Re-understand Ethereum from four dimensions

Author | Packy McCormick

What would you do if I told you about a business with strong network effects and 200x year-over-year revenue growth that was poised to pay a 25% dividend and implement a perpetual share buyback program? Is this something you might be interested in?

That's pretty much Ethereum. It's one of the most fascinating and compelling assets in the world, but its story is obscured by complexity and the specter of encryption.

Ethereum is many things at the same time, all of which reinforce each other. Ethereum is a world computer, the backbone of the decentralized internet (web3), and the settlement layer for web3.

Bitcoin is simple, it's digital gold, it's a store of value. That's its value prop. It is immutable and the most decentralized asset in the world. It will continue to have value as long as others believe in its value.

Ethereum is more than just a cryptocurrency. It is the "world computer" and "value layer" of the Internet. It allows people to build applications and products with assets in the form of code. If you believe that web3 will continue to grow, then you probably believe that over time Ethereum will become the settlement layer for the new internet. Transactions of all kinds will turn to Ethereum to exchange funds and maintain a secure, immutable record.

Before the past year, much of Ethereum's value existed in a theoretical state. Personally, I think it's kind of interesting, after buying ETH in 2017, I sold all 15 ETH in June 2020. As you know, I'm an idiot. Even after the recent drop, those 15 ETHs are worth more than $300,000. I'm missing about a 10x upside.

A few things happened between then and now that made me go from being moderately curious to very curious and very bullish:

1) Explosion of application scenarios. DeFi, NFTs, and DAOs have become real use cases for crypto and have seen incredible growth over the past year;

2) Deflationary currency. With EIP 1559 imminent, ETH supply could become deflationary, removing its greatest currency weakness;

3) ETH 2.0. Ethereum is currently running a test chain that will be merged with the main ethereum chain in about six months. When it happens, Ethereum will switch from Proof of Work (PoW) to Proof of Stake (PoS), and more value will be generated to ETH holders;

4) Narrative. The narrative surrounding Ethereum is becoming more and more popular and mainstream.

To define a bull market, we need to understand why Ethereum is surviving and usage is growing, how it is actually making money, and the differences between ETH and tech stocks.

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01 Ethereum is the Excel of Blockchain

If you're going to be bullish on Ethereum, first you need to believe that it's going to be around for a long time, that more and more people will continue to use it, and that other people believe these things to be true. Then you'll be relieved to know that Ethereum is the Excel of the blockchain.

That's not quite right. This metaphor is broken in some places. But for our purposes, it's good enough.

Ethereum is a Turing-complete, programmable blockchain where anyone can build full-fledged applications using smart contracts. People can build all kinds of decentralized applications on top of Ethereum, providing everything from security to identity to payments. Decentralized finance (DeFi) applications, NFT marketplaces, decentralized autonomous organizations (DAOs), as well as games and virtual worlds can all be built on top of Ethereum, all powered by ETH.

This kind of flexibility is really hard to do. In Excel Never Dies, Ben Rollert and I write about Excel's staying power in the tech space, which typically sees new products replace old ones every few years. We wrote:

If there's one core product design lesson to be learned from Excel, it's that combining usability and flexibility is both difficult and rewarding;

The design principle of developers is to make any piece of software really good at one specific thing, deliberately restricting its functionality to specific areas. Excel is a notable exception to this rule -- it's the equivalent of a mobile phone with a plethora of options, and apparently hundreds of millions of people do want to compose music for it.

You can replace "Excel" with "Ethereum" and it will work just fine. In addition to the product concept, there are some specific similarities between the two, including Turing completeness and composability.

Turing completeness and composability together mean that you can build smart contracts to compute anything, and then chain them together to build increasingly complex things faster. It takes time to get the engine up to speed, but once it moves, it moves quickly.

This is exactly what is happening. After years of building in relative obscurity during the crypto winter, 2020 and early 2021 saw an explosion of real-world use cases for the Ethereum ecosystem in the face of doubts about whether these things had any real use. In Ethereum's announcement of Q1 2021 figures, James Wang produced a chart highlighting this year's progress:

These huge numbers are a hallmark of space power and composability across a wide range of application scenarios:

1) The trading volume of decentralized exchanges such as Uniswap has increased by 76 times, from $2.3 billion in the first quarter of 2020 to $177 billion in the first quarter of 2021;

2) The total value locked in DeFi increased 64 times from $6.4 billion to $52 billion;

Ethereum usage surged in the first quarter, and while NFT sales slowed, partly due to high gas fees and partly because the initial excitement has faded, DeFi remains strong. Despite the surge in activity and transaction volume, the question remains: what does this mean for Ethereum?

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02 How does Ethereum make money

I have known Ethereum for a long time. I first bought ETH in 2017, but it was speculative and I didn't end up getting it. My biggest question mark with Ethereum is how it makes money. How does more activity on Ethereum translate to higher ETH prices?

In the near future, the answer will be that more transactions mean higher returns for ETH holders, and the supply of ETH will decrease. But that's not yet how it works.

Let's start with how things work today and look at the challenges of current models, proposed solutions, and what the future holds.

Today, when you want to transact on Ethereum, you need to use ETH. There are currently approximately 116 million ETH, and the price is loosely controlled by supply and demand. All else being equal, more transactions on Ethereum means more demand for ETH, which means higher prices.

To keep running, Ethereum uses proof-of-work consensus (PoW) to agree on the state of the blockchain. To do this, miners around the world race to solve increasingly difficult cryptographic problems in order to create a new block on the blockchain containing new transactions. These problems are often difficult to solve - require a lot of effort - but easy to verify. When a block enters the blockchain, the transactions in the block officially become part of the record. Miners who successfully create a block will receive 2 newly mined ETH and receive all transaction fees within the block.

Those transaction fees, called gas, are what people pay to submit transactions to be included in blocks. When a user sends ETH to someone on Ethereum, or mints an NFT, or does anything that needs to be verified on-chain, they have to pay a gas fee. Gas fees are used to incentivize miners to spend the required funds in the form of hardware and electricity to solve puzzles and create blocks.

So currently, the price of Ethereum is based on a combination of supply and demand, and what miners spend to secure the blockchain. To participate in the Ethereum network, you need ETH, and you need to pay for gas. Miners receive ETH in the form of newly minted supply and gas.

This system has many challenges:

1) It's slow. Ethereum currently processes about 19 transactions per second. In comparison, VISA has approximately 1,700 transactions;

2) It's expensive. The simplest transaction requires a gas fee of about $5;

3) Very unstable. Gas fees change at any time according to demand. This makes it hard to trade with confidence or predictability; 4) It's inflation. Unlike Bitcoin, there is no hard cap on the amount of ETH that can theoretically be minted, while Proof of Work requires the minting of a large amount of new ETH, which will result in the dilution of the value of existing ETH holders;

5) It is not friendly to the environment. Mining means using a lot of electricity;

6) This is inefficient. Most of the money spent on transaction fees leaves the system — miners are forced to sell the ETH they earn to pay for electricity, hardware, and taxes.

Despite all these challenges, Ethereum’s adoption rate is impressive, but they are still real challenges. When I tweet about reasons not to buy ETH, many of the answers revolve around one of the above issues, most commonly gas cost and inflation.

Additionally, increased demand for Ethereum-based DApps — more DeFi, more NFTs, more DAOs, more games — means more transaction fees that don’t really add up to ETH holders. They leak out of the system to cover the real-world fiat costs of miners in the proof-of-work process.

So today, the price of ETH is based on the demand for more ETH, just like Bitcoin and USD. It's not tied to revenue like a company, but it will soon be.

Proposed Solution: EIP 1559 and ETH 2.0

One of the things Bitcoin maximalists love most about Bitcoin is that you can't really change it. One thing they don't like about Ethereum is that you can change it. It's not easy, but it's possible.

Ethereum is undergoing two changes designed to address the above challenges.

EIP-1559 is a proposal to change the way gas fees are charged by splitting them into a base fee and a tip. With EIP 1559, every transaction consumes a base fee, and miners (and soon validators) keep the tip. This sounds tedious, but it's significant, as burning could potentially deflate ETH.

Plus, tipping allows those who value better block placement to pay more. For example, this could be important for DeFi players trying to arbitrage. The proposal was approved in March and will go into effect in July (as part of the London hard fork).

ETH 2.0 is an upgrade to the Ethereum blockchain itself that changes consensus from proof-of-work to proof-of-stake and introduces sharding. ETH 2.0 promises to make Ethereum more scalable, secure and sustainable. The PoS chain or beacon chain is already live and is expected to merge with the main chain sometime in late 2021 or early 2022.

Proof of Stake is a shift in how the network is secured and who gets rewarded. This means that instead of anyone in the world having to solve math problems to mine blocks, ETH holders can validate block transactions based on the amount of ETH they hold. Validators secure the network in exchange for tips and rewards in the form of newly minted ETH.

Ethereum claims that PoS will be more secure because validators will hold ETH, and if they try to cheat, the ETH price may be destroyed. Critics claim that staking puts more power in the hands of those who hold the most ETH, making it less decentralized and therefore less secure.

In terms of scalability, sharding aims to increase throughput, or transactions per second, by a factor of 100 by creating a chain of 64 shards that validate transactions in parallel. Each shard only needs to verify a small part of the entire chain, instead of each miner needing to verify the entire chain today.

Additionally, Layer 2 solutions (hereafter referred to as L2) such as Polygon and Optimism are already working to speed up transactions and reduce fees by batching transactions off-chain and settling on-chain in one transaction rather than in many transactions ( There are complications, but this is close enough). L2 solutions can increase throughput another 100x, and if theory plays out in practice, combining Eth2 and L2 solutions could lead to a 10,000x performance improvement.

Collectively, EIP 1559 and Eth2 could be revolutionary for ETH holders as they increase performance while significantly changing where value is generated in the Ethereum ecosystem.

The Future: Ultra Sound Money

In 2019, David Hoffman wrote an article called "Ethereum: A New Model for Money". In it, he cites Robert Greer's 1997 paper, What Are Asset Classes Anyway? 》 and indicates that there are three asset properties:

1) Capital assets are productive and generate value or cash flow. Examples include stocks, bonds, or rentable real estate.

2) Convertible/consumable assets can be consumed once, transformed into another asset, and their consumption generates economic benefits. Think energy or commodities.

3) Value-preserving assets are scarce and cannot be consumed, but can only be transferred, and their value lasts over time and space. Examples include gold, currency, art, or bitcoin.

Hoffman believes that Ethereum, as a Turing-complete and programmable currency, can have the above three characteristics at the same time once EIP1559 and Eth2 are passed. He calls it the "triple point," the concept in thermodynamics where a substance can simultaneously exist as a solid, liquid and gas at the right temperature and pressure.

How they happened concurrently with Ethereum is beyond the scope here, it is important to understand the three phases of Ethereum's existence:

1) Store of value. ETH is locked as collateral for DeFi transactions. For example, you can use ETH to get a loan or provide liquidity to a DEX. Currently, nearly 10 million ETH are locked in DeFi;

3) Capital assets. ETH acts as a capital asset in several ways. Owning ETH represents a share of the Ethereum network, just like owning equity in a company. Once staked, ETH gives its owner the right to work for the network through the right to become a validator and receive fees generated by the network.

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03 Legitimacy and the Lindy Effect

Since Ethereum behaves somewhat like a business, with the added benefit of its own currency, we can analyze its strategic position as a business. It benefits from branding and network effects.

In March, Ethereum co-founder Vitalik Buterin wrote an article titled "The Most Important Scarce Resource Is Legitimacy," in which he argued that the real value of any crypto asset is not actually owning the thing, but legitimacy. sex. He defines legitimacy this way:

Legitimacy is a mode of higher order acceptance. A result is orthodox in a social setting if it is widely accepted by the people in that setting to play their part in crafting that result, and everyone does it because they expect everyone else to do the same.

If people believe that other people believe something, it makes more sense for them to also believe that thing and act accordingly. On the popular ethereum podcast Bankless, hosts Ryan Sean Adams and David Hoffman refer to orthodoxy as "the theory of everything crypto." They list a series of questions people often ask about spaces:

Why Are Cryptocurrency Transactions Exceeding $2 Trillion? Why are NFTs valuable? Why can't you fork your own Bitcoin and make it valuable? Why are we confident that Ethereum’s monetary policy will only shift in the direction of reducing inflation?

According to Adams and Hoffman, the answer to all these questions is orthodoxy.

In this blog post, Vitalik highlights six ways in which legitimacy arises. Here are two that are particularly relevant:

Legitimacy of performance: A process can acquire legitimacy if its output leads to results that people are satisfied with (for example, successful dictatorships are sometimes described in this way).

Continuity of orthodoxy: If something is legal at time T, by default it is legal at time T+1.

Performance and continuity create the Lindy Effect, where the longer something lasts, the longer it is expected to last. Something that has been around for a year is expected to be around for another year, but something that has been around for 100 years is expected to be around for another 100 years.

This is an observable phenomenon. Amazon is more likely to appear 30 years from now than a new startup, our children are more likely to listen to The Beatles than Olivia Rodrigo, and our grandkids are more likely to read Socrates than Dan Brown.

Legitimacy helps explain the Lindy Effect, the idea that the longer something has been around, the more likely people are to expect others to keep using it. In the case of Ethereum, more DApps on Ethereum means more users on Ethereum, and more users means more developers building DApps makes sense.

iOS is an example of a two-way network effect of a platform. The more people who own iPhones, the more likely developers are to create iPhone apps, and the more iPhone apps, the more likely people are to buy iPhones. In Apple's case, this network effect is so powerful that it takes a 30% cut of all App Store revenue.

What makes ethereum’s network effects potentially stronger and potentially more durable is that it aligns incentives in a way that traditional software doesn’t.

Both users and developers hold ETH and benefit from its appreciation. With the merger of EIP-1559 and ETH 2.0, the more ETH is used, the more value its holders will receive. Also, the more valuable ETH is, the harder it is to attack.

In "Ethereum: A New Currency Model," Hoffman says that fees paid to Ethereum validators act as a wall protecting Ethereum: "The height of the wall is highly correlated with the total fees generated by the network. The wall's Height is the price of attacking Ethereum.”

Solana’s Ben Sparango went a step further when we spoke, explaining to me that it’s in the best interest of all parties involved that the underlying blockchain be worth more than all the DApps built on top of it. If this is not the case, bad actors are incentivized to spend their time attacking the blockchain to drain the value of their DApps.

What this means is pretty crazy: projects built on top of certain blockchains are actually financially incentivized to support the value of the underlying blockchain in order to protect their projects. They don't pay for AWS or security software; hosting and security are provided by the blockchain.

This is a platform network effect that is different from other platforms. It's hard to imagine an app voluntarily paying to drive up Apple's stock price.

In the traditional software industry, the "Bill Gates Line", coined by Ben Thompson, describes what makes something a platform:

A platform is when the economic value of everyone using it exceeds the value of the company that created it, and then it becomes a platform.

Ethereum has a built-in Bill Gates thread. By owning and using ETH, and by using it to make ETH more valuable, everyone using Ethereum is worth more than Ethereum itself. However, they are also incentivized to make Ethereum more valuable in the process. It blurs the Bill Gates line by tightly aligning incentives to make the Bill Gates line irrelevant.

Importantly, this wall is also why narrative is so important, and why narrative reflexivity is so powerful in cryptocurrency. More demand for ETH doesn't just increase the price; it shifts some of the security burden from builders to investors, raises the wall, makes the network more secure, and increases the attractiveness of building on Ethereum, which makes ETH more affordable. valuable. It's a narrative-led flywheel.

As a result, due to Ethereum's shortcomings thus far, several L1 competitors have sprung up in an attempt to challenge Ethereum's dominance.

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04 Ethereum’s Bull Scenario

More demand and less supply leads to higher prices. The more fees, the fewer tokens.

EIP 1559 and ETH 2.0 will pass smoothly. It's certainly a risk, but people seem optimistic.

Ethereum will still be the main L1 of web3. At this point, Ethereum’s network effects are too strong to overcome. Developers, users, and even other L1s build on or are compatible with Ethereum.

If you believe all of these things, here's what the next bull market looks like.

demand will rise

In the past year, from DeFi to NFT to the virtual world, there has been a substantial increase in demand in all categories. Transaction fees have increased by a factor of 200. All of this happens with poor availability and exorbitant gas costs.

The past year has been worse than ever for Ethereum. It only gets better from here, for several reasons. First, assuming the EIP 1559 and ETH 2.0 merger goes according to plan, transaction speeds will increase and gas fees will become lower and more predictable. Transactions will be easier and cheaper. Lower transaction fees and faster transaction times should lead to more transactions.

Second, short-term bubbles are useful in the long-term, even if what we have just experienced is a bubble. They attract money and talent into this space, and the money and talent will come together to create new products that attract new users and more demand.

In the past few months alone, I've seen dozens of strong teams leave traditional startups to build web3 products, many of them on top of Ethereum. More products and better experience will attract more users. ETH is an exponential bet on this growth rather than a bet on the success of any one project.

Strong trends, lower prices, better experiences and new products = growing demand.

reduced supply

For many ETH bulls, this is the crux of the argument: EIP 1559 means ETH becomes deflationary.

The upper limit of bitcoin issuance is 21 million. This is the strongest bull case for BTC yet. You can't print more money like an evil central bank, it's a mathematical thing and limited.

The supply of Ethereum is currently unlimited. In theory, enough Ethereum users could decide to keep issuing ETH and increase the supply. If you're going to own inflationary assets, why not just use fiat money?

But EIP 1559 and Eth2 reversed that. With ETH 2.0, the new issuance that rewards validators is expected to drop significantly. Using EIP 1559, by burning ETH on every transaction, assuming the daily transaction fee is conservative and 70% of the gas fee is burned and 30% is sent as a tip, then more ETH will be burned per day than issued.

Even crazier, if people and institutions are holding BTC due to its use as a non-inflationary store of value, are they likely to switch to Ethereum? Can Ethereum surpass Bitcoin as the most valuable cryptocurrency?

Increase in value for ETH holders

ETH ownership also grants the Ethereum network the right to work as a validator and receive a portion of the fees.

In Proof of Work, miners need to sell the ETH they earn to cover costs. According to another Justin Drake model, today, this created a daily sell pressure of 22.3k ETH, which means that about $50 million worth of ETH is being dumped into the market every day.

Additionally, value is not leaked from the Ethereum system, but is attributed to validators. Another Drake model estimates that people who stake their ETH (meaning locking it up to secure the network) earn a 25% annual interest rate.

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05 Risks, warnings and conclusions

Part of the reason I'm so bullish on ETH assets is that I'm excited about the potential of Ethereum technology. Last weekend showed how volatile cryptocurrencies are, and how everything is still tied to Bitcoin. If you're doing a quick transaction in ETH, this weekend can be disgusting. If you're in it because you want to learn and explore web3, this is a great opportunity to buy more tokens and play for half the price.

Despite my overall bullishness, there are real risks to Ethereum, both macro and concrete.

On the macro level, what if there is a thunderstorm on Terher? What would happen if the government cracked down on cryptocurrencies in general? What if rates rise early and risky assets shrink? What if Musk tweets again? One of the scariest things about last weekend's sell-off is that there was no apparent catalyst. The crypto market can be crazy.

Somewhere between the micro and the macro, there is a question: what if people outside of the early adopters really don't care about decentralization? What if a more centralized solution like Binance Smart Chain with a built-in user base of millions trading on Binance is decentralized enough and performs better?

On the micro level, Ethereum faces some practical challenges. What if EIP 1559 does not pass as planned? What if the launch of Eth2 is delayed? What if sharding doesn't work as planned and creates more problems than improvements? One very real possibility is that sharding makes the Lego blocks built on Ethereum less composable, undermining one of the most exciting aspects of the network.

Perhaps the biggest problem facing ETH is adopting a decentralized layer 2 scaling solution. While L2 solutions have the potential to significantly improve performance, they present a major challenge that adopting a fragmented L2 solution may make composability more difficult, because executing in L2, solving on L1, Then go back to another L2 for another part of the transaction.

Ideally, one or two L2 solutions would win, but a world of multiple L2s could strengthen Ethereum's network effects while weakening the product experience.