This is a draft post for Block 245 Research - a publication seeking reasonable valuation techniques for cryptoassets.
Cryptoassets are notoriously difficult to value. How do we know if Bitcoin is overpriced? Is the market cap of Ethereum justified? How do you even assign a value to YFI? Why is a Cryptokitty worth anything if I can just save its svg?
Most cryptoassets do not produce cash flows. Most cryptoassets are not utilized as part of a supply chain. Thus, how can they be valued like bonds, equities, commodities, or even fine art?
In recent years, the narrative that Bitcoin is digital gold has taken hold and we believe this is indicative of what is to come for the field of valuation in cryptoassets.
It is our view that cryptoassets have started off as commodities, but their programmable canvas allows them to become ANY type of asset in the future.
In this post, we'll attempt to understand the determinants of Ether's value. No price target in this post.
Bitcoin is digital gold.
If you believe that narrative, a simple valuation technique is to take gold's market cap and assign Bitcoin some percentage of that. By doing so, you are saying Bitcoin will grow to X% of gold, perhaps by way of cannibalizing gold's store of value use case, introducing non-investors to the concept of a financial safe haven, or a bit of both.
We believe that Ether is like digital oil. Unlike Bitcoin vs gold, there is no competition between Ether and oil. However, the metaphor is exceptionally useful.
From inception, its creators gave Ether an important role within the Ethereum network - it is the only accepted payment collateral when using the blockchain's compute and storage capabilities. Each transaction is etched into Ethereum's blockchain for all time - and that should be an expensive operation.
Thus, the answer to "where does Ether's valuation come from?" is simply that space on the blockchain (aka blockspace) is scarce, and Ether is the commodity you must acquire in order to use blockspace.
In our view, the valuation of Ether is thus determined by:
There are, however, two interesting wrinkles that have been added to Ethereum which further complicate the story. That said, they do not fundamentally change that Ethereum's valuation should mostly be a function of the supply of Ether and the demand for blockspace.
There are two structural changes to Ethereum that will adjust how we should value ETH. The first is Proof of Stake, and the second is EIP-1559 (and the introduction of fee burn).
Proof of Stake changes how new Ether is issued. Instead of rewarding a single miner, all staking participants get a share of new issuance. Miners were previously concentrated players who invested in expensive hardware. Now, staking eliminates the hardware advantage and allows most holders of Ether to gain access to staking rewards.
Now that ETH can be used to generate yield, staking should serve as a multiplier to ETH's valuation. In addition, we may one day view this rate of return to be a new form of "risk free rate".
Fee burn, which will be implemented as part of EIP-1559, is an improvement on Ethereum's roadmap which would destroy ETH when used as gas. Currently, gas fees are recycled back into the system as a bonus on top of miner rewards. Once EIP-1559 is implemented, the majority of gas fees will be burned by the network. When this happens, Ether will behave a lot like oil - burn it to use it.
Fee burn will put downward pressure on the growth of ETH's supply, and thus, raise ETH's valuation.
A more complete picture of how to value ETH:
Any investment thesis in Ether should thus be formed around the value of blockspace. This is where all valuation goes to shit, because we honestly cannot imagine what the demand for blockspace is going to be.
But when people say "crypto is like the next internet", what they're really saying is that Ethereum and other smart contract platforms (but mostly Ethereum) have introduced a new primitive that we're still wrapping our heads around: blockspace.
Some people think it's 1995, or the dawn of the Internet. But I think we could be anywhere between 1980 and 1995, the period of Internet innovation which gave rise to critical pieces of infrastructure like TCP, DNS, SMTP, FTP, and a bunch of other protocols that really helped make the Internet useful. How could the early authors of those RFCs have possibly predicted that Facebook, Amazon, Netflix, and Google would be built atop their protocols?
Regardless, we believe the need for blockspace will be astronomical. Great platforms only capture a small percentage of value that is built atop of them, and Ethereum (or one of its competitors) will be no different.
Because blockspace is scarce and thus expensive, use cases for blockspace will tend to be financial in nature. It's no surprise that the significant demands for blockspace today are DeFi and NFTs.
In order for Ethereum to reach its vision and maintain any meaningful valuation in the long run, it first needs to relinquish the restrictions on blockspace and latency.
From a valuation perspective, reducing scarcity of blockspace seems counterintuitive - if Ethereum's valuation derives from the need of blockspace, why would you want to reduce that scarcity? Wouldn't keeping the supply of blockspace limited increase its value?
This question fades away the moment you consider the customer experience today. Due to scarcity of blockspace, gas fees on Ethereum are extremely high. This limits the types of transactions someone can perform and prices out all but relatively large transactions. It will continue to price out transactions as ETH grows in value.
If nothing happens, Ethereum will one day only be useable by whales.
In order for Ethereum to win, it needs needs network effects of all kinds. It needs to grow the size of the blockspace pie to allow as many transactions as possible, and simultaneously, take as small a fraction of that as possible.
All while being sufficiently decentralized and secure.
Another terrible user experience on Ethereum is the lack of consistent latency. Sometimes, transactions settle instantly. Othertimes, transactions can be stuck for minutes if not hours or longer.
In order to win over the masses, the network needs to be able to have consistent settlement times. Latency of three seconds is probably fine for most users. For example, the Stripe API is loved for its convenience and ease of integration, but not necessarily its performance.
However, latency is less of an issue than throughput. Latency is a nice to have, whereas throughput is mission critical.
Blockspace becomes orders of magnitude more valuable if it can scale to billions of users.
There are two ways to approach the blockchain scalability problem:
There are a number of teams working on Ethereum-killer type projects, but they face extreme hurdles to adoption. Most of these solutions work backwards from the user experience, optimizing for latency and throughput. Their thesis is that the user experience is more important than anything else. If you build a faster and cheaper trading experience for the DeFi degens, you will win. (See EOS, Solana.)
Ethereum understands, perhaps intuitively, that platform-developer symbiosis exists. The platform that attracts the most developers attracts the most users, and the platform that attracts the most users attracts the most developers. But this isn't a case of "the chicken or the egg" - it's clear you must attract developers first, otherwise there are no applications for users to use.
For some reason, developers have gravitated towards Ethereum. There's developer magnetism to the project that just doesn't exist anywhere else. Other projects need to incentivize developers to build on their projects (see Solana and Kin). Ethereum gets hordes of developers daily.
And what's emerged in the Ethereum ecosystem is a number of teams working on layer 2 scaling solutions.
Layer 2 solutions, regardless of blockchain, all share a similar concept. Recognizing that blockspace is expensive, the idea is to perform a large number of transactions off-chain, and only use blockspace as the settlement layer.
In Bitcoin, the lightning network could transform Bitcoin into a payment network.
In Ethereum, the design space is far more vast and we may see a patchwork of different scaling solutions, until converging on a few design patterns that ultimately take over.
The Layer 2 space feels like COVID-19 Vaccine Research. We have independent teams across the globe all rushing to find a solution. Unlike with the vaccine, the sense of urgency isn't as dire.
So many solutions feel close, but if the lightning network is any indication, it could be YEARS before we find the right scaling solution. We've got xDai, Matic, Loopring, zkSync, Optimism, Arbitrum, Celer, Connext, Raiden, OMG, and many many more.
While Ethereum is focused on rollups, in particular Optimistic Rollups for now and zkRollups for later, it is important to keep an open mind.
Compound recieved a lot of flack for Compound Chain, but application specific scaling solutions might be key to scaling. In fact, I suspect the ultimate design pattern we may find ourselves adopting is many layers, with public-decentralized Ethereum up top and mostly-centralized (but auditable) application specific chains at the bottom.
Ether's valuation is dependent on the demand for blockspace.
The demand for blockspace is in turn dependent on the utility of blockspace, which would grow exponentially with layer 2 solutions.
Given the time to market for Bitcoin's Lightning network (which has perpetually felt like it is "2 years away from being 2 years away"), we should temper our expectations for the rollout of layer 2 solutions on Ethereum. I am cautiously optimistic about Synthetix and Optimism, but keep in mind that the operative keyword is cautiously.
Meanwhile, DeFi and NFTs are showing legitimate demand for blockspace.