Original title: Ethereum Investment Thesis: Etheruem's Potential as Digital Money and a Yield-Bearing Asset
作者： Fidelity Digital Assets Research
Compiled by: Cookie, bayemon.eth, ChainCatcher
Summary
Users can gain technical utility from the Ethereum network by accessing various applications in the Ethereum ecosystem.
Some may ask, "How does utility translate into value for Ethereum tokens?" In other words, why would an investor buy and hold an Ethereum token, rather than just use it to interact with the Ethereum network? In our last article introducing the Ethereum network, we briefly considered how or why Ethereum tokens might accrue value. In this article, we'll take a deeper look at this question from an investment perspective, and will briefly touch on some technical issues.
Key points:
Ethereum can be understood as a technology platform that uses ETH as a means of payment.
Ethereum’s perceived value and network adoption are tied to supply and demand dynamics, which have changed dramatically since The Merge.
Ethereum's overall platform usage may pass value to token holders, that is, the value of the token increases with the usage of the Ethereum network and platform.
The investment philosophy of holding Ethereum is similar to that of Bitcoin, which is to hold it as an emerging form of currency.
However, due to the characteristics of Bitcoin and its network effects, it is impossible for other digital assets to surpass Bitcoin and become a monetary commodity.
Still, the fact that value is subjective does not mean that other competing forms of money, including Ethereum, cannot exist, especially in specific markets, use cases, and communities.
We will examine Ethereum’s ability to fulfill the two main functions of money: store of value and means of payment.
Ethereum is not a mature network yet, so it is expected to be upgraded every year, which brings constant technical risks and unknowns, thus reducing its prospects. These unknown factors weaken the prospects of Ethereum as a store of value asset.
While Ethereum can be used for a variety of payment purposes, its fee instability remains a barrier to widespread adoption.
We looked at demand models for Ethereum and found that address growth (a measure of adoption) had a smaller relationship with price. Ethereum’s address growth (a measure of adoption) had a smaller relationship with price than Bitcoin’s.
After Ethereum switched from PoW to PoS, token holders can now earn a yield, partly from increased usage of the network. We will examine where this yield comes from and the various drivers and risks.
As an income-generating asset, the value of Ethereum can be examined using a discounted cash flow model. We construct a simple model to illustrate the assumptions driving the model.
Ethereum and Ether
There is a relationship between a digital asset network and its native token, but the “success” of the two is not always perfectly correlated.
Success is not always perfectly correlated. In some cases, a network may provide utility to users and settle a certain number of complex transactions per day, but this does not result in incremental value for Prototype token holders. Other networks may have a tighter correlation between network usage and token value. A common term used to describe the relationship between network design and token value is tokenomics, which helps explain how the design of a network or application creates economic value for token holders.
The Ethereum network has undergone tremendous changes in the past few years, and these changes have also led to changes in Ethereum token economics. In August 2021, Ethereum Proposal 1559 (EIP-1559) introduced a mechanism to destroy part of the transaction fee, the so-called base fee. Destroying ether is equivalent to destroying it, so executing a transaction on Ethereum will cause ether to be withdrawn from circulation.
Additionally, the transition from Proof of Work (PoW) to Proof of Stake (PoS) in September 2022 reduced the network’s token issuance rate and enabled entities to earn revenue in the form of tips, issuance, and Maximum Extractable Value (MEV). Ethereum’s previous upgrades fundamentally changed its token economics, and also changed how people think about the relationship between the Ethereum network and its tokens.
Token Economics: Ether Value Accumulation
Ether’s token economics model generally translates usage into value in three ways. When transacting on Ethereum, all users pay a base fee, a priority fee (tip), and generate additional value for other participants through MEV (maximum extractable value), which is the maximum value a validator can earn by including, excluding, or changing the order of transactions during block production. The base fee is paid in Ether, which is destroyed when included in a block (bundle of transactions), thereby reducing the circulating supply of Ether, and the priority fee is paid to validators, the individuals or entities responsible for updating the public ledger and maintaining consensus. When a new block is generated, validators who gain benefits due to the priority transaction fee will include the highest priority transactions. Finally, potential MEV opportunities (usually arbitrage) are submitted by different users and most of the value is passed to validators through the competitive MEV market in the current state.
The value accumulation mechanism can be thought of as the network's "revenue" being used for different purposes. First, base fee burns put deflationary pressure on the total supply, thereby benefiting existing token holders. Second, priority fees and MEV are collected from users and distributed to validators in exchange for their services. Although these relationships are non-linear, increased use of the platform means more burns and higher returns for validators.
Investment Thesis 1: Becoming a widely accepted digital currency
The common view that Ethereum is best understood as an emerging monetary product raises the question of whether the Ethereum native token can also be considered a currency. In short, Ethereum may face more challenges in becoming a widely accepted form of currency than Bitcoin. As shown below, Ethereum has similar properties to Bitcoin and other currencies in many aspects; however, it differs from Bitcoin in terms of scarcity and history. Technically, Ether has infinite supply parameters that are maintained within certain limits based on the number of validators and burns. While these parameters are strictly controlled by the Ethereum network, they are not equivalent to a fixed supply schedule and can fluctuate unpredictably based on different directions of the underlying components. The history of a digital asset is not only related to the length of time it was "created", but also the time it was "determined". Since Ethereum upgrades the network approximately once a year, it takes a long time for the code to be updated, audited, and more importantly, requires developer attention to rebuild its history. While this concept of probabilistic guarantees of code execution over time is specific to digital assets, it is undoubtedly important to gain the trust of stakeholders.
Many believe that Bitcoin is by far the most secure, decentralized, and robust digital currency, and that any “improvements” require trade-offs, so few other digital assets can surpass Bitcoin in terms of “monetary product.” While network effects are critical in the blockchain ecosystem, and Bitcoin has a seemingly “unsurpassed” position as a monetary commodity in this regard, this does not mean that other competing forms of currency cannot exist, especially for different markets, use cases, and communities. More specifically, the use cases that can be achieved on the Ethereum network, such as facilitating more complex transactions and giving it a unique, currency-like utility, do not exist in the Bitcoin ecosystem and should be included in the overall consideration. Although Ethereum is commonly used to transfer value between addresses, its role as a user executing smart contract logic is where it differentiates itself as a token.
The physical and digital worlds appear to be converging. As we’ve seen from leading tech companies, an application that provides a unique service to its users creates network effects and demand. Widespread mainstream use of applications on Ethereum will naturally lead to increased demand for Ether, which is why this long-term trend may be one of the most compelling cases for considering Ether as a potential alternative currency.
In fact, there are already some notable examples of Ethereum integration in the cryptocurrency and traditional finance sectors:
MakerDAO buys $500 million in Ethereum
European Investment Bank issues bonds on blockchain
NFT-based house sale completed in the US
Franklin Templeton Money Market Fund uses Ethereum and Polygon to process transactions and record share ownership
The convergence of the Ethereum ecosystem with real-world assets has already begun. However, it will likely take years of improvement, regulatory clarity, education, and time for the general public to begin transacting on Ethereum or competing platforms. Until then, Ethereum will likely remain a niche form of currency.
Furthermore, regulation is the most contentious topic regarding how Ethereum’s future may be shaped. Despite being a permissionless blockchain, many centralized exchanges that hold and stake Ethereum are based in the United States, meaning that any guidance provided to validators or investors in that jurisdiction could greatly impact valuation and the state of the network. There have been multiple regulatory enforcement actions and the closure of crypto-related banks and Kraken’s staking services in the United States recently. Therefore, regulatory risk is one of the most serious obstacles Ethereum may face in the short term.
Ethereum as a Store of Value
To qualify as a store of value, a token needs scarcity, or a high inventory/circulation ratio. As of July 2023, Ethereum’s inventory-to-flow ratio is higher than Bitcoin’s. This dynamic has come into focus since The Merge, significantly reducing the amount of ether issued, as shown below.
We have already elaborated on one of Bitcoin’s core value propositions, namely that its maximum fixed supply is 21 million Bitcoins and that the supply schedule has not and is unlikely to change. Bitcoin’s supply schedule is written into its code and enforced through social consensus and incentives of network participants. So what is Ethereum’s supply schedule based on? As mentioned above, Ethereum’s issuance is more of a balance between a set of set parameters than a “schedule”. In practice, there are two variables that determine the total supply of Ethereum, which makes it difficult to assess future supply:
1. Issuance: Ethereum issuance is determined by the number of active validators and their performance. As Ethereum issuance increases with total staked, the rate of increase decreases. Since Ethereum issuance is tied to the staked amount, this part is not prone to drastic fluctuations. The Ethereum protocol has set limits on the number of validators who can enter and exit staking, aiming to ensure the security of the protocol and that the issuance rate is stable over time.
2. Destruction: Since Ethereum blocks can only perform a limited amount of computational work every 12 seconds, the Ethereum network needs to destroy blocks to meet the requirements for block space. Destruction is a very unstable operation, making it impossible to accurately predict the future supply of Ether. Destruction acts as an incentive pendulum and is rarely the same from one block to another. The protocol specifies the Gas Fee that each block should contain. If the Gas of a block is higher or lower than the target value, it will cause the base fee of the next block to be adjusted nonlinearly accordingly. When on-chain transactions are very active, it may cause drastic fluctuations in transaction fees. Therefore, it also acts as a safety mechanism designed to prevent malicious actors from spamming the network indefinitely.
In summary, Ethereum's supply is not based on a fixed schedule, and both components of its monetary policy are likely to change over time. However, based on Ethereum's current structure, it is certain that the total supply of Ethereum will at most result in an annual inflation rate of about 1.5%. This assumes that 100% of the current supply is staked and not burned, meaning that no transactions are taking place on Ethereum. As shown in the figure, it does not take a lot of burning to keep Ethereum issuance on track or to keep inflation at a low level. In fact, higher burn rates generally result in a net tightening or a decrease in the total supply of Ethereum.
It has been proposed that the future supply of Ethereum is related to the number of active validators (issuance) and the demand for transaction execution (burning), the latter of which is relatively unpredictable in the longer term. Furthermore, upgrades to Ethereum may directly affect the amount of burning or issuance on the base layer, so current metrics are still not effective in predicting future supply levels. For example, the Shanghai/Capella upgrades reduce the risk associated with staking and may increase total issuance due to higher staking participation. On the other hand, data availability expansion (an upgrade designed to increase transaction throughput) and the maturation of Layer2, the independent blockchain built on top of Ethereum, may change the supply and demand dynamics of burning in unpredictable ways.
In addition, independent Layer1 public chains with final ownership and native tokens still do not have the same iteration and development time as Ethereum. As dApps migrate to other Layer1s and inherit from other blockchains, investors should pay close attention to the transfer of users and traffic. For NFTs or blockchain games, users may not need the high threshold of decentralization and security provided by the Ethereum base layer.
If users are willing to sacrifice some components of the impossible triangle for scalability, then some user-driven value may well accrue outside of Ethereum. As smart contract platform economies are likely to be multi-chain in nature, investors should consider determining which narratives will long live on the Ethereum chain and which will live outside of Ethereum.
Another key factor that distinguishes Ethereum from other on-chain assets is future upgrades to the supply schedule itself. Parts of the roadmap, such as EIP-1559 and MEV Burn, clearly point out the impact that destruction may have on the supply model. Although it is unclear what the exact impact of these upgrades may be, no matter what the outcome, Ethereum has formed a sharp contrast in value proposition with Bitcoin, which will not change its supply schedule in the long term.
In short, although there are many opinions that Ethereum will be the next "super currency", it is too early to reach such a conclusion under Ethereum's current unstable supply model. Although the usage of the Ethereum platform can pass value to token holders, for Ethereum, which is still in its early stages of life, the so-called value is a subjective judgment from users.
ETH as a means of payment
ETH is used as a means of payment, but these payments are limited to digitally native assets.
Most Ethereum transaction events are typically finalized within 13 minutes, making Ethereum faster than Bitcoin’s six blocks (one hour) probabilistically guaranteed settlement. Ethereum’s finality means that a transaction is included in a block and that block cannot be changed without slashing a large amount of ETH. This mechanism makes Ethereum an attractive payment asset in terms of final settlement time, but there are still obstacles to overcome in terms of payment usage. Much of the reason why it has taken off is related to user experience and continued high transfer fees.
Note: Slashing is the destruction of part of a validator’s stake and forcibly removing the validator from the network. This happens in the network response to a dishonest proposal or block attestation.
Since the Ethereum merger (The Merge), NFT payments consume the second-highest network fees, second only to DeFi-related transactions. NFTs are denominated in ETH and by their nature experience price fluctuations. For a seller selling an NFT for 1 ETH, this amount represents a huge difference in purchasing power, depending on the market price of ETH. This difference degrades the transaction experience (primarily on the sell side) and is a common cited case in many digital asset claim payment use cases.
While Ethereum has a wide range of transaction scenarios, directly transferring value accounts for a large portion of network usage; peer-to-peer transfers have consumed the third most ETH on the rankings since the merger. The biggest issue affecting Ethereum's payment use case is the volatility of transaction fees. Ethereum's dynamic fee model makes it easy for fees to rise quickly and jump. The variable price of transactions can limit payment use cases, so an unreliable and cheap value transfer network degrades Ethereum's user experience.
Users often have to make the decision to transact at the current high cost or wait until network activity dies down. This variable forces developers to get creative in hopes of maximizing transaction speed and efficiency that meets user preferences.
Additionally, if more real-world assets enter the blockchain, payments for these assets may be made using ETH, stablecoins, or other tokens. If these innovations are combined with the lower fees offered by Layer2 platforms, it could create an attractive future for payment opportunities on the Ethereum network.
Network data shows that ETH is used as a means of payment, although it is used for native digital asset payments. However, Ethereum’s potential as a payment network has not yet fully peaked due to fees and price volatility that can lead to a poor user experience.
This concept will permeate analysis throughout subsequent markets as Ethereum developers seek to optimize the network for future use cases. Whether ETH becomes a mainstream payment method may depend largely on how quickly the community can address obstacles such as ease of use, linking real-world assets, and options for secure, low-fee transfers.
Evaluating ETH from a demand perspective
Since applications on the Ethereum network require ETH payments, increased adoption of the Ethereum network may lead to an increase in ETH prices and an increase in the value of Ethereum token holders due to supply and demand mechanisms. In addition, as Ethereum scaling progresses, investors should consider revisiting demand-side models to determine where new users are coming from and the use case trends they seek.
The following diagram shows the process of value accumulation in the base layer (Optimism). The Layer2 blockchain completes transactions and ultimately converts network usage into the value of ETH. Arbitrum is built on the base layer of the network, handling transaction execution and relying on the base layer to provide security and transaction confirmation.
Despite the bear market, Ethereum's daily transaction volume has remained stable at around 1 million, while the price of ETH has fallen 52% since the beginning of 2022. In addition, Layer 2 transaction volume has increased, while Layer 1 transaction volume has remained unchanged. This may indicate that there is a certain degree of sticky demand in the base layer, while new demand originates from Layer 2. These signs may indicate that even if Layer 2 becomes more mainstream, value will continue to accumulate to the base layer.
Measuring the demand for ETH as a monetary asset can be difficult. Metcalfe’s Law is a popular economic model that shows the relationship between address growth, which represents the relationship between Bitcoin demand and price. Compared to Bitcoin, we find that ETH demand is less correlated with price.
In summary, if Bitcoin is understood primarily as a sentimental monetary good, then we would reasonably expect a stronger relationship between demand for the asset, as measured by the number of addresses, and price. For ETH, this weaker relationship could mean that its value is derived from other sources, such as network usage, rather than simply demand to hold the asset itself.
Risks of the Demand-Side Model
1. Ethereum’s core value comes from its usability layer, measured by addresses rather than transactions, volume, or usage, and adoption models do not effectively measure these relationships.
2. While the data shows a relationship between address growth and ETH price, there is no guarantee that this relationship will continue in the future.
3. This model is only a demand-side model, and as discussed earlier, the supply schedule of Ethereum may change in the future. Therefore, even if demand increases, if the supply also increases, the price of ETH may not change, and may even decrease.
Investment Thesis 2: ETH as a Yield Asset
How the ETH revenue model works
Since the merger was implemented, ETH has undergone fundamental changes. Not only does this significantly reduce the energy consumption of the network, it also provides revenue opportunities for users willing to lock their ETH on the consensus layer. This shift involves proof of stake, a major turning point in Ethereum’s security model.
One could argue that proof of stake maintains or even improves the security of the network at a lower cost than proof of work by penalizing validators for misbehavior. Validators contribute resources to the network and perform assigned duties to help Ethereum reach consensus, and are financially rewarded for doing so. Here is a brief description of the various validator responsibilities and rewards:
Attestations: Each validator submits an attestation or vote once per epoch and proposes and validates blocks for 32 time periods. These votes contain key data points about what each validator believes to be the correct content (block) for each epoch. These votes are combined and some rules are imposed to determine the validity of the vote, allowing the network to reach consensus on the blockchain and provide economic benefits. The cost of Ethereum's economic finality (i.e., returning to the finalized chain) is at least one-third of the total amount of ETH staked. As of July 2023, this value is over $15 billion. This safety threshold increases with the value of ETH and the amount of ETH staked.
Block proposals: Each validator proposes blocks relatively infrequently, as only one person performs this task per time period, which is equivalent to 32 proposers per period. Validators are selected pseudo-randomly and are related to their effective balance. Effective balance refers to the amount of ETH that affects reward accumulation. The more ETH held, the greater the potential reward. The maximum effective balance of all validators is 32 ETH, and any balance above this amount will not increase the possible reward.
In addition to the value received from the protocol, proposed validators receive fees paid by users for including their transactions in blocks, as well as MEV (Maximum Efficacy Extraction), a mechanism for validators or others to exclude certain transactions from blocks based on the value of ordering, inclusion, and information extraction. While potential rewards from the protocol depend on the number of active validators, additional income from fees and MEV is directly related to the congestion and activity of the network.
Proof of validity and block proposal rewards are rewards for minting new ETH from the protocol. These rewards can be seen as incentives for the protocol to maintain its security. The proof-of-stake model minimizes the payment security budget by introducing penalties and significantly reducing deductions. The base reward is equal to the average validator reward per period, and the calculation of the protocol's potential rewards can be used using the following formula:
Base Reward = Effective Validator Balance * (16 * sqrt (Total Staked ETH))
The key point of this payment structure is that the base reward is proportional to the validator's effective balance, incentivizing validators to stake up to 32 ETH, and inversely proportional to the number of network validators. As the number of validators increases, the total issuance will also increase, but the average reward per validator will decrease. The rationale for this issuance model is to ensure that there are enough validators participating, because if the validator set is too small, it may lead to high issuance events, while also ensuring that there will not be unexpected high issuance events when many validators participate.
This specific token economics allows ETH to maintain real income. Since the merge on September 15, 2022, 53% of validator income as of July 2023 has come from this mechanism. Here are some other forms of income that are not paid by the protocol but by users, which provides an interesting connection between network usage and validators.
MEV (Maximum Extractable Equity):
MEV comes directly from user transactions, as increased user activity often creates more opportunities to profit from such activity. Since Ethereum has multiple uses, value can be extracted from user transactions in a variety of ways. Flashbots (an organization dedicated to reducing the centralization effects of MEV) says that the most common forms of MEV often come from arbitrage and liquidation, opportunities that thrive in highly volatile environments, such as November 2022.
MEV-Boost is a program that seeks to outsource the role of building blocks to dedicated participants so that MEV-related rewards can be shared with the entire validator set, and most validators have been using the program since the merge. On November 7, 2022, validators using MEV-Boost and Flashbots relays received an average reward of 0.1 ETH per block. Due to multi-level liquidations and intense network activity after this day, the average block reward soared nearly 700% to 0.68 ETH per block by November 9, 2022. This dramatic increase demonstrates the close relationship between network congestion and validator returns. During periods of high volatility, on-chain activity surges, which incentivizes users to execute faster with higher fees and increase the amount of MEV that can be captured.
Despite the strong relationship between MEV opportunities and validator rewards as of July 2023, many different applications, organizations, and individuals within the Ethereum community are exploring ways to change how MEV is managed. Many of these capture efforts are focused on returning MEV to the users who generated it, as proposed by Flashbots in their recently released MEV-Share.
Other solutions include destroying user-created MEV or encrypting transaction data so that MEV is more valuable and becomes difficult to capture. Whichever route the community chooses, it could have a significant impact on MEV-related earnings, which as of July 2023 account for around 24% of validator revenue since the Ethereum merger.
Unlike application-specific chains, Ethereum has a large number of available MEV types, which are likely to continue to grow as functionality is added. This disparity suggests that one solution may not be enough to reduce all MEV.
Tips:
Ethereum's fee market has changed dramatically since the 2021 Ethereum "London" upgrade introduced EIP-1559. Prior to the upgrade, proof-of-work miners received all gas fees from any transactions included in the blocks they mined. As a result of the fee market changes, the network now has two different types of fees: base fees and priority fees (tips). All fees are still paid by users trying to execute transactions; EIP1559 affects the distribution of these fees after they are paid.
Instead of collecting all fees paid by users, validators only collect a priority fee. The base fee is burned or taken out of circulation. Tips can incentivize validators to prioritize transactions for inclusion in their blocks, when otherwise validators might pack empty blocks (which is more economically viable). For users who are eager to execute a transaction, a higher tip than other competing transactions in the mempool incentivizes validators to prioritize its inclusion.
Note: mempool is equivalent to a list of pending transactions, containing block transaction events to be executed.
While MEV plays a major role in determining which transactions are included in each block, tips still act as an incentive mechanism as validators use them to decide which transactions to include in their blocks. Since the switch to proof-of-stake, tips have accounted for 22% of all validator revenue as of July 2023.
ETH valuation based on the “discounted cash flow” model:
As the network moves to proof-of-stake, it becomes easier to model the value of ETH. The demand for block space can be measured through transaction fees. These fees are either burned or transferred to validators, accumulating value for ETH holders.
Therefore, in the long run, the growth of fees and the value of Ether should be intrinsically correlated. The increase in Ethereum use cases creates a greater demand for block space, which leads to higher transaction fees and thus earnings for validators.
We will demonstrate this relationship using a simple discounted cash flow model. The results of such a model vary widely depending on growth assumptions and discount rates, just as in the case of the high-growth cash flow model. The purpose of constructing such a model is not to provide an estimate of the fair value of Ethereum, but rather to describe the relationship between network usage and value accumulation. In addition, it can also show further modeling of the value of ETH based on estimates of future fees paid to Ethereum stakeholders.
The chart below shows the average daily fees paid on Ethereum in US dollars since the implementation of EIP-1559 in August 2021. The chart is calculated using a two-stage discounted cash flow model, with an initial phase of continued large growth in adoption and fees, followed by a decline in the fee growth rate, so regardless of the utility gained by Ethereum users, expansion is likely to lower the upper limit of fee growth.
This is the assumed growth rate for all years after 2030. This result is common when forecasting the future of high-growth businesses. It is important to note that the discounted cash flow model is only useful in theory.
The following figure further describes the responsiveness of the modeled price using a sensitivity model to model the relationship between the modeled price and the assumed growth rate and discount rate. It is extremely important to understand the relationship between ETH's growth and users' willingness to pay fees. However, models that rely on small changes in future growth assumptions and are highly sensitive may not be very useful.
Risks of discounted cash flow model:
If scaling technology cuts into fee revenue, the relationship between ETH and the value it provides to network users could weaken unless transaction volume increases and offsets this squeezed profit.
Modeling the future of any growth-sensitive asset and applying the relevant discount rate is highly subjective, so valuations may only be useful in theory.
Ongoing efforts by the Ethereum community to minimize the negative impact of MEV will improve user experience, which may reduce yields. This has not yet been adjusted or accounted for in the model, along with other minor details that will have an impact.
in conclusion
Ethereum is undoubtedly a leading blockchain technology platform that enables developers to build decentralized applications, many of which are able to do things that cannot be done on the Bitcoin network due to Ethereum's superior programmability. This has enabled the Ethereum ecosystem to have the largest and most active applications in the crypto space, and ETH has maintained its second largest market capitalization position (second only to Bitcoin) for many years.
However, the question that investors ask is, “Does increased developer and application activity translate into increased value for ETH?” We believe that current theory and data suggest that increased activity on the Ethereum network drives demand for block space, which in turn generates cash flow for token holders. But it is also clear that these different drivers are complex, nuanced, and have changed over time as various protocol upgrades and scaling developments (such as Layer 2) emerge, and may change again in the future.
