Ethereum (ETH) Analysis
Bitcoin and The Vision Of Cryptocurrency
Created in 2009, Bitcoin is the first successful cryptocurrency. Bitcoin uses blockchain technology to operate transactions on its network. The ecosystem is built to validate transactions sending Bitcoin between wallets and to keep track of the Bitcoin balances of different wallets. This is done by having a large group of computers provide cryptographic proof of transactions to reach consensus.
There are two players in the Bitcoin ecosystem: transactors and miners. Transactors send bitcoin as a means of payment to other transactors. Miners validate transactions to maintain the integrity of the bitcoin ecosystem. Miners are able to validate transactions by solving cryptographic puzzles that unlock blocks. These blocks store a set amount of transaction data and are linked to the previous block of transaction data (forming a blockchain).
If you have trouble comprehending how internet money with no intrinsic value could accrue a market cap of over one trillion dollars, think about how currencies accrue value:
A long time ago, humans lived in a barter economy where each good would have infinite amounts of exchange rates relative to other goods that were in demand. This was an inefficient system as job specialization was not rewarded. To mitigate some of the problems of bartering, currencies were created as a means of transacting and storing value. The first currencies were made from stones and shells, but they were too easy to counterfeit. Eventually people shifted to using gold and silver coins. The advancement of different forms of currency followed the five principles of the definition of currency
The asset must be acceptable to (that is, usable by) most people.
It should be of standardized quality so that any two units are identical.
It should be durable so that value is not lost by it quickly wearing out.
It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported.
It should be divisible so that it can be used in purchases of both low-priced and high-priced goods
Surprisingly, the average fiat currency survives for less than 25 years, and over 100 fiat currencies have become obsolete due to hyperinflation. The main reason central bank currencies have had trouble surviving is because they hold no intrinsic value other than the value that people ascribe to them. Accordingly, currencies that aren’t backed by intrinsic value are highly reflexive. They are valuable if we all agree they have value.
Originally the United States Dollar was backed by gold, so its value was never put into question. Since the 1940’s, the U.S. dollar has been largely backed by society’s view of its worth. Currently, with 60% of the currency held outside the U.S., the dollar is likely more important for people outside of the United States than those within. Our currency’s stability has led it to be officially and unofficially adopted by countries whose native currency has lost its value.
To summarize, the risk of a currency is dictated by the validity of what’s backing it. A fiat currency’s risk is inherently tied to the success of the nation that has created it. Bitcoin’s value is that it has no governmental risk. The risk is spread equally across society as the world is able to choose whether we agree that it has value. With the United States M1 money supply increasing from $4 trillion to about $17.5 trillion during the coronavirus pandemic, people may start to question how this impacts the world’s reserve currency. Naturally, printing money does not create more wealth, so it must lead to devaluation of the currency vs. other assets in the long run.
If third world countries transact dollars to preserve their purchasing power while their native currency inflates, how do people preserve purchasing power in the event that the U.S. dollar loses value? This is exactly Bitcoin’s purpose.
Bitcoin serves as a means of differentiating currency risk. Although bitcoin certainly poses large risks, they are inherently different than fiat currency risk. Since Bitcoin is a substitute for fiat currency, it’s likely that it will act as a hedge against fiat risk in the long run. This means that the total addressable market for Bitcoin could be as large as the world’s circulating currencies.
Ethereum’s Vision as the Next Iteration of Cryptocurrency
Ethereum was released in 2015 with the vision of improving on some of the limitations of Bitcoin. The limitations that are addressed are:
Lack of Turing Completeness: it doesn’t nearly support every computation. It’s missing loops
Value Blindness: there is no way for a script to provide fine-grained control over the amount that can be withdrawn.
Lack of state: an unspent transaction output can either be spent or unspent: there is no opportunity for multi-stage contracts or scripts which keep any other internal state beyond that
Blockchain blindness: unspent transaction outputs are blind to blockchain data such as the nonce, timestamp, and previous block hash. This limits applications in gambling, by depriving the scripting language of a potentially valuable source of randomness
The purpose of Ethereum is to create an alternative protocol for building decentralized applications by building an ultimate abstract foundational layer. This layer provides a blockchain with a Turing-complete programming language, allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats, and state transition functions.
To explain this more simply, Bitcoin is built to express ownership of an asset. Ethereum is built with more complex features that allow it to do more than simply display ownership of Ethereum. Ethereum is the first cryptocurrency to use smart contracts. A smart contract is a multi-step function that is intended to automatically execute a transaction when its terms have been satisfied. For example, someone could code an Ethereum smart contract that says, “If one Ethereum is sent to this address, the contract will send back two Ethereum from another address”.
Although my example is relatively simplistic, Ethereum has set up a protocol that operates as a platform for applications to be built on.
Use Case for Ethereum as an L1
Ethereum is defined as a Layer 1 protocol. Layer 1s are underlying blockchain architecture for applications to be built on top of them. Some of the applications of Ethereum are:
Token Systems: sub-currencies (USD or gold or stocks), smart property, secure unforgeable coupons.
Financial Derivatives and Stable Value Currencies: options, hedging, etc.(requires price oracles)
Identity and Reputation Systems: email authentication
Decentralized File Storage
Decentralized Autonomous Organizations: an entity with members who have the right to spend the entity’s funds and modify its code
Decentralized Data Feed
Smart multi-signature escrow
Peer to peer gambling
On chain decentralized marketplaces
These different applications provide the potential for Ethereum to be widely adopted across many industries. Some of the more exciting applications of Ethereum are decentralized financial products and non-fungible tokens.
Decentralized finance provides traditional financial products in a decentralized manner. These products range from decentralized exchanges, synthetic derivatives, decentralized lending platforms, wrapped assets, decentralized insurance, and yield farming. Decentralizing financial products provides efficiencies that aren’t offered by banks or traditional financial intermediaries. They make it possible for people to buy and sell assets at all hours of the day, get loans instantly without the need of a good credit score, and earn yield on their assets.
As technology advances, many of the inefficiencies of traditional finance will be eliminated, and Ethereum provides a base layer for these solutions.
Non-Fungible Tokens (NFTs)
Ethereum provides a platform for building tokens. One type of token that is gaining in popularity are NFTs. NFTs are tokens that are unique from each other. They can take the form of art, real estate, in-game items, essays, domain names, even coupons. Ethereum provides a platform for tracking the transaction history of NFTs and verifying their ownership. As the world continues to digitize assets, Ethereum plays an important role in creating a platform to transact and verify ownership.
Current Problems Ethereum Faces & Emergence of Alternative L1s
Although Ethereum has been the second largest cryptocurrency for the past 5 years, the cryptocurrency community has questioned its viability on multiple occasions. A lot of the criticism surrounding Ethereum has been primarily based around scalability issues. Currently, Ethereum can support 15 transactions per second (TPS). As Ethereum has grown in popularity, its relatively low TPS capability is a bottleneck to future adoption. For comparison, Visa is able to handle thousands of transactions per second.
The problem with a scalability bottleneck is it forces transactors to pay high transaction fees to prioritize the inclusion of their transactions in the next block. This has led to people paying exorbitant fees for their transactions. Currently the average transaction price for completing a trade on a decentralized exchange is about $40. This disincentivizes the use of defi products on Ethereum.
Since decentralized technology generally builds itself on L1 protocols rather than building its own platform, this bottleneck has led to the emergence of other L1s that rival Ethereum. Some of the more recent rivals that have been gaining traction are Solana, Dot & Kusama, and Cosmos. Since these L1s were created more recently, they have the advantage of implementing newer blockchain technology and offering significantly more scale.
The competition surrounding Ethereum forces developers to continue to work on scalability, otherwise the future of the chain will be put into question.
Improvement to These Problems (L2s, Eth 2.0)
Although I’ve painted a somewhat bleak future for Ethereum, it’s worth noting how competitor L1s have performed in the past. Since Ethereum’s inception, there have been plenty of attempts to build a better L1. Coins like Cardano, Tezos, and Eos all failed in their attempts to take down Ethereum. Part of the reason why Ethereum can maintain its position is because of its wide adoption and developer support. It seems highly unlikely that Ethereum will ever be dethroned as the number two cryptocurrency, because its first mover advantage as an L1 is insurmountable. Also, developers are constantly working on solutions to scalability, security, and sustainability of Ethereum. Solutions to Ethereum’s scalability issues take two forms: layer 2 solutions and upgrades to Ethereum in the form of Eth 2.0.
The technology required to reach larger scalability is widely available, but much of the easy implementations require a tradeoff of lower security and more computing power. The Ethereum community has been weary of sacrificing security and has waited for better technology to be built where that tradeoff doesn’t need to be made. One of the solutions has been in the form of Layer 2. Layer 2 solutions are designed to help scale Ethereum by handling transactions off the main Ethereum chain. Currently, when a transaction is processed, every Ethereum node stores and executes that transaction. Layer 2 solutions are widely built around bundling several transactions into a single one (Rollups). These rollups take the form of zero knowledge or optimistic.
Optimistic Rollup: Uses a side chain that sits in parallel to the main Ethereum chain. It can offer improvements in scalability because it doesn’t do any computations by default. After a transaction, it proposes a new state to the Ethereum main net.
Zero Knowledge Rollup: Bundles hundreds of transfers off-chain into a single transaction via a smart contract. The smart contract can verify all of the transfers that are included.
Merkle trees are widely used to convey transaction data from rollups in a more efficient manner. Although the topic of Merkle trees is quite interesting, it may be beyond the scope of this article. Essentially, Merkle trees create a chain of previous transactions efficiently, without the need to share all the details of each transaction.
There are several other layer 2 solutions that may be widely adopted, but it’s probably not worth discussing all of them. To summarize, they all publish transactions to the Ethereum main chain without the need for the main chain to process each transaction individually.
The second technological upgrade that is increasing the throughput of Ethereum is Eth 2.0. This is a series of three upgrades that has the capability of pushing TPS to 100,000. The three stages of Eth 2.0 are the beacon chain, sharding, and docking.
The Beacon Chain: The beacon chain was launched onto a testnet where it will conduct the expanded network of shards and stakers. It introduces proof of stake to Ethereum. Eventually the beacon chain will be responsible for randomly assigning stakers to validate shard chains.
The Shard Chains: Sharding is the process of splitting a database horizontally to spread the load. The first version will provide extra data to the network. It won’t handle transactions or smart contracts, but will still offer large improvements to TPS when combined with rollups. The second version will allow shards to store and execute smart contracts and handle accounts.
Docking: All previous Eth 2.0 upgrades will be merged with the Ethereum mainnet and move Ethereum into proof of stake.
To further break down the timeline and specifics of Eth 2.0, Ethereum plans to split its mainnet into 64 smaller versions of Ethereum that operate separately from each other. This will reduce the number of transactions that each node must validate and improve the system. Each shard is tied to the main Ethereum chain in the form of Merkle trees, creating a connection between them.
The beacon chain has already been launched onto a test net in December 2020. It’s likely that Sharding will be operational on a test net in 2021 and that Eth 2.0 will be merged onto the main net in 2022.
EIP 1559/Token Economics
Now that I’ve gone through some of the fundamentals behind the value of Ethereum, its competitive positioning, and future, I’d like to address the economics of the token. Ethereum has no intrinsic value, therefore trying to assign a value to it is difficult. It’s worth as much as people are willing to pay for it. This makes its pricing particularly reflexive and explains why in the past it has had large up moves followed by large bear markets.
That being said, there’s still room to discuss its monetary policy similar to that of another currency like the dollar. Ethereum has historically operated under a fixed annual token unlock. Every year, miners are issued a maximum of 18 million Eth. This means that over time inflation will head towards zero.
Over the past week, Ethereum has agreed to implement EIP 1559 in the London hard fork in July. This EIP is crucial to lowering transaction fees and also creating a value accrual system for Ethereum’s adoption. The EIP sets a fairer system for transaction fee bidding and burns the base fees used in transactions. The token burn mechanics are incredibly important because as more people use the network, the inflation rate of Ethereum goes down. It’s quite possible that Ethereum could become a deflationary asset in the future.
Also, token burning based on network congestion is a great economic tool to soften market cycles. When Ethereum isn’t being utilized, the currency is inflationary and causes more people to spend their tokens. When the token is being utilized, its deflationary and incentivizes less transactions.
Ethereum continues to gain traction across its network. It’s continuing to see an uptick in daily transactions and growth in addresses. It also has over 3000 decentralized applications that have been built on it. As cryptocurrencies continue to gain adoption, these numbers will appreciate with it.
Although Ethereum’s price is purely speculative, I think there’s reason to expect more upside. After investigating other Layer 1 protocols’ on-chain metrics, Ethereum is clearly being undervalued on a relative basis. Also, I think that EIP-1559 hasn’t been priced in yet. As the broader markets come to understand the implications of EIP-1559, I’d expect the price to go up similarly to the consequences of Bitcoin halvings.
Also, I believe that as Ethereum upgrades continue to be rolled out and people start to witness Ethereum’s scalability, Ethereum’s long term viability will be viewed more favorably.
Clearly there are large risks in buying cryptocurrencies, but I think it’s likely they are here to stay. Ethereum will play an important part in the decentralization of society, and I’m happy to be along for the ride.
Disclosure: I own Ethereum and have relative value trades open on Ethereum vs. Bitcoin
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