Month: March 2022

The bull case for Ethereum

As I’m getting frequent questions from my ‘non-crypto’ friends re: why I like crypto and ETH in particular, here is my take as it stands today (March 2022).

TLDR version

  • The coming POS upgrade will enable large institutions to invest as the Proof of Work / ESG complication is removed.
  • The supply of ETH will drop in June from 12,000 ETH per year to 1,200 ETH per year which will all go to the holders of ETH.
  • Staking rewards will rise from the current 5% pa to 10-15% pa
  • ETH is growing like a rocket, with usage up 10x just in 2021
  • Companies like Consensys will hold ETH on their balance sheet
  • In the aftermath of Canadian truckers and Russian sanctions, the importance of de-centralization will increase, working against ETH challengers like SOL, FTM, Terra etc.

Background

Ethereum is the first ‘programmable blockchain’ with the whitepaper written by Vitalik Buterin in 2014, and the blockchain was launched in 2015. The genesis block was mined, so Ethereum today is a Proof of Work (PoW) blockchain. 

Ethereum use cases

Ethereum enables a vast array of ‘decentralized applications’ or ‘dapps’ to be launched on top of it. The dapps are essentially smart contracts (programs) that run on Ethereum, and fees denominated in Ether (the native Ethereum currency) are paid (currently to PoW miners) to record the transactions on the Ethereum blockchain.

Dapps cover a wide array of use cases:

Decentralized Finance / DeFi – where the dapps today provide almost all of the services you can find in traditional finance (trad fi) – such as lending, staking, trading, options, etc. Yields on crypto assets in DeFi can often be very lucrative, with ‘stablecoins’ (e.g USDC – that is US Dollars on a Ethereum) you can earn yields of 8% to 19% p.a. with no fluctuating crypto prices. What is the interest you are getting in your current bank account?

The most popular DeFi dapps include Uniswap, Sushiswap, MakerDao etc. Just to be crystal clear here these are all autonomous programs that “live” on the Ethereum chain, and carry out all those functions with no human intervention. This is why banks are worried about ‘disintermediation’ from DeFi- meaning that banks would be put out of business.

NFTs – or NonFungible Tokens enable creators or communities to prove digital ownership of an asset, membership or status. The use cases range from:

  • Music – e.g. music artists being able to offer their fans different levels of interaction – where die-hard fans could buy access to a VIP lounge after a concert, or access to a discord channel with early releases of the artists more experimental music. This enables a ‘tiered pricing model’ which is much more favorable for the artists and fans.
  • Sports – sites like NBA Top shots allow fans to collect, share & trade ‘moments’ of their favorite stars (like digital trading cards).
  • Community via POAPs – Proof of Attendance Protocols enable you to show on your profile attendance to physical events, making it easier to connect with likeminded people.
  • On-chain ownership: eventually the ownership of your house or your car will be an NFT that you hold in your digital wallet. You will be able to borrow from your house (home equity loan), rent out your car for a weekend (like Turo) or even create an NFT out of the blog post or video you created.

Gaming – the fundamental shift of being able to own the artifacts, loot in the games give players a stake, a reward that was not possible before. Then being able to trade those artifacts for ‘money’ has given rise to the ‘play to earn’ phenomenon – shown eg by Axie Infinity. Granted there is pushback in the gaming community against cheap monetization, so as always the formats will be iterated on.

DAO’s – decentralized autonomous organizations are new ways for communities to organize themselves, and distribute decision making to the community. Quoting from the Bankless DAO article:

“What sets DAOs apart from all previous organizational forms is their flat, decentralized structures and absence of central planning. DAOs share a treasury and raise equity capital through the issuance of their own token, attracting anonymous investors and workers who believe in its mission.

The transparent nature of the blockchain means that all organization’s activities are managed on-chain and anyone can audit its smart contract codes, giving both investors and workers greater transparency into the inner workings of the organization.”

Bankless, Ryan Sean Adams

IMO DAOs are at the earliest stage as they have the promise of re-organizing how we work, how we form communities, how we deliver public goods (see GitCoin), how we do politics (see Andrew Yang on Lobby3).

Move from Proof of Work to Proof of Stake

Ethereum will move to from the current Proof of Work consensus mechanism to “Proof of Stake” within the next 3 months in a process called the ‘Merge”. This will bring the following benefits:

  • Energy consumption to secure the chain will drop around 99.8%. Instead the chain is secured by having ‘node validators’ stake their ETH (in a smart contract). 
  • The cost of attacking the network will increase, and enable further de-centralization down the road.
  • In POS – for every new transaction validators can be called randomly to validate whether a particular transaction is ‘valid’ or ‘fraudulent’. If a malicious actor were to send in fraudulent transactions and your node were to validate the transactions as ‘valid’ – the Eth staked on that node would be ‘burned’ (rendered useless). Instead the nodes which validate transactions correctly are rewarded in ETH – currently on the order of around 5% per annum.

Ethereum Scaling 

TLDR on scaling: Combined the POS / Layer 2 and Sharding solutions could take Ethereum from the current 15 tps (transactions per second) to 100k tps.

Scaling Ethereum will happen mainly via so called ‘zero knowledge’ roll-ups, or Layer 2 solutions. There are multiple Layer 2 solutions that are built today – but not yet in wide-spread use which enable faster, cheaper transactions.

Different variations exist such as:

  • Side chains like Polygon or Gnosis chain
  • ZK-roll-ups – such as ZkSync or Starkware enable batching of transactions so that the cost /speed of execution can be reduced by 100x or so. The key is that the code is ‘EVM / Ethereum Virtual Machine’ compatible so it can be deployed very quickly / instantly by a ‘dapp’. If the Dapp has been developed for Ethereum, it would in many cases work ‘out of the box’ with the Zk roll-up as well.
  • Optimistic Roll-ups such as Arbitrum, Optimism, Metis – bundle transactions as well, and reduce transaction fees by about 50x-100x as well. They have been in use for about one year, but are still experimental. The optimistic roll-ups “optimistically” assume that all transactions are valid during processing, but only validate each transaction later on. This means that it takes up to 7 days to move your funds off an Optimistic Roll-up.

On-chain scaling of the Ethereum main-net will happen via a process called Sharding, which splits the main-net into 64 different ‘shards’ to spread the load. This will happen sometime after the “Merge” – I’m not going to venture a date here… :-).

Ethereum valuation

With staking earning ETH holders ‘dividends’ – Ethereum can be evaluated using business valuation methods. Taking into consideration Ethereum’s growth rate in the past few years and the growing network revenue that will accrue to ETH holders – analysts have estimated ETH to be valued:

And yes there are risks to these investment theses – competitors such as Solana, Polkadot, Terra, there are geopolitical issues, technical unknowns, malicious actors etc so DYOR. (***This is not investment advice***)

The recap

IMO Ethereum is setup for multiple events that I do not think ‘the market’ has fully priced in, such as:

  • The coming POS upgrade will enable large institutions to invest as the Proof of Work / ESG complication is removed.
  • The supply of ETH will drop in June from 12,000 ETH per year to 1,200 ETH per year which will all go to the holders of ETH.
  • Staking rewards will rise from the current 5% pa to 10-15% pa
  • ETH is growing like a rocket, with usage up 10x just in 2021
  • Companies like Consensys will hold ETH on their balance sheet
  • In the aftermath of Canadian truckers and Russian sanctions, the importance of de-centralization will increase, working against ETH challengers like SOL, FTM, Terra etc.

Thanks for reading,

Oskar