Ethereum Investment Thesis

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Ever found yourself scratching your head, trying to figure out why someone would invest in ether (ETH) instead of just using it on the Ethereum network? Let’s look at Fidelity’s recent report on Ethereum’s Investment Thesis.

Ethereum vs Ether

Ethereum vs. Ether: Picture Ethereum as a bustling digital city, and ether (ETH) as the currency people use within that city. While the city’s infrastructure might be booming, it doesn’t always mean the currency’s value is skyrocketing. Similarly, a digital network and its native token don’t always rise and fall together.

The relationship between a digital asset network and its native token is intricate, and their successes don’t always mirror each other. Some networks can offer significant utility, processing numerous intricate transactions daily, without necessarily enhancing the value for their token holders.

Conversely, some networks exhibit a more direct connection between the network’s activity and the value of its token. This dynamic is often referred to as “tokenomics,” a contraction of “token economics.” Tokenomics delves into how a network or application’s structure can generate economic benefits for its token holders.

Over recent years, the Ethereum network has experienced transformative changes that have reshaped its tokenomics. One notable change was the decision to burn a segment of transaction fees, termed the base fee, introduced in August 2021 through the Ethereum Improvement Proposal 1559 (EIP-1559).

πŸ”— Recommended: MEV Burn Ethereum: Greatest Supply Shock in ETH History?

When ether is burned, it’s essentially removed from existence, meaning every transaction on Ethereum reduces the total ether in circulation. Moreover, the shift from proof-of-work to proof-of-stake in September 2022 reduced the rate at which new tokens are introduced and introduced staking.

This staking process permits participants to earn returns in the form of tips, new token issuance, and maximal extractable value (MEV). These pivotal updates have redefined ether’s tokenomics, prompting a reevaluation of the bond between Ethereum and its native token, ether.

Understanding Tokenomics: The Value Dynamics of Ether

Ether’s value is intrinsically tied to its tokenomics, which can be broken down into three primary mechanisms that convert usage into value. Here’s how it works:

  1. Transaction Fees: When users transact on Ethereum, they incur two types of fees: a base fee and a priority fee (also known as a tip). Additionally, transactions can create value opportunities for others through MEV (Maximum Extractable Value). This represents the maximum value a validator can gain by manipulating the sequence or selection of transactions during block creation.
  2. Base Fee Dynamics: The base fee, which is paid in ether, is “burned” or permanently removed from circulation once it’s included in a block (a collection of transactions). This act of burning reduces the overall ether supply, creating a deflationary effect.
  3. Priority Fee and MEV: The priority fee, or tip, is a reward given to validators, the entities or individuals tasked with updating the blockchain and ensuring its integrity. When validators create blocks, they’re motivated to prioritize transactions offering higher tips since this becomes a primary source of their earnings. Additionally, MEV opportunities, often arising from arbitrage, are typically introduced by users. In the current ecosystem, the majority of this MEV value is channeled to validators through competitive MEV markets.

These value-generating mechanisms can be likened to various revenue streams for the network. The burning of the base fee acts as a deflationary force, benefiting existing token holders by potentially increasing the value of their holdings.

On the other hand, the priority fee and MEV serve as compensation for validators, rewarding them for their crucial role in the network. In essence, as platform activity rises, so does the amount of ether burned and the rewards for validators, illustrating the dynamic relationship between usage and value in Ether’s tokenomics.

Investment Perspective: Ether’s Monetary Potential

Bitcoin is often framed as an emerging form of digital money. This naturally prompts the question: Can ether be seen in the same light?

While some might argue in favor, ether faces more challenges than bitcoin in its journey to be universally recognized as money.

Although ether shares many monetary characteristics with bitcoin and traditional currencies, its scarcity model and historical trajectory differ. Unlike bitcoin’s fixed supply, ether’s supply is dynamic, influenced by factors like validator count and the amount burned.

Additionally, Ethereum’s frequent network upgrades mean its code is constantly evolving, requiring time and scrutiny to establish a robust track record. This continuous evolution, while beneficial for innovation, can be a hurdle in building unwavering trust among stakeholders.

Also, many would argue that Ether is more security-like than Bitcoin in that it is more controlled by a few highly interested parties than Bitcoin. The Ethereum foundation (EF) is controlled by a handful of people. If the EF proposes protocol upgrades, even hard forks, these upgrades have a high chance of going through. The decentralization in terms of number of nodes and distribution of nodes globally is much less than Bitcoin.

Bitcoin, for many, represents the pinnacle of digital money due to its security, decentralization, and sound monetary principles. Any attempt to “better” it would involve compromises. However, the dominance of bitcoin as a digital monetary standard doesn’t preclude the existence of other forms of digital money tailored for specific markets, use cases, or communities.

Ethereum, for instance, offers functionalities not present in Bitcoin (at least on the base layer, although many functionalities, such as smart contracts and executing complex transactions, are already being implemented on Bitcoin layer 2s).

Mainstream applications built on Ethereum could naturally boost demand for ether, positioning it as a potential alternative form of money. Several real-world integrations with Ethereum are already evident:

  • MakerDAO, an Ethereum-based project, invested in $500 million worth of Treasuries and bonds.
  • A U.S. house was sold on Ethereum as a non-fungible token (NFT).
  • The European Investment Bank issued bonds directly on the blockchain.
  • Franklin Templeton’s money market fund leveraged Ethereum via Polygon for transaction processing and share ownership recording.

While these integrations are promising, widespread adoption of Ethereum for mainstream transactions might still be years away, requiring enhancements, regulatory clarity, and public education. Until then, ether might remain a specialized form of money.

In a way, Ethereum currently doesn’t have use cases beyond trading digital assets as can be seen in the current “Burn Leaderboard” on Ultrasound Money:

I’m not a huge proponent of “trading applications” because I believe it goes more in the direction of a zero-sum game. Where’s the value of swapping tokens on Uniswap or NFTs on OpenSea? Yet, I understand you could use similar arguments for much of the “real world” industry with banks, online marketplaces, and financial services providers.

Regulation is a significant concern for Ethereum’s future. Given that many major centralized exchanges holding and staking ether are U.S.-based, regulatory decisions in this jurisdiction could profoundly impact Ethereum’s valuation and overall health. Recent regulatory actions and shutdowns of crypto services in the U.S. underscore the gravity of this risk.

Ether’s Dual Monetary Roles: Store of Value and Medium of Exchange

Store of Value: A reliable store of value demands scarcity. While Bitcoin’s fixed supply of 21 million is well-established, ether’s issuance is more fluid, influenced by factors like validator activity and burn rates.

Future Ethereum upgrades could further complicate predictions about ether’s supply. Despite these complexities, current structures ensure ether’s annual inflation remains below 1.5%, assuming no transactions occur. With transaction revenue, Ethereum can even remain deflationary, meaning more ETH is burned than paid out to stakers each year.

However, the potential for future changes to ether’s supply dynamics contrasts sharply with Bitcoin’s steadfast supply narrative.

Means of Payment: Ether is already used for payments, especially for digital assets. Seemingly, Ethereum’s faster transaction finality compared to Bitcoin makes it an appealing payment option.

In reality, however, all payments will be made on second and third layers, such as Bitcoin lightning or Ethereum Polygon, which reduces practical transaction costs for even small payments to almost zero.

As more physical and digital assets integrate with blockchain ecosystems, ether, along with other tokens and stablecoins, could become more prevalent for payments, especially if transaction fees decrease due to the increasing infrastructure of the network application ecosystems.

Valuing Ether Based on Demand

Ether’s value could rise with increased Ethereum network adoption due to basic supply-demand principles. As Ethereum scales, understanding where new users originate and their sought-after use cases can provide insights into potential value trajectories.

Current data suggests that Ethereum’s base layer continues to attract consistent value, even as layer 2 solutions gain traction. However, ether’s value might be more influenced by network usage than mere asset holding.

In a recent article, I analyzed Bitcoin’s price based on Metcalfe’s Law and network effects and found there’s a positive relationship:

πŸ’‘ Recommended: Want Exploding Bitcoin Prices North of $500,000 per BTC? β€œGrow N” Says Metcalfe’s Law

A similar study has been done by Fidelity that found more evidence of Bitcoin’s price scaling exponentially with the number of addresses than Ethereum’s price. But the relationship is still there for both monetary networks (source):