Step into the world of decentralised applications with us in this snippet from Sygnum’s investment research report Valuing crypto assets. We delve into the unique characteristics and challenges of decentralised applications and uncover valuable insights on how these innovative projects generate economic value.
The tokens of decentralised applications building on top of blockchain protocols are more straightforward to value than the underlying protocols (cryptocurrencies).
These projects come close to resembling traditional corporations as far as economic value generation is concerned although they are very different in terms of ownership, governance and alignment of incentives.
As they are projects with cashflows earned from the service they offer (lending, video streaming, gaming, etc.), their fair market capitalisation is the present value of the expected future cashflows that accrue to the token.
The tokens of decentralised applications do not have characteristics that make them good money or store of value because they reside on top of other protocols. Their transactions are processed by the underlying blockchain, which they have no control over.
These tokens derive their value solely from the economic activity of the project. It is, therefore, very important to ascertain how the protocol generates revenue and whether, and how, that revenue is shared with tokenholders.
Protocols that offer a free service may be extremely useful and a common good, but the token of such a protocol has no value. Some protocols offer a free service early on to gain customer adoption or even reward their users rather than earn a revenue. Gaming projects and various spinoffs of the concept such as ‘move to earn’ are examples. This can be a legitimate customer acquisition strategy at the early stages of the project, however, there needs to be a plan and a roadmap for revenue generation and phasing out incentives. It also increases the risk factor for the value of the token, as users often abandon projects once the incentives stop or a fee model is introduced unless the protocol has successfully demonstrated its value and usefulness to its customers.
Decentralised applications can also earn revenues from external sources (for example, advertising to their users). But this may negatively impact user growth and introduces a degree of centralisation. Many early-stage decentralised protocols are necessarily centralised at least to some extent in the very early stages although their roadmap typically points to becoming largely or entirely decentralised. When the roadmap itself necessitates ongoing centralisation, this introduces further risks as the power of decentralised protocols is that they sustain themselves without execution risk or conflicts of interest.
When a credible plan for sustainable revenue generation is lacking, this devalues the project substantially.
The other important questions are whether protocol revenues exceed the costs of doing business and whether the revenue is shared with tokenholders. For example, if lending protocols need to offer higher yields to lenders than they can earn from borrowers, the token only has value if there is a clear path to reversing this as the protocol becomes established.
The protocol also needs to channel revenues to tokenholders in some way, rather than simply feeding it back into the project treasury or even worse (as far as token value is concerned) to a private corporation that built the protocol in the first place. The mechanisms for sharing revenues can be tricky sometimes due to legal and regulatory issues, but we can assume that these issues will be worked out over the medium to long term.
A mechanism often used is buying tokens in the market with the revenue intended to be paid to tokenholders and burning (destroying) them. Additional mechanisms may be offering discounts and rebates to tokenholders.
When protocols share the economics with tokenholders only if the tokenholders take additional risk, this reduces the value that accrues to the token. For example, a lending protocol may offer a yield if tokens are staked in a module that provides safety reserves in case of a liquidity shortfall. This only adds value to the token if the yield is in excess of what would be expected for taking this risk.
The governance mechanism of the protocol influences the value of the token substantially. If tokenholders have the voting rights to affect the distribution of project economics, we can assume that they will make the most financially rational decisions so that maximum value accrues to the token over time. The optimal decision includes providing sufficient incentives to other parties whose participation is necessary for the protocol’s long-term success. For example, token value is maximised for a decentralised exchange protocol if liquidity providers are incentivised to engage with the platform, rather than if all the fees earned are paid to tokenholders.
Where the governance is not decentralised, there is substantial risk that project revenues may be channelled elsewhere and not to tokenholders. Projects necessarily have centralised governance very early on, but with a roadmap to transition to decentralised governance. The lack of such a roadmap reduces the value of the token.
It is also important that the protocol has sustainable funding to support the maintenance of the platform as well as ongoing upgrades and innovation.
Decentralised applications typically create the entire token supply upfront but earmark a portion of the tokens for user incentives and the project treasury, which then funds further development. This dilution should be factored in, as these are de facto future costs that will be borne through dilution.
In terms the risk factors to consider in the valuation, technology risk (smart contract risk) and regulatory risk also apply, in addition to the usual risks of early-stage projects.
Although the tokens of small early-stage projects may be highly illiquid, necessitating a further haircut to value, they are typically more liquid than early-stage corporations of comparable maturity because of the broader engagement of tokenholders in decentralised platforms.
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