Written in January 31, 2022 (Thumbnail image taken from Fortune)

Ethereum Thesis

Ethereum (ETH) represents the largest single innovation within the cryptocurrency space and the blockchain industry ever since Bitcoin in 2009. Since the launch in 2015, Ethereum has captured significant interest as the second largest blockchain network. It is helpful to understand and consider Bitcoin’s value proposition to the world: the promise of a global and verifiable accounting system through the use of the internet. Similarly, Ethereum promises verification, but presents a wider set of scope and information in its own blockchain. While Bitcoin was considered as the digital gold, Ethereum was the first form of programmable money – cryptoasset which allows developers and entrepreneurs to code financial assets like they would for computer programs. Its key feature and strength lies in the smart contract.

Ethereum in itself provides minimal benefits, however when viewed as an ecosystem of itself, it could have a tremendous impact on the global financial system. Akin to Bitcoin, Ethereum 1.0 leverages the predominant Proof-of-Work (PoW) consensus mechanism. Ethereum stands out as the cryptoasset with the most pragmatic roadmap because of its developers’ intention to roll out a new version of the blockchain – Ethereum 2.0. With this new ecosystem design, the network will migrate to Proof-of-Stake (PoS) mechanism in 2022, thereby reducing the environmental impact from PoW and reaching transaction speed up to 10,000 per second.

Proof-of-Work vs. Proof-of-Stake (source: blockgeeks.com)]

Discussing about the ecosystem, Ethereum presents similar features that resembles the traditional financial system: Smart Contracts, Decentralized Finance (DeFi), Decentralized Applications (dApps), Automated Market Makers (AMM), Decentralized Autonomous Organizations (DAO), Non-Fungible Tokens (NFT), and Metaverse.

Introduced as an ERC-20, Smart Contract is Ethereum’s key innovation. These contracts that are embedded in the blockchain are self-executing contracts between different users which represent an agreement over assets on the Ethereum blockchain. Smart contracts are essential in the network as they allow users to create complex financial instruments which are self enforcing and verifiable through the consensus mechanism that ETH has. This simple yet powerful innovation opens up the possibility to Web3.0, in which decentralization and anonymity matters without disregarding traditional financial features.

Ethereum dApps are applications (products or services) that run on the Ethereum network, users need a digital ‘wallet’ to access them. Several examples of this include finance options, arts and collectibles, gaming, and technology. DeFi on the other hand is a global and open alternative to the current financial system. Leveraging smart contracts to trade cryptoassets through Decentralized Exchanges (peer-to-peer), sending money around the globe, accessing stable currencies, borrowing funds with/without collateral, and managing portfolios.

DeFi vs. Traditional Finance (source: De Zilveren Rijder paper)

DAOs are internet native business organizations that are collectively owned and managed by its members in a democratic manner. They have a built-in treasury that no one has authority to access without the consensus of the group. Several examples of this include charities, freelancer network, project treasury, and ventures.

Another and currently thriving application of Ethereum is NFTs (ERC-721), which are blockchain tokens that resembles a unique digital asset that allows individuals to buy and sell ownership. Assets including digital artwork (able to receive loyalties), in-game item, digital collectible, domain name, or even hospital records.

Other possible Ethereum applications that have not been covered extensively include health application, politics polling/voting system, storing data (cloud), and logistics record and tracking.

Does this indicate that Ethereum is better than Bitcoin? Not essentially – both networks specialize on different frontiers with different sets of goals. Comparing Ethereum to Bitcoin’s statistics, though, it mainly revolves around the vibrant community of developers: enthusiasts are the core of the open source community, monthly active developers grew by 215% since 2018 reaching 2,325, and ETH represents 26% of all monthly active crypto devs.

Ethereum stands out from other cryptoassets for having an ambitious roadmap which can be classified into three key developments: Layer 2 (L2), transition to PoS (Ethereum 2.0) and Sharding system. Layer 2 are technologies that are built on top of Ethereum’s base blockchain
which would allow improved scalability without reducing security. Several of the existing solutions here include ZKSync, Optimistic Rollups, and Polygon. L2 protocols help Ethereum’s throughput and even remove bottlenecks. With Ethereum 2.0, the consensus mechanism shifts to Proof-of-Stake and sharding techniques – a scalability effort to improve the ability of Ethereum blockchain to handle a greater number of transactions. This process would ‘split’ the blockchain into multiple different sub-nodes or sub-blockchains. In simple terms, Ethereum 2.0 is a multi-lane approach for blockchain contrary to Ethereum 1.0, Bitcoin, and other blockchains, single-lane approach.

Following the roadmap, Ethereum has introduced an upgrade proposal Ethereum Improvement Proposal (EIP) – BTC’s equivalent BIP. EIP-1559 (London Hard Fork) introduces the upgrade to the economics of transaction fees. Lauded by some as “the final puzzle-piece to Ethereum’s monetary policy”. With this new EIP, users need to send transactions with a fee (gas fees) higher than a predetermined base fee, along with a tip for the miner. The base fee would then be burnt after the transaction and the tip is sent to the miner. Not only solving Ethereum’s prevalent high gas fee, but also introducing a deflationary rate to the unlimited token economics itself.

The largest application built on top of Ethereum is the DeFi ecosystem. The market value for all DeFi projects in 2021 was $18bn in 2021 which grew to up to $116.3bn in early 2022. Total transaction fees (gas fees) of Ethereum reached an annualized revenue of $1.1bn in 2021, spiking due to on-chain trading on Decentralized Exchanges.

Annualized Gas Fee 2021 (source: Etienne medium.com)

Do note that valuing Ethereum itself could not be treated as a common company as the project does not have underlying stock shares. However, it still has some company features in revenue-generation, for example gas fees and deposits on exchange protocols. Methods such as supply based, market cap based, revenue from fees, transaction fees multiples, and locked value.

Ethereum has predetermined issuance schedules far into the future based on the ongoing economic situation. When changes are made to supply, it could be modeled into the future to derive ETH’s fair value. This is not present with fiat currencies where issuance is subject to the government. The model for Ethereum was built from DataAlways based on an initial set of analysis by Nikhil Shamapant. This model assumes there are a set of ~10 million stakers dividing rewards, of which would sell all Ether rewards once received.

Ethereum valuation based on supply (source: Seeking Alpha)

The global crypto market cap is generally at ~$2.0T. Global value of all stocks is $100T. When crypto is considered as a real asset, then there is a 50x upside potential. When viewing through the market cap perspective, taking 1% of the global financial market cap would bring Ethereum’s to $1T. This would make Ethereum’s price into around $8,000, provided that Ethereum’s promise of real-world application has been accepted and implemented.

From a revenue perspective, Ethereum’s main income is from the transaction fees (gas fees). Grayscale models the data through total daily transaction fees collected as a measure of demand. Gas fees are the total amount paid for executing transactions on the Ethereum network. Another way of viewing is to consider that gas fees are the equivalent to sales in Ethereum’s case. The illustration below depicts the relationship with a “Price to Sales” ratio – lower means the network generates high revenue relative to Ethereum’s market cap – undervalued.

ETH to Price to Sales ratio (source: Grayscale)

Following Ethereum’s main revenue from transaction fees, 21shares modeled the multiples compared to other current blockchain networks. The revenues from the protocol are indicators of organic demand in the network and a sign into the blockchain’s economy. Similar to the Price-to-Sales model before by Grayscale, lower means undervalued.

Ethereum multiples Price-to-Revenue (source: 21shares)

With Ethereum 2.0 in the horizon, it would begin an impactful force towards the cryptoasset ecosystem. The chart below predicts the outcome of interest bearing yield rewards from staking.

Ethereum 2.0 Yield APY (source: 21shares)