In this post I will try to create a model that can be used for valuation of medium of exchange tokens.

It’s important to remember however that a model is just a model meaning that it ignores a lot of factors. Second many models can bring different outcomes which of course should put into question the value of a model.

In this post I’m not going to use any formulas. Formulas are very dangerous as they give a false sense of security, they make a complicated world appear simpler and they also make people forget that those formulas only work if all the assumptions are right which is almost never the case.

I’m purposely not analyzing tokens that are securities for the reason that tokens that pay a dividend or make a profit and use it to buy back tokens should be analyzed as securities as per the standard valuation mechanisms that are used on stocks minus a huge penalty for all the issues that they have compared to standard stocks (no power for holders, no accountability, no transparency, no legal framework for example against insider-trading, etc.)

Medium of exchange tokens are very special as so far the only thing that was similar was gold and collectibles. Collectibles however are not liquid meaning that every item is different from another item so it’s not a good example. The only comparison that can be done is precious metals.

Historically both gold and silver have been used as a medium of exchange. So the first question is going to be why is gold more valuable than silver? The answer is not because it’s more scarce, as I’m not comparing 1 g of gold versus 1 g of silver but I’m comparing the value of all the gold in the world compared to all the silver in the world. It’s logical of course that gold will be potentially more expensive than silver because gold is more rare if you compare the same amount of weight. However what we are comparing here is the market capitalization of gold versus silver. Why is the market capitalization of gold so much higher than the market capitalization of silver?

Value of all the gold in the world

Amount of silver in the world

At a price of $17 per ounce the value of all the silver should be around $51b.

The interesting thing I just realized by doing this exercise is that there is actually more gold in weight than silver. There are roughly 5 billion ounces of gold versus 3 billion ounces of silver.

So why is gold more valuable than silver even if it’s actually less scarce? The reason is simply offer and demand and the main criteria for offer and demand is the desire to hold. Historically people have been exchanging silver coins much more frequently than gold coins. Silver coins (and copper coins) were often used for day-to-day commerce whereas gold was used more for reserve of value or very large transactions. Anyone can come up with a theory about why that is but the issue is that theories are always worthless after the fact as the theory has been designed around the observation of facts that have already happened. For example someone can say that humans prefer gold because of its color as it reminds the sun which has always been considered a powerful deity. However had it been the other way around (silver more valuable than gold) someone would have come up with a theory that obviously silver is more valuable because it reminds of the moon :-)

I believe there simply is no answer, it is completely based on hype and self-fulfilling prophecy. If people believe gold is valuable they will start hoarding it and as they buy it to hoard it the price will increase validating their theory that it’s valuable and convincing more people to buy because it’s valuable.

Medium of exchange things work as a positive feedback loop, meaning that the more the price goes up the more the price will continue going up.

So the first conclusion is that you cannot find through a model the potential upside, there was no way to find out if gold or silver would become the standard for reserve of value, and the difference between the value of all the gold in the world and all the silver in the world is something like 100x.

However we can try to build the model to determine the downside. Is there for example some sort of floor to the price? Or at least some intrinsic value so that if the price goes below that value we can claim it is a good deal?

Let’s look at the different properties of medium of exchange tokens:

Unlike metals which are a finite amount (periodic table) there can potentially be an infinite amount of medium of exchange tokens.

Medium of exchange tokens are the product of human intelligence and require to be maintained unlike metals. There is no difference between a good digger and a bad digger, the gold they extract is exactly the same. There is however a big difference between a good developer and a poor developer and you cannot just simply count the lines of code that they produce.

Based on the previous 2 points I believe the first element of analysis should be the barriers of entry. What prevents another token to compete with the current token?

The first thing is the team. Qualified developers with a reputation are not unlimited. So a project which is led by a qualified and reputable developer instantly has a barrier of entry in the sense that it’s unlikely that some unexperienced developer would be able to compete with them.

The second thing is the advisors, advisors act as a form of validators. Since well-respected advisors have a reputation to defend they would do extensive due diligence on the project before allowing their name to be used. This can be very helpful because of the strong lack of transparency in those projects.

Other barriers of entry could be for example patents.

Once the project has been released another barrier of entry that gets created is the traction and the amount of users. Since those tokens are sensitive to the network effect the more users they have the less likely they are to be disrupted. However there is no guarantee against that as a new technology could come out and the transition could be very quick (probably today more people spend more time on Facebook than watching TV, so the traction and user base that TV had didn’t help it to lose the battle against Facebook).

The barriers of entry will indicate the odds of survival which I think is the only floor that can be determined. It’s not unimportant however as knowing that price will fluctuate so much because of positive feedback loops the ability of the project to survive is extremely important as it basically gives the project the chance to fight another day and maybe reach the desired success and price.

Price of Ripple

A lot of people may have thought that Ripple was dead, but suddenly the price exploded. Ability to survive means ability to survive even when there is very little interest and the price is very low.

So basically my conclusion is the following, the best projects are the projects which have the most barriers of entry which usually means the best team and advisors. On top of that the ability of the project to survive regardless of the price or the number of users is very important also as you never know when things will turn around (if the project dies or get abandoned there is no chance for a turnaround). Traction and number of users is also very important but then usually it’s also proportional to the price, it’s unlikely that you would manage to buy something with significant traction at a low price.

I am going to elaborate on some further thoughts without trying to put them in a model so everyone is free to use these ideas as they prefer:

This is a list of the most expensive paintings ever sold:

All those paintings are from famous painters. Is that a coincidence? Can we say that obviously those paintings are the most expensive because they are the best and the best paintings can only be produced by the best painters?

Or is it that those paintings are very expensive mostly because for some reason their painters became well-known?

I think the second hypothesis is more likely as a lot of those painters were regarded as mediocre and their paintings worthless during their lifetime. Take the example of Van Gogh which was never rich during his lifetime and his paintings were considered worthless.

However the name of the artist can be used as some sort of valuation, meaning that a Van Gogh will never be worthless even if it’s price may fluctuate.

Let’s look at another example, land. The land can have value for 3 reasons, the 1st because of its intrinsic value, basically the food it can produce if you plant something. The 2nd based on where it’s located and its utility, clearly if someone could purchase Central Park in New York and built huge buildings on it this land would be very valuable. The 3rd is based on the speculative value and future potential to achieve a good location in the future.

Obviously the 3rd situation is the most interesting as it is the one which is the most difficult to predict. In that context someone could buy some land outside of a city but not too far hoping that the city would grow in size and the land become useful because of its location. Of course this will depend on the growth of the city which is certainly something which is difficult to predict, if we look for example at the list of the biggest cities in history a good number of them are completely gone or at least are certainly not very important anymore:

Another example is food, what we consider good and bad food has completely changed through history, for example lobster was considered one of the worst possible foods:

Similar thing is also true for beauty:

In summary my final thought is that human behavior certainly cannot be explained with formulas, even the simpler ones.

For example the idea that increasing velocity of money will decrease the value of the medium of exchange doesn’t seem to apply in a consistent way, or how could we explain that gold and silver (both having similar physical properties which gives them similar velocity of money) behaved so differently price wise through history? It’s also interesting to note that the ratio between gold and silver has fluctuated strongly through history and since those two were basically just metals used as medium of exchange there is no real logical reason for that ratio to change:

Gold to Silver ratio in the last 100 years

If we really want to model things related to human behavior I think the closer we can get is is the cellular automaton:

To keep it very simple the idea is that an initial state computed over and over with simple rules is going to produce completely unpredictable results. There is no equation that allows to calculate a certain step in the process, if you want to know what is going to be the state after let’s say 1 million iterations you must compute 1 million iterations. Also the slightest change to the initial configuration or to the rule will produce completely different results.