September 04, 2024 | Read Online

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"If you torture the data long enough, it will confess."

— Ronald Coase

Crypto's enduring mystery: Why L1 blockchains have value

Michael Saylor's Bitcoin24 "macro model," released last week, is more a work of choose-your-own-adventure fiction than it is financial non-fiction: Enter how much you'd like bitcoin to go up and the model will tell you how rich you'll be if it does.

Saylor's model is no more rigorous than Wonderland DAO's Lambo calculator, which remains (despite much competition) the pinnacle of 2021-era crypto silliness.

Nevertheless, both models are helpfully instructive.

The redeeming quality of Wonderland's Lambo calculator was that it had a sense of humor — forecasting returns in units of Lamborghinis was its way of signaling that you should not take its headline 84,000% APY too seriously.

Similarly, the redeeming quality of Saylor's bitcoin model is that it's honest — the model doesn't attempt to forecast anything; it only "simulates" whatever future you'd like to imagine.

The fact that there are no fundamental inputs into the model is perhaps Saylor's way of signaling that bitcoin has no fundamentals.

This is a feature of bitcoin, not a flaw.

The primary reason that bitcoin has so outpaced the rest of crypto in this current cycle may be that it has no measurable fundamentals to hold it back — and the primary problem with other layer-1 blockchains may be that they do.

If all else fails…

There are only three reasons why the native tokens of layer-1 blockchains like Bitcoin, Ethereum and Solana might have value: Fees, MEV and monetary premium.

People are increasingly bearish on fees.

Kyle Samani's thesis that blockchain fees will "asymptotically" trend toward zero is becoming consensus, likely because Ethereum's fees recently have, in fact, been trending toward zero.

(Pro tip: If you ever find yourself in a words-Kyle-Samani-says drinking game, don't take any form of "asymptotic" or else you will soon find yourself trending not so asymptotically toward passing out.)

Samani thinks fees will ultimately be close enough to zero that maximal extractable value (aka, MEV) will be the sole reason layer-1 blockchains will have value.

But people are getting increasingly bearish on MEV too.

MEV comprises the profits derived from the right to order transactions and that has historically happened mostly on layer-1 Ethereum, to the benefit of ETH holders.

But, as Ethereum transactions have been moving off-chain, MEV has moved with it — and even there, app developers are trying to internalize the value being extracted from their users.

Noah Goldberg bravely attempts to quantify the valuation implications of this development: "If we use the MEV framework to value L1s, my sense is that the intrinsic value is going to be an incredibly low number — call it less than $1 billion."

If so, MEV (which, as a reminder, Samani says is the only reason L1s have value) would account for just 0.3% of Ethereum's current market capitalization (in other words, ETH is currently 300x overvalued).

That might be too bearish, I don't know — as with fees, there will always be some MEV for blockchains to extract.

But, at the very least, "extracting value" from users is an unsavory elevator pitch and unlikely to attract much demand from non-crypto native investors.

So, in the ongoing search as to why layer-1 blockchains might have value, that leaves us with just "monetary premium" — whatever that means.

Wen Lambo?

The term "monetary premium" sounds like a foundational concept in economics, but as best as I can tell, it was seldom (if ever) discussed before bitcoin.

It's easy to see why its since become so popular in crypto circles, because what other explanation is there for bitcoin's $1 trillion market cap?

Bitcoin has no fundamentals in the sense that there is no mechanism by which fees paid to the network or value extracted from its users can be returned to bitcoin holders — bitcoin is essentially a not-for-profit public good (or public bad, depending on your point of view).

You can say the same for both gold and fiat currencies, of course, but prior to bitcoin there was no common term for why those had value, so bitcoiners had to make one up: monetary premium.

That doesn't make it any less real, though — an asset's monetary premium is simply the portion of that asset's value that can be attributed to its use as money.

You might reasonably object that hardly anyone uses bitcoin to buy anything, but bitcoin does stake a claim to "moneyness" (and therefore monetary premium) from its use as a store of value.

Bitcoin's monetary premium is the same as gold's, which isn't really money either (like bitcoin, you have to swap gold for fiat to buy anything with it).

But gold has a 2000-year history of maintaining its purchasing power and that has made it, if not money, "money-like."

Bitcoin aspires to do the same (or better) and its value can therefore reasonably be attributed to "monetary premium."

Ethereum has different aspirations — its claim to moneyness (and therefore monetary premium) is that people will increasingly use it not just as a store of value but also as a unit of account and means of exchange on layer-2 blockchains.

That, too, would give it a monetary premium, but of a different, harder to achieve sort: Where Bitcoin only has to get people to hold it, Ethereum has to get people to use it, too.

Can Ethereum get enough people to hold enough ETH to justify its current $300 billion valuation?

It doesn't feel that way — I have about $5 of ETH on various layer-2s where the fees are now so low I'm not sure I'll ever have to send any more.

But could you build a financial model that said otherwise?

Sure.

Fees and MEV won't go all the way to zero (only asymptotically!), so they will always have some value in a traditional financial model, especially if you assume that crypto economies will someday be as large as today's big nation-state economies.

It would admittedly take some heroic assumptions to make sense of today's valuations on that basis, but however short that leaves our model, we can make up the difference by adding a row labeled "monetary premium" and putting whatever number we need in there to make it all make sense.

So it could all work out.

Just don't expect any Lambos in your near future.

— Byron Gilliam

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