Introduction
Asset valuation is a widely discussed topic among investors. Different asset attributes determine the appropriate valuation models, while the narrative of the asset subject shapes its potential. Compared to traditional financial assets, valuing on-chain assets is more challenging and uncertain. From the Stock-to-Flow model to the Fisher equation, investors use various models to assess different assets.
This article explores Ethereum's current status and future development trends, evaluating ETH's value from multiple dimensions. It aims to help readers understand the potential impact of investing in Ethereum and its native asset, ETH. Please note that this article does not attempt precise valuation or price predictions and should not be considered investment advice.
Overview
Bitcoin, launched in 2009, pioneered trustless, digital-native currency. Its scarcity and unforgeability position it as a potential global, sovereign-agnostic store of value. By late 2020, institutional adoption solidified Bitcoin's status as digital gold. Eleven years after its inception, institutional investors finally began investing in Bitcoin as this simple yet powerful store of value went mainstream.
In contrast, investors often find Ethereum and its native asset, ETH, perplexing. Smart contracts, decentralized finance (DeFi), and Web 3.0 remain niche topics. ETH is a complex asset, and even full-time crypto professionals struggle to define it precisely.
By design, ETH serves as gas for the Ethereum network, often dubbed the "world computer." But what is the purpose of a "world computer"? Is ETH a consumable, a capital asset, or programmable collateral/currency? How does it appreciate in value?
A unique narrative for ETH has yet to fully form. The remainder of this article will explore ETH's emerging attributes, helping investors understand what they are betting on when investing in ETH.
Popular but Outdated ETH Economic Analysis
The current version of Ethereum resembles a distributed operating system, using its native token, ETH, to pay for computational resources. Miners providing these resources earn block rewards and transaction fees. Historically, ETH's block rewards adjust based on specific transactions, making its monetary policy more active than Bitcoin's.
In this model, Ethereum users pay transaction costs in ETH, and ETH holders bear inflation costs. Implicitly, without speculative sentiment, ETH holders bet that the demand rate for ETH from Ethereum applications will exceed the inflation rate of Ethereum block rewards (which has historically fluctuated significantly).
A popular economic model views Ethereum as an economy, representing the total value generated by the network as GDP. Using the equation PQ = MV, where price multiplied by quantity (total output) must equal the money supply multiplied by velocity, the total value of the Ethereum network equals the circulating supply of ETH multiplied by its turnover rate.
A common speculation is that, long-term, Ethereum's GDP might be substantial but not enormous due to constraints from computational costs. The network must remain cheap to achieve mass adoption. ETH's turnover rate could also be very high, as users have no reason to hold a frictionless payment tool. Consequently, ETH's valuation might remain relatively low while supporting a relatively large economy. In this framework, ETH cannot capture significant economic value as it is a fully fungible commodity不需要 long-term holding.
This argument hinges on:
- ETH's only function is payment.
- The open-source nature of public chains makes it impossible to retain IP value.
- The cost for applications to switch chains is接近 zero.
Resultantly, Ethereum exhibits weak network effects, and ETH should be priced like a commodity, as users won't pay more than the production cost.
Latest Developments
While the logic behind the PQ = MV argument is sound, reality hasn't reflected this theory. Ethereum still leads significantly in user adoption and developer acceptance. Its network effects seem undiminished, with ETH's market cap five times larger than the third-largest Layer 1 project.
Today's Ethereum is very different from two years ago. In 2017 and 2018, its primary use was for ICOs (most of which were worthless). Now, Ethereum supports a thriving DeFi ecosystem, alongside NFTs, gaming, the metaverse, and other Web 3.0 developments.
DeFi has become the first widely used application class on Ethereum. Currently, DeFi boasts $60 billion in AUM (peaking at over $120 billion in early May 2021), over $17 billion in loans, and facilitates an average of $5 billion in daily trading volume. Overall, these DeFi applications generate over $4.5 billion in annual revenue (fees paid to protocols over the past 30 days represent earnings) and have established considerable liquidity, creating network effects.
A positive feedback loop has formed in the Ethereum ecosystem. Users bring liquidity-based network effects to DeFi and benefit from its market liquidity. As more assets are locked in DeFi, slippage on automated market maker (AMM) decentralized exchanges and borrowing costs on lending platforms decrease, making DeFi more attractive (though liquidity pools themselves don't have network effects, the overall network should have a sub-linear relationship with total locked value).
Furthermore, the composability and interoperability of DeFi protocols create a lock-in effect for Ethereum, making it difficult for other Layer 1 projects and sidechains to compete. To rival Ethereum, other chains must cultivate a complete DApp ecosystem and provide liquidity from scratch, requiring significant work and substantial token subsidies. Indeed, chains like Polygon and BSC have succeeded by replicating Ethereum's DeFi applications, offering low gas fees, and liquidity mining campaigns.即便如此, cross-chain connections between these公链 disrupt DeFi protocol composability, forcing Layer 1 projects to develop independent ecosystems.
Architecturally, Ethereum's next significant changes include Ethereum 2.0, Layer 2, and EIP-1559. Without delving into technical details, Ethereum 2.0 will transition the network from proof-of-work to proof-of-stake consensus. Instead of using computational power to validate the next block, Ethereum 2.0 will rely on ETH holders (validators) to vote on the next block, establishing security based on game theory and economics. Ethereum 2.0 will also shard the network into 64 pieces, enabling parallel operation and future scalability.
Recently, Ethereum might adopt a new monetary policy, EIP-1559. This proposal modifies the transaction fee algorithm. For this analysis, the most crucial change is that EIP-1559 causes most Ethereum transaction fees to be burned instead of paid to miners. If proof-of-stake and EIP-1559 are implemented, ETH's inflation will significantly decrease, transforming it into a capital asset alongside its consumable property. This will profoundly impact ETH's value appreciation. More on this later.
Where Are We Now?
As exciting as Ethereum's story is, DeFi has primarily attracted a limited user group through short-lived liquidity mining and project IDO mechanisms. However, the development of various projects on Ethereum has rendered the PQ = MV valuation model outdated. New methods for evaluating ETH must continuously adapt to the network's rapid evolution.
The next three sections introduce different approaches to defining ETH qualitatively and quantitatively, aiding in its ultimate assessment. It's worth reiterating that these mechanisms and final evaluations should not serve as definitive judgments on ETH. Nonetheless, this remains an excellent attempt to understand ETH as an asset and Ethereum as a platform.
Ethereum as the Future Financial Layer
Ethereum enables contracts to execute automatically without trusted third parties. Various token standards allow assets other than ETH to hold value on the network. In summary, code dictates value and ownership on Ethereum, making it an alternative for trading and settlement in traditional finance. As technology improves and transaction costs decline, Ethereum and DeFi will enable many new use cases impossible today.
We believe Ethereum and DeFi have the potential to disrupt traditional finance for several reasons:
- Permissionless innovation speed: All DeFi protocols are open-source and composable. DeFi innovators can recombine and innovate financially at astounding speeds, reaching global users with almost no fixed costs.
- Aligned incentives: Through proper token mechanism design, all stakeholders (protocols, users, liquidity providers, engineers/maintainers) are incentivized, enabling growth cold starts without excessive upfront costs.
- Reduced costs: DeFi lacks costs associated with law, labor, compliance, and infrastructure. Traditional financial transactions operate within government-enforced legal systems. Recourse costs in complex situations like bankruptcy liquidation are high and opaque. These costs are absent in DeFi, as code entirely controls all value.
- Frictionless funds and instant settlement: Funds within DeFi move frictionlessly and programmatically, settling in sub-minute intervals—a truly digital-native experience. In contrast, payment rails from different jurisdictions in the traditional world don't interconnect seamlessly (improved somewhat by companies like Stripe and Plaid). These processes require manual intervention, and many systems are decades old.
- Mass customization and synthetic assets: Just as the internet enabled companies to reach niche users, DeFi allows users to access almost any global asset. Today, via AMMs like Uniswap, anyone can create a new trading pair if they hold the relevant assets. Synthetic assets take this further. Theoretically, with a reliable data source, anyone can create synthetic assets by providing on-chain collateral. Teams like Synthetix, UMA, and Mirror are exploring this direction.
- Government neutrality: The financial system built on Ethereum is open and accessible to anyone. While less appealing to users in countries with mature financial systems like the US, it offers unparalleled advantages for those in regions with inefficient and corrupt local financial systems.
ETH as a Capital Asset
ETH's function as the default payment form in Ethereum network activities gives it a relatively straightforward value-based pricing model. This will become more apparent once the network upgrades to Ethereum 2.0 and implements EIP-1559. Even if other tokens, like stablecoins, might replace ETH as payment alternatives, ETH will still be used by network validators for staking and receiving rewards. Thus, ETH could accumulate value from demand like a consumable and from cash flows like a capital asset.
Suppose in 10 years, the Ethereum network processes 4 billion transactions daily, valued at $5 trillion. $5 trillion daily represents a 74% growth rate. If you believe Ethereum will develop like the early internet, this seems reasonable.
Looking at Ethereum's growth record, these numbers might even underestimate it. Currently, Ethereum handles $8 billion in ETH and $10 billion in stablecoin transactions daily (an underestimate, as we exclude other ERC-20 transactions), growing 6x and 15x from 2019 to 2020, respectively.
In this scenario, the number of transactions is a more aggressive assumption (from 1.2 million daily to 4 billion daily, a 125% annual growth rate), but it is plausible if Ethereum fees are cheap and scalable to programmable micro-payments between contracts. After over three years, Ethereum is on the verge of releasing its scaling solutions. As emphasized earlier, DeFi transaction costs could decrease 20-50x in the next 6-12 months, potentially enabling exponential transaction growth.
It's also conceivable that in the future, high-value transactions (not necessarily by dollar value but perhaps by extractable value) should be fee-based (a percentage of transaction value), while low-value transactions should be based on standard usage (fees varying slightly with network usage).
High-value transactions should be value-based because transaction ordering within Ethereum blocks is crucial, especially when transactions can yield user profits. Today, high-value transactions are often front-run, nearly impossible to prevent (see Ethereum's dark forest), unless sent to private mining pools (which might charge value-based fees). Some teams are working on solutions to create an orderly market for MEV, achievable in the medium term.
However, there will always be transactions where value far exceeds the base fee (e.g., highly competitive arbitrage trades), requiring high tips for priority processing. Though these constitute a tiny portion of the network.
In EIP-1559, value-based transaction fees are formalized as tips to miners/validators (possibly not ETH-denominated), while routine transaction base fees are ETH-denominated and burned. Unlike Ethereum 1.0, where miners receive all fees, post-EIP-1559, value from base fees and tips will be captured by ETH holders. Base fees create deflationary effects and generate demand for ETH, while tips (in any asset) become cash flow for ETH miners/stakers (who are also ETH holders).
Let's use the hypothetical numbers above for rough calculations, assuming:
- 5% of $5 trillion will be high-value transactions with a 0.05% fee rate. Most might come from DeFi applications.
- The average base fee is $0.01 per transaction, with 4 billion daily transactions.
- At this stage, Ethereum is mature, with fee growth reduced to a perpetual 5% annual increase.
- In the long term, the economy's long-term risk-free rate is 2%. ETH stakers will require an additional 5% return to compensate for slashing and technical risks (these will stabilize long-term, so 5% suffices), making ETH's long-term required yield 7%.
Under these assumptions, Ethereum would generate $60.2 billion in annual fee revenue. This is only an 18x increase from today, while transaction volume and count increase 250x and 3300x, respectively. This is the deflationary power of technology!
Finally, pricing ETH as a capital asset using a dividend growth model, with the above revenue of $60.2 billion, implies a final value of $3.2 trillion for ETH in 10 years. While this seems enormous, it's a decade away and doesn't account for any risk factors (e.g., technical, competitive, regulatory). Savvy investors need to calculate with appropriate probabilities or discount rates.
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Ethereum as a Monetary Asset
Ethereum's value stems from two aspects. First, its utility value, as argued above. The second source is its monetary premium, derived from its use as a "currency-like" asset in the Ethereum economy.
As a medium of exchange and unit of account, ETH is unlikely to succeed. In an extreme ETH bull case, this might occur if the Ethereum network becomes ubiquitous and its fees stabilize, enabling ETH to become a mainstream currency. Generally, this possibility is small; even if Ethereum becomes the dominant platform, stablecoins are inherently better suited for both roles. Today, the total on-chain transfer volume of ERC-20 stablecoins already exceeds ETH ($10 billion daily vs. $8 billion daily), despite ETH having five times the market cap of stablecoins. The difference in off-chain trading volume between stablecoins and ETH is even more significant.
However, as a sovereign-agnostic store of value, ETH might still gain some market share by serving as collateral in DeFi.
Long-term, it's conceivable that ETH could even compete with Bitcoin in scarcity, durability, and unforgeability, due to:
- ETH's monetary policy will stabilize, with its inflation rate halved by EIP-1559 (from 4% to 2%, according to Tim Roughgarden). Of course, this differs from a fixed total supply, but low-inflation assets are still valuable.
- Ethereum 2.0's security model will eventually undergo large-scale testing like Bitcoin (in 20 years, Bitcoin will only have existed 20% longer than Ethereum). Additionally, if ETH is valuable enough, Ethereum 2.0's PoS mechanism might enhance Ethereum's security (we acknowledge this circularity).
- Similar to BTC, ETH, as DeFi's first collateral asset, benefits from a strong Lindy effect. History shows that adopting new technologies/assets/products heavily depends on path dependency. Often, better distribution beats better product/technology. If Ethereum and DeFi truly become the future financial layer, ETH will likely remain a primary collateral, as it was the first at scale, and the DeFi ecosystem built around it.
Nonetheless, if Ethereum and DeFi continue growing, ETH might capture 10% of Bitcoin's market share. Assuming Bitcoin's potential market cap is between $4.7-14.6 trillion, ETH's potential monetary value could range from $0.5-1.5 trillion.
Potential Valuation of ETH
Ethereum's narrative is complex, and mapping ETH's various value appreciation mechanisms is even more challenging. We believe ETH's potential value should be the sum of these categories: 1) consumable, 2) capital asset, and 3) monetary value (subdivided into payment and store-of-value functions).
Based on our above speculations, ETH's total potential value in the future could range from $3.7 to $4.7 trillion, derived from:
- ETH's valuation as a consumable is limited by its high velocity.
- ETH's valuation as a capital asset with cash flows might be just over a trillion dollars. $3.2 trillion is extrapolated from one conceivable success scenario.
- ETH's monetary value might be between $0.5 and $1.5 trillion. We assume ETH's payment function value will disappear, and all its monetary value will come from being a DeFi-driven, sovereign-agnostic store of value.
Important Note: These numbers are by no means precise predictions. We use this thought exercise to help readers understand the Ethereum network's potential impact and ETH's corresponding value. The goal is to highlight Ethereum's potential narrative and provide readers with a mental model for ETH value appreciation. We haven't adjusted for many risks (e.g., technical, competitive, regulatory) with probabilities or appropriate discount rates. Savvy investors must consider these risks to ultimately gauge ETH's risk and return as an investment.
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Frequently Asked Questions
What is the primary use of ETH?
ETH serves as the native cryptocurrency for the Ethereum network, primarily used to pay for transaction fees (gas) and computational services. It also acts as collateral in DeFi applications and is staked for network security in Ethereum 2.0.
How does EIP-1559 affect ETH's value?
EIP-1559 introduces a fee-burning mechanism that destroys a portion of transaction fees instead of giving them to miners. This reduces ETH's inflation rate, potentially making it more scarce and valuable over time, similar to a deflationary asset.
Can Ethereum scale to handle global transaction volumes?
With ongoing upgrades like Ethereum 2.0 and Layer 2 solutions, Ethereum aims to significantly increase its transaction capacity and reduce fees. These improvements could enable it to process billions of transactions daily, supporting global adoption.
What risks could prevent ETH from reaching a multi-trillion dollar market cap?
Key risks include technological failures, intense competition from other blockchains, regulatory crackdowns, and unforeseen security vulnerabilities. Each of these factors could impede Ethereum's growth and ETH's value appreciation.
How does DeFi contribute to ETH's value?
DeFi applications lock up ETH as collateral, generate transaction fees, and create demand for ETH through various financial services. This utility enhances ETH's value beyond mere speculation, embedding it deeply in the ecosystem's economy.
Is ETH a better investment than Bitcoin?
ETH and Bitcoin serve different purposes. Bitcoin is primarily a store of value, while ETH offers utility within a vast ecosystem. Investment suitability depends on individual risk tolerance, belief in Ethereum's vision, and portfolio diversification strategy.