Fundamentally, cryptocurrencies get their value through use as a medium of exchange. This includes cryptocurrencies paid for goods and services, and tokens paid for fees, collateral, and other tokenomic levers within a protocol.
Most cryptocurrencies and tokens are best valued using the equation of exchange.
The equation of exchange was first derived by John Stuart Mill, referenced by Adam Smith, and popularized by Milton Friedman.
Using the equation of exchange and circulating supply, we can calculate the fundamental value (and minimum sustainable price, price floor) of each unit.
Equation of Exchange Components
The equation of exchange, MV = PQ, describes how a token’s use as a medium of exchange drives its price.
Solving for M, the equation reads intuitively.
M = PQ/V
For any given time period, M, the monetary base is worth the total value of purchases (PQ) divided by the number of times each coin is used (V, velocity or churn).”
For example, if CashCoin is used to buy $1,000,000 worth of products per year, and each CSH is used an average of 5 times, the variables are as follows:
- M, unknown
- PQ = $1,000,000
- V = 5
Solving for M using M = PQ/V gives us M = $200,000.
So the monetary base of CSH is $200,000.
Solving for p, Price Floor
Now imagine there are 10,000 cashcoins.
We can easily solve for the price of each, dividing monetary base, M by circulating supply, c.
$200,000/10,000 = $200 per CSH
Note that this only concerns circulating supply of CSH.
Coins which are lost, locked up, or in cold storage are not part of an economy – they’re not subject to supply and demand.
Stored coins may be relevant to speculators, but speculation is not priced in directly; the price floor of a cryptocurrency and its speculative price premium are different.
Price floor vs speculative price premium
A cryptocurrency’s price reflects:
- Fundamental value, price floor
- Speculative price premium
Cryptocurrency price floors
Fundamental value reflects supply and demand for a cryptocurrency as a medium of exchange.
This fundamental value is a price floor – a price a currency will not sustainably trade below.
When a currency trades at its price floor, volatility will naturally cause it to dip below, but buying pressure from aggregate demand brings the price back up.
A currency might trade below its price floor, but not for long.
Speculative price premium
The rest of a cryptocurrency’s price is speculative.
It may be rational to price in future returns (see Burniske’s DEUV), but it makes sense to distinguish speculative premium from fundamental value.
Price/price floor ratio is a meaningful measure of risk/reward – the closest
Most cryptocurrencies’ price floor can be extrapolated from on-chain data.
Identifying price floors using on-chain data
Price floors can be worked out using on-chain analytics.
The components of price floors – circulating supply, velocity, and total purchases are all found on-chain.
Some on-chain data, like ERC-20 token data is easy to interpret. ERC-20 transactions are easy to reconstruct from blockchain analysis.
Commercial transactions on medium-of-exchange currencies are harder to distinguish from speculative trading, self-transfers, mixing, but it can be done.
Determining which transactions are speculative, self-transfers, part of mixers using just metadata requires getting creative.
Conclusion
This cryptocurrency valuation framework is used to identify and take advantage of price floors, calculate risk/reward ratios, and engineer tokens with price floors using the principles of tokenomics.
Further reading: