$RUNE: Beginning to Define Value on the Blockchain

Disclaimer / Disclosure: As at the time of writing, Blockpoint and/or its team members have positions in RUNE. This statement is intended to disclose any conflict of interest and should not be misconstrued as a recommendation or endorsement of any protocol or token. This content is for informational purposes only and you should not make any decisions based solely on it. This is not investment or financial advice.

The title of this article is misleading; this is because, in our opinion, the value of everything, both tangible and intangible, is speculative. That is to say, in simpler terms, one can never, with one hundred percent certainty, definitively say, “the value of X is Y.” That is because a price, or value, is set by a willing buyer and willing seller - based on their distinct circumstances. For example, a rational buyer purchases an asset as they believe that the price at which they are purchasing will either; (i) provide them with some form of utility which they feel is greater than or equal to what they ‘paid’;¹ or (ii) be lower than the price at which they ultimately hope to sell the asset - hence, speculation.

Now you’re probably thinking - interesting - but what does this have to do with the price of tea in China, India or Pakistan, let alone any given blockchain solution or cryptocurrency? The answer? Everything.

In traditional finance (“TradFi”), valuation is best described as a mix of art and science, and therefore, by definition, is subjective, as every valuation method has assumptions. There are agreed upon principles and formulas (which we loosely will refer to as the “science”), but at the end of the day - factors that require subjectivity are what ultimately drive the end product in valuing private companies² (which we loosely will refer to as the “art”). We won’t go into too much detail, but have put a quick primer together below³, splitting methodologies into two buckets; (i) relative; and (ii) intrinsic.

At the end of day, however, in our opinion, true valuation is simply the present value of all future cash flows that are attributable to the holders of the security in question. If this function yields a value lower than net tangible⁴ asset value (that is to say, the value of tangible assets less liabilities - effectively a value at the point at which in time the balance sheet is presented⁵), then there is a sufficient margin of safety between intrinsic value and book value that can absorb value leakage from unforeseen issues, prompting one to effectively ‘speculate’ that they are entering into a profitable trade. That is not to say that short-term arbitrage opportunities should not be explored - but as a wise man once told us - if you can’t understand why the arbitrage has not yet been exploited - more often than not, you are the arbitrage.

A Brief Interlude on Risk

Imagine you go to the fishmonger (let’s assume that stringent food safety regulations don’t exist for a minute) to buy a £10 fish, but you see that there’s a special offer on a fish for £5 as the best before date was a few days ago and the fishmonger wants to recoup as much of his cost as possible (you would have happily paid £10 at the point that you walked in); you decide why not, I’ll save £5. You take the fish home and eat it for dinner - you will end the day either having saved £5 and had a fantastic meal or having to spend an additional £10 at the pharmacy due to horrible food poisoning (taking your tally to £15 instead of purchasing a fish in date for £10 - spending an additional 50% of your hard earned money) and even more on a potential doctor visit (not to mention the time off work due to food poisoning). You could always look to try and mitigate this risk by bringing lab equipment to the fishmongers to test the fish for any signs of spoiling, but the cost of doing so would not be worth it as it would require spending considerably more money than the amount you would potentially save (e.g., a farfetched example, but illustrates the concept of a hedge, or mitigation strategy against loss). In the financial world - risk is rarely, if ever, binary, but the principle above illustrates the two ‘extreme’ positions, with a majority of investors falling somewhere in between. Managing risk is, in our opinion, the most important aspect of managing a portfolio, and in fact, is inherently baked into decision making, whether or not one is cognisant of it or not. As a last thought on the topic of risk - we’ll borrow a few words from Ari Paul - “Half of risk management is a single sentence: don’t take risks you don’t understand.”⁶

Relative Valuation Methods

Just as its title suggests, relative methods are those which are computed as a function of comparable companies or transactions. The two most commonly used methods are; (i) trading comparables analysis; and (ii) transaction comparables analysis. In essence, these methods will take a financial metric of the company which is being valued (most commonly either of Net Income/EBITDA/Operating Profit/Revenue) and apply a multiple against that metric - this is the generally accepted practice, and therefore, we will loosely define this part as the “science”. The multiple is derived from a basket of comparable companies; these companies are selected by the valuer based on subjective assumptions (e.g., similarity with target company with regards to geographic scope/size/financial metrics etc) - this is the “art” as seldom will you find two analysts who independently compose identical baskets. Moreover, this effectively prices the asset based on where the market is, at that point in time (some analysts [we believe all should] employ cross cycle multiples - e.g., calculating the mean or median multiple over a discrete time series) - but again, this method prices an asset relative to the market (whether it be valuations at which comparable companies are trading or valuations at which comparable companies were purchased⁷), not based on intrinsic value. That is not to say that this analysis is not a helpful tool when it comes to valuation.

Let’s look at an example.

As illustrated above, we can see various metrics outlined for SushiSwap and Uniswap. In our opinion, there is a clear discrepancy in the way in which the market is pricing the three underlying protocols - logic dictates (assuming the principles of the efficient market hypothesis hold) that either UNI is overpriced or SUSHI is underpriced. Experience has taught us that the convergence probably lies somewhere in the middle (if we calculate price as a function/multiple of TVL)⁸. Notwithstanding the metrics, a lot more work is needed to analyse the factors which may or may not be influencing the stark difference. @matt_sbtc has an interesting take on it here, highlighting a strong case for SUSHI. Meanwhile UNI bulls point to V3⁹ as justification as it is expected to; (i) give LPs the ability to provide liquidity at specific price ranges, thereby significantly increasing capital efficiency; (ii) support flexible trading fees, compensating LPs for pairs with higher probabilities of impermanent loss; and (iii) start compensating token holders by turning on the protocol fee. That being said, as at the time of writing this article, no fees accrue from LPs to UNI token holders, therefore, any value attributed to the token is speculative based on actions yet to be taken, if at all. The basic financial analysis illustrates a potential opportunity, however capitalising on it in a calculated risk-adjusted manner requires significantly more research.

Intrinsic Valuation Methods

Generally speaking, intrinsic value seeks to capture what an underlying security is worth, by taking into account its future cash flows as a function of risk and the time value of money. However, models are highly sensitive to inputs, and moreover, because every variable is an assumption, the valuation is only as reliable as the quality of analysis and research that has gone into determining variable values (the “art”). The generally accepted method here among practitioners is a Discounted Cash Flow analysis (the formula, or the “science”). We won’t go into the details of how to perform a DCF analysis, as if you’ve reached this far, you probably already have a grasp of the concept¹⁰. Instead, we propose to explore two key concepts underpinning the “science” behind the formula; (i) the risk-free rate; and (ii) cost of capital.

Now, we started off by stating that there is no such thing as zero risk, and that is a fundamental belief that we hold. We also bucketed valuation methodologies into being either intrinsic or relative. BUT because we have to price risk somehow, we need a benchmark or goal post to compare everything to, hence the risk-free rate - without it we wouldn’t be able to compute the cost of capital (e.g., opportunity cost). In traditional finance, the generally agreed upon risk-free rate is a US Treasury Bill; this is because US Treasury Bills are; (i) backed by the US Government; and (ii) have effectively become the global reserve currency. However, what happens if it can’t pay back those debts? Does it default, print more money or something else¹¹? Can insolvency be solved by liquidity, in the long term? Given that this is a subject that engenders much debate, we won’t discuss this point further here as there is a much longer read that we are putting together, highlighting our belief in the importance of strategic sovereign re-basements, CBDCs and the role that we think they will play moving forward. When it comes to cost of capital, we have a fairly simplistic view - this is the rate of required return, and therefore, unless doing a comprehensive analysis, we will use 20%¹² as a benchmark unless otherwise stated.

To get back to an example using SUSHI from above.

The above chart has the following assumptions (all of which are for the sake of example); (i) xSUSHI generates 0.05% fees from LPs¹³; (ii) cost of capital of 20.00%; (iii) perpetuity growth rate of 3.00%¹⁴; and (iv) 30% growth p.a. for four years until the terminal year (N+4). For the sake of illustration, two additional scenarios in which 24H volume is two or three times greater than today have been simulated. As we can see from the metrics in an earlier section, 24H Volume is roughly 10% of TVL (that is to say that roughly 10% of TVL generates fees in a 24-hour period). The annualised expected cash flow to token holders (simplified for the sake of example) would be equal to ( [% Fee Attributable to Token Holders] * [24-Hour Volume] * 365 ).

The four assumptions show that the fully diluted market capitalisation has a range from US$ 1.978 - 5.936 billion (or 0.54x - 1.63x the fully diluted market capitalisation as at the time of writing), based on 24-hour volume. Using our estimate of 1:10 for 24H Volume : TVL, this implies TVLs of US$ 8.928 - 26.786 billion (or 2.05 - 6.14x greater than the TVL today). Given the way in which we believe that DeFi (and the protocols/tokens that make up the space) will evolve and grow to become a part of tomorrow’s financial infrastructure, we don’t see why this is not theoretically possible, but to put things into perspective, the TVL in Defi as at the time of writing this article is US$ 45.43 billion¹⁵.

RUNE

If you’re not familiar with RUNE, we would suggest reading the documentation on Thorchain, Multicoin Capital’s Analysis and Delphi Digital’s Analysis.

At Blockpoint, we think of RUNE as an ETF which derives its value from the non-RUNE TVL in the system (e.g., akin to Book Value) - it’s that simple. Additional value (income) arises from liquidity pool fees (PIK in underlying pool pairs) as well as system rewards (more RUNE), however these benefits are only afforded to liquidity providers and node operators (which must post a minimum bond, acting as a deterrent towards malevolent actions).

So, why do we call it an ETF?

RUNE employs an incentive pendulum, which adjusts rewards between node operators and liquidity providers in order to reach an optimal state in which capital bonded is equal to capital pooled (50:50).¹⁶

This state is effectively what, in an efficient market, leads to the price of a RUNE token being equal to ( [3 * NON-RUNE TVL] / RUNE Circulating Supply ) as, by definition, 1/3 of RUNE is pooled against other assets (e.g., BTC, ETH, USDT etc). This value is called Deterministic RUNE; as more RUNE is staked into the system (either bonded for system security or contributed as liquidity into LPs), the more accurate Deterministic RUNE becomes (that being said, it is largely theoretical, as it would require for all RUNE in circulation to be staked into the system for the principle to absolutely hold). So, theoretically - RUNE is equal to 3x the value of NON-RUNE assets which RUNE is pooled against; as the value of those assets goes up or down, arbitrage opportunities present themselves as the ratio within the LPs has to remain 1:1, and thus, an efficient market would re-price RUNE to the value of its underlying basket. To us - that sounds a lot like an ETF!

But wait - what if less RUNE is staked into the system? For example - assume that only 10% of RUNE is staked (and assuming that 2/3 is bonded by nodes and 1/3 is in LPs). Then, technically speaking, only 3.33% of RUNE is what drives ‘value’ - even the smallest changes in the underlying pegged assets can have huge ramifications in price (in a perfect market); that’s effectively why more RUNE needs to be staked in order to reach a more certain value. In calculating true deterministic RUNE, there is only a 3x multiplier (given the 2/3 and 1/3 ratio), but in the example above where only 10% of all circulating RUNE in staked, that multiplier is technically 33x!

One can imagine that in a bull market, this would lead to a positive loop, while in a bear market it would lead to a negative loop. For example, in a bull market, the value of RUNE would increase as the values of the other assets in the LPs increase; more $RUNE is bonded or contributed into LPs in an effort to increase gains, and the circle starts again. Similarly, as noted by Multicoin Capital in their analysis (pasted below) - $RUNE becomes more profitable as more trades are routed through Thorchain.¹⁷

The launch of MCCN for RUNE, in our opinion, is significant, as it enables native swapping on an unprecedented level; there is no more need for synthetic wrapping (plus associated wrapping and gas fees, not to mention the lessened utility provided by synthetic tokens in their respective protocols). For example, the 24 hour volume of BTC as at the time of writing this article was US$ 63 billion¹⁸; of this, Binance, alone, accounted for US$ 3.57 billion¹⁹. That is a huge TAM, which as of today, in our opinion, lacks an efficient mechanism. The demand is clearly present, with over 140,000 wBTC as at today (over US$ 8.2 billion at the BTC price as at the time of writing²⁰) - to put that in perspective, that is less than 1% of BTC. The opportunity is clear - long term BTC holders want a way earn yield. Impermanent/divergent loss²¹ is a clear risk in contributing to LPs, however, Thorchain will be implementing a protection mechanism, which will ensure that liquidity providers are no worse off than if they simply held the two assets, provided that they act as liquidity providers for a set amount of time.²²

The table below illustrates the value of Deterministic RUNE as a function of various dates²³ and Non-RUNE TVL (illustrative projections at various levels). Of course, this is based on the assumption of at least 80% of circulating supply being locked to yield a more certain deterministic value.

Let’s now discount the token values back to today to take account for the time value of money; for this, we will use a 20% discount rate.

Essentially, in the event that one believes that RUNE will reach the TVL (2*Non-RUNE TVL) that either UNI (c. US$ 5.17 billion) or SUSHI (c. US$ 4.36 billion) are at today, RUNE offers a compelling case.

Moreover, what about the cash flow and system rewards attributable to those running a node or providing liquidity into LPs opposed to just holding the token? System rewards are paid in RUNE and were set aside at the time of issuance to be paid based on a pre-determined schedule. Since a pre-determined amount of tokens are emitted at pre-determined dates, there is an incentive to participate in the security and liquidity of the network as one knows what their upside is. This structure was designed to start at c. 30% APR, falling to a target of 2% APR after 10 years, at which point revenue generation would largely be driven by fees.²⁴

Fees are calculated by a slip-based method, instead of the standard flat fee on other AMMs.²⁵ The best way to summarise this would be: shallower pools with larger transaction sizes generate higher fees while deeper pools with smaller transaction sizes generate lower fees. This method incentivises liquidity providers to seek out shallow pools with strong demand (e.g., smaller pools with a high percentage of 24-hour volume compared to the size of the pool), keeping the broader system in equilibrium (incentivising capital to flow to where it is needed most).

We have put together fee projections, based on RUNE reaching and surpassing the current levels of UNI and SUSHI over the course of 2023. Moreover, the below is also based on the assumption that all pairs move symmetrically over the entire period (which they will not), and therefore, does not take into account any gain/loss associated with pooling against certain assets (e.g., if one symmetrically enters a RUNE:BTC pool and RUNE appreciates faster than BTC, the pool will rebalance by selling RUNE to buy BTC; if BTC appreciates faster than RUNE, the pool will rebalance by selling BTC to buy RUNE). Like all analysis in this article, the below is for illustrative purposes only.

We have assumed that; (i) 24 hour volume is equal to 10% of TVL (and for simplicity’s sake, taken an average of FY and FY-1 for the average liquidity in pools); (ii) the fee decreases over time to account for the slip-based fee and the deeper liquidity within LPs; (iii) a discount rate of 20%; and (iv) perpetuity growth rate of 3%. Our assumptions effectively surmise that the fees generated by contributing to LPs, discounted back to present value, are US$ 5.08 per token (or US$ 3.89 on a fully diluted basis).

On that note, we eagerly await the launch of MCCN alongside the new initiatives that the team is working on.

1. For example, in purchasing a watch, you are purchasing an instrument which can tell you the time at any given moment, but what’s the difference between a simple watch and an expensive tourbillon? Why is one, in some cases, over 1,000,000x more expensive than the other when the utility (being able to tell the time, on demand) is the same? This is the subject of a short article which we will be publishing over the course of April.

2. Public companies, by definition, have their values determined by a liquid market in which there are usually at least thousands of buyers and sellers, each of which does its own analysis as to what they believe fair value is. The market will therefore, resultantly, price the underlying security based on the presumption of rationality on the part of a majority of the investors.

3. We are assuming that the reader is familiar with basic corporate finance.

4. Quantifying intangibles for these purposes is sector-specific, and for simplicity, has been left out.

5. A balance sheet is a snapshot in time, while a profit and loss statement shows a dynamic position over the course of a defined period. A cash flow statement is the result of movement in the balance sheet over the periods which are being measured.

6

Ari Paul ⛓️ @AriDavidPaul

Half of risk management is a single sentence: don't take risks you don't understand.

7. An additional note that usually, there is a slight premium in transaction vs trading comparables as the former usually encompasses some element of control (e.g., a buyout); this is known as a control premium.

8. Aside from being a metric which can benchmark market share (and implied confidence), TVL, in our opinion, is also helpful in estimating fees (insofar as the protocol in question attributes a portion of fees generated from the LP to token holders) as, along with 24-hour volume, it can project effective cash flow (albeit PIK by way of issue of additional tokens).

9. https://uniswap.org/blog/uniswap-v3/

10. In the event that you do wish to learn more, we would recommend browsing through Aswath Damodaran’s blog (http://aswathdamodaran.blogspot.com/).

11. It’s not this simple, but for brevity and sake of argument, we have left it at this.

12. An IRR of 20% is generally accepted as a top quartile, if not, top decile return.

13. We can safely assume that the fees attributable to token holders will be more likely to fall than rise as the cost of providing liquidity becomes more streamlined and commoditised.

14. As an aside, theoretically, the perpetuity growth rate is a rate at which cash flow is expected to be generated into perpetuity; any rate above what the long-term global GDP growth rate is expected to be (historically this has been around 4-5%) implies that the cash flow will grow at a faster rate than the world economy, therefore, eclipsing it at some point in the future. This triggers a break in logic as if the security eclipses the global economy, then it is the global economy (e.g., an asymptotic relationship at the tail end).

15. https://defipulse.com/

16. https://docs.thorchain.org/how-it-works/incentive-pendulum

17. https://multicoin.capital/2021/02/23/thorchain-analysis/

18. https://coinmarketcap.com/currencies/bitcoin/

19. https://www.binance.com/en/trade/BTC_USDT

20. https://coinmarketcap.com/currencies/bitcoin/

21. Contributing to LPs does carry substantial risk, and we would strongly recommend learning more on LP University before jumping straight in (there are some great channels on their Discord which go over various strategies and scenario analysis).

22. https://gitlab.com/thorchain/thornode/-/issues/794

23. https://docs.google.com/spreadsheets/d/1e5A7TaV6CZtdVqlOSuXSSY7UYiRW9yzd1ST6QTZNqLw/edit#gid=918223980

24. https://docs.thorchain.org/how-it-works/emission-schedule

25. https://docs.thorchain.org/how-it-works/fees