The Big Long – Contrary to Popular Belief, Digital Assets do have Cash Flows – 02/28/18
In this post I will explain, in general, how POS-based chains produce sustainable cash flows to maintain and enhance the protocol and earn stakeholders a return on their money.
In previous posts I have made the case that proof-of-stake (POS) is potentially better than proof-of-work (POW) because POS wastes much less energy and takes that savings and puts it into productive use. I also believe POS will win out over the long term because it is much more investor-friendly by providing stakeholders with residual income in the form of a cut in transaction fees. This, in my opinion, is much more sustainable in the long run.
Participants in the digital asset space are in the early stages of attempting to model the valuation of digital assets. In “Cryptoasset Valuations”, the author Chris Burniske makes the case that cryptoassets don’t have cash flows. This is incorrect, at least to a certain extent.
TOLL BOOTHS VS NETWORK NODES
How can a blockchain-based network have cash flows that move in and out of the network? I like to think of this as analogous to owning a system of toll booths and the associated roads that are managed by those toll booths. Think of the toll booths as network nodes and the roads as communication channels. Toll booths allow users to access the roads after paying fees. This is similar to nodes on a network that allow users to use the services of the network after paying fees. Toll booths and roads have operational and maintenance costs similar to how networks have operational and maintenance costs. Toll booths need people employed to operate them, electricity to keep the lights on, ect. Roads need potholes fixed, lines repainted, ect. Similarly, nodes need people to keep them updated and running 24/7. Developers need to get paid to write new code to maintain and enhance the network. With toll booths, a pool of investors may own the booths, collect fees from users, and in turn use a portion of those fees to pay for operational costs, maintenance costs, and future improvements. Any remaining money left over from collected fees is retained as earnings for investing in the toll road system. Network investors do the same, only in the context of a digital network.
However, one key difference is that with blockchain-based networks, investors may pay for maintenance costs, operational costs, and future improvements partially or wholly through inflation of the native asset instead of completely with earnings. This is mostly just an accounting measure that technically works better for these protocols because the native asset can be accounted for in-protocol. This would be similar to shares of stock trading to represent ownership of our toll booth system and new shares of the stock being issued to pay toll booth operators, maintenance crews, ect instead of paying them directly with cash, similar to stock compensation in traditional companies. The end result is the same. Whether investing in a system of toll booths and roads or blockchain-based networks, operational costs, maintenance costs, and future improvements must be paid for, either through earnings or through new issuance of shares of stock (or the native asset in the case of networks).
In the toll booth example, if fees collected outpace the costs of the system, then the system is profitable. In blockchain-based networks, if fees outpace the rate of inflation, the system is profitable. For example, if transaction fees provide investors with a 3% annual rate of return and network operational and maintenance costs are 1% per year through inflation, then the network is profitable at a rate of 2% per year.
REAL INWARD AND OUTWARD CASH FLOWS
The concept of a native currency that is wholly contained within a blockchain-based system is foreign to most folks, leading them to believe that money does not leave or enter the system, i.e. no cash flows. However, this is incorrect because blockchain-based networks have real operational costs – i.e. hardware, software and electricity resources required to maintain the network. It doesn’t matter whether these charges are paid for directly in a fiat currency or in the native currency of the chain – the costs are real and completely exogenous to the network – i.e outward cash flows. Users pay transactions fees – it doesn’t matter whether these fees are paid for with a fiat currency or with the native currency of the chain, the value required to pay for these fees often originates outside of the core system, making this value transfer an inward cash flow. Users may not even know they are paying with a native asset in some cases, as the exchange between fiat and native asset can be automated.
For example, suppose a user needs to record the hash of a mortgage document in the blockchain in order to have a permanent record of that document. The cost of this transaction is $1 in transaction fees on the network. The user pays $1 to have that mortgage document recorded and that $1 is automatically converted to the native asset of the blockchain. This all occurs behind the scenes. This $1 did not come out of nowhere. The user obtained this $1 from working at their job. This is inward cash flow to the system. Next, the stakeholder that mined this transaction receives $1 worth of this native asset and gives $0.25 to the node operator for maintaining the staking pool and node. The investor then exchanges the remaining $0.75 for a cup of coffee at their local coffee shop. This is outward cash flow. Perhaps the investor retains the $0.75 of native currency received and adds it to their stake, thus increasing the value of the network. This is how money moves in and out of the network or is retained by the network, i.e. cash flows.
CASH FLOWS IN POW VS POS
In POW chains, nearly all inward cash flows go to burn electricity and hardware resources, which represents significant overhead that is not found in POS chains where inward cash flows are used to maintain the network, enhance the network, and compensate stakeholders. The argument against POS has long been that POW was necessary to secure the system because of the reliance on consuming resources outside of the system. However, it is becoming more apparent that POS can be just as secure, or more secure than POW. After all, stakeholders must exhaust real-world resources by working to generate the money to buy stake.
I will concede that utility token cash flows may not be as clear as base-layer-asset cash flows, but these utility tokens ultimately add value to the base-layer-asset because transaction fees are generated when these secondary layer assets are used. The value proposition for secondary assets are the subject for another day. However, the distinction between primary and secondary assets of a blockchain-based system does establish what I like to call ‘root value’ of the system which is derived from the ‘root asset,’ or primary asset, of the chain. All other assets are built on top. An example would be Maker being built on top of Ethereum, with MKR being the secondary asset and ETH being the root asset.
This should provide a good initial foundation for continuing the work of modeling fundamental valuations for digital assets. We have established that POS chains do indeed have cash flows – not in the traditional sense, but value does flow in and out of these networks. The next step is to determine a reliable valuation model, if possible. Burniske has begun this work but I think it is lacking a bit because of the failure to identify cash flows. Although cash flows have to be more or less derived from the root asset, these cash flows are nonetheless real and we can model these systems more closely with something similar to a discounted cash flow (DCF) model, at least for root assets. Certain other variables may need to be considered including the number of applications built on top of the primary layer and their frequency of their use. The wonderful thing I like about blockchain-based networks vs companies is that networks don’t have debt, so we don’t have to take debt into account when valuing a network. In my opinion, this makes networks easier to value than companies.
Finally, if we can determine the expected interest rate from staking, minus any expected inflation rate, then we can determine whether a given root asset is worth investing in or not. This interest rate accounts for all core network activity, including speculation. Inflation rates should be easy, as these parameters are generally pre-set in these systems with little ability to change them, as it should be. Determining the expected interest rate from staking will be the tricky part. It all depends on the expected earnings from transaction fees, which depends on overall usage of the chain.
Disclaimer: None of this is advice of any kind.