Valuation Methods: Finding PQ

Posted By under Cryptocurrency Valuation, Valuation Methods

PQ in the equation of exchange represents the total value of all purchases made with a cryptocurrency.

There are two ways to find total purchases.

The first is through direct, on-chain observation. The second is to use orthogonal metrics as a proxy for on-chain data.

Estimating PQ

Estimating PQ through proxy metrics is useful where data is unclear.

For example, Monero, whose chain can’t be surveilled – is impossible to gather data from.

XMR transaction amounts are hidden, and transaction histories are unclear.

XMR is mainly used on the dark web – exactly like Bitcoin when it started.

If you know the volume of purchases on the dark web, and the percentage of dark web transactions using Monero, you have a large component of PQ for XMR.

Finding PQ On-chain

In transparent blockchains, data is easy to parse.

Most blockchains are transparent, so on-chain data can be used as inputs to the equation of exchange.

It’s easiest to do this for Ethereum-based tokens. Transaction data can be interpreted according to documentation for the smart contract, which makes it easy to identify which transactions are speculative and which are to be included as part of total purchases.

For example, you can look at a Chainlink (LINK) transaction and understand which tokens are being paid to data providers, and which are simply being sent between exchanges by arbitrage traders.

[LINK dashboard Dune Analytics]

Etherscan is a helpful site to find known addresses like exchange wallets. Dune Analytics is a visualization platform with crowdsourced insights.

Combining Methods

Transparent medium-of-exchange coins, especially those which are UTXO-based (Dash, Litecoin, Bitcoin Cash) require a combination of on and off-chain analysis to find PQ for the equation of exchange.

It’s not always clear which transactions are self-sends, speculative purchases, or those sent to mixers for obfuscation, etc.

In this case, it’s helpful to identify known wallets and work from there.

Exchange addresses are publicly available, flagged on sites like Etherscan and Dune Analytics.

Source: Detecting Roles of Money Laundering in Bitcoin Mixing Transactions: A Goal Modeling and Mining Framework

On UTXO-based chains visualizations of transactions coming from mixers look different than visualizations of regular transactions, it just takes a little digging to identify these.

Going Further

Fundamental valuations of cryptocurrency are built on the equation of exchange – required reading for this article and others.

The equation of exchange is foundational to cryptocurrency valuation and the Tokenomics 101 article series.

We use these frameworks to design valuable tokens.

If you’re interested in building a token with fundamental value or valuing cryptocurrencies with a simple framework, reach out to us for a free consult.

Terra (LUNA) Tokenomic Post Mortem

Posted By under Blog, Tokenomics ,

Terra is a base-layer (L1) blockchain with native asset, LUNA, used primarily to collateralize the Terra ecosystem’s stablecoin, UST.

This week, the UST stablecoin lost its peg to the dollar, causing a “death spiral” that brought LUNA down from $90 to $0.

It was an unprecedented event whose implications are still being worked out in the crypto space.

Takes on the fundamental reason LUNA crashed range from “it was an inside job” to “20% yields are unsustainable,” with “LUNA itself was undercollateralized” and “LFG, the Terra treasury mismanaged funds” falling in between.

Shady dealings not withstanding, it was Terra’s tokenomics that caused its demise.

Examining LUNA’s fundamental value

All currencies get their value from use as a medium of exchange.

Cryptocurrencies are no exception.

In LUNA’s case, this value comes from use as collateral.

LUNA collateralizes UST, and LUNA holders make decisions about the protocol – governance.

Like all pure-governance tokens, LUNA doesn’t derive much value from its ability to make these changes.

Most of LUNA’s value came from the belief that it would be used as collateral for borrowing UST.

Terra: a short summary

Over the past two years, Terra ascended to the top of CoinMarketCap, fueled by “guaranteed” returns on Anchor Protocol.

In March, founder Do Kwon announced Terra would buy $10 billion in reserves, to fortify LUNA.

By May, ~$2.5 billion in BTC had been accumulated by LFG, the Terra treasury, but there were $14 billion UST outstanding, making Terra an easy target since the foundation couldn’t cover deposits.

Taking profits in stablecoins like USDT, DAI, and UST is popular way for traders keep money the ecosystem, and avoid centralized exchanges.

UST holders were attracted for this reason, but the fundamental driver of Terra’s growth was 20% yields on stablecoins deposited into Terra’s Anchor protocol.

On May 12, series of shorts on UST caused it to fall below $1.00.

Over the next few days, a bank run followed.

UST fluctuated wildly, causing Terra to mint new LUNA by design, and prompting LFG to sell its BTC reserves for LUNA, hoping to bring the UST peg back to $1.00.

It didn’t work; the crypto community had lost faith in UST, recognizing Anchor as a pyramid scheme.

After several days, facing a hopeless situation, Terra network validators paused the blockchain to prevent further attacks.

For blockchains, less than 100% uptime is a cardinal sin.

Lessons from Terra (LUNA)

LUNA’s use was rather limited. It was primarily used to create UST.

Irrespective of LUNA’s sizeable Total Addressable Market – a multiplier of demand for stablecoins – LUNA’s TAM is fickle.

Anchor’s 20% yield ultimately depended on LUNA’s continued growth.

A few takeaways:

  1. Cryptocurrencies get their value from use as a medium of exchange.
    1. The resilience of a cryptocurrency depends on the diversity of its economy. LUNA was used for a single purpose; when Anchor failed, LUNA failed.
  2. All value is belief.
    • Once the belief that LUNA could create UST was shaken, the price spiraled.
    • To Terra’s credit, it (still) has lots of supporters, and a vibrant community, but even this isn’t enough to fix bad tokenomics.
  3. Tokenomics must be sustainable. Without sustainable tokenomics, projects risk stagnation or collapse.

The bulk of the implications from Terra’s collapse are likely to play out over the coming weeks and years. In such an interconnected system, these effects are not immediately obvious – tokenomic design can be complex.

If you are creating a token and would like some help with tokenomics, feel free to reach out for a free consult.

Equation of Exchange: Simple Examples

Posted By under Equation of Exchange, Valuation Framework ,

The Equation of Exchange

The equation of exchange, MV = PQ is foundational to the Eat Sleep Crypto valuation framework. The following articles explain each component in detail:

Equation of Exchange Examples

Imagine an auto mechanic needs to purchase $10,000 worth of parts from China. The seller demands payment in CNY, which is traded on exchanges.

To complete the payment, there must be at least $10,000 worth of Chinese Yuan in circulation.

If there isn’t at least $10,000 worth of CNY in circulation, there are two ways to make it so:

1) CNY is printed by some means, and acquired by the buyer to complete his purchase.

Or,

2) The entire circulating supply is bought up on order books until the buyer’s CNY is worth $10,000.

The first method acts on the supply side, increasing the circulating supply.

The second is based on demand, where the currency’s price appreciates to meet demand for its use.

Valuing Cryptocurrencies With the Equation of Exchange

Our microeconomic example of the equation of exchange using CNY works the same at scale, with a couple more moving parts.

Since cryptocurrencies can’t be inflated at will, the buying up of cryptocurrencies and tokens on exchanges for actual use cases is how price discover occurs.

Let’s say Bitcoin is used to buy $100 billion worth of goods and services annually. We’ll imagine that 10 million BTC are in the circulating supply – they not lost or otherwise unavailable. And we’ll say that each bitcoin moves between 5 people per year, on average (historical velocity of the dollar).

So our velocity is 5.

So we have M = $100 billion (PQ)/ 5 (V) = $20 billion

Applied to cryptocurrencies, this fundamental value is a *price floor* – the minimum sustainable price of a cryptocurrency, absent speculation. Dividing $20 billion by 10 million BTC to get the price per unit gives us a price floor of $10,000 per Bitcoin.

In the Investor Series articles, we find price floors of various cryptocurrencies using models with adjustable assumptions.

Equation of Exchange: M, Monetary Base

Posted By under Equation of Exchange

The equation of exchange, MV = PQ is an algebraic equation used to solve for various components of a currency’s value.

It is typically reordered to solve for M by economists, who want find the necessary supply of a currency – the minimum monetary base – needed for commerce.

If more demand than currency exists, notes will trade above their face value.

Cryptocurrencies experience the same demand pressure, but don’t have this problem. Instead, their prices appreciate to meet demand for purchases.

Increasing demand pressure and decreasing circulating supply causes the price floor of a cryptocurrency to increase.

If a cryptocurrency’s price on exchanges is close to its price floor – the price below which it cannot sustainably trade – the traded price must also increase to meet demand for value to be transferred through it.

The Eat Sleep Crypto valuation framework uses the equation of exchange in this way to identify price floors and design tokens.

Why Market Cap Is A Bad Metric

Posted By under Cryptocurrency Valuation, Valuation Framework

Market cap, short for market capitalization is a misleading metric when valuing cryptocurrencies.

Market cap is borrowed from traditional finance’s equity valuation methods. Cryptocurrencies and tokens are valued using the equation of exchange.

Types of supply

The cryptocurrency space has started to recognize the inadequacy of “market cap” in valuing cryptocurrencies.

Popular metrics now distinguish between issued supply, and total supply at some later date – fully diluted market cap.

This is only a partial solution, since not even all coins which have been issued are still in circulation (e.g. Satoshi’s coins).

Circulating supply in the Eat Sleep Crypto valuation framework refers to only those coins which have moved in a time frame.

The time frame is arbitrary; it’s only important that the other components of the equation of exchange use the same one.

Why circulating supply is best

The most meaningful comparisons can only be made by looking at different sets of coins – i.e. coins with the same Cryptocurrency Valuation Methods; Determining Coin Age at different dates.

Looking at circulating supply allows more useful comparisons of velocity and supply for the same coin over time.

Valuation Methods: Identifying Circulating Supply

Posted By under Valuation Framework ,

Circulating supply is the number of coins (cryptocurrencies, tokens) in circulation.

It can be defined different ways – the key is that it’s defined the same across components of the equation of exchange.

For example, if circulating supply means “coins which moved within the past year,” the velocity, monetary base, and total purchases should also reference those specific coins.

Generally, it’s helpful to define circulating supply to include coins with a coin age less than one year, and exclude coins on-exchange, staked, and burned.

Read Why Market Cap Is A Bad Metric to learn why other measurements of supply are misleading for valuing cryptocurrency with the equation of exchange.

What is the Equation of Exchange?

Posted By under Cryptocurrency Valuation, Equation of Exchange ,

The equation of exchange is as old as economics itself.

First derived by John Stuart Mill, then referenced by Adam Smith, the equation of exchange has gained popularity more recently through Milton Friedman and other monetary theorists.

The equation of exchange is the foundation of cryptocurrency valuation in the ESC framework.

The Equation of Exchange, MV = PQ

The equation of exchange, MV = PQ is an algebraic equation used to solve for various components of a currency’s value.

It is typically used by economists to find the necessary supply of a currency – or, the minimum value of the monetary base needed for commerce.

When not enough fiat currency circulates, notes trade above their face value.

Cryptocurrencies experience the same demand pressure, but since cryptocurrency prices are floating, their prices appreciate to meet demand for purchases.

Increasing demand pressure and decreasing circulating supply causes a cryptocurrency’s price floor to increase.

If a cryptocurrency’s price on exchanges is close to its price floor – the price below which it cannot sustainably trade – the traded price must also increase to meet demand for value to be transferred through it.

The cryptocurrency valuation framework uses the equation of exchange to identify price floors and design tokens which hold their value.

Equation of Exchange articles:

Valuation Methods: Calculating M, Monetary Base

Posted By under Cryptocurrency Valuation, Valuation Framework ,

The equation of exchange is used in the Eat Sleep Crypto valuation framework, and in tokenomic architecture, analysis, and design.

To do this, the Equation of Exchange is reordered to solve for monetary base, M.

This gives us, M = PQ/V

We define M, the monetary base as including all circulating coins – not those on exchanges, lost, or burned.

M divided by circulating supply to find the price floor of a coin.

Other inputs are required to value cryptocurrencies with the equation of exchange.

First, circulating supply – the actual number of coins still accessible and in “hot wallets,” ready to be spent or sold, must be estimated.

Second, irrelevant transactions (e.g. speculative transactions, self-transfers) must be excluded from calculations.

Third, distinct uses for tokens must be identified and evaluated separately before combining them to find a price floor.

You’ll learn how in Valuation Methods: Identifying Circulating Supply and Valuation Methods: Estimating Velocity and using off-chain data in Valuation Methods; Finding PQ.

The economics of #Monerun and the hidden benefits of rehypothecation

Posted By under Blog ,

Monero (XMR) is the best-in-class privacy coin and continues to gain adoption in real-world transactions.

Monero’s relative anonymity makes it ideal for transactions where privacy is required. Recently though, it’s come to the attention of XMR users that this anonymity comes with hidden costs.

According to the Monero community, exchanges are using Monero’s anonymity to conceal their trading of ‘paper contracts’.

A thread in r/cryptocurrency summarizes the issue.

In short, exchanges are accused of selling Monero they don’t have, which suppresses price.

On April 18th, Monero users coordinated to withdraw their XMR from exchanges to create a bank run, forcing exchanges to buy XMR on the market, increasing its price.

This financial sleight of hand happens with cash, too. It’s called fractional reserve banking. Banks are permitted by the Federal Reserve to lend 5 to 10 times more than they hold in cash, thus creating money out of thin air – inflation.

If exchanges are doing the same thing with XMR, inflation doesn’t occur because these paper contracts aren’t circulating in the XMR economy, but speculation is not being priced into the coin.

Hidden benefits of rehypothecation

Caitlin Long warned of this phenomenon as a threat to Bitcoin in 2018, calling it “rehypothecation.”

In #TradFi, rehypothecation is to the reuse of the same underlying collateral in multiple financial contracts.

In the private sector, rehypothecation is illegal, as it can leave its beneficiaries on the hook for more than they’re able to pay.

Proponents in all sectors argue that done carefully, it enables liquidity.

This is ostensibly also the accused exchanges’ argument.

Accusations of rehypothecation may just be a convenient explanation for Monero (XMR)’s stagnant price, but it wouldn’t be the first time exchanges acted unethically to make a buck.

Most coins get their price primarily from speculation, and rehypothecation would decimate many of them.

Monero (XMR), on the other hand, is used primarily for real-world purchases. Because of this, it actually stands to benefit from rehypothecation.

MV = PQ

ESC Investor Series valuation models are based on the equation of exchange.

The Equation of Exchange, MV = PQ is the standard way to value a currency. In short, it says a currency is as valuable as the things it’s used to pay for.

We use it to find cryptocurrency price floors given a set of assumptions.

To use Monero as an example, the price of all circulating XMR must be at least enough to facilitate commerce.

If the price isn’t high enough to meet demand for payments with it, XMR will be bought – and importantly, withdrawn and used to buy things.

Because they’re not circulating, paper contracts don’t affect XMR’s price floor – given Monero’s use profile, it’s unlikely much is sent within exchanges as payment.

“Printing” contracts, though, still suppresses price as speculation is absorbed.

Takeaways

#1) Rehypothecation of XMR has mixed implications.

On the one hand, users miss out on speculative swings due to price suppression.

On the other, XMR gains price stability, arguably Monero’s greatest obstacle in the way of adoption.

#2) Monerun is unlikely to have lasting effects.

5/2/22 editor’s note: XMR’s price is down ~25% since recent highs on 4/18 during Monerun.

Exchanges lose no face by simply refusing withdrawals.

5/2/22 editor’s note 2: Binance withdrawals were suspended on 4/17, ahead of Monerun.

Furthermore, nothing stops exchanges from continuing to rehypothecate XMR.

#3) XMR has major upside.

If the XMR price was purely speculative, rehypothecation would be cause for concern.

But it’s not.

Monero best fits the main use case of cryptocurrencies – private, uncensorable payments.

Regardless of whether Monerun sustainably raises price, XMR has 100x growth ahead of it.

It won’t be long before the world realizes the importance of financial privacy.

For more articles on these valuation methods, read these articles and follow Nate on Twitter @EatSleepCrypto.