Monopolies with Growth: Ethereum

This report originally began as a slide deck. If you’d prefer it in that (far messier) format, here we are:

The layout of the essay is as follows:

  1. The Pitch: A Quality Company
  2. The Pitch: A Special Situation
  3. The Basics
  4. DeFi, NFTs and DAOs
  5. The Real World (scaling is discussed here)
  6. Valuation
  7. Parting Thoughts

The Pitch

A Quality Company

Ethereum is somewhat like a high quality “company” with a win-win ecosystem, which is trading at a pessimistic valuation. It’s deeply resilient, carries sizeable optionality, and – with the upcoming forks in August and December/early 2022 – it also presents a “special situation” with expected upside volatility.

As a 10 second primer (we’ll review the basics later), Ethereum is the protocol that underpins the decentralised finance (DeFi) movement, where users transact peer-2-peer without 3rd parties like banks. It also underpins the non-fungible token (NFT) movement, which creates digital scarcity for objects like art and certificates, and the decentralised, autonomous organisation (DAO) movement, which enables groups to join up in new ways to achieve certain preset goals.

Source: VanEck

Same page? Cool. Back to The Pitch.

Quality is a subjective metric. Usually agreed requirements are talented management, favourable unit economics, and a sustainable advantage over competitors. It gets even better when that company has provable innovation in their product and adapts to continually find the best product-market fit.

In the wake of Big Tech’s earnings, I’ve seen several tweets about “increasing returns to scale” and how “good companies surprise to the upside”. This essay will hopefully convince you that Ethereum – like any good company – exists well within that scale-advantaged world and has historically (often) surprised to the upside.

While Vitalik Buterin is the founder and face of Ethereum, the core development team exists worldwide in these decentralised clusters. Some of the smartest and most driven people I know are now working in crypto.

The “company” also has platform-like unit economics, with a hyper lean cost structure (post the Proof-of-Stake merge) where most participants are well-incentivized owner-operators. One of the key differentiators of a quality company is a win-win ecosystem. Both the dynamics of the ETH token and the dynamics of a scale-economics-shared platform mean that Ethereum is one of the least zero-sum ecosystems out there.

With an operating cost-to-income ratio around 20x lower than traditional banks, the lower legacy costs in Ethereum mean that there are hefty cost savings passed on to the end user. Add to this that as users and developers usually hold ETH themselves, they accrue value like shareholders. It’s like AWS, but you pay and get paid in Amazon stock for using it.

Ethereum has a far lower (and decreasing) take rate than many internet companies, has grown at several times the pace, and is trading at a similar forward price-to-sales, and a PEG of 0.03, compared to the software/finance average of around 2.5.

Roughly 80% of all decentralized apps (dApps) are being built on the Ethereum protocol, all of which are built to interoperate with each other. The more of these dApps that are built, and the more they interact with each other, the more entrenched Ethereum’s network becomes. Add to this the multi-year track record of Ethereum developers upgrading their product, and the hefty amount of innovation being built by non-Ethereum developers on the protocol, and you have a highly adaptive ecosystem.

Ethereum’s innovation, anti-fragility, and widespread network effects are the foundation for its optionality in future dApp developments. Its product is superior to blockchain peers and traditional finance, and is increasingly competitive with compute providers. This is the foundation for its resilience.

As a technology, Ethereum faces stiff competition from the likes of Terra, DFINITY, Binance Smart Chain, Polkadot, Cardano… the list goes on. Each competitor usually has one or two things they do better than Ethereum (usually lower transaction costs or higher transactions per second). These teams are all rapidly growing, highly innovative, strongly motivated and cash flush. And none of them come close to Ethereum’s network. The technical advantages these protocols have usually come as a result of the centralisation of a particular process, but they are building off a far less adopted base and (some of them) have far higher node costs. The likelihood of any one of these protocols displacing Ethereum is low, given the network effects and the amount of innovation currently on the latter’s platform, while the likelihood of Ethereum continuing its trend of lowering costs, decreasing take rates and improving throughput via Layer 2 solutions is tough to bet against.

Source: VanEck

So how superior is it to non-blockchain alternatives? I’ll get into the benefits of decentralisation, P2P, the “ultrasound money” meme, and the individual value-adds of DeFi, NFTs, DAOs and other dApps later. Off the bat though, the big question facing Ethereum is its ability to scale in competition with off-chain payment infrastructure, and off-chain compute providers.

Source: David Hoffman

Currently, it’s not great. Costly gas fees prohibit frequent transactions and complex code. To make Ethereum viable, throughput needs to increase, and transaction costs need to compete with other software development platforms. Beyond this, decentralisation and security are just two features in a stack of many that are needed. A thriving digital economy has many other equally important requirements (ease of use, real-world integration, utility-cost platforms, stability and predictability, state-adoption, etc.). While Ethereum is gaining these rapidly, existing alternatives already have these in spades. A large percentage of non-crypto-native adoption rests on how well Ethereum competes on these factors, not how decentralized or secure it is.

To get to the point quickly: The rollout of Ethereum 2.0 and the scaling solutions being built will get Ethereum to a competitive level within the next 12-18 months. Ethereum currently outcompetes all alternatives on interoperability, and cost per transaction when the transaction requires absolute validity (such as for payments and value-transfer).

It is possible folk will pay a premium for the decentralisation and data privacy, but even with Eth2.0 and the scaling solutions, it will still be around 10x more expensive than centralized, off-chain alternatives for computation. Speculatively, future scaling may solve this. Notably, Ethereum will likely never be competitive as a storage platform. It may one-day compete by outsourcing storage to side-chains, but that is speculative for now.

A Special Situation

Below are the key forks coming to the Ethereum protocol. The August fork (EIP1559) is known as the “London” fork, and the Proof-of-Stake is the “merge”. Both are expected to notably improve the transaction costs and decrease supply.

Source: Finematics

In a nutshell, the base of the supply squeeze comes from the combination of EIP1559 & the Proof-of-Stake (PoS) merge. In a staking-based chain there would be:

  • A decrease in miner sell-pressure (estimated to be around 22 300 ETH/day), as miners are no longer required to validate transactions, and no longer have to recoup energy costs,
  • plus a decline in supply (~2% per annum) caused by burned gas fees,
  • plus a structural outflow of supply as more ETH holders stake their ETH for yield (from roughly 12% of ETH currently staked, to >30% of ETH staked post merge).

The selling pressure is estimated to fall to roughly 2 600 ETH/day, a ~90% decrease from current levels. Combine this with the decreased float (as a result of the structural staking/DeFi supply outflow) and it’s almost inevitable ETH will become more volatile. Why this volatility is likely to be to the upside is because:

  • Current demand pressure will likely exceed future sell pressure when sell pressure drops.
  • Demand inelasticity comes from passive inflows via upcoming ETFs.
  • Price appreciation leads retail narrative adoption of “internet money”+ staking yields.
  • There are increasing retail onramps (Visa, PayPal).
  • Institutions are already familiar with BTC.

Quick dive into the mechanics: Taking the place of miners, staked ETH is awarded a yield by the protocol for securing the protocol – by validating transactions and “staking” your Ether on the fact that that your validation is accurate and true. This yield means staked ETH (or, stETH) is worth more than unstaked ETH as it is essentially ETH + a capital yield.

The interplay between these derivatives means there are arbitrage opportunities to make sure ETH and stETH never deviate too far from their relative value. However, the fact that stETH offers yield means that most rational actors will swap their ETH for stETH, and then swap/sell/lock-up that stETH for a yield-on-yield. The incentives here make it likely the original stETH yield (offered by Lido/the Ethereum protocol) will trend lower over time. Staking yields of <2% are the minimum, which would only occur when 90% of ETH is staked.

The benefit of the ETH/stETH dynamic means that institutions – who were previously pretty locked out of illiquid situations – will be able to take advantage of ETH as they come to understand the economics. It also means that folk in need of liquidity now no longer have much of a justifiable reason not to stake their ETH. The result? More staked ETH.

Sidebar: if you are wondering where all this Ponzi-like yield is coming from, it’s really just the regular value created by liquidity provision to regular markets. Only, it is now accruing to users, rather than being absorbed by the legacy costs of the banking system.

To summarize: Buying ETH in the next 18 months is a special situation. Staking ETH for the long term is a quality asset at a pessimistic valuation.

The Basics

To understand Ethereum, you need to first understand decentralised computing and what Bitcoin was created for. As a rough definition, decentralized computing is a computer application, which creates some useful result for its users, can be run simultaneously on many computers around the world rather than on just one central server, and the network of computers can work together to run the application in a way that avoids trusting the honesty or integrity of any one computer or its administrators.

Bitcoin was the first successful application of this. Within Bitcoin, three core innovations were embedded:

  • Peer-to-Peer networking. Nothing new here – think BitTorrent,
  • Blockchains. A fairly novel way of storing data (new, but not revolutionary),
  • Consensus mechanisms. This was the game-changer. Bitcoin relied on a proof-of-work system as the mechanism through which networked computers agree on and record changes to a shared set of data.

It was the Proof-of-Work consensus mechanism that enabled Bitcoin to ensure agreement across the blockchain: As miners must pay for energy costs, they are incentivized not to waste energy validating transactions nobody else will agree with. The chains which have the most validations are definitionally the longest chains. Each linked block represents the work done to verify those transactions. The longest chains are the most valid, thus agreement is arrived at by proof of work done.

It is this second mechanism – the ability for transparent, publicly-owned identity data verification – that has become the focus of the 2nd generation blockchains (of which Ethereum is the foremost). Currently, the main use case for blockchain tech is speculation. The next main use case is for value storage – the “sound money” and “ultrasound money” memes which people use to argue for Bitcoin and Ethereum respectively. Increasing numbers of folk believe crypto has a better value proposition here than gold or fiat.

Ideologically, Bitcoiners tend towards a libertarian view, espousing Mises, Rothbard, Spitznagel, and Hayek. The belief here is fundamentally that decentralisation enables politically neutral individual sovereignty, which is a worthwhile pursuit. They usually hold that Bitcoin’s simplicity makes it superior at storing and transferring value, and little else. The base layer is minimal by design, having lower barriers to access running a node and rather scaling through Layer 2’s like the Lightening Network. Thus, Bitcoin’s path dependency, security, decentralisation and its Lindy-ness as a cryptocurrency make it the best (and only, if you’re a maximalist) option among cryptocurrencies.

Source: Notboring

However, stepping past the digital cash/store of value argument for a second, fringe use cases of decentralised computing include a growing replacement to the traditional finance system – DeFi, and the growing community around digitally scarce goods – NFTs. These are almost exclusively built on Ethereum.

Source: VanEck

So how does Ethereum work? Before we get there we need to unpack smart contracts. These are the auto-executing and immutable agreements that underpin the Ethereum ecosystem. Think of them as a bunch of If-Then instructions. Developers code smart contracts using Ethereum’s programming language (Solidity) and upload it to the Ethereum system (the Ethereum Virtual Machine). Everyone running the application as a verifier (called a “node”) gets a copy of that code. When users transact using those contracts, all nodes must verify the outcome per contract rules. This verification process is the computation that blockchain relies on.

Source: EthHub via Lyn Alden

Ethereum’s monetary policy is a pretty complex topic, having been hard forked (crypto-speak for “changed”) roughly 10 times before. At the moment there’s a roughly 0.2% issuance/inflation rate. These newly minted ETH are given to miners. After the London fork (EIP1559) and Eth2.0’s rollout, the issuance rate will be determined by a Staked Ether/Total Ether algorithm, incentivizing the added security where needed with higher staking yields (issuance rates). Theoretically, the net effect will be a rules-based, deflationary, throughput-enhancing policy.

Source: VanEck

However, if too many teams join too quickly, gas fees surge, preventing hyper-adoption. This negative feedback loop governs the protocol, as hyper-adoption would likely see an equivalent surge in rapidly released code, rife with bugs and poor UX, hogging scarce network space from the more useful, resilient dApps. Together, these positive and negative feedback loops govern both the growth of the ecosystem, and the trajectory of value accrual. Historically, we’ve seen far more value creation at the app/platform level (like Google/Maps) than we have at the infrastructure level (HTML/GPS). The dynamics I’ve just outlined ensure the Ethereum protocol will always have to be worth more than the dApps built upon it, lest the protocol face a 51% attack purely to rob the dApps of their value.

Beyond being gas fees and the staking asset, ETH is also used in DeFi as a reserve asset, as collateral, for financing, and as a medium of exchange. Certain retailers accept ETH, and ETH is the default unit of account for digitally scarce goods (NFTs/on-chain in-game items). The combination of all of these means ETH is currently a highly transactable asset, unlike Bitcoin which is predominantly just HODL’ed.

Whether folk will want to transact a rapidly appreciating token is a curious concept. In BTC’s case the culture has decided “No. Not until we’ve monetized the new financial system”. In ETH’s case, people are seemingly deciding “Yes. If we believe what we are buying is worth more than the token”. But, what they are currently buying (NFTs, DAO governance tokens, DeFi swaps etc.) is all caught up in a wave of higher-ETH-higher-NFT-prices, and is also all serving to push the ETH price higher through ecosystem growth and gas fee demand.

The above picture can mean one of several things. It could mean ETH is being seen increasingly as a store of value, or a speculative instrument by HODLers. It could mean that more users are transacting on centralised exchanges. Or it could just mean that there were a bunch of people who emptied their accounts of ETH over the years and there are now a stack of unused wallets. It is tough however, to see the number of unique addresses up nearly 40x since the start of 2017 and say Ethereum’s network is not growing.

  • Growth in Ethereum ecosystem → more transactions → more demand for gas fees → more demand for ETH.
  • Adoption of Ether (or BTC on Ethereum) as money/store of value → more demand for ETH.
  • Users stake ETH → less supply.
  • Staked ETH generates yield as it’s a share of the Ethereum network and a claim to Ethereum’s fees → more people buy ETH to stake.

DeFi, NFTs and DAOs

The Ethereum ecosystem has to expand beyond just making tokens that help with trading tokens.” – another fantastic quote from Vitalik. Today, the bulk of crypto exists in traders swapping one token for another on exchanges in circular bouts of zero-sum speculation and inter-currency arbitrage. By USD volume transacted, DeFi accounts for 99% of the ecosystem value. Yet in total number of transactions made, gaming makes up 81%. Similarly, NFTs have been accused of being speculative art bubbles and much of the media around 2021 crypto has centered on these odd-looking digitised pictures.

DeFi, NFTs, DAOs, these are all example use cases for decentralised applications (dApps). DeFi is an ecosystem is made up of a collection of finance-like dApps, NFTs are on-chain strings of code which are bought, sold, minted, and owned using dApps, and DAOs are organisations usually governed by, operating through, and interacting with dApps.

Essentially a set of smart contracts, dApps are currently limited to relatively simple use cases (a structural result of the high gas fees incurred with more complex code and computation).

This is arguably the key limitation in distributed computing: since the state management system is – by definition – in more places than its centralised counterpart, computation costs will inevitably be higher. Since each action a dApp takes on-chain (minting NFTs, transacting, interfacing) incurs gas fees, the cost of computation increases exponentially with code complexity.

Crypto enthusiasts will tell you that DeFi may one day allow folk to pay, send remittances, buy and sell things, apply for loans and mortgages, crowdfund startups, and everything the existing financial system does. NFTs will theoretically bring all certification on-chain. From digitised IDs, title deeds, state documents, multi-game digital goods, and IP protection to security infrastructure, data storage, supply chain optimisation and censorship-resistant social media, crypto may seem a little Shangri La-esque in its promises. While the potential for this is all there, it’s good to temper the hope with a little objectivity.

DeFi

Decentralized Finance (DeFi) is a developing ecosystem of financial dApps aiming to displace the existing financial system with one not reliant on trusted intermediaries like banks. A common crypto meme is that DeFi is Money Legos composing pieces of the financial system together.

Source: Andrew W.

Sometimes folk want a non-ETH token because they like what a particular project is doing, and would like some say in that project’s governance (these projects are called DAOs, and DAOs are governed by token holders in a similar way to public companies and shareholders). Other times, they just want the other token because they think they can trade it at a profit elsewhere. While this all seems wildly speculative, remember that this is very similar to what the big banks do with debt and derivatives normally.

Locking something up in DeFi is different to staking your ETH to secure the Ethereum protocol. The ETH stake rate offers the “risk-free rate” for DeFi. The more ETH locked in DeFi, the more the Ethereum protocol recognizes the need for security (via the Value Staked/Total Value function) and increases ETH stake rate. The inverse is true too. The more ETH staked, the higher the cost of liquidity in DeFi, so folk are willing to pay higher fees and increase the yield of liquidity pools.

So what does DeFi offer that the traditional world doesn’t?

Firstly, it’s permissionless. Theoretically what this means is that there is no difference between a Jeff Bezos and a homeless man in Cape Town. Because there is no KYC/AML, there are no limits on who can participate. In practice, what this means is that you currently need a working Internet connection, the time and willingness to spend a good week or more familiarising yourself with the various risks, platforms, and projects, and you need sufficient money that a couple trial-swaps won’t cost your life savings. Good for the developed world, but still a work-in-progress for “the unbanked”.

Self-custody and control will also theoretically disperse the effects of a systemic failure (ala 2008 or LTCM’s blow-up). The phrase “not your keys, not your coins” is thrown around a lot in crypto, but in reality, not many non-crypto-native folk want to think about custody. They’d rather, say, keep their money in a bank which their friends tell them is safe. For crypto to move mainstream, it needs to shed the “we are hackable, make sure you look after yourself here” stigma, and begin to ingrain the non-custodial tech within a better UX.

If this sounds wild to you you’re not alone. Right now, this kind of interoperability looks gimmicky and Ponzi-like, but it doesn’t take much imagination to see the kind of innovation that can come from this kind of open platform.

DeFi is also inherently higher-yield. The current narrative is “high yields for early adopters”. While it is unlikely high double digit yields on blue-chip tokens are sustainable, users should not be anchored to the non-crypto yields in traditional finance, which must cover legacy costs and rent-seeking. The combination of permissionlessness and interoperability means there’s likely to be several opportunities for new business models, financial products, and ways of working.

Source: VanEck
Source: VanEck

Economically, a surplus of cash means incremental capital allocated to that industry carries lower ROIC than alternatives. This essay is not pitching allocation to any particular project – many crypto startups are at heady valuations. However, because the bulk of the value is captured at the protocol level, and because of the long runway for growth that DeFi contains, Ethereum remains a high ROIC bet on indexing this industry.

Two current causes for concern in the DeFi space revolve around the limited real world use cases, and (ironically) the centralisation of many of the dApps. Many of the dApps are reliant on 3rd party node-aggregators (like Infura) who often run nodes via existing cloud servers like AWS. This is because the time, money, and storage cost of running a node that transacts can be too high for small-time developers. These chokepoints are vulnerabilities in the ecosystem.

NFTs & DAOs

While digital assets are usually downloadable, this does not damage the value of an NFT. Think of a photo for instance: in the same way a meme is only a meme when lots of people know about it, your ownership becomes more valuable the more people know about the original. Unlike the music industry where the pleasure comes from listening to a song, a bulk of pleasure of art comes from owning it. It is currently for this pleasure and the ability to resell that NFTs exist. In the art world, for instance, the concept of provenance – validating an artwork’s authenticity, origin, and history – is a costly and essential part of the art market. With NFTs, that entire process is automated and infallible.

Two more great things about NFTs: they allow granular pricing, and they (like DeFi) remove rent-seeking from intermediaries and orthodox distributors who usually carry substantial legacy costs. More money to the creator, more ownership to the fans. Creatives can price NFTs individually, selling originals, limited editions, and other copies all at different prices and in different mediums. They may not need to take sponsorships, or rely on Patreon-like support, and the possibilities for new business models opens up. One of these models is the sale of an NFT which accrues royalties in perpetuity as a percentage of future sales or sales of derived similar NFTs.

Source: Chris Dixon

And what about DAOS? These are a little complicated – basically, DAOs are algorithmically governed groups of stakeholders who come together to achieve a particular goal or set of goals. The rules of the organisation are set out on the blockchain, with smart contracts governing everything from the flow of funds throughout the organisation to the incremental tasks allocated to stakeholders or processes, depending on how the DAO is structured.

The value adds of DAOs over orthodox organisations are their transparency, accessibility and, in many cases, automated decision-making. As the governing rules are transparent on the blockchain, anyone can view tasks and task rewards, examine the financials, and understand the incentives. Because DAOs are usually global, they are not a constrained by border controls, have lower barriers to entry, and have lower switching costs than existing organisations. If a DAO is not meeting member needs, or is evolving too slowly, members can disband quickly and form/join other organisations. Finally, DAOs, by virtue of their rules-based nature are a step towards AI-driven organisations. Whether this is a good or a bad thing is up for debate, but an immediate benefit is the hardcoded impartiality.

Source: Linda Xie

Crypto receives a disproportionate amount of hype, and many proselytisers would have you believe it is a “solve everything” type of asset. It is not even a single asset at all. I expect that over time the definitions of Ethereum, Bitcoin, and their peers will both separate from each other and crystalise into their own various use cases. Definitions will narrow, use cases will emerge, and the technology underpinning the hype will come to the fore. Until then, examining blockchains for their real world applications will hopefully prove useful. In doing this, three of the leading technologies coming off the Ethereum platform are DeFi, NFTs and DAOs. All three face growing adoption, and all three are built on a platform that – should that adoption continue – will keep bumping up against the limits of its capability.

The Real World

The Scalability Trilemma

To compete with centralized alternatives, Ethereum needs to at least be as fast, as cheap, and able to handle as much data. Already Ethereum competes with existing payment providers on cost/txn size. However, Ethereum cannot yet compete with non-financial network providers and software companies (like CDNs and cloud providers) on cost/byte. Decentralized databases inherently require higher cost per transaction than centralized alternatives, because the number of “places” where the ledger state needs to be changed/maintained are greater. Where the transaction fee is a small percent of total transactions, this is no problem. But it is very costly to run complex smart contracts in series, where data (not money) is being transacted.

Source: CoinMetrics
Source: CoinMetrics
Source: CoinMetrics

Currently, Ethereum1.0 lags several of the more centralised Layer 1’s (the base protocols upon which dApps are built). Eth2.0 however will likely outcompete many of them, and when Layer 2 (L2) scaling solutions are added it will be tough for the less developed chains to rival Ethereum without sacrificing decentralisation or interoperability.

Sources: SinoGlobal, Notboring, Bitinfocharts
Source: Polygon

The more Ethereum can integrate with alternatives, the more it will lower gas fees and increase thoughput. This incentivizes building of dApps on chains which only interact with Ethereum when absolutely necessary. While in the short run this sacrifices gas fee revenue, it builds in resilience and key dependency on Ethereum for the long run. If every app interfaces with Ethereum at some point, even if minimally, then new developers will have little choice but to do the same or risk losing their interoperability.

However, Ethereum needs to outcompete not only Layer 1’s but real world payment systems too. As a value transferal protocol, Etherum1.0 is only cheaper than Visa or PayPal. It is arguably more secure too, but with the incumbents security is only a risk at the systemic level. To compete Ethereum needs to process more transactions, at roughly one-tenth of the cost and time, and must be accepted by a roughly equal amount of people. With the rollout of Eth2.0 and where transactions are of more than, say $25, Ethereum is the clear technical winner. However, its network effect still severely lags the payment giants.

Sources: company financials, VanEck, Messari. 2021E used for Eth1.0 at $18bn revenue/$4tn transaction value, creditcards.com

For Ethereum to grow its network to a rival base, it will compete with the payment processes not just on technical ability, but on:

  • UX
  • Financial system integration (especially with the likes of Stripe, and B2B integrators)
  • Accurately forecastable cost, transaction value, transaction time
  • Public sentiment (merchant acceptance, asset credibility), and
  • Payment providers offering fraud protection, KYC/AML and having better legal protection.

While necessary for adoption, these elements are ancillary, and arguably far easier to build on top of a technically superior base.

Currently, Around 60% of Ethereum nodes are run on either AWS, AliCloud and GCP, as the set-up costs for full scale nodes are expensive for individual users. Further, Most devices/browsers/app-stores run on MacOS, Windows, or Android, and with Facebook, Apple, and Google’s push into wearables, they are the leading players in home IoT as well.

Sources: ethernodes.org

To compete, Ethereum needs to beat Big Tech on compute, storage, and interoperability. It is well on track with the latter. With sharding and rollups, Ethereum may be able to compete on computation costs within 1-2 years, although this is still largely speculative.

Household compute is essentially a utility. Between CDN providers and cloud IaaS (like AliCloud, fastly or AWS) computation costs for centralised compute is virtually negligible relative to paying ETH gas fees. It’s possible that completely decentralized computation being at a premium to censorable/centralized compute might be a reasonable tradeoff for some developers, but if Ethereum hopes to become a genuine “world computer” then it will need to bring computation costs down accordingly.

To recap the scaling summary picture (you’ve probably forgotten it by now) – Ethereum currently outcompetes all alternatives on interoperability, and cost/transaction when the transaction requires absolute validity. Ethereum will be competitive when used as a computation platform when a premium is afforded data privacy and decentralisation but will still be around 10x more expensive than centralized, off-chain alternatives for developers not willing to pay the premium. Speculatively, future scaling may solve this. Ethereum will likely never be competitive as a storage platform. It may one-day compete by outsourcing storage to side-chains, but that is speculative for now.

Sources: see slide deck, Amaznog.com, Ethereum.org

“There are two ways to try to scale a blockchain: fundamental technical improvements, and simply increasing the parameters. Increasing the parameters sounds very attractive at first: if you do the math on a napkin, it is easy to convince yourself that a consumer laptop can process thousands of transactions per second, no ZK-SNARKs or rollups or sharding required. Unfortunately, there are many subtle reasons why this approach is fundamentally flawed.

Computers running blockchain nodes cannot spend 100% of CPU power validating the chain; they need a large safety margin to resist unexpected DoS attacks, they need spare capacity for tasks like processing transactions in the mempool, and you don’t want running a node on a computer to make that computer unusable for any other applications at the same time. Bandwidth similarly has overhead: a 10 MB/s connection does NOT mean you can have a 10 megabyte block every second! A 1-5 megabyte block every 12 seconds, maybe. And it is the same with storage. Increasing hardware requirements for running a node and limiting node-running to specialized actors is not a solution. For a blockchain to be decentralized, it’s crucially important for regular users to be able to run a node, and to have a culture where running nodes is a common activity.

Fundamental technical improvements, on the other hand, can work. Currently, the main bottleneck in Ethereum is storage size, and statelessness and state expiry can fix this and allow an increase of perhaps up to ~3x – but not more, as we want running a node to become easier than it is today. Sharded blockchains can scale much further, because no single node in a sharded blockchain needs to process every transaction. But even there, there are limits to capacity: as capacity goes up, the minimum safe user count goes up, and the cost of archiving the chain (and the risk that data is lost if no one bothers to archive the chain) goes up. But we don’t have to worry too much: those limits are high enough that we can probably process over a million transactions per second with the full security of a blockchain. But it’s going to take work to do this without sacrificing the decentralization that makes blockchains so valuable.

Currently, the proposed scaling solutions improving the Layer 1 are Ethereum2.0 and EIP1559. The former will divide the chain into shards, each randomly served by dedicated nodes. This will reduce network congestion and increase transactions per second by creating what is effectively coordinated, new chains.

Source: Vitalik.ca

The second Layer 1 solution, EIP1559, will not directly enable better throughput or lower costs, but allows for more accurate demand/supply pricing with algorithmically variable fees optimising for throughput. This makes gas fees more certain, and lets developers budget better – hopefully also reducing congestion.

The Layer 2 solutions are generally protocols that collect transactions and batch them before putting them on the main chain. These include:

  • Rollups, which computes off-chain, but stores the outputs on-chain. These are still decentralised as the cryptographic output (which is needed to make sense of the data) is stored on-chain. Roughly, these are expected to constitute a ~10-100x scalability improvement.
  • State Channels are where participants “stake” ETH on-chain, opening up a separate off-chain channel wherein they transact freely and frequently. When the transaction(s) are finished, final data is stored on-chain and the ETH staked is reimbursed.
  • Side Chains are other blockchains (technically L1s) which are purpose-built to interoperate with Ethereum, and use “bridges” to port final data across. These are usually less decentralized and have alt. consensus mechanisms.
  • Plasma, which are mini “child” chains anchored to the Ethereum mainnet which can be checked by the mainchain for fraud. These chains don’t facilitate general computation, but can be used for more basic, preset activities (like token swaps and such) thereby taking some of the “grunt” work off the mainnet.

All considered, scaling is a focal point for many Ethereum developers with numerous independent projects working on solving the issue. There is a long way to go, and if Ethereum wants to hold its decentralisation as critical, none of the solutions will come easily. The optimistic news, is that while usage and capacity for transactions has been increasing, cost per transaction has remained relatively steady.

Risks & Threats

“… Speculators should understand that the base layer of Ethereum is still in alpha development, with rapid change in terms of its security model, monetary policy, and addressable market, at a time when competition in the smart contract industry is not insignificant.” Lyn Alden

Thus far, this essay has tried to be as realistic and fact-based as possible. This segment is intended to be a brief overview of some of the major competitive, internal, and external risks and threats facing Ethereum presently.

The DC/EP’s primary goal is to supplement or replace traditional physical cash; it will therefore not pay interest. The PBOC plans to adopt two-tier issuance—the PBOC will issue digital currency to commercial banks and require 100% reserves. If individuals or companies want to use digital currency, they must request a commercial bank or qualified payment provider to open up a digital currency wallet on their behalf, with authentication by the PBOC. From a technology standpoint, DC/EP will be based on a centralized ledger operated by the PBOC, in contrast to cryptocurrencies, which rely on a decentralized ledger.

The threat that CBDCs hold to decentralised cryptocurrencies is more as cash than as a platform or computation-provider. While the eCNY may compete directly with Bitcoin, it is unlikely to be as programmable or as interoperable as Ethereum, thus unlikely to have as sophisticated an ecosystem develop atop it.

Three more brief competitive considerations are the relatively low switching cost for utility protocols, the disinterest of the masses in “verifying” blockchain code or transactions, and the price decentralisation incurs.

We’ve covered the cost of decentralisation ad nauseum, but to summarize: It is possible companies won’t want to develop on-chain, simply because the compute cost of doing so is higher than the cloud/CDN alternative. If this is widespread enough, the use case for crypto become limited exclusively to value transfer. However, to believe this, you have to believe that innovation in the crypto community will not continue finding ways to lower gas fees, and that the use cases for NFTs, DAOs and DeFi are either unnecessary, or replicable through big tech.

The low switching costs are increasingly offset by the interoperability requirements of Layer 1s and 2s, but will likely continue to be a threat to Ethereum as long as the bulk of on-chain transactions are simple token swaps or trades.

One of the most common memes in crypto culture is “Don’t trust. Verify”. Unfortunately this is unrealistic. Most people won’t read code, and “the unbanked” certainly won’t verify. Trust – of code, or people – is an inevitable part of a world with division of labour. However, people are oddly willing to trust a great UX, especially when they don’t have to pay much and see adverts for the product coming from billboards and celebrities. This is counter to the average Linux-using, anti-consumerist Etherean, but is likely the fastest route to mass adoption at a public level.

While the Federal Reserve could not really mandate Facebook to us “Fedcoin” as the medium of exchange for WhatsApp Pay, the CCP has no such constraint. Given current geopolitics, it’s pretty unlikely either WeChat or the eCNY would be used much in the Western world. This tension arguably helps the politically agnostic crypto market. It also, however, means that a hostile nation would be more predisposed to launch an attempted 51% attack on Ethereum if it believed it could both drain the protocol of its value and hamper the flow of value in its national rival. This is a pretty late stage risk though, as neither China nor the US has widespread Ethereum adoption. Fortunately, as Ethereum improves and grows in value it becomes more costly to attack.

Volatility is accepted as a law of nature in crypto. Laws of nature are usually derived from certain causes though, and this holds true for crypto too. One of the reasons why Apple is such a low-vol equity is because so much of it is traded per day. The liquidity ensures there’s a constant buyer for every seller and vice versa. When you have an asset like Bitcoin, with its strong HODL culture, or Ethereum with its staking model to-be, the float of tokens available for trade is structurally limited. This thin float means every incremental purchase or sale affects an increasingly large price swing. Volatility is structural because of the illiquidity.

This means two things: firstly, The Pitch’s “special situation” is more at risk of a sentiment change than it may appear. If ETH is priced in line with Bitcoin, and Bitcoin sentiment flips, ETH post-Eth2 will suffer markedly more downside volatility than token holders may be used to. Secondly, institutions require liquidity. Overcapitalised buyers need to trade material amounts of Ethereum for it to make sense for them. If the system is not able to accommodate these flows without rocking the price, institutions will hang back until it can. stETH fixes this.

Source: Finematics
  • Scaling could fail to reduce fees, although this is unlikely as many protocols are already showing 100x improvements on computation costs.
  • Code bugs are always a concern. There have been several bugs allowing exploit or contract failure. In Ethereum, the DAO hack was the most well known. However, given the auditing and extensive research on Ethereum’s core protocol, this seems unlikely. Bugs are more likely to occur in L2s and products built atop Ethereum.
  • DeFi could fail to gain sufficient adoption, making Ethereum’s pricing system highly inefficient.

Beyond these more technical risks, there are concerns raised by many non-crypto-native investors. These range from ethical to game theoretic, legal and sociological. They are often nuanced, well-thought out critiques, and there is not space in this already-long essay to address all of them. Here are some of the more common ones:

“So, what’s wrong with it? Well, there are lots of things wrong with it, and people have written lots of articles about various problems with the Gini coefficient. In this article, I will focus on one specific problem that I think is under-discussed about the Gini as a whole, but that has particular relevance to analyzing inequality in internet communities such as blockchains. The Gini coefficient combines together into a single inequality index two problems that actually look quite different: suffering due to lack of resources and concentration of power.”

His argument is that the apparent inequality in the Ethereum community is more an indicator of engagement than lived experience. Those who own the bulk of the value do so because they have dedicated the last 5 years of their lives to building it, whereas the majority of the “poor” are really just regular folk, living middle income lives, who have decided to dabble a $15 bet on ETH.

Image
Source: Spencer Noon

Whether this is a good thing is the point of debate between the Austrians and the rest of the economic faculties. Both sides present convincing arguments, and if this essay were able to sway you one way or the other, it’d simply be because you hadn’t heard enough from the other side. We’ve never actually lived in a world with an auto-adjusting net deflationary monetary supply. There’s also never been an asset that is concurrently cash, capital, and consumable. In a nutshell, nobody really knows for sure how it would look.

The final critique is far more philosophical: The belief that the world was constructed for or grew around centralisation, and that individual sovereignty is antisocial or immoral.

A sizable appeal for many of the crypto-phenomenon is its libertarian roots. It preaches autonomy, independence of state, and self-reliance. There is, in the technocratic buzz, undertones of the rugged individualism and dump-the-tea, built-on-the-backs-of-cowboys behavior. “We don’t trust, we verify”. “Bitcoin fixes this”. This is the newspeak of a self-centered movement. And I mean that with all respect.

Anyways, this is actually an investment thesis, so let’s jump back to the money.

Valuation

The “income statement” for Ethereum is laid out in brief below. Revenue grows through expanding Ethereum’s network effects into dApps and transactability, increasing transaction fees accrued. Expenses are currently ETH sold to recoup the high energy cost of mining. After the PoS merge, the network costs will be ~1% of sales, putting margins (FCF is earnings in this case) at 99%.

Source: James Wang

A word on the conservativism: this is a rough intrinsic valuation – I am neglecting flow-induced price-action here. I am also using a load of heuristics in the potential growth and optionality estimates. This is intended to be directionally correct and breakdown what I think currently is and is not priced in. The value of a model is getting to see the inputs.

This is the “core business” at zero growth post FY21. A conservative discount rate of 15% is used in lieu of Ethereum’s perceived risk profile, high beta, and approximate WACC. The value of this core is $300/ETH, assuming 177M ETH in issue. It changes to $383 and $500 if we lower the discount rate to 10% and 5% respectively. It looks like the bulk of ETH’s valuation presently comes from expected growth.

Conservatively assuming ETH trades a a 1x Sales multiple, that there is no overlap between industries (there obviously is), and that none of these industries have grown by the time of capture, you land at a value of $1 945/ETH. Our total is now $2 245/ETH. Roughly the price it trades at today. But what about the “right tail” outcomes – we haven’t really priced in much of the moonshot potential here. Well, we can use the abominable Black-Scholes model to approximate the price of a real world option, but we’ll have to butcher it with some assumptions.

Assuming some moonshot potential over the coming decade, with assumptions above, you arrive at a rough valuation for the optionality embedded in Ethereum at $2 297/ETH. This brings our total to $4 542/ETH. Adding in an expected 2% deflationary supply burn over the next decade, the intrinsic value of Ether currently arrives at around $5 448/ETH.

In theory, buying Ether at ~$2 234/ETH is buying the core business on the expectation that there is, at most, a 15% chance that it captures only 5% of all the markets it is busy disrupting. If you do that, you get the optionality for free.

Parting Thoughts

I’ll leave you with a couple parting thoughts from some folk I admire.

“Kind of like a bet on a startup company management team, a bet on Ethereum is a bet that the developers will perform a massive transformation on the base layer and successfully maintain its dominant network effect against competitors.”Lyn Alden (2021)

“You come to the realization that the blockchain is really a general mechanism for running programs, storing data, and verifiably carrying out transactions. It’s a superset of everything that exists in computing. We’ll eventually come to look at it as a computer that’s distributed and runs a billion times faster than the computer we have on our desktops, because it’s the combination of everyone’s computer.” Tim Sweeney (2017)

“As great as open-source software development has been, far more people are willing to do far more things for money than for free, and suddenly all those things become possible and even easy to do. Again, it will take 30 years to work through the consequences of this, but I don’t think it’s crazy that this could be a civilizational shift in how people work and get paid.” – Marc Andreesen (2021)

4 thoughts on “Monopolies with Growth: Ethereum

  1. Hi. Interesting analysis. I’ve been a DeFi user since spring 2020 (only position is ETH and BTC) and this (good) analysis made me incrementally more negative. Also been a Tencent shareholder, really liked the analysis.

    Could you provide the title of the Mauboussin real option research piece? The whitepaper link is dead. Or maybe a small explanation what you are doing there? Aren’t you double counting growth potential as some of it is already counted in “Base Growth”? But yeah, only a small part of optionality growth is double counted.

    Best regards,
    Pembridge Cap

    Like

  2. Hi. Interesting analysis. I’ve been a DeFi user since spring 2020 (only position is ETH and BTC) and this (good) analysis made me incrementally more negative. Also been a Tencent shareholder, really liked the analysis.

    Could you provide the title of the Mauboussin real option research piece? The whitepaper link is dead. Or maybe a small explanation what you are doing there? Aren’t you double counting growth potential as some of it is already counted in “Base Growth”? But yeah, only a small part of optionality growth is double counted.

    Best regards,
    Pembridge Cap

    Like

    1. Hey Pembridge

      Earlier reply didn’t come through. Glad you enjoyed the article. As a DeFi user, how’s your experience of staking/yield farming been?

      Here’s the link to Mauboussin’s paper (http://www.capatcolumbia.com/Articles/FoFinance/Fof10.pdf). If that doesn’t work, just search “Mauboussin Get Real” and it should be among the top results. Alternatively, Fred Liu of Hayden Capital has a similar paper on the concept (Q3 2020 letter I think).

      In short, it’s pricing an EV for a project after modelling for a range of volatilities and taking the median. Usually project capex requirements is the “stock price”, expected payoff is the “strike price”. You can see the issues with my applying it immediately: How does one account for ETH’s “project requirements”? How many outcomes ought one to model for? What volatility range? Does ETH even have a WACC?

      I think you’re right, it does double count base growth. I think you could offset that by pricing the “strike price” for base growth and applying Mauboussin’s thinking. I imagine you’d still end in the $4.5-5k range. But I think the mental model is more important than the actual valuation outcome.

      Anyways – thanks for the comment! Good catch.

      Liked by 1 person

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