Blue Macellari, T. Rowe Price’s head of digital assets, puts it like this: “If you don’t start out as a cryptoskeptic, there’s something wrong with you.” The neophyte’s journey to understanding digital assets parallels the passage that cryptocurrencies themselves are going through. It is a journey that requires an investment in time, a stomach for turbulence, and a plasticity of mind to deal with rapid change. Yet, if I am right in my belief that crypto is on its way to becoming more of a risk‑off¹ asset, it is a journey that most of us will have to make.

After all, the first step to understanding crypto is admitting you don’t understand it. The final step is realizing that “understanding” is a moving target.

Let’s start with some definitions. Cryptocurrency is a digital or virtual currency (token) that uses cryptography for security. Non‑fungible tokens are tokens that are backed by unique assets such as art or collectibles but are primarily property rights. Blockchain is a decentralized, distributed digital ledger that records transactions across a network of computers that is immutable, transparent, and secure.

"...to grasp the concept of ‘value’ in crypto, we must put aside the notion that all assets are merely the sum of future discounted cash flows...."

Cryptocurrencies exist in digital form and should have some value or utility. But to grasp the concept of “value” in crypto, we must put aside the notion that all assets are merely the sum of future discounted cash flows (a method that has its limitations anyway). Understanding value in crypto means applying alternative notions of utility; it is a parallel world to “Trad‑Fi,” with a different lexicon.

Like many innovations, cryptocurrency (bitcoin was first) had its genesis in crisis, having been developed to circumscribe the banking or official payment systems during the 2008/2009 banking crisis. Unlike traditional currencies issued by government agents, cryptocurrencies operate on decentralized networks based on blockchain technology.

The salient features of crypto are: (1) decentralization—they are controlled by peer‑to‑peer networks; (2) security—cryptocurrencies cannot be stored in a vault but exist in the ether, and ownership is conferred by control of cryptographic private keys (this makes it difficult to counterfeit or double‑spend, but there is no recourse if you lose your key); and (3) anonymity and the absence of borders—this has pro and cons.

For the sake of simplification, let us divide crypto between bitcoin (BTC) and everything else (altcoins). The “everything else” in crypto is dominated by Ethereum, but Ethereum’s native token (ETH) is a distant second to BTC in terms of value traded. Inspired by blockchain technology, Ethereum has taken the concept further in allowing developers to build and deploy (stack) applications on its network. Think of it as a decentralized cloud computing platform.

However, unlike incumbent cloud computing platforms such as Amazon Web Services or Microsoft Azure, Ethereum is open source. This lends itself to unrestricted use cases. ETH has two general uses: to spend or be earned by using or securing the Ethereum Ecosystem or for investment or speculation on the growth of the Ethereum network, or a belief in the long‑term adoption of blockchain technology.

Proof of work versus proof of stake

Bitcoin’s intrinsic value comes from problem‑solving or digital mining. This is known as Proof of Work, underwritten by the copious energy required. Proof of Stake (PoS) is another consensus mechanism used by many cryptocurrencies, including ETH, to validate transactions and secure the network. Instead of using massive amounts of computing power, PoS selects validators based on how much capital or tokens they stake (lock up as collateral).

"In theory, the value of the token should grow with increased usage of the blockchain...."

Blockchain users stake their coins, and the validators are chosen by the system, skewed toward the highest stakers, who check and add new transactions to the blockchain. In turn, the validators earn rewards in the form of transaction fees or new coins. In theory, the value of the token should grow with increased usage of the blockchain, or network effects, as described by Metcalfe’s law.

DApps, DePIN, slashing, and burning

Just like apps that are built on operating systems such as iOS or Android, blockchain is a new architecture on which decentralized applications (DApps) are built. The difference is that no one entity controls or owns the DApp—it exists in a peer‑to‑peer network, and the code is often publicly available.

The network requires physical assets, in this case a decentralized physical infrastructure network (DePIN), such as a hotspot, sensor, router, storage unit, or camera, also known as a node. Assuming the node operator has acted in good faith, the stakers will earn rewards or tokens. If, however, the node operator has acted in bad faith, the value of the capital stake can be reduced or “slashed.” “Burning” is the permanent removal of tokens from circulation. Think of it as reducing money supply in fiat money to retain the value of the unit of currency.

Even if they have assimilated some of the jargon, at this point the neophyte is likely so bamboozled that their head is about to explode. With real‑world assets, you can readily build a profit and loss account, balance sheet, and cash flow statement. With crypto, the concept of a profit and loss account and balance sheet is alien and cannot be modeled, so how does one pin down the value? At T. Rowe Price, our crypto analyst, David Kroger, has adapted a traditional discounted cash flow valuation framework using staking rewards in place of cash flow. The revenue and cost protocols may be different, but the methodology is the same.

So there you have it. Don’t be put off by a new language; embrace new concepts of valuation as well as using what’s already in the toolbox, and your application to become a crypto convert is in the post.