A Taxonomy Of Digital Assets For Investors
How to think about value in the cryptoasset space
Coming from the traditional financial world, I struggled for years to understand how the thousands of various coins and tokens that make up the digital asset ecosystem could possibly have any value. While I believed I had a decent handle on Bitcoin, I wrongly assumed that essentially all the others were a casino where the house took advantage of unwitting “investors”.
This is my attempt to help you move beyond that misunderstanding much more quickly than I was able to. My hope is that by the end of this article, previous skeptics will think twice before writing off all cryptoassets as Dutch tulips and will be armed with a framework for understanding the cryptoasset ecosystem and the immense potential the space has.
The Most Common Misunderstanding
Before diving into why individual types of cryptoassets have value, let’s clear up the biggest misconception about why cryptoassets have value at all.
Misunderstanding: Since open source code can be copied infinitely, cryptoassets and virtual assets generally are not “scarce”, thus they are worthless.
Rebuttal: Cryptonetworks like Bitcoin are best seen as mini economies, with their cryptoassets allowing transactions within the economy, much like the U.S. Dollar does for the U.S. economy. Bitcoin the asset would be nothing without Bitcoin the network and the only way to get access to Bitcoin the network is with bitcoin the asset.
A decent web designer could create a site that does pretty much the exact same thing as Amazon without too much trouble. If no one uses it, that website still will not be worth anything, despite having similar technology to Amazon. People go to Amazon because they know there will be liquidity, a community and assurance of security when they make a transaction. Amazon’s value comes not from its technology, but from its network.
Taking that logic forward, if Amazon forced people to use a virtual currency to transact on its platform, that currency would be valuable since it would provide access to the service that Amazon provides. This is exactly what cryptoassets do, only the excess value that the network creates accrues to cryptoasset holders rather than to shareholders.
Now that this initial barrier has been removed, let’s explore the various types of cryptoassets and why they are valuable.
Comparable financial assets: Store of value commodity (think: gold)/currency
Elevator pitch: “Digital Gold”
· Network (asset) currency ticker
· Bitcoin (bitcoin) BTC
· Litecoin (litecoin) LTC
· Bitcoin Cash (Bitcoin Cash) BCH
· Zcash (Zcash) ZEC
Commodity money assets attempt to create a secure network to store value with a monetary policy that links increased demand to increased prices. Different assets possess different features around supply schedule, privacy, transaction capacity, etc.
Why you should care: While unquestionably a solid store of value, gold suffers from the same value accrual problem as every commodity — that higher prices incentivize greater production. While entities like OPEC in the oil space have attempted to mitigate this concern with moderate success through collusion, commodity monies bypass the issue altogether.
Algorithmically mined tokens like bitcoin have fixed intervals where the difficulty of mining changes, the equivalent of “moving” all the world’s gold less or more underground. By making it more difficult to mine when there are more people mining, the network effectively fixes supply issuance to a stable but exponentially decaying rate. As such, new demand for the asset translates much closer to 1 to 1 into higher prices, rather than catalyzing market mechanisms to increase supply to offset these gains. This system makes these assets much more effective in accruing and storing value than traditional commodities. Legendary macro investor Stanley Druckenmiller summed it up in a recent interview, noting “if the gold bet works, the Bitcoin bet will probably work better”.
Comparable financial assets: Arcade tokens, sports tickets
Elevator pitch: Access to a crypto network
· Basic Attention Token (BAT) BAT
· Augur (REP) REP
These tokens are used within a crypto application to transact but typically have more advanced features than commodity monies. Such applications support “if, then” logic (if Mary interacts with the application, then the network sends Mary some cryptocurrency) whereas commodity money networks only support transactions. Think about applications with utility tokens like arcades. You need tokens to be able to play games in the arcade, the machines won’t accept other currencies. Kids want to access the service an arcade provides, so they spend real dollars on purchasing tokens.
Why you should care: Do not misinterpret me saying that these crypto tokens resemble arcade tokens as saying they are worthless. Access to a popular application is always valuable if supply is limited. While Super Bowl tickets are really just pieces of paper, people pay huge sums to own them since they provide access to a valuable service (viewing the Super Bowl) and are in very limited supply since there are only a fixed number of seats available. If demand to use a network outpaces new supply and the tokens are essential to the network’s existence, price of the token would naturally rise in value.
The application Augur, built on top of Ethereum, is a prediction market (think PredictIt, Betfair, etc.) where participants can create and bet on any market they can think of. Its potential is massive if scale can be achieved. Imagine a small-town government able to write an insurance contract on a potential natural disaster by creating a market and buying into it with speculators at the ready to take on both sides of the trade and make the market. The platform already racked up millions of dollars of volume in the closing days of the 2020 U.S. election as bettors speculated on the winner.
Comparable financial assets: Consumption commodity (think: oil)/Fiat currency (think: U.S. Dollar)
Elevator pitch: Allow crypto-based decentralized internet applications
· Ethereum (ether) ETH
· Solana (SOL) SOL
· Cosmos (ATOM) ATOM
Application platforms attempt to act as a base layer for crypto-based applications much in the way applications such as Facebook, Google and Amazon are built on top of the internet. The application platform allows for communication between applications built on its network and provides critical security against hacks by allowing small applications to obtain security from the larger base layer. The cryptoassets for these application platform networks are designed to accrue value as activity in the ecosystem increases.
Why you should care: The protocols that make up the internet (think “HTTP” or “TCP/IP”) have had staggering impacts on human well being, yet are not owned by anyone and have no inherent value. The internet allowed the application layer to accrue all the value created from the system. Like the internet, crypto application platforms support valuable apps that create new ways to organize people and incentivize behavior. Unlike the internet, you need to use the platform’s asset, i.e. ether, to be able to interact with applications built on the platform, making this asset necessary and valuable.
Looking back at the Augur example, transactions like betting on markets and reporting outcomes require verification both within Augur and on Ethereum to make sure they are legitimate. Ethereum charges Augur users a fee to verify on Ethereum, which is paid out via ether to Ethereum miners. Ether holders benefit as demand for their ether rises, while Augur users benefit from the security provided by the Ethereum miners. Greater app usage on the Ethereum network would create larger demand for its ether token as app users are forced to pay higher fees in aggregate. If the demand for ether to pay fees increases faster than new supply is mined, the value of ether would increase.
Value Capture Governance Tokens
Comparable financial assets: Equity
Elevator pitch: “Ownership” stake of a decentralized network
· MakerDAO (Maker) MKR
· Yearn.finance (yearn.finance) YFI
Governance tokens are a relatively recent innovation in the space mostly used in applications built on Ethereum. While they do not give ownership over the network, holders of the value-capture variety of governance tokens are entitled to cash flow generated from economic activity on the network. MakerDAO, a crypto lending platform built on Ethereum, provides Maker holders value by deleting Maker tokens (like a share buyback) every time a lending transaction occurs. By taking tokens out of the total supply, the value of existing tokens rises, all else equal.
Governance tokens also give holders a vote on managerial decisions in the network. The action available to token holders goes far beyond the ability to elect a board of directors as possessed by traditional stockholders. Token holders can propose new fee structures, approve new project proposals from developers and more. Maker token holders, for example, have previously proposed different collateral requirements for borrowers to increase lending market functioning. Because token value is directly tied to activity, holders are doubly incentivized to make good governance decisions that benefit the entire network to maximize economic activity and their token value.
Why you should care: Even though there are no crypto applications successful in the mainstream (yet), the ability to organize and incentivize economic activity in a completely decentralized and trustless way is a truly massive innovation. By completely aligning management incentives with owner incentives to optimize decision-making, these networks may in the future be more efficient engines of economic activity than traditional corporations.
Pure Governance Tokens
Comparable financial assets: Start-up equity/equity options
Elevator pitch: Management of a crypto network
· Compound (Comp) COMP
· Uniswap (UNI) UNI
Pure governance tokens provide holders with a vote on decisions within the network, but don’t receive cash flows from transactions like value capture governance tokens do.
Why you should care: Pure governance tokens are generally used on newer blockchains where holders are committed to the development of the network. Pure governance token holders believe that by not taking a cut of the cash flows, the network will grow faster as users experience lower fees. Tokens of this type come with potential for future cash flows. Holders could in the future use their voting rights to demand cash flows from a successful network.
The ability to govern is also inherently valuable. Many eligible people would accept a salary lower than the governor of a state receives to run it. However, because the position is so important, we have (expensive) elections to determine who gets to hold the coveted position. While not immediately monetizable, we consider the power to organize behavior and run the government to still be quite valuable. Pure governance tokens provide holders a say in making those decisions.
Comparable financial assets: Dollar-pegged currencies
Elevator pitch: Use of crypto applications without price volatility
· MakerDAO (DAI) DAI
Stablecoins are used within applications to make the services they provide more useful by eliminating the volatility of cryptoassets. Imagine if the price of a new laundry machine on Amazon had the potential to rise 20% in the time between researching the different options and purchasing. Many fewer people would use Amazon since they couldn’t be sure of prices in advance.
Why you should care:
Stablecoins fix the volatility issue for crypto applications by holding a peg to the U.S. dollar, allowing users to transact in a currency where they can be much more certain of the value in the future. MakerDAO’s DAI does this for lending transactions, allowing borrowers and lenders to be much more confident in the value of their transaction for its duration.
All this said, just as dollar-pegged currencies are uninteresting for a dollar-based investor given the lack of any volatility, so are stablecoins. Their value is in supporting a digital economy, not accruing value themselves.
Potential Securities/Unnecessary Tokens
Comparable financial assets: Equity
Elevator pitch: Ownership stake or access to a centralized network
· Ripple (XRP) XRP
· Stellar (XLM) XLM
Without going into too much detail given my lack of legal background, coins of this type are overwhelmingly held by one entity and lack sufficient decentralization to obtain its benefits. Like a security, these coins derive value almost entirely from the work of the issuing organization that holds managerial control.
Why you should care: Careful legal research should be done in addition to typical diligence on any token backing a centralized structure before investing given the risk of being declared an unregistered security offering.
This list is by no means exhaustive. Some tokens fit into multiple classifications or could even represent their own entirely. Decred’s DCR for example straddles the line between commodity money asset and value capture governance token. The purpose of this piece is to help create a framework for the crypto ecosystem, not get specific on the functionality of individual networks.
With that said, I hope you come away with enhanced understanding of how cryptoassets get value from the network they are built into. By providing access to valuable services, the cryptoassets that flow through these mini economies gain value as real as the thin green pieces of paper in your pocket have. My greatest wish is that you come to the same realization that took me years to see — that this innovation represents a potentially world-changing leap forward in human organization and economic incentivization where Bitcoin is only the tip of the iceberg.
The materials in this article are for education and discussion purposes only and do not constitute investment advice. Opinions and projections included are provided as of the date of publication, may prove to be inaccurate, and are subject to change without notice. No recommendations are made to invest in any asset. Past performance is no guarantee of future results.