Hello Ethereans,
A few weeks ago I posted A break down of the bull case for Ethereum and how it relates to Bitcoin on the CC sub. Since then, a few members from the /r/ethfinance sub have assisted me as I continued to work on a complete investment thesis for Ethereum. The original post has gotten the attention of Bankless, which is in my opinion the best Ethereum related news site that I know of. They will be publishing this thesis (or at least parts of it) once it is complete. Progress has been slow because it has been very hard for me to find time outside of my daily job and family, but I am finally almost finished with it. At this stage, I would like to ask for help from the Ethereum community to help to polish the thesis, and right any wrongs that I may be mistaken about. I have tried to cover all aspects of the bull case for Ethereum in a way that is accessible to a person with a superficial understanding of cryptocurrencies and economic principles. I am hoping that it could serve as a reference document to assist changing the narrative about the market's understanding of Ethereum.
Constructive criticism will be much appreciated, but no trolls. I also have a google doc open to commenting and I will post a like here if mods are OK with it (if not just PM me and I'll send you a link).
The Bull Case For Ethereum And How It Compares To Bitcoin
There is a general understanding among Ethereum investors that the technical enhancements that are currently being implemented will result in a sustainable monetary policy with near 0% issuance and the potential for ether to become a deflationary asset. What is even more interesting is that the net return of ether as a SoV (store of value) becomes superior to bitcoin the moment that issuance is lower than the staking yield. In other words, even if Bitcoin had already ceased issuance, it offers no mechanism to provide yield to long term holders with a negligible risk exposure as Ethereum does. There is an execution risk that Ethereum will not deliver on what is currently planned, but if it does, then it will become more scarce than Bitcoin could ever become under its cryptoeconomic model. However, the focus on scarcity as the primary contributor of value to a monetary asset is arguably misplaced. A dissection of the intrinsic value of money and how it is used can reveal a different story where value is primarily derived from the facilitation of economic activity rather than scarcity. In this regard, Ethereum has a tremendous advantage over Bitcoin because what is often described as “Ethereum’s utility” is actually the economic activity occurring in its digital domain.
It is impossible to separate BTC/ETH's payment rails from their respective monetary policies. Issuance is just a subsidy, and without it the network will need to operate as a profitable business with a cash flow that is entirely dependent on network fees. For this reason, the revenue collected from fees is the most important metric to determine the sustainability of a non-inflationary monetary policy. Circumstances around Bitcoin that reduce incentives from operating directly on-chain are a potential threat to its security model. We are observing new situations that are causing such degradation of the on-chain utility of the Bitcoin network. The incentive for users to transact directly on the network is being diminished by the tokenization into Ethereum (wrapped Bitcoins) and by the introduction of custodians (like PayPal) and traditional banking services who will soon be entering this space. If these trends continue, I suspect that the only activity that will end-up happening on-chain will be done by whales sporadically transacting to “hodle” and the occasional settlement from institutions.
Bitcoin seems fast and frictionless, but that is only because it is being compared to something in the physical world. In digital terms Bitcoin emulates the friction of operation that is found with gold: it is difficult and expensive to move it, securing it yourself is not trivial, and it does not make for a great medium of exchange. I don't think this will be a good dynamic to generate enough transaction fees. This may be just my subjective interpretation of it, but regarding this particular situation it is nearly impossible to make objective assertions at this point. It is possible to assert that, in the digital world, the expectation of frictionless money would entail near instant transactions with negligible cost and without the relative risk/paranoia of dealing with nuclear waste and having a hacker watching your every move waiting for you to make a mistake to snatch it away. Cryptocurrencies do not offer any mechanism to recover lost funds in case an account gets compromised by a hacker or a mistake is made during a transaction (like keying in the wrong recipient address); this is a serious problem. Digital money would also need to be fully programmable and interact with other digital assets, preferably defined and operated within the same ecosystem. Ethereum is steaming ahead on all ends.
Ethereum is fostering a digital economy (this is a very important part of understanding the value of ether) with DeFi at its center. It is currently generating about three times as much transaction fee revenue as Bitcoin. Layer 2 solutions are going live as we speak, and it appears that they will be much more practical and provide better UX when compared to the Lightning Network. This will help to amplify Layer 1 block space value and push revenue even higher. That will be followed by EIP-1559, which will help to stabilize fees, improve security related to edge cases, and create a deflationary mechanism through the partial destruction of transaction fees. Mining is currently excessively profitable and the hash rate cannot keep up. This means the financial incentives can be reduced, and by burning transaction fees we achieve the equivalent of an issuance reduction while stabilizing mining revenue. Eventually the transition to Proof of Stake (PoS) will dramatically cut the operational cost of the network. That means that Ethereum as a business will become more profitable and less reliant on the issuance subsidy. Finally, we will see the introduction of sharding which will scale Layer 1 by up to 1,000 times, compounding the effect of Layer 2 solutions and making it feasible for the network to operate as a platform for new use cases. A solution to the hacker/nuclear waste security situation is being explored via social recovery wallets. Social recovery wallets leverage Ethereum’s programmable capabilities to create a dynamic that is a mixture of self-secured “be your own bank” cryptocurrencies with the protection advantages offered by the traditional banking system. It is still in the early stages of research and design, but it is important to realize that the Ethereum community recognizes it as a problem and is working on a solution.
What is Ethereum?
Ethereum and ether are not the same thing. Ether is the name of Ethereum’s native digital asset. No one can buy Ethereum; when someone says they have Ethereum, what they really have is ether. A simplistic analogy would be to say that Ethereum is to ether what traditional banks are to the dollar. However, it is more appropriate to define what Ethereum is by comparing it to the internet. The internet is nothing else other than a network of computers running a data agnostic protocol to exchange information. Ethereum is a network of computers running a value agnostic protocol to exchange digital property. Both sound generic and unimpressive, but society has restructured itself around the internet, and in the next couple of decades Ethereum may have a similar effect upon it.
The Ethereum network is value agnostic because it allows anyone to create, issue and transact any type of digital asset (not just ether). This is very different from the Bitcoin network because it only allows users to transact its native asset which is also called bitcoin. Bitcoin with a capital B refers to the network, while bitcoin with a lowercase b refers to the asset that can be bought and transacted in the Bitcoin network.
Ethereum has one more trick that Bitcoin does not have: it allows for users to create and execute computer programs with the same awesome properties that make Bitcoin’s value proposition so compelling: they are inclusive, transparent, trustless, permissionless and censorship resistant; these programs are called “smart contracts”. They are operated autonomously by the network, and they can interact with any digital asset. This opens up a world of possibilities. Amongst one of them the ability to function as a global financial system that is in many ways far superior to the existing traditional financial systems which are siloed, inefficient and prone to questionable administrative practices and fraudulent activity.
In a nutshell, Ethereum reduces the friction of almost any activity that requires trust and/or permission by hosting a fully programmable money and the ability to create an infinite variety of digital assets while achieving a scalable infrastructure with a sustainable net zero issuance monetary policy. These properties make ether the world’s preeminent monetary asset by a large margin. There is nothing in the world that can be compared to ether with the same network effect of Ethereum. The rise of ether will generate an enormous amount of disruption to all pre-existing forms of reserve and monetary assets - it effectively makes them obsolete. It will suck out the monetary premium from gold, bonds, equities, real estate and eventually Bitcoin.
It may be difficult to see the value of reducing friction caused by trust and/or permission. These are often things we do not think about because they carry hidden costs. Let’s look at how the traditional banking system is affected by trust and permission. First a banking institution must be given permission to operate by the government. Then, customers must trust the institution and the system as a whole before they desire to open an account. The bank needs to give each individual permission to open the account upon request. Customers must trust the bank management will operate in a manner that does not jeopardize the balance under custody. They must trust that the bank (and consequently the ruling governmental authority) will give them prompt access to their balance while preventing bad actors from accessing private information and/or charging their account without permission. This means that every transaction must be permitted by the bank and the Government. Finally, individuals must also trust that the authorities will administer fiscal and monetary policies effectively to ensure fiat money’s status as legal tender and that it retains purchasing power. Each individual step adds real costs and operational risks to traditional monetary and financial systems. They are manifested through a multitude of fees, the risk of temporarily/permanently loss of access to balances and the continued devaluation of money through inflationary forces. The inefficiencies of these systems are also reflected directly in the cost of goods and services (payment processors charge vendors, and that cost is transferred to consumers via higher prices).
Bellow is a list of a few other ways that modern society is enduring costs associated with systems that are overly reliant on trust, permission and a lack of transparency:
- Our reliance on communication and social platforms that can arbitrarily dictate who is given permission to use them (Twitter, YouTube, Facebook, Google, etc). We are also entrusting these corporations with our personal data, which can potentially be used/shared without our permission.
- The annual cost of counterfeit products sold on the internet is estimated between $300-600 billions. The total annual cost of counterfeit products is estimated to be approaching $2 trillions. Many of these products are channeled through trusted vendors, and the consumers are unaware they are purchasing counterfeits.
- Financial service providers can arbitrarily choose who/when gets access to their services in order to favor their own interests. This has been manifested by the notorious stonewalling that traditional banks have enacted against cryptocurrency assets, and more recently by the Robinhood-Gamestop scandal.
- The lack of trust in the validity of our electoral process (at least by part of the USA population) has caused social resentment and political instability. Other countries have allegedly violated public trust and produced fraudulent election results.
What is Ether?
Ethereum (the network) is not trying to be money, but it utilizes ether exclusively for its monetary properties and not because it can be magically burned by an imaginary engine of sorts. It costs money to participate in the network as a miner, and their engagement is financially incentivized with ether. Any activity in the Ethereum network requires the use of block space. Block space is a scarce resource, therefore participants who wish to transact must use ether to bid for it. These interactions are utilizing ether as a monetary medium of exchange. In the long run, as the price of ether goes up, the ether denomination of gas prices goes down. That happens because no one is using ether as gas/oil, and it is actually being used as money. In the short run you may see the opposite occurring because of the dynamic between the portion of block space demand that is inelastic and the increased demand for ether and block space that move in tandem during market cycles.
Why are so many people insisting ether is like oil, but not money? The crypto space has a few analogies that have been used to describe technical/economic mechanisms that are somewhat tricky to understand: mining, Ethereum's gas, and the infamous analogy between ether and oil. Crypto "mining" is not like real world mining. It's purpose is not to extract resources, but it is rather a decentralized mechanism to process transactions. Newly minted BTC tokens are not "mined", they are minted by the protocol and awarded to operators. Furthermore, it is impossible to change the total mining output of the network... adding/removing miners does not affect the mining output. If you are new to crypto, you can read a more detailed explanation of mining here. ETH's "gas" is not like fuel (it cannot even be stored). It is just a computational metric that is more akin to the distance a car must travel, but not what actually makes it move. The fuel is electricity and it must be paid for with ether. When you transact you are also paying for the "car" which is the use of all active mining hardware/validators for a fraction of a second. And ether is just money.
To better illustrate why ether is not like oil let’s imagine I have a car with a 14-gallon fuel tank and I want to take it on a road trip. The car is not aware of the price of gasoline, and it would not travel any farther if the price of gas would double the next day. That’s because the intrinsic utility of oil has nothing to do with its monetary value. The car needs gas because of its particular physical properties and how the internal combustion engine is designed to utilize it. If I want to drive from point A to point B and it takes a full tank to get there, it will take that full tank no matter what happens to the monetary properties of gas/oil. This is fundamentally different from how Ethereum uses ether.
It is always better to understand the principles of cryptoeconomics than to rely on analogies. If you put too much weight on these simplified analogies, you will not understand the economic actuality behind them. This is a source confusion in the crypto space, and it is used to support false narratives. From an economic perspective, ether is money. Once you understand this, you will know that the narrative that Bitcoin and Ethereum are not competing because they are different things is analogous to saying fax machines do not compete with the internet.
It is important to stress that ether is a natively defined asset, and as such, counterparty risk is eliminated. This is not the case with wrapped Bitcoins and other tokens that are based on assets that require the involvement of a custodian (like tokenized US dollars). This, along with the fact that users need ether to engage in any activity in the Ethereum network (transactions fees can only be paid with ether), makes ether a natural choice to be used as a monetary asset. However, the beautiful thing about ether is that it is actually not "just money". It is a mixture of a scarce monetized commodity, money, bond and growth tech stock.
- Monetized Commodity: Ether is becoming more scarce and will continue to do so with the transition to Proof of Stake (PoS) and EIP-1559. Ethereum does not have a supply cap, but it does have a roadmap for a sustainable security model and if it achieves a positive cashflow then it will not only eliminate issuance, it can become deflationary. An argument can be made about potential issues with Bitcoin's sustainability in the long run.
- Currency: Ether is used as a unit of account and medium of exchange to pay for every activity in Ethereum. It is also used in the same way for venture capital related to ICOs, and for digital art commercialized via NFTs. Ether is also used as collateral in the DeFi space and new monetary uses will continue to emerge. It is an immature form of digital money, just like Bitcoin is an immature form of digital gold. Some people prefer to say that ether is just a utility token. However, a utility token is just a narrowly scoped form of money. Not only is ether's scope within its digital economy growing, by next year users will be able to pay millions of merchants with ether through Paypal and Visa. We have never seen the adoption of a new form of money grow organically. New forms of money have always been imposed by authorities. What would the organic growth of money look like? It would look like ether.
- Ethereum's digital economy: Ethereum has limitless use cases and it is already generating economic activity with real world usefulness. Ether's value will benefit from acting as the native monetary asset for Ethereum. As Ethereum's economic activity grows, the velocity and/or value of ether must also increase.
- Bond: With Proof of Stake you need to lock up ether to receive a yield in return. It is similar to how bonds work.
- Growth Tech Stock: Ethereum is essentially operating as a cloud based service provider, and the network will be entirely operated by stakers who happen to be the recipients of transaction fees. Ethereum provides a service - that service is paid with ether. The network is controlled by holding ether that is staked. The more valuable the service provided by Ethereum becomes, the more users will be willing to pay for transactions and the more valuable the protocol and the ether token become. It is not exactly the same as holding a stock, but there are a lot of parallels.
- Full reserve banking model: This is a bit of a stretch, but it is a potential end-game for Ethereum. It can serve as the base infrastructure and reserve asset for a full reserve banking system. In a nutshell: a consortium of banking companies can be formed to standardize a framework to hold and stake ether under custody in exchange for wrapped Ether (wETH). Customers deposit ether, banks exchange it for wETH, and stake the original ether. Resting balances of wETH on customer accounts can receive a cut of the staking rewards. Banks get their profit model, customers get to spend wETH with traditional banking services and potentially receive a share of the staking yield. Customers could also have access to a yield curve based on variable reserve requirements. This would allow banks to create money (which is actually good for the economy when it is done with moderation), but for the first time ever customers would have the choice of how much risk exposure they are comfortable with. This dynamic could help to establish a form of democratic check and balances system that discourages moral hazard. Ether could become a godsend to banks in the land of negative yields. It's a pipe dream, but not entirely impossible. Don't forget that the US OCC has essentially given banks the green light to take the first steps in this direction (US banks have been approved to use the Ethereum blockchain for their operations AND they can become validators... yup this happened).
Understanding Cryptocurrency Scarcity
Anyone who is insisting cryptocurrencies are not scarce does not understand how the concept of scarcity works in this asset class. The value of a cryptocurrency is derived from a combination of the code, computers, people and amount of money that is participating in the network. It is the fusion of all these elements that defines scarcity and the impact it has on each unique cryptocurrency.
I am going to use Bitcoin as an example, but the following concepts apply to all other cryptocurrencies. Computers are used to establish the security of the Bitcoin protocol, and it can be broken down in two distinct categories: the number of distinct nodes, and the mining computational power (known as the network’s hashrate). Nodes are like messengers that send requests from users to operators and retrieve information back to the users. Nodes do not process transactions, but they ensure the communication between users and operators is undisrupted. It does not cost much money to operate a node, but it is important that nodes exist in large numbers that are independently operated. This is what protects the network from attackers trying to take it offline.
Operators are the computers responsible for processing transactions, except they are actually called “miners”. Bitcoin uses a clever combination of cryptography, economics and networking to establish a resource intensive mechanism that allows transactions to be processed in a decentralized way while providing financial incentives to participants. Long story short: it is expensive to operate as a miner (miners spend several million dollars every day to participate in the operation of the Bitcoin network). They do it because they are paid by the network with a combination of transaction fees paid by users and newly minted bitcoins created by the protocol. This is what prevents transactions from being reverted and/or censored. At the time of this writing the Bitcoin network has over 10,000 individual nodes, and a total mining computational power that consumes the equivalent of $22 million worth of electricity per day (using the US average electricity cost of 13.19 cents per kilowatt hour).
When a person buys a bitcoin for the first time, he/she becomes a new member of the network as a participant who can now send and receive bitcoins. What is perhaps even more important, many participants extend their support for the network into the real world by advocating for its value proposition; participating in the Bitcoin network is also a social phenomenon.
Finally, the demand for Bitcoin has an indirect impact in the security capabilities of the network. Miners are partially financed by the issuance of new tokens, which happens at a fixed rate denominated in bitcoins. This means that the higher the price of bitcoin is, the higher the financial remuneration for miners will be. Ultimately this attracts more miners to the network and results in greater protection against the reversal and/or censorship of transactions.
Anyone could copy the Bitcoin code, make slight changes to it and deploy a new crypto called “FunkyDonkeyCoin”. It would be a worthless network with a single participant, secured by nearly zero computational power. There is only one reason why anyone would possibly want to buy a donkey token: for the comedic/meme value of having something called FunkyDonkeyCoin because it sounds funny and it uses a picture of a silly looking cross-eyed donkey as its symbol. “Dogecoin” is a real life dog-themed version of FunkyDonkeyCoin. It was created as a joke, but it has surprisingly gained popularity over time and it has reached over $7 billion market capitalization. Most pundits agree that this valuation is not sustainable, but it still speaks volumes about the impact of network effect on cryptocurrencies. The bottom line is that the Bitcoin code can be copied, but the network of computers, people and market valuation cannot.
Bitcoin vs Ethereum Monetary Policies
One of the aspects central to Bitcoin’s value proposition is its immutable monetary policy, and the determination of a maximum supply cap of 21 million bitcoins. However, the idea that Bitcoin's monetary policy cannot be changed is a myth. It is a false narrative that takes for granted that the issuance subsidy will no longer be necessary at some point, but there is no way to objectively assert this. There is no divine power preventing the monetary policy from being changed. If the security model for Bitcoin was jeopardized because of insufficient cash flow to miners, then Bitcoin's monetary policy would be the first thing on the chopping board to go in order to remedy the situation.
Bitcoin’s monetary policy has been proven to work very effectively under specific circumstances. Since its inception, the price of Bitcoin has increased exponentially, and up until recently, there was a lack of alternative payment rails that were capable of transacting with bitcoin. Most importantly, Bitcoin has been generally perceived as the strongest (arguably the only institutional grade) store of value asset in the cryptocurrency market. These dynamics are changing and the sustainability of Bitcoin’s monetary policy is entering uncharted territory. Sooner or later the price of Bitcoin will no longer double (or more) every four years. When this happens, the issuance subsidy will be effectively reduced on each halving event. Transaction fees will have to fill the gap left by the reduction of issuance, but the incentive to use the Bitcoin network is being reduced by the introduction of so many alternatives systems (wrapped bitcoins on Ethereum, PayPal, Visa, Mastercard, commercial banks and even tech giants like Apple and Google are likely to join the custodial and payment rail crypto party). To make matters worse, Ethereum is starting to be recognized as an institutional grade store of value asset. It is a mistake to assume these changes will be inconsequential to Bitcoin’s security model.
The criticism against Ethereum’s dynamic monetary policy and ETH 2.0’s proposed perpetual 1% issuance may seem strong on the surface level, but they crumble once all the pieces of the cryptoeconomic puzzle are put together. For starters, if an argument can be made that the financial incentives to operators (miners/stakers) are excessive or insufficient then an argument can be made for the implementation and execution of a dynamic monetary policy. Additionally, I can’t see how an arbitrarily picked issuance schedule determined during the genesis of a new highly complex system is likely to be efficient through its lifecycle. Bitcoin's monetary policy provides the certainty of stability and protection from abuse, but it sacrifices the possibility of efficiency and jeopardizes longevity. It would be like if a captain of a ship pointed it in the direction of its final destination, set the throttle, then fell back to his cabin for a nice bottle of chianti and hoped that the ship would arrive safely. There would be no one at the helm to navigate the seas, no one to make sure it stayed on route, no one to avoid the storms or to take advantage of currents. In my opinion it is a pretty bad approach to something as critical as monetary policy.
With respect to how Ethereum is administering its dynamic monetary policy: I don't see any evidence to suggest developers have been enriching their pockets by keeping issuance at current levels. Developers are stakeholders and the Ethereum Foundation holds a lot of ether - debasing ether is against their self interest. There is a great misunderstanding that the ones who are adjusting issuance are the recipients of the new tokens or that they are somehow colluding with miners. Is there any documented case of this happening?
Ultimately, the 1-2% nominal issuance rate of ETH 2.0 must be interpreted as a maximum issuance level; the actual issuance is anticipated to be near zero or potentially negative thanks to EIP-1559, multiple scaling solutions and high demand for Ethereum’s block space. In the worst case scenario, ETH 2.0 will have a 1-2% issuance rate while providing 2-3% staking yield to long term holders via staking. The market is still skeptical these changes will be executed successfully and/or that they will provide an equivalent level of security to PoW. However, as we approach the full realization of new features, it will become self evident that Ethereum is a superior store of value when compared to any other asset (including Bitcoin).
Ethereum’s Bull Market Catalysts
- Wide adoption of Layer 2 solutions: these will amplify the base layer block space value while encouraging further network adoption by a significant reduction of fees. A successful integration with DeFi protocols will dismiss the "Ethereum killers" theory and consolidate market confidence.
- EIP-1559: this enhancement involves a new methodology to determine base transaction fees, along with flexible block sizes and transaction fee burning (partial destruction of transaction fees). It will improve security and user experience by stabilizing transaction fees, as well as introduce a deflationary mechanism to ether.
- Sharding: scale Layer 1 bandwidth, compounding the effect of Layer 2 solutions, further consolidating Ethereum's dominance in the DeFi space, making it feasible to introduce new use cases and eventually increase transaction fee revenue.
- The switch from PoW to PoS: discontinuing Proof of Work (PoW) will eliminate the operating costs related to mining and will allow for a reduction of issuance (~4% will be reduced to ~1%). Money that was previously allocated to buying mining equipment will be redirected to the acquisition of ether. Staking ether will remove it from circulation for extended periods of time. Operating cost will be negligible, allowing validators to withhold most of the ether revenue. This will be the greatest bull market catalyst in the history of cryptocurrencies and it will eclipse the effect of Bitcoin’s halvings.
Bitcoin maximalists will be naysaying all the way through and past a market cap flip. Do not get caught up in their narrative. If you are not sure, then it is better to rebalance your portfolio proportionally to market caps. This is a smart risk mitigation strategy that has a huge upside. If none of these enhancements are successfully deployed and Ethereum turns out to be a failure, then you would only have reduced your gains by 20-30%. Otherwise, ETH will be making you mountains of money.
