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27 May 2022

In this issue

The ‘underlying value’ of cryptocurrencies || The Top Five stories this week || "Hard fork” and “soft fork,” explained

Hello, Crypto markets saw muted activity in the past week as we continue to emerge from the crash but attacks by crypto-sceptics went on unabated. One of them, unsurprisingly, was from RBI Governor Shaktikanta Das who used a lot of colourful words to describe crypto and stated yet again that cryptocurrencies have no “underlying value.”

As crypto enthusiasts, we would ideally like to brush this statement off – it is made way too often. But when such statements are made repeatedly to delegitimise crypto, often by people in positions of power and influence, we think they deserve a legitimate response.Let us settle this debate for you.

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THE BIG STORY

The ‘underlying value’ of cryptocurrencies

Let’s start by defining “underlying value.”Underlying value is the fundamental evaluation of a product or service to assign a market value as of today.The market value can be based on something tangible (like, cashflows, profits) or intangible (like brand, goodwill).Simpler way to look at it: if a product or service needs to be wrapped into one and sold to a single buyer, based on what will we price it? Another closely associated term is “market capitalization.” It is an extension of underlying value along with demand-supply dynamics. Apple has a market cap of $2.27 trillion. If a single buyer were to buy all its operations including its business, products, patents, production units, employee contracts, and brand, what would be the fair worth? It will be a bit more or less than the market cap. Underlying value of an aggregate is usually higher than the sum of above components individually valued, most of which are tangible.Now, when sceptics throw “but crypto doesn’t have any underlying value” as a barb against cryptocurrencies, they are implying two things: one, obviously, that cryptocurrencies have no underlying value whatsoever, and two – that we should invest only in assets which have underlying value the way, say, Apple does – something tangible.Let’s get the second point out of the way first, because it is an obvious contradiction to our reality. One word: Gold. Gold has a market cap of around $11.7 trillion and it doesn’t have underlying value the same way Apple has. And how does Gold get its underlying value? How has its value increased massively over the years?

Price of gold in the past 5 decades. Source: goldprice.org

Gold has a network of users or investors who believe in its potential and usability. This includes governments who have deposits, investors who believe that gold has enough demand to convert to currency when required and other users who believe in its potential to be used as jewellery. Gold’s underlying value comes more from an intangible association and a network effect of its user base.If investing in gold is legitimate, then why not cryptocurrencies?

Further, there are products that do not have a market cap but still can hold underlying value. Technology-based products and services are a good example. Their value stems from how other products can be created on top of them, like 4G or 5G spectrums for telecom companies. Without telecom companies, spectrums are useless, yet governments do auction it for billions?With that let’s get to the main point we are making here: why cryptocurrencies have immense value. Cryptocurrencies are essentially an embodiment of a new technology – blockchains. There are two essential functions that blockchains currently serve: 1) an account of storing and exchange of value and 2) infrastructure for Web 3.0-based internet.Bitcoin and Ethereum, the top two blockchains (and cryptocurrencies), represent the above two use cases.Bitcoin: underlying value as medium of exchangeBitcoin is a blockchain that stores and represents exchange of value between its users. Bitcoin will be 8th on the list of global companies by market cap given its $567 billion market cap today. 

Top companies by market cap. | Source: Companiesmarketcap.com

Bitcoin’s underlying value, akin to gold, derives from its intangible aspects i.e. network effect and market dynamics. Essentially, the more people use the blockchain, the more valuable it becomes.When we say ‘use the blockchain’ – it means that people actively do transactions on it. Investing in Bitcoin or other crypto assets without transacting (say via an exchange) does not add to the network effect. In the US, according to a recent study, 12% of the population has exposure to cryptocurrencies and about 25% of them have used the underlying blockchain for transactions. For this figure to grow, governments must willingly accept Bitcoin as a medium of exchange (a currency) or implement CBDCs (a digital rupee) powered by a blockchain. India is currently evaluating the issuance of a CBDC – the blockchain that it chooses for implementation will naturally become valuable for providing the base infrastructure.Ethereum: underlying value as infrastructure of Web 3.0 internetEthereum is powering the next evolution of the internet termed Web 3.0. In Web 3.0, users also own the infrastructure on which the internet is built unlike in previous versions.

Evolution of the internet | Illustration | Source: State of Crypto 2022, a16z

Ethereum is today comparable to a Google Play Store – it is a platform for companies to build decentralized applications (dApps) that serve various use cases. Ethereum’s market cap is $236 billion and is derived from its ability to be the backbone infrastructure of many products.In comparison, users spent $133 billion on apps in 2021 (Apple Appstore and Google Play Store combined). The stores take a 30-45% cut of this revenue annually. The adoption of Ethereum over the years is highly similar to the early adoption of the internet in the 1990s. With an estimated 50 million users today, Ethereum (and other such blockchains) will likely hit 1 billion users by 2031 if this trend continues.If there is anything we have learned from the past few decades, it is that digital technologies can emerge out of nowhere, take the world by storm, altering the way we live or trade, and give windfall profits to early investors. Sure there were ups and downs on the way, but the internet was rubbished, too, and we cannot imagine our world without it.So, it is in our collective interest to see the underlying value of cryptocurrencies.

  THE TOP FIVE 

Stories from this week you cannot miss

1.  Emirates, the largest airline in the United Arab Emirates, announced its intention to add bitcoin as a payment option and to make NFT collectibles tradable on the company’s website.2. Dukascopy Bank SA, a Swiss financial services company, announced that it had enabled blockchain operations in ERC20 Tether (USDT) for holders of multi-currency accounts.3. Paraguay’s Senate approves proposal regulating crypto mining and trading, seeking to take advantage of the country’s energy surplus.4. Ethereum processed 4.5 times more transactions than Visa in 2021, handling the equivalent of $11.6 trillion in transactions to Visa's estimated $10.4 trillion.5. Microsoft is collaborating with Kawasaki for their “industrial metaverse” — a fancy way of saying factory workers will be wearing HoloLens to help with production, repair and supply chain management.

  EXPLAIN, PLEASE 

Demystifying the world of cryptocurrency

If you follow crypto markets closely, you would often see news stories about forks in cryptocurrencies  – the most recent one being the proposed “hard fork” of LUNA, after its humiliating downfall which dragged the rest of the crypto market along with it.In this issue, we explain HARD FORK and SOFT FORK. First, what’s a fork? As you know, cryptocurrencies are powered by blockchains – which are decentralised and open-source. Any modification to open-source code is called a “fork.” Sometimes, forks are intentional upgrades. Bitcoin and Ethereum have effected several forks in the past few years. But, sometimes, a fork can also happen accidentally, which can be identified and resolved. A hard fork is a major modification – a radical upgrade which is not backward-compatible. It is a permanent separation from the original version of the code. A soft fork is a minor modification – small changes to the code which doesn’t change the underlying protocol too much.

That’s it for this issue guys – in the next issue, we will take the idea of “underlying value” further and explain how you can assess the value of a cryptocurrency before investing in it.If you have any questions or feedback for us, write to us at [email protected]. You can check out the previous issues here.