By Christian Gazzetta from WIT.insights
Since cryptocurrencies are means of payment, the volume of transactions they undertake can be seen as a good driver for their inner value. But it’s important to acknowledge the advantages and flaws of that metric.
NVT is, presently, the most popular metric used for cryptocurrency valuation. It is based on the idea that the intrinsic value of those assets is their liquidity and that it can be represented by the volume of on-chain transactions (executed by the protocol, differently from those that happen on exchanges).
To find the NVT ratio of a token for a given period, we just have to divide the market cap at the time (US$) by the daily on-chain transaction volume in the network (US$). This way, what we have is the value perceived by the market of each US dollar transacted in the blockchain. Like in some traditional market’s valuation approaches, the NVT ratio can be used to compare similar protocols and, looking at their sector, figure out which of them are over or undervalued.
But NVT is far from being an ideal ratio. To look at the historic evolution of some token’s NVT, we must keep in mind that occasional events and the development of substitute solutions can have lasting effects upon the level of the ratio. Considering the present state of the crypto market, it’s extremely risky to assume any level of NVT as a stable equilibrium. This indicator should be used only to compare assets that serve the same market with similar specifications and technologic solutions.
Investors should also know that NVT is subject to abrupt movements in daily transaction volume, due to the activity of exchanges and big holders. That’s why Dmitry Kalichkin proposed the NVT Signal, a metric that inputs the average volume within 90 days to calculate the price of transaction volume.
And there is another noteworthy limitation: both the variables used to calculate the NVT are strongly dependent on the price of the analysed asset, and the effect of price movements on those two is not equal. Therefore, some changes in the NVT can be consequences of pure market flotation and have no fundamental importance to the value. To overcome this limitation of the methodology, some use a similar ratio called Network Momentum, which is obtained dividing the market cap by the transaction volume expressed in tokens (for example, Bitcoin).
Now that we discussed the limitations of the methodology itself, let’s focus on the problems of the inputs used. Nic Carter and others specialists warn that volume registered in blockchains is always overestimated because i) exchanges keep sending tokens back and forth between their wallets; ii) privacy solutions called mixers create fake volume in order to erase the track of users who want to remain anonymous; and iii) transactions can generate changes, which are not easily distinguished from normal outputs and hence cause double counting problems.
Still, NVT is still quite efficient to identify overbought or oversold moments on cryptocurrencies. It is also important to note that, since cryptoassets are becoming less volatile, the thresholds used tend to be each time closer — specially the upper one.
On next posts we’ll discuss alternative metrics that address some of the downsides of NVT, starting with realised cap.
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