How to value digital assets in the context of fraud

Fraudsters have embraced digital assets as a mechanism to facilitate fraud, with digital assets themselves being stolen. Frauds involving digital assets aren't a unique category of fraud but can be characterised as variations on traditional frauds, including Ponzi schemes, investment schemes, boiler room scams, advanced fee fraud and Authorised Push Payment (APP) scams. Fraud involving digital assets is increasing in prevalence and given the often-significant value of digital assets, effective valuation is pivotal to understanding the extent of harm.

Freezing and seizing digital assets is becoming increasingly well-established. AA v Persons Unknown, Ion Science and Fetch.Ai set out that digital assets are assets in a legal sense and are therefore subject to existing remedies.

Our digital asset recovery team was involved in the tracing and recovery of stolen cryptocurrency in the case of Law v Persons Unknown, which resulted in a landmark decision to order that the stolen cryptocurrency be exchanged into fiat currency and transferred to the Court Funds Office. This judgment raises the question of how different types of digital assets are valued when seeking such redress. The diversity of digital assets means that there's no one-size-fits-all approach to valuation.

To demonstrate this, we consider possible approaches to the valuation of two of the most commonly held digital assets: cryptocurrency and non-fungible tokens (NFTs).

Characteristics of cryptocurrencies and NFTs

This table shows the are areas of commonality and divergence between cryptocurrency and NFTs.

Each cryptocurrency token of a given type can be exchanged for another cryptocurrency token of the same type without any loss of value – they are fungible. By contrast NFTs, as the name would suggest, are not fungible. Each NFT is distinct, often representing photos, music, videos, artwork, or some other form of digital asset including through its value of ownership in tokenisation projects.

The fungibility of cryptocurrencies implies that they can be used as a medium of exchange akin to how people use fiat currency. This creates liquidity and the ability to easily convert the most popular cryptocurrencies, such as Bitcoin and Ethereum, into fiat money. NFTs are more similar to assets such as fine wine and fine art: they have value but are not used as a medium of exchange.

As a result of their fungibility and acceptance as a medium of exchange, cryptocurrency has a listed price or exchange rate on exchange platforms where one can buy and sell cryptocurrencies using a range of fiat currencies with ease. This is not the case for an NFT, where each has its own price, and while one can find past prices through platforms such as OpenSea, there can be significant periods of time in which the NFT is not exchanged and therefore a price is not observed. The implication of this is that the market price for cryptocurrencies in terms of fiat currency is directly observable but this is not the case for NFTs making their valuation in the context of fraud inherently more complex.

It's important to note that there is further variation within cryptocurrencies and NFTs. One important example is that many NFT projects rely on the systematic and/or algorithmic generation of artwork. The implication of this is that each NFT in a collection that's algorithmically generated has a set of attributes that fully describe each NFT. Information on what attributes the NFT has, and the relative uniqueness of each attribute within the collection, are key drivers of value. One of the most prominent examples is CryptoPunks: the total value of all CryptoPunks sales was USD2.69 billion on 29 January 2024. 

Finally, whereas cryptocurrencies can be purchased using fiat currency this is not the case for NFTs, which are typically purchased using cryptocurrency. This intermediate step between fiat currency and the NFT means that NFTs are less liquid than cryptocurrencies.

Different conceptual approaches to valuation

Common approaches to digital asset valuation could include the following:

• The market approach – where there is either a market price which can be observed or where a market price can be derived with reference to a comparable asset accounting for relevant market forces
• The income approach – derives the value of an asset with reference to the discounted value of its future cash flow (only relevant in the case that the asset confers a future flow of cash)
• The cost approach – derives the value of an asset with reference to the associated opportunity cost; in the context of a digital asset, a proxy for value is derived by observing the quantity of tokens required to purchase a particular product or service which itself has a published price

Based on our experience and a review of the small number of cases that are in the public domain, the market approach is emerging as the preferred valuation method for cryptocurrency and NFTs.

In the case of fraud involving the most commonly traded cryptocurrencies many exchanges list a price in fiat currency, which can be used to infer value at any point in time. More challenging are digital assets, including NFTs and some cryptocurrencies, where exchanges are less frequent and prices therefore less readily available.

In these cases, we've adopted the use of an alternative market-based approach utilising information on prices across the market to construct an econometric model for asset prices. This econometric model provides an estimate of what the value of the digital asset in question would have been at the relevant point in time. The use of a model allows one to control for macroeconomic factors and the characteristics of the NFT in order to arrive at an estimated value that's appropriate for the time period and particular NFT under consideration. These methods have long been applied in the valuation of other assets which share characteristics with NFTs in terms of trade infrequency and heterogeneity, such as fine wines and houses.

For digital assets, where there is neither a market price nor valid comparator from which to derive an estimate of value, there are some cases where at least some of the value could be estimated using the income approach. However, in many cases the NFT or cryptocurrency under consideration won't confer any future flows and as such its value cannot be estimated on a discounted cashflow basis.

The cost approach is unlikely to be relevant in the case of NFTs as they're not used as a medium of exchange and their lack of fungibility means that it's unlikely that goods and services will be exchanged for NFTs. This is less true of cryptocurrency so there may be merit in considering a cost approach if the market approach is not tractable and the income approach not relevant.

Using monetary economics to value cryptocurrency

Where cryptocurrency is being used as a medium of exchange, ie, in the same way as fiat currency is used, it might be appropriate to apply insights from monetary economics to the context of valuing cryptocurrency.

The quantity theory of money, expressed in the form of the Fisher equation, is central to the economic theory of monetarism. The Fisher equation sets out how increases in the supply of money drive inflation by relating money supply and the rate of its use to the price level and the volume of goods brought and sold using the currency. This gives rise to the theory from monetary economists that increases in the supply of money drive inflation. Interestingly, from a valuation perspective, the Fisher equation can be rearranged to solve for the average price level, which means that it could be used to infer the value of the currency under consideration.

This raises the question of how to define the constituent elements of the Fisher equation in the context of a cryptocurrency:

• The money supply is relatively easy to interpret in this case – it is the number of tokens of a particular cryptocurrency that are currently in circulation
• The velocity of circulation is the number of times that a token is used in a transaction during a particular period; the use of blockchain technology means that this quantity is observable
• The volume of goods and services transacted, and the appropriate derivation of this quantity in the context of cryptocurrency, is a key area of consideration – one interpretation could be that it is the volume of goods and services purchased using the cryptocurrency in question within the economy of interest

Armed with these three data points, it's possible to derive the value of the token in fiat currency terms by solving the Fisher equation.

There are two main challenges to applying the quantity theory of money to the valuation of cryptocurrencies.

Firstly, the derivation of the volume of goods and services transacted in a particular cryptocurrency within the economy is not always easily identifiable. In the case of Bitcoin, it would require an estimate of the subset of all spending in the economy that is carried out using Bitcoin. In systems where the cryptocurrency in question is the sole medium of exchange, this issue can be resolved.

Secondly, if the cryptocurrency under consideration is held as a store of value rather than solely being used as a medium of exchange – similar to how gold is used rather than fiat currency – this is a violation of the assumptions that underpin the quantity theory of money and therefore it is not appropriate for valuation.

In summary, the quantity theory of money could be used to value a cryptocurrency if it is exclusively used as a medium of exchange and if it is the sole medium of exchange in a given system.

How we can help

There are differences in the appropriate valuation technique depending on the nature of the digital asset under consideration. Regardless of which approach is deemed applicable, economics is pivotal.

If the market approach is used, as is commonly the case, an econometric model may be required to arrive at a precise and analytically robust estimate of value. If the income approach is used, economic factors must be taken into account, including how discounting is done and how future income is valued. In some cases, it may be possible to leverage insights from economic theory, such as the quantity theory of money, to derive the value of digital assets that don't have a quoted price.

The combined strength and experience in these matters of our teams across digital asset recovery, economic consulting and valuations mean we're well placed to help victims of fraud in their pursuit of redress.

For more insight and guidance, contact Tom Middleton.