Written in close collaboration with Alex Felix.

On July 20th, 2016 the market capitalization of Steem briefly reached $386M and over subsequent weeks quietly retreated to under $150M. Many other cryptocurrencies followed a similar pattern at one time or another. But regardless of the speculative hype cycle that drives prices in either direction, the more fundamental question I’d like to examine is the perceived connection between a cryptocurrency’s market cap and its measure of a network’s value.

The term market capitalization originally comes from the stock market. To simplify the picture significantly, a stock gives its owner a share of ownership in some company. Ownership in this case has a very specific meaning. It refers on one hand to having the right to a portion of the company’s future income distributed in the form of dividends. On the other hand, if the company is sold, the stockholder will receive a portion of the proceeds.

Value of future income and growth X earned by the company can ideally be expressed as a stock price Y today. This would somehow account for various risks and unknowns, a factor that increases significantly as the time horizon extends into the future. The total value of all the shares of a company’s stock, its market capitalization, is a proxy measure for the currently expected capacity of the company to produce both income and growth. In theory, market efficiency means that everyone will use some version of this approach to valuate a company, which in conjunction with high liquidity means that markets do not deviate too far from this picture.

But what about cryptocurrency? When we multiply the price by supply and call it market capitalization, what have we achieved? What does this measure really mean for Bitcoin, Ether or Steem?

The confusion arises when we think of the market cap of cryptocurrency along those same lines: as the measure of value of the currency’s decentralized network. Firstly, neither Bitcoin, nor Ether, nor Steem give you any promise of future passive income. No dividends are associated with any of these currencies (for Steem, it is slightly more complicated, but Steem inflation payments are still not the same as dividends). The typical argument you hear amounts to the claim that the market capitalization of cryptocurrency reflects expectations of the future use of its network. Let’s go back to July 20th and see whether this argument holds water.

Steem economics back then was pretty complex (it still is, but with better parameters now after several major iterations). It had a special feature that Steem could be made to earn significant returns if it was locked up and made illiquid for an extended period of time. The lockup period was 2 years and unlocking your funds happened at equal weekly intervals. Consequently anyone who followed this model had no way of selling their funds any time soon. As demand for Steem grew due to investors and new users rushing to buy into the network, its supply remained extremely thin and locked up in individual accounts. When supply is thin price moves reflect outsized effects from small changes to investor activity. This creates a market dynamic that is far from being an efficient indicator of true value.

What’s even more important is the fact that some part of the supply can always remain dormant in the wallets of founders and crowdsale participants. This is the case with Ether where a large portion of the supply is held by the Ethereum Foundation, and for Bitcoin, whose early mined coins are held in anonymous wallets with humongous present value. This is fundamentally different from the common practice in the stock market whereby a significant percentage of company’s stock is held long-term by founders and other large shareholders. The difference is that while stock owned by founders earns dividends and dilutes the other shareholders’ portion of income, cryptocurrency laying dormant in someone’s wallet has no interaction or bearing on the market whatsoever.

If the liquid supply of the cryptocurrency is small it will prompt the coins to be spent more often. This phenomenon is called the velocity of money and underlies the important distinction between stocks and currencies. For currency the share of the network’s value is correlated to the number of times coins are spent, considering that every transaction captures some unit of network’s utility. Velocity is market-driven and will allow the market to function under a broad range of possible liquid supplies. It is also conceivable that in some cases reducing the liquid supply may drive prices up (as was the case with Steem) further exaggerating the effects I am describing.

These observations point out the fact that there are fundamental differences between stocks and cryptocurrencies. For stocks, the total supply, or number of shares outstanding, is grounded in a real meaning: it defines a distribution of a company ownership. For cryptocurrencies, the price dynamics, velocity, and the fact that illiquid supply does not interact with markets in any way mean that the market cap is not a good measure of value, if at all. For example, it would be pointless to compare the market cap of one currency with the market cap of another (without regard to all these other factors) and on that basis alone make conclusions about the relative value of their networks.