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One of my favorite pastimes is meandering. Tremendous things can happen on a walk with no destination; it is convex exposure to random interactions that you otherwise would not have had. Recently, one of my meanderings led me to cross paths with a neighbor who happened to be a reader of the blog. Our conversation started out innocently enough, but it quickly morphed into a discussion on the philosophical implications of inventing new money, the security of cryptocurrencies, and methods for valuing these digital assets. This was an interesting moment because there was a generational gap here – my friend is decades older than me, and I found myself trying to explain mental frameworks about the crypto space that I believed to be pertinent to discussions occurring within the broader community.
The crypto camp is infinitely diverse – this means that there are often many different philosophical interpretations about the problem crypto purports to solve. To that end, I recall a remark on Twitter from a widely followed account that asserted something to the effect of “crypto is a monetary innovation, not a technological one.” Not only I do think this assertion is asinine, but it contradicts itself; the inception of new money in the flavor of crypto is inherently a technological innovation. We have leveraged cryptography, software, and economics to create an improved form of money that is threatening the status quo.
The clear front runners in this race for dominance are currently Bitcoin and Ethereum. Bitcoin’s pitch is its structural soundness – the core blockchain is rarely iterated upon, it has been engineered to be scarce, and there is limited ambiguity about what Bitcoin’s future looks like. Thus, BTC (in the minds of maximalists) is the ultimate form of sound money, predicated upon scarcity, immutability, and consistency due to the relatively low churn of development within the space. Its proof of concept is the fact that it hasn’t blown up yet.
Ethereum’s pitch is quite different: it purports to be the native collateral and unit of transaction in a software ecosystem that is threatening multiple industries. ETH would be Ethereum’s native collateral because one will soon have to post ETH to validate transactions on the blockchain. Additionally, it would be the native unit of transaction because I must transact in ETH to access the software network that exists within the Ethereum blockchain, better known as the Ethereum Virtual Machine (EVM). Consequently, ETH does not solely exist as a play on alternative money; rather, the value of ETH is a referendum on the value of the Ethereum blockchain, as I have harped on again and again. [1]
While ETH and BTC seemingly aim to solve different problems – one can view ETH as the token of computation, and BTC as the token of money – ETH may prove to be the more valuable currency since its utility within its blockchain is indispensable. If a token becomes an indispensable currency within the world’s most valuable software network, by definition, it must be sound money since it is useful tender inside of the world’s most valuable digital ecosystem. To quote Su Zhu:
Yeah, I think philosophically, right, it gets back to the question of what did Satoshi invent? I saw this Vitalik presentation, one of the dev cons where he said he invented crypto economics, that’s what he invented. And I think that, that idea is I think a startling one, because what it would mean is that if there were a coin that managed to get its community together, to coalesce around its value proposition and also to transact and use it as the underlying chain that they work on, then that would be, I mean, basically Bitcoin is also that and so to sort of compare and contrast their valuations, you also have to compare and contrast how they function in their ecosystem and how they function, not just as a store value in the mythological sense or in the narrative sense, but in its ecosystem itself.
And so from that point of view, it’s quite easy to see why EIP-1559 is hyper bullish because it represents an assertion that Ether is the native collateral of Ethereum, and that ETH will accrue value within this ecosystem and will try to be as sound as possible as something that people will hold. [2][3]
But enough gross philosophizing and logical deductions – this piece is for the value crowd. We’re going to construct a framework for understanding Ethereum’s value proposition (and specifically ETH, since this wouldn’t hold for blockchains with different token economics) – to understand why the value of ETH is a referendum on the value of the Ethereum blockchain – not to provide a price target, but to substantiate this abstract claim.
Here goes nothing.
Proof of Work versus Proof of Stake
I am going to assume that most readers know what a blockchain is. If you don’t, you can click the hyperlink here which will provide a satisfactory explanation. Alternatively, you can think of a blockchain as a chain of transaction blocks. This is almost tautological, but not quite; it is literally a database of transactions that are grouped together and then sequentially ordered in a chain which leads us to the most recent block. This is how blockchain participants can come to consensus about the validity of transactions. Since each participant has access to this historical database, or ledger, of transactions, a sole bad actor who attempts to falsify a transaction is going to be shut down by the other participants who are in consensus.
A key component of the creation and validation of this ledger is mining. Mining is simply the process of adding a new block to the blockchain, and a block is added when a group of transactions is validated via a cryptographic hash function. Specifically, miners competing for validation on a proof of work blockchain must iterate through millions of numbers in the hopes to be the first miner to guess the input that provides the correct output. If, for instance, the first 30 numbers of the output were expected to be 0’s, then under SHA-256, the probability of randomly selecting the input to the hash function correctly would be approximately 1 in a billion. Since the hash function’s output can be easily validated by other miners in the network, they can be reasonably certain that the provider of the solution went through an extensive amount of work in order to obtain the correct input – indeed, the probability that they found the correct number on the first guess would have been astronomically low. [4]
The miners are not benefactors here, however, because they expect to be compensated for the computational overhead they expended for validating a new block. Consequently, they receive a small reward in the form of newly minted tokens (in addition to potential tips and/or fees) for finding the consensus solution of the hash function. This is what drives the mining landscape – the higher the price of the tokens in fiat, the larger the reward for validating a block, which begets more competition for validating a block, which consequently leads to more work being performed (in essence, more numbers being guessed, and energy expended).
If this seems relatively inefficient – having thousands and thousands of miners providing random guesses at a solution to validate new transactions – that’s because it is. It currently takes Bitcoin ten minutes to validate a new block, and this is a significant knock on its claim as a feasible transactional “currency.” The cost of sending BTC is relatively high, and one would need to wait quite a bit to ensure that the transactions truly did occur. I do not believe this detracts from maximalists’ claim that Bitcoin is extremely sound money, however, for it is still assumed to be impossible to modify existing transactions or to successfully hijack the consensus mechanism of the Bitcoin blockchain.
For instance, if two competing blockchains are broadcast out to participants of the network, participants need only defer to the longest blockchain, since that chain had the most work involved (we’re putting the work in proof of work here). Additionally, since modifying a transaction with a block alters the solution to the hash function of that specific block, and since each successive block begins with the solution of the hash function that came before it, the only way to alter the historical record of transactions on a blockchain would be to redo all of the work up to that point on the blockchain. This is for all intents and purposes impossible and protects against any ex-post tampering of blockchain consensus. Sound money indeed. [5]
The Ethereum blockchain is similarly using proof of work as its consensus algorithm. But – extreme emphasis here – it is currently undergoing a migration to a proof of stake consensus algorithm for validating new blocks. This consequently leads to a fundamental shift in Ethereum’s token economics and is a significant factor underlying its rally since the start of the year.
Proof of stake is a consensus algorithm that eliminates mining entirely. Instead of forcing users to find solutions to a cryptographic hash function, Ethereum’s proof of stake mechanism randomly selects users who validate new blocks that they are assigned to. Hence, these users are called validators and they are analogous to miners on a proof of work blockchain.
A user must stake a minimum of 32 ETH to enter the validator pool. The more Ethereum a validator has, the more likely they are to reap the rewards for validation since the probability of selection is a direct function of the number of ETH staked. In the event that a validator has ill intent, and attests to a malicious or fabricated block, the validator will lose a portion or all of the ETH they have staked. This significantly disincentivizes malicious behavior and reaffirms a point we made at the outset – ETH seeks to be the native collateral of the Ethereum blockchain. In this context, it is the collateral underlying transaction and validation.
Proof of stake consequently changes the game for users within a blockchain looking to reap the rewards of validation by lowering barriers to entry; a user need “only” possess 32 ETH to participate – no mining hardware is needed. For users who do not meet this minimum threshold, there are decentralized finance (DeFi) protocols that leverage smart contracts where users can receive a fixed annualized rate for lending their ETH to other users on the Ethereum network who are functioning as validators, and demand for receiving ETH on loan is significant since the more ETH a user has, the greater the probability of reaping the rewards of validation.
Lending your ETH so that you may reap the rewards of staking is really an option for users who have not accumulated 32 ETH. In the event one did accumulate this magic number, they should almost certainly stake their ETH independently as (1) the yields will be higher and (2) becoming a validator will eventually be as simple as running a client and ensuring you are online when you have been selected to validate new transactions. This eliminates the negative externality of energy consumption posed by proof of work consensus and eliminates competition among validators since assignments are a weighted probability of the ETH a user has staked.
Proof of stake has a second-order effect on the valuation of ETH that is non-existent under proof of work, and that is the restriction in the supply of ETH. Since staked ETH cannot be transacted while validation is occurring, this removes ETH from circulation, leading to more fluid dynamics with respect to the inflationary/deflationary dynamics on the Ethereum blockchain relative to Bitcoin.
Above all, since proof of stake is not currently active on Ethereum’s mainnet, or its live blockchain, users who are electing to stake ETH currently have no way to access the ETH they initially staked, nor the additional ETH they are accumulating via validation rewards.
This is leads to a significant restriction in ETH supply until Ethereum’s proof of stake branch – here on out known as Eth2 – docks (i.e., reconciles, or merges) with Ethereum’s mainnet (or Eth1). Once docking occurs, users will be able to access their resultant ETH and transact with it in the open market. This terminal point is months away, but it all depends on three fundamental concepts: the Beacon chain, EIP-1559, and shard chains.
Eth2: The Great Deflation
The Beacon Chain was released in late 2020 and it officially launched proof of stake consensus to the Ethereum blockchain. Its function is simple – the Beacon chain will monitor all of the transactions occurring on the network and is responsible for ensuring that Eth2’s independent blockchains, called shard chains, are aware of other activity occurring across the network.
As I said earlier, however, Eth1 is still actively using proof of work. Consequently, the Beacon Chain only exists in Eth2. Eth2 is currently a parallel universe relative to Eth1 where validators have already begun reaping the rewards of transaction validation. As Ben Edgington wrote on May 8, there are already “over 132k active validators. 4.2m ETH staked, worth $16 billion as of writing. And there’s been a recent uptick in the rate of new deposits.” [6] That means that 4.2m ETH have been removed from circulation until Eth2 docks with Eth1, and users are continuing to stake their ETH at an increasing rate which accelerates ETH’s short-term deflationary dynamics. Eth2 is currently a unidirectional black hole with regard to ETH supply.
Perhaps the greater deflationary catalyst in the short term is EIP-1559, however, which modifies the fee mechanism of the Ethereum blockchain. As we alluded to earlier, when network congestion is high, miners typically receive larger transaction fees due to the computational overhead that’s required to validate a new block.
EIP-1559 makes transaction fees independent of network activity on Eth1. Instead, a base transaction fee is set given the current state of network activity, and users can elect whether to pay this base fee or forgo transacting altogether. Furthermore, the base transaction fee – paid in ETH –is now burned, which serves to offset the dilution of ETH that occurs upon block settlement. In instances where network congestion is very high, miners who receive newly minted ETH via validation internalize the benefit of this burn, for when network congestion is high, the net issuance of ETH can decrease significantly even when new blocks are validated. The benefit is consequently propagated to all holders of ETH on the network via the same deflationary dynamics.
As a veteran cryptocurrency trader, Colbie (@CryptoCobain on twitter) explains:
Yeah, I mean, I don’t know the exact number if I’m honest, but I think it’s something like if 1559 and the merge were active already, there would be something like 800 new ETH issued yesterday and like 15,000 ETH burned. And the validators receive like 6,000 of those ETH in transaction fees, which if you annualize, works out as a 60 to 70% APR from staking. But if you take a look at those numbers a little bit more closely, 15,000 ETH burned is gigantic compared to the daily issuance now. At the moment, I think it’s about 70 million, go to minus everyday and about half of that is from inflation like new ETH’s issued. This is going down to 800 issued with so much supply burned, the pure really basic supply demand equation just becomes incredibly favorable to Ethereum, not to mention that the staking reward also incentivizes people if it gets to 60, 70%, I think it may get to like 50% and it incentivizes people that hold these to lock up their ETH for even longer, which compounds the supply demand issue even further. [7]
Consequently, EIP-1559 compensates ETH holders via deflationary dynamics. The magnitude of the deflationary pressures imposed by the Beacon Chain and the eventual release of EIP-1559 cannot be understated – deflation has arrived, and it is only going to accelerate as fee structures are modified in the upcoming release, and staking incentives remove ETH from circulation as it is used to collateralize transactions on the blockchain. Where things get particularly interesting for Ethereum’s value proposition, however, is in the advent of shard chains – for these data structures will be fundamental to the development of the Ethereum Virtual Machine (EVM), speeding up computations, transactions, and validation.
The EVM: A Software Vending Machine
Before we get into the advent of shard chains, we must understand a fundamental component of the Ethereum blockchain: the Ethereum Virtual Machine, or EVM. The EVM is effectively a collection of software applications, known as smart contracts, that exist within the Ethereum network and that can be used at any point in time. For instance, the EVM smart contracts currently validate unique ownership of NFT assets, validate DeFi financing rates, and perform a variety of other operations. However, in order to perform the function provided by a smart contract, I must pay some ETH for this computation to occur in the form of a gas fee. This mechanism is highlighted by the diagram below:
Unfortunately, it is currently quite expensive to perform computations on Eth1. The cost of committing assets to liquidity pools, purchasing NFTs, or sending assets to parallel blockchains like Matic can be astronomically high for users looking to move small amounts of tokens, and this places a strain on the viability of Ethereum as a blockchain of computation in the short-term. However, a solution is on the horizon, and the solution takes the form of shard chains.
Shard Chains: ETH as a token of computation
Shard chains are simply Eth2’s term for a blockchain with a special caveat – there will be 64 of them, each responsible for handling groups of transactions within a “shard” of the Ethereum blockchain. Each shard will then communicate its regional state to the Beacon Chain, which communicates that state to every other shard chain on the network, creating a synthetic blockchain. Since validators need only store and run data for the shard they are validating, this speeds operations up and reduces hardware requirements for validation. [8] Per Ethereum’s website, “when the first shard chains are shipped they will just provide extra data to the network. They won’t handle transactions or smart contracts. But they’ll still offer incredible improvements to transactions per second when combined with rollups… Combine this with all the extra data availability provided by shards and you get 100,000 transactions per second.” [9]
This increase in transaction speed will eventually make validation via smartphones feasible – anyone with a thin Eth2 client and internet connection can stake their ETH and obtain rewards for validating new blocks. This lends itself to the creation of an ETH risk-free rate, or the minimum yield expected for owning ETH. If users are not looking to actively transact their ETH, they are best to put their ETH to work through staking channels, for staking enables users to obtain a minimum of 6% APR at the time of this writing. You cannot find this form of yield in the world of fiat at the moment, and I believe this is a key force underlying the institutional bid for ETH in recent months.
Shard chains may also be able to “execute smart contracts and handle accounts,” creating a decentralized software network that is accessible to adopters of the Ethereum network. If I need a task to be performed, I can leverage a smart contract that exists within the EVM, and pay some ETH for this computation to be performed – and I can do this from a smartphone. Shard chains facilitate the creation of Ethereum as a hand-held software library, owned by nobody, used by everybody. It’s a sophisticated app store that charges users on a computation basis – it is AWS bundled with a software vending machine. The more valuable the software that exists on EVM, the more valuable the ETH that is required to pay for computation. It follows that the value of ETH is a referendum on the value (or cost) of computing, transacting, and validating on the Ethereum blockchain.
The Future of Ethereum and the Autonomous Financier
Ethereum’s innovative solutions to issues currently affecting the crypto space should illuminate its value proposition: ETH is the token of a (potentially) high-valuable software ecosystem. Ethereum purports to be the backbone of DeFi, a new suite of technology that will enable individuals as opposed to institutions to lend, borrow, and make markets, by leveraging smart contracts that exist within the EVM. DeFi is still in its infant stages, but it appears that Ethereum is the platform of choice with regard to building these projects out. I will be following this piece up with a much deeper discussion of DeFi soon, but it’s important to note the network effects at play here – as Ethereum’s integration into DeFi increases so too does the amount of software existing within its ecosystem. As the value of this software increases, so too does the value of ETH, for ETH is the core unit of transaction within Ethereum based applications.
This eventual state does not come without incurring some risk, however. There will always exist a probability that software fails or that security is jeopardized. Indeed, the greatest risk to the ETH thesis is likely a failure in the Eth2 docking with mainnet, or an indefinite delay. But this risk is latent with most of the cryptocurrency space. and bearing this risk comes with significant compensation in the form of a crypto risk premia.
In any event, we are in the infant stages of a new technology that will fundamentally alter the way humans transact. I am excited to invest my time to remain informed about the innovation occurring in the space.
The question remains, after reading this piece, will you do the same?
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Disclaimer
Opinions expressed are solely my own and do not express the views or opinions of my employer. The above references an opinion and is for information and entertainment purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
[1] ETH may be more than strictly a referendum on the value of the Ethereum blockchain; it could also be interpreted as the value (cost) of leveraging (executing) and computation through the EVM.
[2] Su Zhu is the co-founder of Three Arrows Capital (Kyle Davies being his counterpart), a crypto focused hedge fund. Bloomberg recently ran a piece discussing their exploits here, and I view Zhu as an authority on the crypto space. I am certain I am not alone in sharing this sentiment.
[3] This excerpt was obtained from the transcript of the Uncommon Core podcast’s 24th episode. The full link to the transcript is linked here. The podcast is run by both Su Zhu and Hasu (Twitter handle @hasufl) and Hasu is similarly a thought leader within the crypto space.
[4] This discussion on blockchain was strongly motivated by the terrific YouTuber 3blue1brown. Grant Sanderson is a genius, and he has a gift for making challenging concepts easy to grasp. You can find his video on cryptocurrency and proof of work blockchains linked here – it is well worth the watch.
[5] Again, this is motivated from Grant Sanderson’s video. Seriously, watch it.
[6] This article is linked here.
[7] ibid.
[8] This is paraphrased from https://ethereum.org/en/eth2/shard-chains/
[9] Ibid.