May

A corporate finance model for Cryptocurrencies

After the credit crunch of 2009, you may have heard of Bitcoin or cryptocurrencies in general. Bitcoin and altcoins (terminology used to refer to all other cryptocurrencies) are digital currencies built on distributed ledger technologies such as Blockchain and so are not regulated by a central authority. Whether cryptocurrencies are perceived as currencies by authorities, or treated as financial assets by investor and regulators, or whether they can be used as security token or utility token, it is clear the digital currencies’ market is a small but growing market’ as commented by Christopher Woolard, executive director of Strategy and Competition at the FCA (UK Financial Conduct Authority) [1].

From Bitcoin, invented by the so-called Shatoshi Nakomoto, more than 2000 other altcoins have been created for various purposes [2]. The market capitalization for the largest 100 cryptocurrencies has increased from 1.5 Billion in 2013 to 250 Billion in May 2019, with a peak of 795 Billion in January 2018. With such an interest from not only individual consumers but also Business users, authorities in countries such the UK, France, Switzerland, South Korea, the United States and others have initiated regulatory sandboxes either to educate consumers (UK, Guidance) or to create high level government task forces to investigate the technology and regulatory implications.

Authorities around the world, including governments and central banks, often remain skeptical about the digital currencies, rightfully because many questions either on the scalability of the underlying technology [3] or concerning the nature of the crypto assets are subject to investigation and clarification prior to potential wider adoption of the technology.

As mentioned above, the price of cryptoassets on exchange places shows extremely high volatility compared to for instance the equity market. Authorities and trading exchange often warn that prices can fall to zero overnight. This raises the questions as to whether any cryptoasset has a fundamental value which can sustain its market price or whether crypto prices follow a completely different pricing model which need to be investigated.

In ongoing work, CERF Research Associate A. Ekponon and K. Assamoi (Liquidity analyst at MUFG Securities) propose a corporate finance model for the pricing of cryptocurrencies.

First, they model the scale level of a cryptofirm, e.g. Bitcoin or Ethereum, following Bhambhwani et al (2019) and Hayes (2015). This scale is assumed to be constant but may change (infrequently) up or down over time following fundamentals. Cryptofirms remain to be clarified in term of investment. This paper takes the view that a cryptocurrency is classified as a financial asset [4].

If so the overall activity around a cryptofirm could be transcribed in a usual firm setting. Fundamental values represent initial cash-flow level whenever the firm changes scale. Miners, which work consist in validating these peer-to-peer transactions, represent labour. Successful crypto mining produces new bitcoins to miners (block fees) and improves the trust in and security of the technology, making crypto-firm more valuable. Validating transactions are also rewarded by bitcoin users through transactions fees. Rewards to miners constitute wages. Computation costs incurred by miners are also counted for.

Second, this article assumes that a cryptocurrency corresponds to equity for the firm and its cash-flow evolves around its fundamental levels following standard Brownian motions.  

Third, the optimal level of firm fundamentals, among which, the difficulty in the validation of operations, the rate of unit production, the cryptologic algorithm employed or the aggregate computing power, and also cryptocurrency price are derived by using methods from dynamic models of corporate finance (See Strebulaev, 2007).

The paper findings are tested with daily prices of more than 100 cryptocurrencies among the most actively traded. Results from the model implications and empirical tests will be detailed in a future blog.