Why We’re Bullish on ATOM

Please note that VanEck may have a position(s) in the digital asset(s) described below.

Please note that VanEck has a position(s) in the ATOM token described below.

Based on our discounted cash flow analysis of potential Cosmos ecosystem value in 2030, we arrived at a $140 price target for the ATOM token, with downside to $1. With ATOM’s price at $10 as of 8/2/2022, we like the 14-1 odds presented and believe this is a buying opportunity for the token.

To arrive at the model’s assumptions, we found it helpful to answer the following questions:

• What is a layer 0?
• Why is cross-chain bridging so hard?
• How will value accrue to ATOM holders?
• What is the role of market-makers in crypto?

An Introduction to the Cosmos Hub: What Is a Layer 0?

A layer 1, smart contract blockchain like Ethereum is simply an enterprise platform that hosts decentralized applications while enabling payments between users. Ethereum generates revenue by charging deployers of smart contracts storage fees, while exacting a toll on users who send transactions or utilize the deployed smart contracts. Conceptually, these customer bases can be segmented into B2B and B2C components, with the deployers of smart contracts thought of as businesses and the end users of the blockchain thought of as consumers. Ethereum rents secure storage space to those businesses to host their enterprise and sells the blockspace to users that allows them to interact with those businesses or send funds. This simple business model, with some tweaks, defines most layer 1 blockchains.

By contrast, layer 0 blockchains like the Cosmos Hub, Polkadot and Avalanche are highly specialized B2B models. The main customers are other blockchains, and the product provided is security. In essence, a layer 0 is a type of blockchain software that coordinates a network of computers where hosted blockchains can deploy their blockchain data and blockchain logic to have it executed to make transactions. This allows the hosted blockchain, or (security) consumer chain, to execute its suite of functions and applications in an environment protected by the layer 0’s security. Because consumer chains deploy as blockchain logic to the layer 0s rather than as smart contract code on a layer 1, they are free to create custom environments for their hosted applications.

To ensure the layer 0 computers are honest, each computer in the network must put up collateral, or “stake”, consisting of the layer 0 tokens. If a computer acts maliciously or fails to properly execute the hosted blockchains’ logic, the computer, called a validator, can lose a portion or all of its stake. This is termed a “proof of stake” (PoS) security model. Effectively, layer 0s are outsourcing host blockchain security to enable each blockchain to focus on its own business model. Security fees can be paid by the consumer chains through a number of different mechanisms, including renting one of a limited number of security spots on a layer 0, collecting a portion of transaction fees, receiving inflationary rewards from consumer chains, or some other combination of these mechanisms. Because layer 0s are secured by validators backed by staked tokens, the value of the security flows through to those staked tokens.

The Cosmos Hub’s target market is the blockchains that make up the Cosmos ecosystem of blockchains. 48 of the 49 blockchains that populate “the Cosmos” are written using the Cosmos Software Development Kit (SDK). Released out of a blockchain start-up called Tendermint in January 2018, the Cosmos SDK is the most popular blockchain framework in terms of number of deployments. Cosmos SDK chains include Binance Smart Chain, Thorchain, Oasis, OkEx, Terra and Crypto.com’s Cronos chain.

The Cosmos SDK is a modular framework for developers to create proof of stake (PoS) blockchains. Rather than having to write each component of a blockchain from scratch, developers can pick, choose, and modify components from the Cosmos SDK to assemble their own blockchain. At the heart of the Cosmos SDK is the consensus engine known as the Tendermint Core. Tendermint, utilized in the Terra blockchain, has proven itself extremely robust under the extreme duress of Terra’s collapse. Though the coin values of Terra and Luna were eradicated in the panic, Terra’s Tendermint-based blockchain remained fully operational throughout the entire melee.

Arguably the most important and revolutionary component of the Cosmos SDK is the IBC module. Using IBC, separate Cosmos SDK blockchains can open up communication channels to exchange data, messages, tokens and other digital assets. The permissionless and trustless communication technology of IBC solves many of the issues presented by trusted bridging solutions that have led to over $1B in funds stolen through bridge hacks. IBC not only allows assets to transfer across chains, but also enables cross chain composability. Composability is the property of seamless communication between applications. This allows applications on Ethereum to work together to create a super application whose combined edifice is greater than the individual components.

An example of this concept is pairing an options protocol application with a DEX application. The DEX application could embed a feature on their application that enables a liquidity provider the ability to automatically have their liquidity position hedged using the options protocol. Essentially, the ability to compose a structured product has been created. Users can save both time and gas fees and gain the ability to hedge, while each application builder only needed to understand their respective product but have also added new use cases. As a result, both businesses and the consumer are better off.

Many projects choose to deploy to the Cosmos by becoming stand-alone blockchains because being a sovereign chain enhances each chain’s ability to offer a great product and a friendlier user experience. IBC enables these application specific blockchains (ASBs) the ability to smoothly and safely collaborate using secure message passing and safe asset transfers. This capability will lead to both new use cases for blockchain technology and potentially scale up blockchain processing capabilities. IBC is such an important component of future blockchain communication that recent advancements have brought IBC outside of the Cosmos to connect to both NEAR and Polkadot. The team building these extraterrestrial IBC connections, Composable Finance, is currently working on connecting IBC to ETH as well and it’s rumored IBC may be added to Ethereum 2.0s roadmap in the future.

Why Is Cross-Chain Bridging So Hard?

A peak beneath the hood of how cross-chain bridging typically works and why IBC is different helps illustrate why IBC is so important and revolutionary. Blockchains have great difficulty trusting data introduced from the outside, because blockchains are designed as closed loop systems that use complex mathematical processes to verify information occurring inside of their domains. As such, introducing data from the outside requires extensive computational proof and entities to verify the data’s veracity and liveness. Chainlink, for example, incentivizes a network of data providers to bring data from offchain sources to blockchains by combining proofs of data validity with economic incentives tied to the provision of reliable, demonstrably correct. If a data provider presents incorrect data, it is penalized, but if the data is correct, it receives rewards. Bringing data from trusted centralized repositories to blockchains using these economics and mathematics is a feat arguably worthy of an academic prize. However, introducing data between blockchains has proven to be even more complex.

Passing data between blockchains is exponentially more difficult because most blockchains have different designs that make the certainty of what is transpiring on one chain very hard to prove to another chain. This is due to the fact that, depending on the type of blockchain consensus mechanism, not all transactions on blockchains are immediately considered final and irreversible. Likewise, there are different mechanisms by which each chain proves the validity of transactions. For example, Ethereum’s consensus currently operates on the assumption that transactions are considered final with only a high probability until the block they are included in is built upon by enough follow-on blocks full of transactions.

On the other hand, Cosmos blockchains that run the Tendermint consensus engine have instant finality once transactions are included in a block. The consequence of these two different consensus mechanisms is that each chain, Ethereum and Cosmos, has difficulty trusting what is happening on the other chain with enough certainty to risk sending assets, passing message or sending data. To solve the issue of bridging these two ecosystems, a clunky and relatively unsafe mechanism has been adopted. This is referred to as a multi-signature bridge, which relies on a set of trusted parties who verify each chain and assume the risk of asset transfer failure. This popular bridging mechanism is far from optimal as it takes far too long to for many cross-chain important use cases while placing enormous risks on users due to hacks and bridge failures.

IBC’s Secret Sauce Explained

IBC is a superior technology that relies upon several unique components enabled by the Cosmos SDK underpinning each Cosmos chain. First, every Cosmos chain shares the Tendermint consensus engine where finality is instant. Once a block is produced, the transactions included in that block are irreversible. Because of this commonality, offchain counterparties, called light clients, are able to quickly query and sample the current state of each blockchain. Light clients are computers that are used by applications or blockchains to understand the recent history of another blockchain. These light clients understand what is happening on each blockchain by simply proving that the mathematical code that each blockchain uses to link together its blocks, its history of transactions, is correct. The light clients then use this code to deduce the recent history of transactions of each blockchain. Utilizing light clients solves the first issue of trusting and proving what is going on in each blockchain. Now, because light clients enable a blockchain to understand what is occurring on another blockchain, IBC architecture then enables each blockchain to perform activities on another blockchain without relying upon a trusted third party.

In IBC, cross-chain interaction is not accomplished by direct messaging between chains. Instead, when one chain, Chain A, wishes to interact with Chain B, it commits the desired action to its own finalized block with a specialized message. Then, a trustless third party, called a relayer, who is looking for these types of messages, remits the observed specialized message to the other chain. Thereafter, Chain B performs the action wanted by Chain A and finalizes the result of that action in a finalized block on Chain B through a specialized message. The relayer then picks up Chain B’s action and relays a confirmation of that action to Chain A. As a result, both blockchains have agreed to an action and committed it to their respective history books without intervention of a trusted party. This action was also seamless and accomplished extremely quickly – in seconds. This is arguably the most powerful piece of technology today, because it unifies blockchains in the Cosmos, which both solves scaling issues and enables complex use cases.

IBC Packet Flows

Source: ibcprotocol.org

How Value Accrues to ATOM

While the Cosmos SDK enables coders to spin up PoS blockchains out of open source software and use IBC to connect them, each blockchain still needs to secure large sums of high value digital assets on its own. That is because in the PoS security model, a blockchain’s security is only as great as the economic value of the stake backing the validators of the chain. Nascent chains in the Cosmos are currently forced to either pay highly inflationary token rewards to validators or increase the probability of hacker attacks on their chains. Both these choices are suboptimal, and there exists a clear need in the Cosmos ecosystem for a well-capitalized provider of security.

The Cosmos Hub will fulfill its security duties, called “Interchain Security,” by leasing out its high-valued, ATOM token-backed validator set to secure budding blockchains. The Cosmos Hub has 175 validators who collectively have 193M ATOM tokens staked, worth just north of $2B. An attacker who wants to economically attack the Cosmos Hub will need to spend much more than this figure to hack the Cosmos Hub and its hosted blockchains. While the precise economic model of that security pricing and its roadmap have not been solidified due to large stakeholder disagreement, the revenue will come from the transaction of hosted blockchains and inflationary (security) rewards from those blockchains. As the Cosmos Hub progresses, it may eventually form the backbone of IBC by functioning as the secured element in cross chain data passing through IBC and collect tolls from those messages. At its onset, the Cosmos Hub will act as a permissioned security environment where all of its validators must validate hosted consumer chains. Onboarding consumer chains will be conducted by online community vote using the ATOM tokens. After a future Cosmos Hub upgrade, consumer chains who seek Hub security can onboard permissionlessly and each validator will select which chains to secure.

Our bullish thesis on Cosmos’s ATOM rests upon:

• The power of the Cosmos SDK.
• The revolutionary importance of IBC.
• Clear product market fit of the Cosmos Hub.
• Strong token value accrual.

We believe that the ease of use of the Cosmos SDK and the seamless communication of IBC will enable 5,000 Cosmos blockchains to spawn by year 2030. Consequently, there will be an ample market for the Cosmos Hub’s B2B model to secure customers. Because the Cosmos Hub will offer greater security at a more affordable rate than most bootstrapping chains can supply themselves, many Cosmos chains will lease security from the Cosmos Hub.

Our reservations about ATOM stem from questionable tokenomics, competition and key developer disputes. The inflation of the ATOM token under its current economic model is targeted roughly at 13%, which may be too high to sustain strong token price appreciation over the long term. At the same time, several blockchains in the Cosmos have achieved strong communities and economic momentum. These chains, such as Juno, EVMOS, Osmosis and Axelar, have expressed desire to becoming security hubs themselves. If these chains choose to compete in the interchain security market, this will clearly decrease market share and pricing power of the Cosmos Hub. At the same time, the core contributors of ATOM are dispersed among more than seven different entities with different ideas about the future of the Cosmos Hub. The result of this dynamic has been public disputes on Twitter between key figures building the Cosmos Hub as well as delays in execution due to the highly contentious environment.

Model Assumptions

Under our base case assumptions for the long-term estimates of crypto penetration, we see potential for the Cosmos Ecosystem to increase by over 100x its current valuation by 2030, with downside to $1. By consequence, we estimate the value of the Cosmos Hub to be 160x its current market capitalization by 2030. This value is calculated using a revenue estimate based upon the MEV, transaction tolls, ecosystem airdrops, and inflationary security payments received from the Cosmos Hub’s consumer blockchains and multiplied by a free cash flow (FCF) multiple of 33.37. The FCF multiple is estimated from a terminal FCF growth rate of 3.6% and a FCF yield of 6.6%. To find a token price in 2030, the chain’s value of 540B is then apportioned among the ATOM token supply of 609M in 2030. The supply of ATOM in 2030 is estimated using today’s token supply figure of 302.3M and a target inflation rate of 13% with an estimated deceleration rate of 10% per year. Discounting that price back to today using a 26% discount rate, we arrive at a price today of $139.62.

We derive these dramatic estimates from our expectation that public blockchains will settle transactions, coordinate real-world activity and host data for several key end market verticals. We then assume blockchains will capture a portion of the revenues and monetary value hosted on the crypto “rails”. Our projections for crypto begin with assumptions of the most feasible use case end markets. The most logical applications for blockchain technology can be sectioned into three distinct categories: Finance, Banking and Payments; Metaverse and Gaming; and Web Infrastructure.

In our first category, Finance, Banking and Payments, we predict that due to significant back-end and personnel cost savings, 10% of the transactions of the financial services industry including commercial and retail banking, trade finance, financial exchanges, wealth management and cross-border payments will be settled using public blockchains by the year 2030. As a result, 10% of the revenues of those activities will be monetizable by smart contract blockchains. Consequently, we see blockchains accruing, by various value capture mechanisms on transactions, 1% of this monetizable revenue. We project this end market’s annual revenue to be approximately $11.7T by 2030 and therefore calculate public blockchains monetizing $11.7B of this revenue each year.

With respect to the Metaverse and Gaming sector, we believe public blockchains to be the ideal settlement and storage layer for immutable global repositories of digital identity, social graphs, gaming assets and the property rights to digital assets. As a result, we project that 50% of these end markets will be settled on public smart contract blockchains by 2030. Likewise, we estimate that blockchains will be able to capture 2% of the revenue settled on chain by transaction fees. We forecast Metaverse and Gaming to be a $4.1T market by 2030, which implies blockchain revenue from this segment to be $82B annually.

Finally, we see public blockchain as the optimal mechanism to globally coordinate and provision business and retail digital infrastructure services such as cloud data storage, cloud compute and other SaaS businesses. We classify these sleeves of businesses for crypto usage under the category of Web Infrastructure. We forecast that 10% of these services will be allocated utilizing public blockchains in 2030 and estimate blockchains will derive revenue equal to 1% of the Web Infrastructure revenues deployed to them. With total Web Infrastructure revenue expected to be $2T, we calculate $20B of revenue annually accruing to blockchain through transaction tolls.

The Role of Market-makers in Crypto

Most controversially, in our long run estimates of blockchain revenues, we believe a significant portion of revenue will arise from the value capture of MEV. MEV, or maximum extractable value, is the amount of money that can be derived from ordering transactions on each block. Because most blockchains do not order transactions based upon first-in-first-out, but upon willingness to pay for block inclusion and ordering within that block, there is enormous value to be gained by traders by getting the ideal position. Thus, traders who insert their transaction in front of, behind, or sandwich other orders, can make arbitrage profits. As a result, traders are willing to pay validators for better positioning, and validators will in turn remit those payments to token stakers who back the validators. The ability to gain the profit-maximizing queue slot is being democratized over time by mechanisms such as Flashbots, Skip Protocol, and Jito Labs. Each of these firms offer blockchain software patches for validators to auction off ordering priority to the highest bidder in a sealed bid auction. This creates a balancing mechanism that will fairly distribute profits away from traders and towards the blockchain ecosystem stakers. We calculate MEV to be directly correlated with the amount of assets, or total value locked (TVL), held on a blockchain. Therefore, as blockchains scale to hold more digital assets, we believe that MEV will appreciate accordingly. However, we expect decreases in blockchain asset volatility and deepening liquidity to emerge and consequently reduce the dollar for dollar take MEV has over time. We calculate that MEV was able to extract 0.52% of all TVL on Ethereum over the last 12 months. We believe that this extraction figure will decrease to approximately 0.10% by 2030 of all TVL in an ecosystem like Cosmos – a significantly lower expense ratio than traditional asset managers charge.

Inherent in our assumption in MEV is that a significant portion of the world’s assets migrate to the blockchain to become tokenized representations of value. Though there exists much work to be completed before enabling the world’s financial system to be entirely moved to blockchain, we see a clear path for many important assets to be moved to the blockchain “rails.” Besides digital native assets like cryptocurrencies and metaverse assets like in-game items and virtual property, we see enormous potential for real-world assets to be transitioned to blockchain. Projects like Centrifuge are tokenizing asset-backed business loans, Avalanche is digitizing initial litigation offerings and Medibloc is building a blockchain to secure personal health records. As a result, we estimate that 10% of all the world’s financial assets migrate to blockchain by 2030, approximately $60T. Based upon this assumption and our MEV extraction estimate, MEV would constitute $60B in potential revenue annually that accrues to blockchains.

Conclusion

To tie together our blockchain projections to value accrual of the ATOM token, we then assume Cosmos ecosystem blockchains represent 33% all future blockchains and estimate that the Cosmos Hub secures 50% of Cosmos blockchains. Thereafter, we derive a take rate for ATOM based upon transaction revenue, consumer chain security inflation and MEV revenue. Current community expectations, not yet proposed and subject to a future ATOM community vote, suggest that the Cosmos Hub will price security at 25% of consumer chain transactions. Additionally, we see Cosmos Hub also accruing 25% of the inflation rewards of its consumer blockchains. We then apply this same split between the Cosmos Hub and its consumer chains to arrive at our MEV revenue share of 25%. Given our forecast of Cosmos Ecosystem growth and inflation, we determine that the Cosmos Hub will accrue $21.6B annually by 2030. Since this revenue comes net of all fees and costs of running a blockchain, we classify it as free cash flow.

Because of efficiency, cost-savings and user experience arguments, there exists a massive target market for blockchain technology. Due to the reliability and ease of use of the Cosmos SDK and the boundless interoperability offered by IBC, we believe that a substantial portion of future public blockchains will exist in the Cosmos. In turn, it is likely that the Cosmos Hub becomes the security layer for a significant portion of the Cosmos ecosystem blockchains and accrues value accordingly. As a result, the Cosmos Hub’s ATOM token is in a premier position to capture a substantial share of the public blockchain market’s value, and we expect its price will perform according to this expectation.

Daily Transaction Volume by Number of Transactions: Ethereum vs Cosmos Hub

Daily Transaction Volume by Value of Transactions in USD: Ethereum vs Cosmos Hub

Source: Dune Analytics, VanEck Research. Past performance is no guarantee of future results.

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