10 years later, can the market value of Ethereum reach 3.2 trillion US dollars?
Original title: "A Guide to Understanding ETH as an Investment"
Original Author: Kevin Hu, Celia Wan
Original compilation: 0x88, 0x71
Asset valuation has always been a topic widely discussed by investors. The different attributes of assets determine the selection of an appropriate valuation model, and the narrative of the asset subject determines the imagination of the asset. Compared with traditional financial assets, the valuation of on-chain assets is more difficult and uncertain. From the S2F model to the Fisher equation, different investors use different models to evaluate different assets.
This article comes from Dragonfly Research, which details the current situation and future development trend of Ethereum, and evaluates the value of ETH from the multi-dimensional asset attributes of ETH. Rhythm BlockBeats translated the original text:
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overview
Bitcoin was born in 2009 and became the first trustless, digital native currency. Due to its scarcity and unforgeability, it has the potential to become a global non-sovereign store of value. As a large number of institutions began to accept Bitcoin in the second half of 2020, Bitcoin's status as digital gold was strengthened. Eleven years after Bitcoin was created, institutional investors are finally getting into Bitcoin as the simple yet powerful store of value goes mainstream.
On the other hand, investors are at a loss to understand Ethereum and its native asset, ETH. Smart contracts, decentralized finance and Web 3.0 are still niche topics. As a complex asset, ETH is difficult to define precisely even for full-time workers in the encryption industry.
By design, ETH is the gas fee for the Ethereum network, also commonly referred to as the "world computer". But what is the "world computer" for? Is ETH a consumable, a capital asset, or a programmable collateral/currency? How does ETH increase in value?
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Today's popular (but slightly outdated) ETH economic analysis
The current version of Ethereum is similar to a distributed operating system and uses the system's native token ETH to pay for computing costs. Miners who provide computing resources to the system are rewarded with block rewards and transaction fees. Historically, ETH’s block rewards have been adjusted for specific transactions, making ETH’s monetary policy more aggressive than Bitcoin’s.
In the current model, Ethereum users pay transaction costs in ETH, and ETH holders bear the cost of inflation. Implicitly, in the absence of speculative sentiment, ETH holders are betting that the rate of demand for ETH for Ethereum applications will exceed the inflation rate of Ethereum block rewards (ETH block rewards have historically fluctuated widely ).
A popular economic analysis model for ETH today considers Ethereum as an economy, expressing the total value generated in the network as GDP. Then, we can calculate the value of the Ethereum network according to the formula of PQ = MV. Among them, the product of price multiplied by quantity (total output) must be equal to the money supply multiplied by the currency turnover rate. Therefore, the total value of the Ethereum network is equal to the total amount of ETH in circulation multiplied by the ETH turnover rate.
A common guess is that in the long run, the GDP of the Ethereum network may be substantial, but not too large, because it is limited by the deflationary nature of the computational cost, because the use of the Ethereum network must be very cheap to be able to achieve large-scale use. The turnover rate of ETH can also be very high, because users have no reason to hold this frictionless payment tool. As a result, ETH could be relatively cheaply valued and still be able to support a relatively large economy. Under this framework, ETH cannot capture significant economic value because it is a completely fungible commodity that does not need to be held for a long time.
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latest progress
While the logic behind the PQ = MV argument is sound, the theory has yet to manifest itself in reality. Ethereum is still far ahead in terms of user usage and developer acceptance. Its network effects don’t seem to be waning, with ETH’s market cap 5x larger than that of the Layer 1 #3 project.
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The average gas cost of Ethereum (to reflect the purpose, source: Etherscan)
DeFi has become the first widely used application on the Ethereum network. At present, DeFi has an AUM of 60 billion US dollars (peaking at more than 120 billion US dollars in early May 2021), a loan scale of more than 17 billion US dollars, and an average daily transaction volume of 5 billion US dollars. Collectively, these DeFi applications generate more than $4.5 billion in annual revenue (represented by fees paid to protocols over the past 30 days) and have built significant liquidity to create network effects.
At present, the Ethereum ecology has formed a positive feedback closed loop. Users not only bring liquidity-based network effects to DeFi, but also benefit from the liquidity of the DeFi market. As more and more assets are locked in DeFi, slippage in automated market maker (AMM)-based decentralized exchanges, and borrowing costs on lending platforms have repeatedly dropped, making DeFi more attractive to users (Although there is no network effect between liquidity pools, the overall network should have a sub-linear relationship with the total amount of USD locked).
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DeFi total locked positions (source: DeBank)
From an architectural point of view, Ethereum will usher in the biggest changes next, namely Ethereum 2.0, Layer 2 and EIP-1559. Without elaborating on the technical details, Ethereum 2.0 will transform the Ethereum network from a proof-of-work consensus mechanism to a proof-of-stake consensus mechanism. Instead of using computing resources to verify the next block, Ethereum 2.0 will rely on ETH holders (verifiers) to vote for the next block, building a security model based on game theory and economics. Ethereum 2.0 will also divide the network into 64 pieces, which will allow the network to run in parallel and leave room for future expansion.
In the short term, Layer 2, especially the Rollup scheme based on fraud proof and zero knowledge proof, may optimize the scalability and cost of use of the Ethereum network by an order of magnitude. Ethereum currently handles about 15-17 transactions per second (tps). We expect that the next changes will increase the throughput of Ethereum on Layer 2 to 2000+ tps (on-chain data) and 9000+ tps (off-chain data). Layer 2 will also significantly reduce transaction costs. Today, a typical DeFi transaction costs between $10 and $100+, which daunts most applications and users. Layer 2 will likely compress DeFi transaction costs to less than 1 dollar (sometimes as low as 10-20 cents), increasing the usability of DeFi and Ethereum by 100 times.
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Where are we now?
As exciting as the Ethereum story we are telling so far is that DeFi has already had a lot of appeal to a limited user base through the ephemeral liquidity mining and project ID0 mechanism. However, the development of various projects on Ethereum has made the PQ = MV valuation model obsolete, and the new method of evaluating ETH needs to constantly adapt to the rapid development of the Ethereum network.
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Ethereum as the financial layer of the future
Ethereum enables contracts to be executed automatically without a trusted third party. Various token standards allow assets other than ETH to exist in the network. In short, the code determines the value and ownership in the Ethereum network, which also makes Ethereum an alternative to traditional financial transactions and settlements. As technology improves and transaction costs fall, Ethereum and DeFi will enable many new use cases that are not possible today.
We believe that Ethereum and DeFi have the potential to disrupt traditional finance for the following reasons:
- Speed of permissionless innovation in software: All DeFi protocols are open source and composable. DeFi innovators can restructure and innovate financially with incredible speed, and they can reach users around the world with almost no fixed costs.
- Consistent incentives: Through a reasonable token mechanism design, all stakeholders in the ecosystem (protocols, users, liquidity providers, engineers/protocol maintainers) will be motivated, and the cold start of growth will not require too much upfront cost.
- Reduce costs: DeFi has no legal, labor, compliance, and infrastructure-related costs. Traditional financial transactions are established within a legal system enacted and enforced by governments. In complex situations such as bankruptcy and liquidation, recourse can be costly and opaque. These costs do not exist in DeFi, because all value is completely controlled by code.
-Frictionless Funds & Instant Liquidation: Funds within DeFi can flow frictionlessly, programmably, and be liquidated at sub-minute levels—a truly digitally native experience. In contrast, in the traditional world, payment rails from different jurisdictions cannot communicate with each other (better after the emergence of companies like Stripe and Plaid). These processes need to be done manually, and many systems are decades old.
-Mass Customization & Synthetic Assets: Just as the internet enabled companies to reach diverse niche users, DeFi gives users access to almost every asset in the world. Today, through AMMs like Uniswap, anyone can create a new trading pair as long as they hold the corresponding asset. Synthetic assets are taking this one step further. In theory, anyone with a trusted source of data can create synthetic assets by providing on-chain collateral. Synthetix, UMA, Mirror, and many other teams are exploring in this direction.
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ETH as a capital asset
ETH's function as the default form of payment for Ethereum network activity gives it a fairly straightforward value-based pricing model. This will become more apparent once the network upgrades to Ethereum 2.0 and EIP-1559. Even though other tokens, such as stablecoins, may replace ETH as a payment alternative in the future, ETH will still be used by network validators for staking and receiving rewards. Therefore, ETH may accumulate value from demand like a consumable, and from cash flow like a capital asset.
Let’s say 10 years from now, the Ethereum network is processing 4 billion transactions worth $5 trillion a day. $5 trillion a day represents a growth rate of 74%. This seems reasonable if you believe that Ethereum will develop like the early Internet.
If you look at the growth record of Ethereum, the numbers mentioned above actually underestimate Ethereum. Ethereum is currently processing $8 billion in ETH and $10 billion in stablecoin transactions per day (this is an underestimated total since we exclude other ERC-20 transactions), an increase of 6 each from 2019 to 2020 times and 15 times.
In this case, the number of transactions is the more aggressive assumption (1.2 million transactions per day to 4 billion transactions per day, which is a 125% annual growth rate), but if Ethereum is cheap and scalable to Programmable micropayments between contracts, then this assumption is reasonable. After more than three years, Ethereum is finally on the cusp of releasing its scaling solution. As we have highlighted before, the cost of DeFi transactions may be reduced by 20-50 times in the next 6-12 months, which may make the number of transactions increase exponentially.
It is also conceivable that in the future, high value transactions differentiated (not necessarily in dollar value, but possibly extractable value) should be billed based on transaction value (fee as a percentage of transaction value), and low value transactions should be based on Standard for everyday use (fees vary slightly based on network usage).
High-value transactions should be value-oriented, because transaction ordering is a critical part of blocks in the Ethereum network, especially when transactions are profitable for users. Today, high-value transactions are often frontrunned, which is nearly impossible to prevent (see Ethereum Dark Forest), unless the transaction is sent to a private mining pool (which may charge a fee based on the transaction value). Some teams are working hard to find solutions to create an orderly market for MEVs, which may be possible in the medium term.
However, there will always be transactions that are worth much more than the base fee (such as highly competitive arbitrage transactions), so these transactions need to pay a high tip in order to be processed first. Although these transactions represent only a small fraction of the entire network.
In EIP-1559, the value-based transaction fee rate will be normalized in the form of tip payments to miners/validators (may not be based on ETH), while the daily transaction base fee will be based on ETH and will be destroy. Unlike in Ethereum 1.0, where miners get all fees, after EIP-1559 is implemented, the value generated by both base fees and tips will be captured by ETH holders. The base fee will create a deflationary effect and generate demand for ETH, while the tip (no matter what asset is backed) will become a cash flow for ETH miners/stakers (who are also ETH holders).
Let's do some rough math with the assumed numbers above, and assume the following (these numbers are for this example only):
-5% of the $5 trillion will be high-value transactions with a transaction fee rate of 0.05% of transaction value. Most of these transactions are likely to come from DeFi applications.
- Base fees average $0.01 per transaction, 4 billion transactions per day.
- At this stage, Ethereum is fairly mature and fee growth will be reduced to an eternal 5% annual increase.
- In the long run, the economy's long-term risk-free rate is 2%. ETH stakers will need another 5% yield to compensate for slashed and technical risks (these risks will stabilize in the long run, so 5% is enough), which brings the long-term required yield of ETH to 7%.
Based on the above assumptions, Ethereum will generate $60.2 billion in annual fee revenue. This is only 18 times more than today, while the transaction volume and number of transactions have increased by 250 times and 3300 times respectively. Such is the deflationary power of technology!
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Ethereum as a monetary asset
The value of Ethereum comes from two aspects. The first is its practical value, as stated in the arguments above. The second source of its value is its currency premium, which stems from its availability as a "money-like" within the Ethereum economy.
ETH is unlikely to succeed as a medium of value exchange and unit of account. In an extreme ETH bull market, which could happen, ETH could become a mainstream currency if the network becomes ubiquitous and its fees stabilize. In general, this is highly unlikely, and even if Ethereum does end up being the dominant platform, stablecoins are inherently better on both counts. Today, the overall on-chain transfer volume of ERC-20 stablecoins has surpassed ETH ($10 billion per day vs. $8 billion per day), even though ETH has 5 times the market cap of stablecoins. The difference in off-chain transaction volume between stablecoins and ETH is even greater.
However, as a non-sovereign store of value, ETH may still have an opportunity to gain some potential market share by serving as collateral in DeFi.
In the long run, it is conceivable that ETH could even compete with Bitcoin in terms of scarcity, durability, and unforgeability, for the following reasons:
1. ETH’s monetary policy will stabilize and its inflation rate will be halved (from 4% to 2%, according to Tim Roughgarden) due to EIP-1559. Of course, this is still somewhat different from a fixed total supply, but assets with low inflation rates are also good.
2. The security model of Ethereum 2.0 will eventually be tested on a large scale like Bitcoin (20 years later, Bitcoin will only exist 20% longer than Ethereum). In addition, if ETH is valuable enough, the PoS mechanism of Ethereum 2.0 may increase the security of Ethereum (we admit that this idea is circular).
3. Similar to BTC, ETH, as the first mortgage asset of DeFi, has a strong Lindy effect. History tells us that the adoption of a new technology/asset/product is extremely dependent on its path. Usually, having a better distribution channel (allocation ratio) is more important than having a better product/technology. If Ethereum and DeFi can really become the financial layer of the future, ETH is likely to remain one of the main collaterals, because it is the first large-scale collateral, and the DeFi ecosystem is built around it.
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Potential Valuation of ETH
The narrative of Ethereum is very complex, and it is even more challenging to map the various value growth mechanisms of ETH. We believe that the underlying value of ETH should be the sum of these categories of value: 1) consumables, 2) capital assets, and 3) currency value (broken down by its payment and store of value functions).
According to our above speculation, in the future, the total potential value of ETH will be between 3.7 trillion and 4.7 trillion US dollars, and based on the following parts:
1. The valuation of ETH as a consumable will be limited by its high flow rate.
2. The valuation of ETH as a capital asset with cash flow may only be in the early ten trillion. The $3.2 trillion is what we extrapolate from a conceivable success story.
3. The monetary value of ETH may be between 0.5 and 1.5 trillion US dollars. We assume that the value of the ETH payment function will cease to exist, and all the monetary value of ETH will come from non-sovereign value storage tools driven by DeFi.
Important Note: These numbers are by no means exact predictions. We use this thought exercise to help readers understand the potential impact of the Ethereum network and the corresponding value of ETH. Its purpose is to highlight Ethereum's underlying narrative and give readers a mental model of how ETH will increase in value. We did not make probability adjustments or apply appropriate discount rates for many risks (eg, technology, competition, regulation). A savvy investor needs to take these risks into account to finally measure the risk and return of ETH as an investment target.
