryptocurrency systems running on blockchain. With blocks on Bitcoin’s blockchain storing data about monetary transactions, it is undeniable that blockchain is really a trustworthy way of storing data about other types of transactions as well.
There are companies who have started incorporating blockchain like Pfizer, Siemens, Walmart, AIG, Unilever, among others.
Banking and Finance
The banking industry reaps the most benefits from integrating blockchain into its business operations. Blockchain never sleeps, so via its integration into banks, the transactions of consumers are processed in no less than 10 minutes (which is basically how long it takes to add a block to the blockchain). That is regardless of holidays or the time of day or week.
Blockchain allows the exchange of funds between institutions securely and quickly. When it comes to the stock trading business, the process of settlement and clearing usually takes three days (or even longer for international trading). This means that the money and shares are frozen for a specific period of time.
With blockchain, banks also have the opportunity to exchange funds between institutions more quickly and securely. In the stock trading business, for example, the settlement and clearing process can take up to three days (or longer, if trading internationally), meaning that the money and shares are frozen for that period of time. Take note also that even a few days of waiting for the money to come has costs and risks for the bank (given the size of the money involved).
Blockchain forms the foundation for cryptocurrencies such as Bitcoin. The Federal Reserve controls the US dollar and under this central authority system, a user’s data and currency are in theory at the impulse of their bank or government. So when a bank is hacked, the private information of its clients is at risk. The same way that if the bank collapses or the client is resides in a country with an unstable government, their currency’s value may also be at risk. These are just some of the concerns when Bitcoin was invented and developed.
Blockchain allows Bitcoin and other cryptocurrencies operate free from a central authority through spreading its operations across a network of computers. The goal of this is to reduce risks and eliminate a number of the processing and transaction fees. For countries with unstable currencies or financial infrastructures, using blockchain can give them a more stable currency with more applications and a broad network of individuals and institutions with whom they can conduct business with (both domestic and international).
For those who do not have state identification (like those who are living in war-torn countries or those whose government does not have real infrastructure to provide identification), the use of crytocurrency wallets for savings accounts or as a mode of payment is very useful.
Blockchain is a game changer in the healthcare industry as it can securely store patients’ medical records in a way that when a medical record is generated and signed, the blockchain writes and patients are provided with proof and confidence that no changes would be made with their records. Privacy is ensured as patients’ health records are encoded and stored on a blockchain with a private key where only certain individuals are given access.
The process of recording property rights is arduous and inefficient. There’s a lot of manual processes needed when it comes to storing information in a country’s central database and public index. Aside from the tedious process, this manual process is also prone to human error. Blockchain can eliminate the current challenges. With the use of blockchain, property owners are ensured that their property deed is accurate and permanently recorded. This would be very useful if war-torn countries or those that have little to no government or financial infrastructure would be able to leverage blockchain for establishing transparent and clear time lines of property ownership.
Using a computer code called the smart contract (a code that can be built into the blockchain to facilitate, authenticate, and negotiate a contract agreement), the fees and processes that are typically associated when carrying out any contract agreement are eventually eliminated.
Using blockchain, the origins of materials purchased can be recoded allowing companies to verify the authenticity of their products and label them accordingly (i.e. “organic”, “local”, “fair trade”). There is an increase adoption of blockchain use in the food industry because of its usefulness in tracking the path and safety of food throughout the farm-to-user journey.
Blockchain is a promising means in facilitating a modern voting system to eliminate election fraud and boost voter turnout. Transparency is maintained due to the blockchain protocol eliminating the need for recounts or any fraud concern that might threaten an election. The number of personnel needed in conducting an election is also reduced while providing neatly instant results to officials.
What Are Cryptocurrencies?
Why Do Cryptocurrencies Have Value?
A virtual currency is kind of like a bank account (with no bank) that purports to have vaue, but only has it because people believe that it does and are willing to buy and sell it. Like a bank account, your money is an electronic entry, but you can see the account value, transact by transfer in and out, and even deposit and withdraw through ATMs.
But many bank accounts are insured by governmental entities like FDIC.
So a virtual currency is a form of stored value that has value because people believe that it does.
Cryptocurrencies as Hedge Against Inflation
Cryptocurrencies are becoming a popular sanctuary for inflation-phobic investors. New crypto assets and Bitcoin’s “digital gold” are intended to be inflation-proof and at the same time a means of making the most of rising prices. Cryptocurrencies’ attractiveness depends on the type of inflation being feared.
Supply-chain interferences are believed to be transient factors of soaring prices. But if economic efficiency and the enthusiasm to work among a large group of the population would be permanently reduced as an effect of the elevated cases of the pandemic, fewer goods and services would be experienced and would have a deeper impact on the economy. Government can respond through stimulus spending, subsidies, and deficits to boost the supply of money and the move of wealth from the private sector workers to government workers, retired people and the unemployed fueling inflationary spirals. In this case, a slow economic growth is the problem (and the fear) and not inflation. While cryptocurrencies can potentially provide protection against inflated money supply, it does not generate more goods and services. Majority of crypto ideas are executed by technology start-ups as decentralized independent organizations and not as the conventional ones. This is because start-ups flourish in growing economies and not in torpid ones.
Currently, there have been crypto ideas that are intended to enhance (or evade) supply chains and others that provides employment opportunities that some workers may choose post-lockdown. Though they may have the potential to offer good venture capital investments, they’re far too dangerous to be regarded as inflation hedges. The issue with supply chains is a global concern and may possible be driving inflation in China, the euro zone and the rising economies (all of which are raising). International tension is another global peril to the value of currencies. Seething conflicts around the world brought about by war brings inflation like no other leading to economic sanctions, financial barriers and tariffs.
The benefits of cryptocurrencies over traditional finance ascend during wartime and financial clash. The most established coins such as Bitcoin and Ethereum are the best bets during circumstances like this (which both have large holders across the globe) plus cryptocurrencies bearing strong privacy protections (like Dash and Monero).
Moving investments to countries and currencies with a healthier monetary policy and fiscal management is an option when you are concerned about US dollar inflation. In this case, crypto is categorized as a country where investments can be shifted to. It is an option that can give protection against inflation scenarios (while taking advantage of others). Although crypto is not a magical hedge against inflation, almost all crypto assets exhibit a lot of non-inflation-related risks that are suitable only as small parts of broadened portfolios and not either core holdings or pure hedges.
How the Accounting Model Makes Sense (Sample Scenario)
– Company A receives 10 Bitcoins for Goods and Services provided in November of 2018
– Bitcoin value: $6,300
*Debit Intangible Asset for $63,000
*Credit Revenue for $63,000
– Bitcoin value drops to $3,900 at December 31, 2018
*Debit Impairment Loss: $24,000
*Credit Intangible Asset: $24,000
*Balance Sheet Value of Bitcoin: $39,000
– Bitcoin value increases to $7,200 at December 31, 2019
*Note Disclosure; Intangible Asset (Bitcoin) Fair Value equals $72,000 (reported at $24,000)
– Bitcoin value at September 30, 2021: $48,000 Unrealized gain (reported in notes): $441,000
Note: Investment Company Accounting Treatment differs.
A company receives 10 Bitcoins for goods and services provided in November of 2018. Let’s assume that the value of a Bitcoin back there was $6,300. Let’s debit intangible assets ($63,000 and credit revenue for $63,000). The Bitcoin value then dropped to $3,900. So in the accounting model, we have an impairment and a balance sheet value now of the Bitcoin of $39,000. Now we have to take that impairment loss. A year later, the Bitcoin increases to 7,200 (though the accounting rules don’t allow to take into account that uplift and value). So we can now disclose that we have 72,000, but on the balance sheet, we still got 39,000 or, or the $24,000. In 2021, it was at $48,000 and an unreported game of $441,000 (that are disclosed in the notes but that not reflected anywhere in the financial performance).
Factors that Influence Crypto Values
Community involvement is the basis of the value of cryptos (just like with every other currency). Factors may include demand for the coin, its utility, and scarcity. Evolving from private blockchain firms, the value of cryptos arises from the company’s image, apparent value and project capability.
The node count shows the number of active wallets in a network indicating how strong a community is. A high node count signifies a strong community while a low node count suggests the opposite. Furthermore, an extensive node count may also indicate the decentralisation and power of a network, both of which are vital factors when it comes to cryptocurrencies.
If a token is available in several exchanges, it means that more people are buying it (investors who need two or more exchanges to trade their cryptos would need to pay for each swap). This results to an increase in the investment cost.
Special servers or hardware are being used by miners to produce new tokens and validate daily network transactions. They are then rewarded with a network fee and virtual takens for their painstaking work.
There’s a high chance that cryptocurrencies would eventually attract specific regulations by the government as they become mainstream and regain momentum. While there are governments in many countries who do not welcome the unregulated and decentralised nature of this currency, they eventually take certain measures to manage this market. A straightforward way to control the crypto market is to add taxation in transactions. These regulations and limitations will augment the centralisation of virtual currency which in turn would affect the cryptocurrency price.
Cryptocurrency price will increase if there is a limited supply of cryptos. Price decreases if there would be more supplied in the market. Furthermore, some cryptocurrency projects ‘burn’ current coins by guiding them to an permanent address inside the blockchain. This is a crucial way to control supply.
Market cap or market capitalisation is the most clear-cut gauge of a coin’s market value. One can compute for the market cap by multiplying the total coin supply with each coin’s price.
Note: There are several ways to establish cryptocurrency value but there is no error-free way to determine this. A proper market research and consideration of all risks must be conducted prior to investing.
Valuation Models for Cryptocurrencies
A number of models have been recommended to appraise cryptocurrencies’ underlying value. This resulted to a broad range of valuations and emphasizing the challenge investors encounter when valuing cryptocurrencies.
With cryptocurrencies being fairly new to global financial markets, longer-term value may vary significantly from the day-to-day fluctuations in prices. Based in the history of Bitcoin, we have seen how the narratives have changed from a collectible to an unpredictable store of value. Given this, it’s important to be cautious when choosing any valuation model to use and make sure to acknowledge the likelihood of a structural break from the present narrative.
Store of Value (SoV) Thesis
Potential Total Store of Value / Number of Tokens Outstanding = Potential Price per Token
This method indicates how a digital asset’s value is a function of its ability to act as a store of monetary value for its users and investors. Simply put, a digital currency or token becomes more valuable in the future if it can be used more as a store of value. Based on this theory, a digital asset becomes a store of value if it is immune to theft, have realistically low inflation, and a low cost of conversion.
To compute for the fair value of the price of bitcoin using Store of Value (SoV) method, we assume (looking at the price of gold) that bitcoin could replace gold one day as the go-to store of value for investors. At the present price of gold of about $1,300 per troy ounce, there is a total value of around $8 trillion gold bullion in the world.
As an example of calculating the fair value of the price of bitcoin with Store of Value (SoV) in mind, we could look at the price of gold and make the assumption that bitcoin could one day replace gold as the go-to store of value for investors. Supposing bitcoin would replace gold as a popular store of value worldwide and the total network value rose to $8 trillion (as we know that the total supply of coins is capped at 21 million), BTC price would end up at $380,000.
High velocity tokens are likely to have little utility in their networks. Therefore, when evaluating the token velocity of different digital assets (especially utility tokens), investors can distinguish if a platform’s implementation will really lead to an increase in network value and, so, the price of the network’s token in the long run.
This can be derived from the Equation of Exchange (MV=PQ), where token velocity is an important driver of token price.
M = size of the digital asset base
V = token velocity
P = price of the token
Q = quantity of the token
When the token velocity is lower, it means the greater the token price is via an appreciation of M on the left side of the equation. This thesis indicates that tokens with low velocity will see higher prices than other digital assets.
Metcalfe’s Law is a popular valuation method that is used in the digital asset markets. Originally used to measure communication networks, this law states that the value of a network is relative to the square of the number of the network’s connected users. It can be applied to digital asset networks since blockchain networks are failry well modeled by Metcalfe’s Law in which the value of a network is identified as proportional to the square of the number of its nodes or end users. This law is an excellent way to analyze the growth of a network as a function of its daily users.
MET Ratio = Market Cap/(Daily Active Address)²
Network Value to Transactions (NVT) Ratio
NVT Ratio = Market Cap/Transaction Volumes
The network value to transactions (NVT) ratio computes for the dollar value of digital asset transaction activity relative to network value (measured by market capitalization). The NVT Ratio is the digital currency industry’s valuation that is equivalent to the P/E Ratio.
To compute for the NVT Ratio for a coin or token, divide the market capitalization by its latest 24-hour transaction volume. The resulting NVT Ratio can then be used to compare one digital asset with another. This is why the NVT Ratio is a relative valuation method.
In the traditional stock markets, the P/E Ratio, is used to value companies by looking at their share price relative to company earnings. But a different metric is needed to value bitcoin and similar digital assets since there are no considered earnings for digital currencies.
In the world of bitcoin, there is a price per token. However, it’s not a company, so no ratio should be done since there are no earnings. But since bitcoin is fundamentally a payment and store value of network, we can consider money flowing through its network as a substitute to “company earnings”. With the value transmitted on the Bitcoin blockchain closely tied to its network valuation, the notion that we can use the money flowing through the network as a proxy for network valuation is applicable, can be expressed as a ratio and call it Network Value to Transactions Ratio (NVT).
A high NVT ratio for bitcoin or any other digital currency means a high speculative value as the price is high relative to its network activity. This is an indicator that investors are convinced that this digital asset network has the potential to grow in utility in the future.
The INET Model
INET is considered as a fictional token that is crafted as a placeholder for whatever digital asset is essentially being appraised or analyzed, INET is considered as a fictional token.
The INET model is a comprehensive financial model that approximates the value of a token using the Monetary Equation of Exchange (MV=PQ) which is also called The Quantity Theory of Money by economists.
In the INET model, the pricing of tokens is broken down even further into two additional parts. These are the Current Utility Value (CUV) and the Discounted Expected Utility Value (DEUV). CUV corresponds to the value associated with current utility and usage of the token, and DEUV stands for the value of the token associated with investment speculation.
The current value of any token can thus be represented and projected into the future using a variety of inputs, including:
- Supply-side drivers;
- Token adoption;
- Market saturation growth rate;
- Token demand;
- Token velocity.
It is also possible to model and estimate the influence of CUV and DEUV on token price.
Based on the Monetary Equation of Exchange (MV=PQ) any token (INET) price is equal to the future projected monetary base (M) divided by the number of circulating coins at that future date. M is calculated as equal to PQ/V, where PQ is the value of on-chain transaction value, also considered network GDP, and V is token velocity.
In this model, velocity is a crucial input value, and the assumptions made regarding velocity means the model suffers from drawbacks related to token velocity and its interaction with other factors, including the fact that velocity cannot be measured or defined precisely. This is also true for the other variables in the equation, and when velocity changes recording that change as it relates to P, Q, and M is often arbitrary.
Daily Active Addresses/Users (DAA)
This is an indication of the number of users who are conducting transactions on a blockchain network everyday. Take note that one user could be performing transactions using a number of different addresses so there’s a possibility of overcounts. This metric is often used to compute for the number of users of a software platform (also called DAU) giving valuable data about the users of a network. The said data can facilitate the detecting of emerging and continued trends complimentary to Metcalfe’s Law and the Network Value to Transaction (NVT) ratio.
Crypto-Networks as Small Emerging Economies
Crypto assets can possibly be appraised just like how economists evaluate the currencies of small emerging market countries with the consensus protocol be similar to a country’s constitution. The users would be on the demand side of the economy with the blockchain community similar to a country’s constituency. Then the core developers are like the executive branch of the government whose codes are executed based on the community’s approval. Then the tokens act as the currency of the country. Depending on how attractive the project is, investors buy and sell the same way that they buy and sell fiat currencies according to how attractive the small EM country is.
Investors search for the same features like productivity, low corruption, a good degree of equality, good governance, and sound fiscal policy whether we are talking about fiat currencies or cryptocurrencies.
Stock to Flow
This model is used to value limited commodities such as gold and platinum. And since bitcoin is considered as “scarce” because of its limited supply, the Stock to Flow model can also apply to digital assets.
In this case, the existing supply of a token is called Stock (the total number of bitcoin mined to date). The annual rate of production is the Flow (number of tokens mined in a year). The ration of these two is thus called the stock-to-flow (S2F). A higher value indicates how more scarce the substance is.
Market Value to Real Value Ratio(MVRV)
The MVRV is the ratio of an asset’s market capitalization to its realized capitalization.
MVRV Ratio = Market Cap / Realized Cap
Bitcoin’s market cap, as an example, is the sum of mined bitcoin multiplied by the latest trading price. The realized cap is computed individually by valuing each unit of bitcoin at the last transacted price on-chain. The MVRV ratio is used when comparing these two metrics to understand when the price is below or above the “fair value”. This helps in locating market tops and bottoms.
Realized value eradicates some of the lost, ununsed, unclaimed coins from the entire value calculations. It indicates the total levels where groups of long-term, legitimate, buyer-hodlers enter goes into their Bitcoin positions (with local and direct emotions and manias stripped out).
High MVRV ratio means overvaluation because of hype-based excitement, while a low ratio means undervaluation of assets.
Principles of Crypto Asset Valuation
Price on Intrinsic Value, Not Short-Term Volatility
Crypto assets should be appraised as a long-term investment (more than five years) just like other investments. As traditional value investors, we tend to search for projects that have the potential to become leaders in their category (and then we patiently wait for it to grow).
Liquidity Risk Discount is Included
Digital assets are thinly traded (low volume/high volatility) so a smart move is to apply a discount between 0 – 90% (depending on the asset). For riskier altcoins, the strategy to get a higher discount is to sell it whenever you want to.
Valuation Frameworks Should Be Steady
It is hard to assess different types of crypto assets: an NFT is unlike an exchange token, and you want frameworks that can help you compare “apples to apples.” Credo can help you look at very different investments and assess each one of them.
Digital Assets are Diverse
As crypto assets have different sizes and shapes, digital currencies like bitcoin, Litecoin, and Monero are relatively different blockchain platforms like Ethereum, Solana, and Avalanche. So when assessing potential investments, it is important that you use different valuation models.
Is cryptocurrency a currency, an asset class, or totally something else?
When investing in cryptocurrency, it is important to evaluate their potential role within a portfolio, just like with any other type of investment. Take note of the diversification advantages and return enhancement and evaluate them along with the risks (volatility, liquidity, regulation).
Using Bitcoin, the major cryptocurrency, emphasizes some key issues investors should reflect on.
Bitcoin’s returns originally came from tough retail demand for an asset engineered for shortage, but the future price path depends on the partaking of traditional institutional investors, which may have varied needs and risk appetites. For Bitcoin to experience constant high returns, it would need expansive adoption (particularly among venture capital investors, hedge funds, and high-net-worth individuals).
In the meantime, Bitcoin’s price swings have been impressive, as it’s an up-and-coming technology with fast implementation and no consensus valuation anchor, which creates ambiguity in the price-discovery course. One more contributor to volatility is the involvement of highly levered investors, whose quick liquidation may raise drawdowns in tail events.
Liquidity on the spot market remains fairly low. It is known that a majority of outstanding bitcoins are “buy-and-hold”, meaning no recent trading movement (according to the timestamps of transactions). This produces a tendency to limit liquidity and recommends many investors look at Bitcoin more as an unstable store of value than a means of exchange or short-term speculative instrument.
The guidelines in Bitcoin and cryptocurrencies are a vital source of ambiguity, and greater regulatory transparency could present a risk or a prospect for broader adoption. Correspondingly, the environmental trace of Bitcoin’s proof-of-work protocol can cause alarm for ESG (environmental, social, governance) investors, and improved transparency about renewables use is needed.
What are the key concerns when evaluating Bitcoin or other cryptocurrencies as a prospective investment?
As with any investment, it is crucial to assess their potential role within a portfolio – such as diversification benefits and return enhancement – versus the risks, which include volatility, liquidity, and regulation, among others.
Using Bitcoin, the predominant cryptocurrency, as an example highlights some key issues investors should consider.
Bitcoin’s returns initially came from strong retail demand for an asset engineered for scarcity, but the future price path depends on the participation of traditional institutional investors, which may have different needs and risk appetites. In order for Bitcoin to experience continued high returns, it would need broader adoption, in our view – especially among venture capital investors, hedge funds, and high-net-worth individuals.
Meanwhile, Bitcoin’s price swings have been dramatic, as it’s an emerging technology with rapid adoption and no consensus valuation anchor, which creates uncertainty in the price-discovery process. Another contributor to volatility is the participation of highly levered investors, whose rapid liquidation may increase drawdowns in tail events.
Liquidity on the spot market remains rather low. Based on the timestamps of transactions, we know that a majority of outstanding bitcoins are “buy-and-hold” (i.e., no recent trading activity), which tends to limit liquidity and suggests many investors see Bitcoin more as a volatile store of value than a medium of exchange or short-term speculative instrument.
Regulation of Bitcoin and cryptocurrencies is an important source of uncertainty, and greater regulatory clarity could present a risk or an opportunity for broader adoption. Similarly, the environmental footprint of Bitcoin’s proof-of-work protocol can cause concern for ESG (environmental, social, governance) investors, and improved transparency about renewables use is needed.
How is the cryptocurrency market developing as compared to other investable markets?
Unlike the conventional assets, cryptocurrencies are intended for self-custody thru virtual wallets. Institutional investors usually depend on custodial wallets, whereas a third-party financial institution holds bitcoins or other crypto assets in trust.
There has been a growing financialization as the market of cryptocurrency grows. In 2017, when US dolla-settled Bitcoin futures were launched, many other non-traditional financial institutions also tendered Bitcoin futures and options with margin transactions also happening in bitcoins. It was October of the same year that the first exchange-traded fund based on Bitcoin futures was launched.
Other markets similar to cryptocurrency are still in their formative years compared to the other financial assets and liquidity on the spot market remains a valuable consideration. Figures on the real liquidity is difficult to attain as most exchanges remain self-reporting. Additionally, the ownership framework appears to be highly concentrated, which is fairly due to network entities that merge a larger amount of underlying individuals under one roof.
Even though this illiquidity has risks to short-term investors, a still-emerging market configuration can also present opportunities for investors who can provide liquidity to benefit from dislocations in the market without material beta exposure to cryptocurrencies. As an example, spot Bitcoin against futures, or purchasing investment vehicles backed by Bitcoin at a discount to net asset value (NAV), have sometimes provided more arbitrage opportunities than normally seen in more traditional asset classes.
Credo’s take on digital assets’ role in large portfolio asset allocation
Cryptocurrencies are at this point ill-suited for investors who are preparing for retirement or with short-to-medium-term time horizons because of high volatility, lack of liquidity, and valuable operational and financial risks. A conservative allocation to digital assets is recommended for investors with a very high risk tolerance and capability to withstand significant volatility.
It’s also crucial to think about diversification advantages (or lack thereof) when adding exposure to digital assets to a portfolio within an asset share framework. Despite the challenges because of the limited history in assessing cryptocurrency’s role in a portfolio over several business cycles, evidence for diversification still exists. The prices of cryptocurrency in general have not changed in tandem with those of gold or other inflation hedges, or of other risk assets like equities, despite the considerably higher volatility.
Within an asset allocation framework, it’s also important to consider the diversification benefits (or lack thereof) of adding exposure to digital assets to a portfolio. Although limited history makes assessing the role of cryptocurrency in a portfolio over multiple business cycles challenging, there is some evidence Nevertheless, in tail events, cryptocurrencies have been more associated with other risk assets, reducing some of the diversification benefits.
Opportunities seen in digital assets
The evolving milieu in cryptocurrencies and other digital assets have shown three high-level classes of opportunities:
Market Structure: Investors can check how they can benefit from structural inefficiencies in the market for a promising asset class, despite not having significant beta exposure to cryptocurrencies.
Financial System Innovation: With the landscape of the digital asset rapidly evolving, investors can expect that the disruption to the current financial system infrastructure can generate opportunities for them.
High Risk, High Return: Various digital assets may fit within strategies targeting a high-return strategy that can endure significant volatility and risk.
We’re closely watching anarray of investment risks related to digital assets:
ESG Concerns: ESG-sensitive investors from an environmental perspective are threatened with mining Bitcoin and other cryptocurrencies based on the proof-of-work consensus mechanism due to its requirement for an enormous amount of electricity. This remains a major concern for investors despite the Bitcoin mining industry’s acknowledgment to increase transparency and the need to shift to more sustainable energy sources.
Regulation: Countries and even regulators from the same country regulate and treat Bitcoin tax-wise differently. The regulatory environment can transform rapidly which often drives price volatility.
Volatility: Heightened market frictions and liquidity risk are the usual challenges that the Bitcoin market faces. A tremendous high volatility and restricted liquidity make digital assets unsuitable for many types of investors.
Operational Risk: Crypto investments are in danger of being hacked by those targeting exchanges or lost keys in case of self-custody. Thus, there’s a need for secure custody and some combination of digital and physical security plus insurance against theft or loss. Regardless of the idea of decentralization, Bitcoin is systemically levered to existing large exchanges, concentrated ownership, and a number of large mining operations.
What are the biggest risks you see?
We’re monitoring a range of investment risks associated with digital assets:
- ESG concerns. Mining Bitcoin and other cryptocurrencies based on the proof-of-work consensus mechanism requires enormous amounts of electricity, posing significant challenges for ESG-sensitive investors from an environmental perspective. Although the Bitcoin mining industry has started to increase transparency and has acknowledged the need to shift to more sustainable energy sources, this area remains a major concerns among investors.
- Regulation. The regulatory and tax treatment of Bitcoin varies significantly between countries, and even between regulators in the same country. The regulatory environment can change rapidly and often drives price volatility.
- Volatility. The Bitcoin market appears subject to liquidity risk and heightened market frictions. Extremely high volatility and limited liquidity make digital assets inappropriate for many types of investors.
- Operational risk. Crypto investments are at risk of hackers targeting exchanges or lost keys in case of self-custody. This calls for secure custody and some combination of digital and physical security plus insurance against theft or loss. Despite its idea of decentralization, Bitcoin is systemically levered to existing large exchanges, concentrated ownership, and several large mining operations.