Growspace Research: Ethereum (ETH)
Updated: Dec 13, 2022
Introduction
Ethereum is the world’s first programmable blockchain, designed for building apps, holding assets, transacting and communicating without being controlled by a central authority. Ether (ETH), 2nd largest cryptocurrency by market capitalization, is the native currency of the Ethereum network. Ethereum builds on the innovation initiated by Bitcoin. Bitcoin created a decentralized method to make digital payments. Ethereum took things to the next level by incorporating the smart contract functionality for the first time, providing a programmable platform to build real-world applications on blockchain.
Difference between Ethereum, Ether, and ETH: Ethereum is the name of the blockchain network. Ether is the native cryptocurrency of the Ethereum network. ETH is the symbol used to represent Ether. In day-to-day usage, many people call the cryptocurrency ETH, Ether, Ethereum, which might be a source of confusion for some. On a side note, as means of transfer of value and store of value (or investment), both ETH and BTC work in a similar manner.
Value Proposition
Ethereum builds on the foundation laid by Bitcoin. Along with enabling decentralized transactions, Ethereum provides a platform to build decentralized applications (dApps), opening up a whole new world of potential use cases for blockchains. These dApps could range from games to financial services to cloud storage and so much more.
How does Ethereum Work
Key components of the Ethereum are:
1. Smart Contracts: Smart contracts are self-executing contracts with the terms and conditions of the agreement coded in them. Smart contracts live on blockchains and self-execute when the predetermined conditions are met. They make it possible for parties to engage in trusted agreements and transactions without needing a centralized authority.
2. Ethereum Blockchain: The Ethereum blockchain maintains a record of all the past transactions in Ethereum’s entire history. All the transactions are stored in blocks arranged in chronological order, forming a chain of blocks (thus the name ‘blockchain’).
3. Consensus Mechanism: Consensus is the process for nodes on a blockchain network to agree about the current state of the data in the blockchain, basically to agree on which transactions are valid and which are not. Consensus mechanisms are the methods to achieve consensus. There are various kinds of consensus mechanisms with their respective advantages and disadvantages. Although they differ in energy usage, capital requirements etc, their end purpose is to ensure security and maintain the validity of transactions on the blockchain. The most popular ones are Proof of Work (PoW) and Proof of Stake (PoS). Bitcoin and the current version of Ethereum operate on the Proof of Work consensus mechanism, and Polygon, Solana, Cardano etc, operate on the Proof of Stake consensus mechanism.
In PoW, miners compete with each other to solve computationally intensive puzzles. The winner, the miner who is the first one to solve the puzzle, adds the new block and earns block rewards in return. This method has been heavily criticized for its impact on the environment due to its high energy requirements.
In PoS, miners have to lock a certain amount of required cryptocurrency (stake) for the possibility of being selected as a transaction validator. Generally, the higher the staked amount, more the probability of being selected. PoS is a more sustainable method than PoS due to its much lesser energy requirements.
Currently, Ethereum is a Proof of Work blockchain, but post “The Merge” (more on it later), it will become a Proof of Stake blockchain.
4. EVM: EVM stands for Ethereum Virtual Machine. It enables the developers to build and deploy decentralized applications (dapps). It ensures that all the smart contracts developed on Ethereum execute in the expected manner as designed in their code. Basically, EVM is the part that understands code and is in charge of executing what the smart contract is supposed to do.
5. Ether (ETH): ETH is the currency of the Ethereum network. All transactions on the blockchain require users to pay fees in ETH tokens.
Tokenomics
Current circulating supply of Ethereum is 120,297,637.80 ETH (as of 29th Aug 2022) and can be broken down as follows:
Source: https://etherscan.io/stat/supply
A key point to note is that the supply of ETH is not fixed as in the case of Bitcoin. Now let’s understand Ether's supply and demand dynamic.
Key players in the current Ethereum ecosystem (pre Merge):
Token (ETH) holder
Miners
3 critical components of the economic activity on the Ethereum blockchain:
Base fee
Priority fee/ Tip
Block rewards
The fees users (token holders) pay for transactions comprises two components: base fee and tip (or priority fee).
The base fee has a dynamic value depending upon the network congestion. When the block is mined, this base fee component is burned (taken out of circulation), thus reducing the ETH supply (deflationary). The following chart shows the amount of ETH burned per day for the last 300 days. The fluctuation is due to the amount of daily transactions and network congestion (the 2 factors affecting the base fee value)
Source: https://watchtheburn.com/insights
To incentivize miners to validate your transactions more quickly, a higher priority fee has to be paid to outbid the competing transactions. This amount goes directly to the miners and neither increases nor decreases the ETH supply.
Miners also receive block rewards (of 2ETH per block, currently) for mining new blocks. These block rewards increase the ETH circulating supply (inflationary).
The following chart shows the amount of blocks and tips (priority fees) earned by miners per day for the past 300 days.
Source: https://watchtheburn.com/insights
The net effect of the inflationary and deflationary forces on the amount of ETH is shown below. An interesting point to note is that it’s possible for ETH supply to be deflationary if the amount burned (positively correlated with the number of transactions) is high enough to compensate for the inflationary block rewards.
Source: https://watchtheburn.com/insights
Business Model
3 key players of the Ethereum ecosystem are: The Ethereum Foundation, Miners, Tokenholders (ETH holders).
The Ethereum Foundation is a non-profit organization, based out of Switzerland, that supports the growth and fund development of many significant components of the Ethereum ecosystem. Note that they do not own Ethereum, operate it, or manage it. Also, they don’t generate any profits through their involvement in Ethereum, however they hold a substantial amount of Ether (ETH) in their treasury (0.3% of the total ETH in circulation, as of 31st March 2022).
Miners are the ones earning real money through the Ethereum ecosystem. Miners validate the transactions on the Ethereum blockchain and thus keep the network running properly and are rewarded for it. They earn income in 3 ways:
1. Gas fees: This is the transaction fees received from the users.
2. Inflationary rewards/ Block rewards: Miners are rewarded for mining new blocks. The current reward is 2 ETH for mining one block. (Mining refers to the process of creating a new block of transactions to be added to the Ethereum blockchain)
3. MEV: Maximal Extractable Value is the value miners are able to generate in addition to the gas fees and inflationary reward by including, excluding, or changing the order of transactions in a block.
ETH token holders primarily earn through price appreciation and staking on the Beacon chain (either by themselves or through staking service providers like Kraken and Lido).
Competition
Ethereum’s slow transaction speed and high fees have created a way for other blockchains to enter the infrastructure market. Key competitors of Ethereum include Solana, Avalanche, Cardano and Tezos. Although these blockchains have improved upon Ethereum’s weaknesses, they still haven’t been able to catch up to Ethereum in terms of adoption and other key metrics like revenue generated, TVL, and number of developers etc.
Source: https://defillama.com/chains
Above chart shows Ethereum to be a clear winner in terms of the total value locked, representing over 57% of the total TVL of all the existing blockchains.
Source: Token Terminal
As can be seen from the above chart, Ethereum’s revenue is significantly higher than its key competitors, the so-called “Ethereum Killers”
Source: https://github.com/electric-capital/developer-reports/blob/master/dev_report_2021_updated_012622.pdf
According to the Number of Total Developers data by Electric Capital for 2021, Ethereum is by far the largest and 2.8x larger than the next.
Ethereum remains the favorite among the infrastructure blockchains due to its high decentralization and security. Layer-2 solutions like Polygon, Arbitrum and Optimism have emerged as a way to leverage the benefits of Ethereum by keeping it the settlement layer along with having faster transaction speed and low fees enabled through techniques like Rollups (eg: zkRollups, Optimistic rollups).
Key Metrics
1. TVL (Total Value Locked)
Source: https://defillama.com/chain/Ethereum
Although the TVL of Ethereum has dropped significantly compared to the all-time high value of over $111 billion, it's still the number 1 blockchain based on TVL (with Tron as the runner up). [Data as of 30th August 2022]
2. Number of addresses with non-zero balance
Source: Glassnode
There has been a clear and relatively sharp uptrend in the number of addresses with non-zero ETH balance, indicating rising adoption.
3. Revenue generated
Source: Token Terminal
Revenue has been declining since achieving an all-time high in Nov 2021. But still, Ethereum is the highest fee generator in the crypto ecosystem.
Upcoming Merge
First let’s understand what “The Merge” actually means. Current version of Ethereum's main chain operates on a consensus mechanism called Proof of Work (PoW). The Merge refers to the actual merging of 2 blockchains: the Ethereum Main chain and Beacon chain. Beacon chain, a Proof of Stake (PoS) blockchain, was launched in December 2020. Note that there are no transactions on the Beacon chain, nor are there any dApps on it. It’s supposed to be an empty blockchain running on the PoS consensus mechanism. It being empty of transactions will enable an easy merging of the PoW Ethereum chain with the PoS Beacon chain resulting in a final Ethereum chain with PoS consensus mechanism.
Source: https://ethereum.org/en/upgrades/merge/#after-the-merge
Effects of The Merge:
Effect on ETH token: ETH’s tokenomics is going to be significantly impacted by Merge in 2 ways: ETH issuance will drastically reduce (after merge, total new ETH issuance will drop by ~90%), and ETH will become a yield-generating asset. This significant ETH issuance reduction will reduce ETH's sell pressure in the market. Also, reduced issuance and fee burning can make ETH a deflationary asset in the future (good for HODLers).
Effect on energy consumption: Ethereum’s energy consumption will drop by ~99.95% of the current amount post Merge. This is because in PoW, transaction verification requires high computing power. PoS replace the role of computing power with capital staked (# staked ETH tokens) in securing the blockchain.
Misconceptions about The Merge:
Gas fees will reduce: Gas fees will not reduce post Merge. That’s supposed to happen post Sharding gets implemented. Note that sharding will reduce the fees on Ethereum but when that happens, fees on Ethereum layer 2 solutions like Polygon will reduce by a much larger magnitude.
Transaction speed will increase: Although factually transaction speed will increase post Merge but the increment is almost negligible. Ethereum’s average block time (time it takes to mine a new block) is going to reduce from 13.6 seconds to 12 seconds.
Staked ETH can be withdrawn: Withdrawals of staked ETH tokens will not be enabled until Ethereum’s Shanghai upgrade.
Growspace Thesis
Ethereum is the foundational infrastructure for the decentralized future. Ethereum:
Has the largest presence in DeFi (Ethereum has the highest TVL of $34 billion with the 2nd highest TVL being $5.8 billion of Tron, as of 30th August 2022)
Strong presence in the DAO ecosystem: 39 out of top 50 Largest DAOs (by treasury size) are on Ethereum, as of 30th August 2022 (Solana is the runner up with 5)
Dominant position in the NFT ecosystem- 18 out of top 20 NFTs collections by trading volume over the last 30 days are on Ethereum (as of 30th August 2022)
18 out of top 20 DeFi protocols with over $500 million worth of assets locked are on Ethereum (as of 30th August 2022)
Ethereum is clearly a dominant force in the blockchain space. Post the upcoming Merge, ETH issuance will reduce significantly (after merge, total new ETH issuance will drop by ~90%), putting a strong deflationary pressure on ETH’s supply and consequently having a positive effect on the value of ETH in circulation. We are long on the future of crypto and with all things going right for Ethereum, we believe it will be the foundation of the imminent Web3 revolution.
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