*MVF: Minimum Valuation Framework for Cryptoassets
Disclaimer: NOT financial advice.
Past Attempts at Valuation Frameworks
In crypto, people have attempted to apply a wide array frameworks to reason about asset prices, primarily borrowing from traditional finance frameworks and understandings. Some of the most popular models include:
Quantity Theory of Money
The quantity theory of money (QTM) of money states that the average price level is determined by three key factors: the money supply, the velocity (the number of times an asset changes hand), and the transaction volume of goods and services. This is framed via the equation:
MV = PQ
Under EIP-1559, which drastically decreased issuance, some have applied the QTM and arrived at seemingly astronomical valuations for ETH, suggesting that this model should primarily be used in a theoretical (relative) manner as explained by Austin Vernon here.
This is largely due to the fact that the QTM does not capture the novel forms of cryptoeconomic activity beyond the traditional macroeconomic framework. Cryptoassets have further use cases beyond money. Other implied properties of the QTM includes nation-state level sovereignty effects, which for crypto protocols, is inappropriate, or at least questionable at best.
Dividend Model
The dividend discount model (DDM) is another valuation approach reasoning about valuations through cash returns to stockholders. In crypto, this is generally in the form of a buy-and-burn model, where protocol revenues/fees goes towards a burn mechanism, decreasing total outstanding supply of the token.
The DDM falls short in three main ways. First, like the quantity theory of money model, it fails to incorporate other cryptoeconomic activity not captured by the fee burn. Second, this model relies on the assumption that relative scarcity guarantees higher value. This is obviously incorrect as there are many assets that are scarce but not valuable (e.g. outdated computer chips). Third, the model fails to consider additional exogenous capital entering the system in order to exploit this mechanism without organic revenue (e.g. VC money being used to generate non-organic revenue through wash trading).
MVF: Minimum Valuation Framework
The MVF provides a more comprehensive framework that enumerates the lower bound for cryptoeconomic protocol valuations from first principles.
The MVF is comprised of two components (A, B) and posits that the value of a cryptoeconomic protocol must be greater than the maximum of both components. In other words:
valuation >= max(A,B)
A: Discounted Cash-Flow (DCF) of MEV Revenue for Stakers Securing the Protocol
The following assumes familiarity with MEV. Oversimplified analogy for finance folks: MEV is to crypto as HFT (high-frequency trading) is to traditional finance.
If you are a validator and you are designated leader for consensus of a given block, you decide (1) what transactions are included in that block and (2) the order of transactions within that block. Validators extract profits when they are the leader of consensus by rationally choosing one's own arbitrage transaction (DEX arbitrage, liquidations, etc.) yielding the maximum risk-free return. The result of this is the extracted MEV of that block.
As of December 9th, 2022, Flashbots (the primary MEV tool on Ethereum) has extracted a total of $686 million in MEV profits, providing a ballpark for a lower bound of the total MEV market on Ethereum:
Source and up-to-date statistics can be found here.
By converting (or hedging) one's stake and staking rewards into cash -- removing any exposure to price volatility -- one can begin to discount cash flows to determine the present value of the asset.
Additionally, MEV grows, and MEV opportunities increase, as the relationships between crypto assets deepen and the crypto industry grows. There will be more one-hop and multi-hop arbitrages available, increasing the total MEV pie.
I've written a bit about EigenLayer in the past and it directly applies to this aspect of the MVF. Leveraging native or pristine ETH, validators are able to opt-in and receive additional cash flows of middleware solutions unlocked via EigenLayer. This unlock is a strict Pareto improvement, increasing revenue opportunities and directly increases the value of ETH to validators. Ceteris paribus, EigenLayer (with a single yield-bearing protocol built on top of it) increases the price of ETH.
B: Aggregate Volume Secured by the Protocol over a Given Time Horizon
One corollary that many have drawn from the Fat Protocol Thesis is that the value of the underlying protocol asset must always be greater than the aggregate value of everything built on top. In other words:
Market Cap(ETH) >= Total Market Cap(ERC-20s)
This is provably false, not only in theory but also in practice. The aggregate value of the decentralized app (dapp) layer built on top of Ethereum has exceeded ETH's market cap in 2020, 2021, and 2022. Through the lens of Aggregation Theory, as dapps continue to find product-market fit and blockspace becomes increasingly commoditized, dapps will gain more leverage (since they bring the users and liquidity) and accrue more lasting value by commoditizing downstream suppliers.
Instead, a given crypto protocol's valuation is related to its dapps and middlewares (or any party that purchases its secure blockspace) in a more subtle way. One should compare the economic security provided by stakers (not the total market capitalization) and the aggregate volume secured by the stakers over a given time horizon. This is to ensure that the net amount of secure, decentralized blockspace being sold is not greater than the aggregate amount being purchased and transacted on by dapps, middlewares, etc. This is to ensure that the protocol is not overleveraged and resides at a local equilibrium.
The time horizon here is not necessarily on a per-block basis, but rather the amount of time it would take to detect fraudulent transactions or activities, including double spends and re-organizations (re-orgs). The amount of time is likely not linear: re-orging a finalized block 1 year ago is much more difficult than a block from 1 minute ago by orders of magnitude.
As understood by the Ethereum Foundation, one corollary to this time horizon approach suggests that since ETH secures many rollups (buyers of large amounts of economic security from Ethereum), all other things being equal, ETH's price must increase in order to support and facilitate this additional economic activity.
Applying the MVF
The MVF applies to multiple layers of the crypto stack, including L2s. When MEV gets extracted on a given L2, it is not being extracted on the respective L1 (whether on Ethereum or otherwise). In this way, one can think about an L2 as an L1 for MVF purposes, and value the L2 based on its own indepedently analyzed MVF.
Similarly, the valuation of sidechains like Polygon and Binance Smart Chain (which operate as effectively their own L1s), can also be analyzed by calculating their own independent MVF.
Essentially, all marketplaces for decentralized trust (that operate in a similar manner for value accrual) must abide by the MVF.
Going Forward
Recent crypto trends has us going towards a more heterogenous, fragmented world where liquidity is split across new layers and ecosystems (just a few years ago, effectively all activity was occurring on a single-sharded environment of Ethereum). The ability to accurately value these new layers that facilitate economic activity via methods like the MVF will be necessary to understand the future of the cryptoeconomy.
Hopefully this framework provides a starting point to help builders, investors, and academics better understand cryptoeconomic value and quantitatively determine the maturity, sustainability, and security of a given crypto protocol.