What are the Crypto Fair Value Considerations?

What are the crypto fair value considerations? In the last decade, crypto has come a long way and has gained a lot of traction among individual crypto investors and large corporations.

But, when it comes to determining the fair value of a crypto coin, there seems to be a lot of discrepancies in the price of a crypto asset and the overall market value of the project.

As a result, a lot of crypto coin market capitalization aggregators have come up but that has not resolved the issue primarily because all these aggregators follow a dissimilar process for evaluating market caps.

While some multiply the spot price of a unit with the supply of the coins others measure the fair value based on the present usage of a crypto coin without any implied theory.

There are few others that simply list the market cap of each crypto in a decreasing order while those aggregators that are dedicated for Bitcoin and Ether measure it against the top stocks in the world such as Amazon and Apple.

Typically, fair value is a broad concept and it needs considering a lot of factors to ensure accurate valuation.

If you want help in this regard, this article will guide you through the laborious process of determining the fair value of the crypto assets.

Going through the article you will know how exactly you can integrate the expected supply of coins to calculate the Total Discounted Supply, which is the trickiest part.

The traditional market cap aggregators may not be able to present the real picture because they may not consider the different perspectives of the crypto assets, which, by themselves, are considered to be highly speculative.

What are the Crypto Fair Value Considerations?

What are the Crypto Fair Value Considerations

According to the definition in International Financial Reporting Standards or IFRS 13, fair value measurement is that which assumes an orderly transaction made in order to sell an asset or transfer the liability by one market participant to another.

It actually refers to the data measured at the prevailing market conditions.

It also assumed that such a transaction takes place in the principal active market or, in the most advantageous market in absence of a principal market.

Now, a principal market is considered to be the one that has the highest level and volume of activity.

On the other hand, the most advantageous market is the one in which the amount that can be received by selling the asset can be maximized or the one wherein the amount to be paid for transfer of liability is minimized, both done after taking the transaction and transport cost into account.

There are a number of challenges to overcome while measuring the fair value of the crypto assets.

One significant challenge is that the crypto assets are traded on several different crypto exchanges and platforms that are not regulated completely.

As a result, the quality of information regarding the volume of transactions varies significantly.

Another significant challenge is that there are a few specific crypto exchanges that exchange different types of crypto coins for one another rather than cash since it is illiquid.

In such situations, the extent of the commercial substance is pretty unclear.

This makes it quite difficult to find out the principal or most advantageous markets and judge whether or not the transactions are logical.

There is another issue related to the price of the crypto assets which are volatile and swings considerably.

Therefore, it is crucial to know how a crypto exchange determines the quoted price of an asset before evaluating the fair value.

This is because this may exclude the anomalous transactions that may be otherwise irregular.

This, once again, makes it difficult to assess correctly whether the quoted price is in accordance with the idea of IFRS 13 regarding fair value or not.

Therefore, as you can see, it is quite difficult to measure the fair value of a crypto asset.

In order to make the right assessment, you will need to consider the guidance under IFRS 13 which includes:

  • The description of fair value
  • Application of the valuation procedures and
  • Inputs to these valuation techniques.

Apart from the above, you will also need to consider a few other specific factors for assessing the fair value of a crypto asset.

Level 2 liquidity discounts:

The inputs of Level 2 are observable inputs apart from the quoted market price that is included in the Level 1.

While calculating the fair value price of the crypto asset it is the public equity price actively traded on ‘as-if’ converted basis considered.

This is excluding the discounts applicable for legal restrictions, price volatility, liquidity risk, and other assumed risks.

In general, such discounts may range anywhere between 5% to 30%, and when it is less significant, the positions automatically move into Level 3 just as it does when there is no convertible security in the money.

When liquidity discounts are applied, the assumptions made from the point of view of the market participants to determine the fair value is to be considered.

However, on the date of measurement of the fair value of crypto assets neither the objective of the fund to hold an investment nor the amount of investment held is relevant.

ICOs and Level 3 SAFTs:

When there are no observable inputs available, ICOs, SAFTs or Simple Agreement for Future Tokens, and other digitized interests of equity ownership are tagged as Level 3 investments.

Traditionally, the fair value of such investments is recorded at the initial cost of transaction.

The subsequent adjustments are made when there is new financing.

This initial cost is not the fair value but an approximation of it.

There should be a fund valuation policy for recording the fair value of the digital assets and the private equity investments of a company by using three specific things such as:

  • Reviews of financial statements
  • Internal analysis and
  • Comparison of the fair value of public securities and investments in private equity.

At this point it is important to remember that the cost of transaction for a fresh round of financing may not always be suitable to input while measuring the fair value of the crypto asset.

In order to make sure it is, the portfolio company will need to consider these following factors:

  • Complications of the capital structure
  • Characteristics and attributes of the transaction
  • Immediacy of the reporting date
  • Degree of involvement in the round of financing by the additional third party and
  • Any changes made in the intervening period between the reporting and transaction date.

Once again, the initial transaction cost will not be considered as the fair value.

Therefore, the financial reporting team of the fund needs to record the fair value measurement of the private equity investments.

This must be done by using multiple valuation procedures to corroborate and complement the fair value of the asset depending on the transaction cost of a new private equity financing.

Hierarchy of IFRS

While accounting for the fair value of a crypto asset you must remember that it has to be done in accordance with the fair value hierarchy of IFRS 13.

For this a variety of situations and factors need to be considered such as:

  • The inventory in custody of a broker-trader calculated on the value minus costs to sell
  • The expense paid in crypto assets for third party services
  • The intangible crypto assets where revaluation model is followed
  • The employee expenses paid in crypto assets
  • The revenue earned by the ICO issuer
  • The crypto assets acquired during business combination
  • The disclosed fair value of the crypto assets held on behalf of others and
  • The measured or disclosed fair value of the crypto assets held by the investment fund.
Read Also:  Economic Limitations of Crypto Overtaking Fiat Currency

The IFRS 13 defines ‘Fair Value Measurement’ as well as sets out a structure for determining the value.

And, there are three levels of hierarchy in which the fair value is divided on the basis of the levels of inputs in each valuation model.

These are:

  • Level 1 – This is the level where the quoted prices of similar assets and liabilities in the active markets can be accessed by an entity at the measurement date. These are the most observable inputs that help a lot in estimating the fair value of a crypto asset.
  • Level 2 – This is the level where the observable inputs are available apart from the quoted price in Level 1 for similar assets and liabilities in an inactive market or private funds in public companies, or any other input of the market that is not considered as a directly observable quoted price. It may also include OTC derivatives and bid/ask prices of OTC securities, and also a few specific types of assets and securities that are illiquid or thinly traded.
  • Level 3 – This is the level where only unobservable inputs are available. These include situations when an option pricing model has historical volatility or in the data and assumptions of the fund. Several valuation techniques should be used if an investment is more illiquid in order to get the fair value of the crypto asset. In this level, the assets without any public market are found as well as the complex OTC derivatives such as a few foreign currency options, swaps and long-dated commodity options are included.

However, at this point you should remember that the hierarchy level of the crypto assets may change over time.

Furthermore, there are also a few other disclosure requirements of IFRS 13 which typically depend on the measurement basis of the financial statements as well as the level of hierarchy the fair value measurement falls into.

This is a complex subject considering a few specific factors such as:

  • The degree of detail required to meet the disclosure requirements
  • The emphasis required to make on each of these requirements
  • The amount of aggregation or disaggregation needed to undertake and
  • The need for added info in the financial statements of the users to estimate the quantitative info disclosed.

If, in case, these are insufficient to meet the disclosure requirements, according to the IFRS 13, a few additional information may be required to be disclosed for assessing the fair value of a crypto asset.

One such factor is the time at which the crypto asset is valued because these are extremely volatile and so the price during reporting may be significantly different from the price at the close of business on that particular day.

Remember, crypto markets are open 24/7 and therefore the closing time of the day is usually taken to be 11:59 PM.

Also, the time zones should be disclosed as a note on the financial statements.

Active Market

It is also required to consider whether the market is active or inactive while determining the fair value of a crypto asset.

In fact, determining whether or not an active market exists at the measurement date of a particular crypto asset is considered to be the first step of the entire process.

This will help in determining whether or not the Level 1 valuation is applicable.

According to the Appendix A to IFRS 13, an active market is defined as one where the transaction of asset or liability typically happens in significant volume and frequency that is enough to provide the necessary pricing info on an ongoing basis.

Apart from that, the depth and activeness of a market can also be calculated by looking at the active trading days in a specific period of time.

You may also consider the average daily turnover ratio which is the quotient of the average daily trading volume and the total outstanding amount of the crypto assets.

However, there are no specific thresholds defined by IFRS 13 regarding the frequency or active trading days and the volume or turnover ratio in order to determine the existence of an active market.

This means that you will need to use personal judgment to come to a conclusion.

Remember, there can be several assets that may have a very low daily turnover rate of less than 1%.

However, these assets may also be considered to be traded in an active market if it is found that the active trading days are sufficient within a specific period of time.

Therefore, based on the quantitative information available, it may be possible to deduce whether or not an active market exists for a crypto asset.

However, you will need to do some further analysis of the related data as well as consider a few qualitative factors such as:

  • Data reliability and
  • Trading pairs.

And, there may be a few specific situations where a particular crypto asset may have several markets, all of which may meet the definition of an active market but may have variable prices at the measurement date.

In these situations, you will need to identify the principal market of the crypto asset according to the IFRS 13. This refers to the accessible market with the highest level of activity and trading volume.

However, if there is no clear and identifiable data to determine a primary market, IFRS 13 contains a ‘tiebreaker,’ where the most advantageous market is considered among all.

It is defined in the Paragraph 17 of IFRS 13 that an entity need not have to search extensively to figure out a principal market but should take into account all info that is available reasonably.

If not, then the market in which one would prefer to enter normally to sell the asset is to be considered as the principal market.

After the principal market is figured out, you will need to consider the pricing mechanism of it and scrutinize it based on the description of orderly transactions in paragraphs 15 and B37–B44 of IFRS 13.

The entry price will be the price of a crypto asset purchased outside an exchange.

This will certainly not be considered as the pertinent valuation basis of the fair value of the assets.

This is because it is typically based on the exit price according to the definition in the paragraphs 9 and B2 of IFRS 13.

Also, the crypto assets that cannot be converted to fiat directly in an active market will also not fall into the Level 1 hierarchy according to definition in the paragraphs 76–78 of IFRS 13.

This is because there will always be some sort of spread or fee associated with it.

Now, when this fee is observable the fair value of the crypto asset will qualify for Level 2 fair value hierarchy.

And, the crypto assets that cannot be converted to fiat directly in an active market are expected to qualify as a Level 3 asset.

Read Also:  Carbon Footprint of Bitcoin Mining: How Big & Serious?

While determining the active market, there can be two significant issues you will need to consider as well.

These are:

One, there may be notable differences in the prices in some cases due to the price differences between the principal and most advantageous market.

This will lead to difference in the real price received resulting in a confusion regarding profit or loss in a day if a fair value model is used.

These price differences will however not indicate that there is no active market existing.

Two, there may be a few crypto assets that are backed by fiat currency but these crypto coins may not be considered as a foreign or functional currency according to the definition in IAS 21.

In such situations, these specific crypto coins are treated just like any other crypto assets when it comes to figuring out whether or not an active market exists.

Data Reliability

Reliability of data is a very important aspect for estimating the fair value of a crypto asset.

This is because several analysis reports have shown that various crypto exchanges often report inflated data regarding the trades made on the platforms.

Therefore, it is important that you consider the source of the particular data you intend to deal with.

Typically, the data available on regulated exchanges are considered to be more reliable in comparison to the data sourced from the unregulated exchanges.

However, it is important that along with it you also consider the criteria of regulation and whether or not there is any kind of surveillance over the data for the trades conducted on the platforms.

Trading Pairs

The trading pair is the next important thing to consider while determining the fair value of a crypto asset.

Typically, the transaction of a crypto asset can be of two major types such as:

  • A particular asset being exchanged for some other crypto asset, called as ‘crypto to crypto’ transaction and
  • A crypto asset being exchanged for a traditional fiat currency, called ‘crypto to fiat’ transaction.

The crypto to crypto exchanges are included normally in the trading volumes and prices of a specific type of crypto asset that may be published in the websites of the data provider.

In these cases, the trading prices are derived from the implied conversion of the crypto asset into fiat.

This is typically done at a rate determined by the crypto exchange or the data publisher.

While determining an active market, for a specific type of crypto assets it can only exist when the crypto to fiat trading pairs are published by a reliable source.

Usually, while determining the existence of an active market, crypto to crypto trading pairs should not be measured.

In practice, there are a few exchanges that do not allow making crypto to fiat transactions at all.

In such situations, a crypto asset can be exchanged for another type of crypto asset on one particular crypto exchange and then again the second type of crypto asset can be exchanged for fiat but on a different crypto exchange.

This means that even if there is a possibility of a market to exist for a crypto asset where the volume and frequency of trades for a particular trading pair are quite significant but cannot be considered as an active market according to IFRS 13.

Valuation Inputs and Techniques

Therefore, as you can see, there may be several different types of crypto assets that may not have any active market according to the definition in the IFRS 13.

Therefore, it is elementary that you know about the different types of valuation techniques and inputs for estimating crypto fair value and then consider the one that may be applicable.

Typically, the most apt valuation technique will be the one that will allow you to estimate the price of an orderly transaction made to sell an asset or to transfer a liability under the given market situation at the measurement date.

There may also be times when you may need to use several different valuation techniques.

However, no matter whichever valuation technique or techniques you use, it is very important to make sure that you consider how exactly a participant in the particular market will determine the fair value of the crypto asset that you intend to measure.

Most of the time, it will be more feasible to follow the market approach, according to Paragraph B5 of IFRS 13, for evaluating the fair value of a crypto asset.

The simple reason behind it is that this particular technique will be typically used by the market participants.

However, there may be a few times when the market participant may use a completely different technique.

This is called the cost approach, according to Paragraph B8 of IFRS 13 or it can also be the income approach according to Paragraph B10 of IFRS 13.

Though these practices are quite rare, the IFRS 13 indicates that you should always use the most appropriate valuation technique based on the given circumstances.

It also states that the technique followed should be able to maximize the use of pertinent observable inputs.

On the other hand, it should also be able to minimize using the unobservable inputs. This will ensure accuracy in the evaluation process.

The types of observable inputs for a crypto asset may include:

  • Information available on mutual transactions made outside the active market
  • Specific quotes from the broker-trader and other relevant information.

While using the broker quotes, you should make sure that these are evaluated carefully because the crypto markets and exchanges are mostly unregulated.

The best way to go ahead is to use broker quotes that are derived from specific models and not on the basis of observable market dealings.

Since broker quotes are not used extensively today, it is better to go for a specific valuation model that is applied constantly from one period to the other.

However, you must remember that the valuation techniques used by the market participants keep on changing due to the simple reason that the crypto market is itself evolving continually.

And this is not violating any rule because the IFRS 13 allows making changes in valuation techniques and even allows changing weightings when multiple valuation techniques are used.

This is allowed because it is felt that such changes will result in more accurate representation of fair value under the given and ever-changing market conditions.

The valuation techniques may also be needed to change from time to time based on different other factors such as:

  • Developments in the markets
  • New market developing
  • Availability of new information
  • Unavailability of information used previously
  • Improvement in the existing valuation techniques and
  • Changes in the existing market conditions.

And, when it comes to calibration of the valuation techniques according to IFRS 13, you will need to consider the specific limitations on figuring out the fair value of a crypto asset at initial recognition of the transactions.

This is because the observable transaction of a crypto asset is represented by the acquisition transaction of the crypto assets.

Here are a few important valuation techniques that you may use to calculate the fair value of a crypto asset.

These evaluation techniques typically vary based on the way you view a crypto coin.

Read Also:  Why is It Not Likely for Crypto to Kill Central Banks?

Based on expected value:

If you consider crypto coins to be the same as stocks and bonds, you should consider the pricing model of it because that will appraise the expected value of it.

This expected value is actually the discounted value that is recognized as the future payoff of the investment.

If you are estimating the value of Bitcoin in particular, you should know that it will not pay any interest or dividends.

Therefore, the expected value of it will be determined on the basis of the degree of trust the users have in the underlying technology or on its potential to be revolutionary or a disruptive currency.

This type of approach is very much the same as that you would use to evaluate an infantile tech stock or a start-up company that is yet to make earnings or profits. When the expected value is estimated, the current fair value of the crypto asset can be evaluated.

Based on supply and demand:

This is a very useful and most commonly used valuation technique of a crypto asset.

In this alternative method, you typically use the basic principle of economics namely, supply and demand and their relation.

Just like any other traditional market, the crypto market also accomplishes price discovery based on the interaction between the buyers and sellers.

The buyers determine the demand of the crypto asset and the sellers influence the supply of coins in the market.

In simple words, when the demand for a crypto asset is more than the supply of it in the market, it will push its fair price up due to the scarcity.

Since the supply of a crypto coin is usually finite and cannot be increased by voting, a decree or otherwise, the price of it is typically linked with its scarcity factor.

This means that the fair value of a crypto is more of the same kind as a collectible, such as a piece of art.

There can also be a completely different outlook to the supply and demand factor which is based on the stock versus flow theory.

This stock to flow ratio comprises mainly two major elements – one is the stock circulating and currently available in the market and the other is the newly induced stock flow by adding more of it to the circulation.

In the case of crypto, especially Bitcoin, the mining reward is halved after around every four years.

Each of these halving events raises the stock to flow ratio because fewer numbers of new coins are produced.

This may also result in a Bull market where the prices reach to new all-time highs.

Effects of the network:

If you view a crypto coin not as an asset but simply as a network, which is quite reasonable, the fair value of it will be derived from the size of the network as well as the robustness of it.

Actually, the network effects refer to the number of nodes or miners involved or engaged on the particular network for validating transactions.

The value of a network is typically proportional to the square of the number of nodes or users, according to Metcalfe’s law.

Therefore, evaluating a crypto asset on this basis implies that the value of a crypto coin will increase when the value of the underlying network increases, though there are a few specific limitations to this process that you should also consider and overcome.

Production cost:

The cost of production of the intrinsic value of a crypto coin is another way that you may consider, provided you view it just like any other produced commodity such as silver or oil.

In this approach, the price of the commodity is basically derived from the marginal cost of production of the commodity.

This is actually the cost incurred by the producers for producing an additional unit of the commodity and not the average cost of all the commodities taken together.

This valuation technique is also based on a major economic theory that states when there is a large number of producers of the same commodity they have to compete with each other in order to sell their products to their customers.

This competition may result in forced reduction of the selling prices down to their marginal cost.

In case of crypto mining, similar competition is experienced while producing a new coin and the price of the crypto coins is driven by the same kind of dynamics.

Therefore, in both the cases, the producers will not be ready to sell their products, in this case the mined crypto coins, at a cost that is lower than the cost of production and incur loss as a result of the demand falling short of supply.

However, as it is in the case of mining ore or producing any other products where the supply can be increased with an increase in the demand, in the case of crypto it is not so, no matter how hard the crypto miners try.

This is because there is a specific time interval to produce a new block on the blockchain, which is 10 minutes or so in the case of Bitcoin.

This means that a large number of new and larger miners may join a network if there is a rise in price of the crypto asset in the market but that does not necessarily translate to a larger number of crypto coins produced.

In fact it remains the same.

What really alters is the difficulty level in the mining process of the crypto coins.

If it is raised then the 10-minute gap to produce a new block will be maintained thereby regulating the coin supply.

This eventually means that the marginal cost of production enhances but the supply of coins does not.

In a nutshell, it can be said that passage of time between the measurement date and the initial transaction date will make the initial transaction price less relevant.

However, the fair price valuation methods for crypto assets should be made with respect to IFRS 13 requirements.

For that, all appraisal reports from third parties may not meet the IFRS 13 calibration requirements.

Therefore, make sure that you choose one that is consistent with IFRS 13 in all aspects.

Consider the transaction price and the worth of the crypto assets held at the measurement date.

Remember, apart from doing your due diligence, it is also very important to know how exactly you should appraise the fair market value of the coin in order to make profits from crypto transactions.

Conclusion

Therefore, as it is evident from this article, crypto fair value estimation is not an easy task and there are several important considerations to make for accurate estimation.

This will ensure that it is in accordance with the IFRS 13 calibration conditions.