Originally published: January 2021
The anonymous founder of Bitcoin, Satoshi Nakamoto, solved the hard problems associated with digital scarcity with a white paper in 2008, and launched Bitcoin in 2009.
After that invention, numerous other projects came in its wake. There are now over 8,000 separate digital assets that CoinMarketCap recognizes.
Of these, Ethereum is the second largest digital asset in the world by market capitalization after Bitcoin, and it enables a big ecosystem of other tokens on top of it. This gives it the only other major network effect in the space.
A number of people have asked for my view on Ethereum, and why I don’t personally invest in it at this time, even though I do invest in Bitcoin.
The short answer is that although I’m bullish on a number of utility protocol use-cases, I am more cautious about betting on the long-term price appreciation of the utility protocol tokens themselves, since there is not necessarily a correlation between the size of the overall ecosystem and token appreciation of any particular protocol.
So, here is my analysis of the Ethereum protocol from an investor (rather than developer) perspective. It was originally published on January 17, 2021, and after feedback from the Ethereum developer community including its founder, I finalized this slightly revised version a week later on January 25, 2021, with additional clarifications and details.
Ethereum 1.0 Overview
Ethereum was proposed by Vitalik Buterin in 2013, crowdfunded in 2014, and went live in 2015.
Buterin, who was about 19 at the time, wanted to create a platform for decentralized applications. As he jokingly describes, the large game maker Blizzard nerfed his game character, setting off a multi-year search for a technological solution to rectify these sorts of terrible injustices:
I happily played World of Warcraft during 2007-2010, but one day Blizzard removed the damage component from my beloved warlock’s Siphon Life spell. I cried myself to sleep, and on that day I realized what horrors centralized services can bring.
He describes finding Bitcoin in 2011, and from there, a fire was lit.
Bitcoin uses a blockchain as a savings and payments technology, and the base layer is elegantly simple. It focuses on doing one thing exceptionally well: storing and settling value. Additional layers can be built on top of this base layer, harnessing its ability to store and transmit value for more complex purposes. An example would be the Lightning Network, which extends Bitcoin’s scalability for small payments.
Ethereum, on the other hand, is an attempt by Buterin and other developers to apply blockchain technology to a much broader scale right within the base layer of the protocol. It has marketed itself as a “world computer”, like an app store that is not controlled by any central entity. It’s like a distributed operating system, with a built-in token system, and programmers can use that ecosystem to make decentralized applications or “dapps” for short that often use their own tokens as well.
The underlying technology for Ethereum is based on smart contracts, referring to programmed agreements in the blockchain that trigger when certain events occur. It requires fractions of Ethereum tokens to pay for a smart contract to be executed by miners on the blockchain.
Ethereum has been used to create a variety of projects. DappRadar is one site among several that lets you explore decentralized apps across categories for Ethereum and other smart contract protocols. DeFiPulse lets you track decentralized apps specifically for decentralized finance.
One of the most popular examples is stablecoins. An institution can collect fiat currency, store it as collateral, and launch tokens that run on Ethereum’s protocol. These tokens are ostensibly backed up 1-to-1 and redeemable for fiat currency, and as such tend to hold a stable price. These are basically dollars that make use of blockchain technology to transmit and store the tokens. People rely on a third party in the sense that they have to trust that the custody and collateral backing up the tokens are solid, but the exchanging of the tokens between counterparties is permission-less. There are creations that make decentralized stablecoins as well, such as Maker DAI.
A set of applications called “Defi” for “Decentralized Finance” became very popular in 2019 and 2020. These apps replicate various banking features, including ways to earn yield or borrow funds or exchange tokens. An example is Uniswap, a decentralized digital token exchange. Rather than a company serving as the central exchange hub, this is an exchange that runs in a decentralized way based on blockchain software and incentive mechanisms. Several other DeFi exchanges exist as well.
Many other protocols exist for providing liquidity to these exchanges, often referred to as “yield farming”. People can deposit tokens and collect interest, and other people can borrow tokens and pay interest, in a decentralized manner. Because there aren’t manual/human credit checks or risk analysis for most of this, these systems often rely on a policy of “overcollateralization” to secure loans.
Gaming and gambling are also significant areas of interest. A big early example was CryptoKitties. The game lets users purchase, collect, breed, and sell virtual cats. Each token represents a cat, and each is unique. Once generated, users own their cat tokens and nobody can take their cat token away from them or alter it, like Blizzard did to Buterin’s beloved warlock. This application was popular enough to slow down Ethereum’s network in late 2017.
Nowadays, there are a number of crypto-based games. I’m not as much of a gamer as I used to be, but if I were, I could certainly see why blockchains can potentially add something of value to the gaming ecosystem. The idea of having items/pets/characters that the user can hold independently of the game publisher, and maybe even have those items/pets/characters recognized by other games as well, certainly is cool.
Noteworthy, however, is the fact that many crypto-based games run on competitors to Ethereum, like EOS or TRON.
Broadly, nonfungible tokens, or “NFTs” are an area of demand and recent interest. Unlike a liquid and standardized unit, like a Bitcoin or an Ethereum token, a nonfungible token is a unique collectible, such as a unique digital kitty, or more broadly a piece of digital art, event tickets, or a domain name, that can be traded on a blockchain.
Lastly, social networks and other systems are also projects that exist in the dapp ecosystem. In theory, the sky is the limit, but the question is whether or not they make enough economic sense.
Are Decentralized Apps Really Decentralized?
One of my concerns, when reviewing the biggest use cases for decentralized apps, is that a lot of the use-case is circular and speculative.
Ethereum is heavily used for decentralized exchanges of crypto tokens, crypto stablecoins that serve as liquid units of account for trading crypto tokens, and lending and earning interest on crypto tokens which is a practice that serves as a liquidity/borrowing source for traders of crypto tokens. To a lesser extent, it is also used for gamified ways to earn or trade various crypto tokens.
So, it’s a big operating system powered by crypto tokens, for the purpose of moving around… crypto tokens.
A healthy banking system in the real world would consist of people depositing money, and the banks making various loans for mortgages and for business financing, to generate real-world utility.
A speculation-based banking system, on the other hand, would consist of a bunch of banks taking deposit money, and then lending to speculators in the nearby stock market, along with technology providers that make this easier, and then what those speculators are trading mostly consists of shares of those banks, shares of those tech companies, and shares of the stock exchange, resulting in a big circular speculative party. The biggest use case so far for Ethereum is a decentralized version of that circular speculation-based system.
There are games that are fun and collectible on their own, but in large part, Ethereum is currently mainly about decentralized finance and speculative trading.
In fact, it can be argued that the main reason why some of these decentralized finance apps like exchanges and yield-farming techniques have become popular compared to their more centralized competitors, is that they get around Know-Your-Customer “KYC” regulations.
Governments try to enforce KYC checkpoints on regulated exchanges and custodians, so that they can track who is buying and selling crypto tokens. They can do analytics on the public blockchains, but in order for them to enforce tax fraud or other lawsuits, they want to be able to link blockchain transactions to specific individuals by having KYC gateways on the exit and entry points as much as possible.
Decentralized apps make that a bit harder, and are of course more appealing for users that wish to retain their privacy. Increases in government surveillance in recent decades have been a key catalyst for the development of privacy technology or off-the-grid transactions. There’s a common saying that if cash were invented today, it would be illegal, since it’s hard for the government to track and they wouldn’t like it.
If centralized crypto exchanges and centralized crypto banks are bound by KYC rules, and decentralized crypto exchanges and decentralized crypto banks are not, then of course we should expect some growth in the non-KYC decentralized versions unless or until there is some regulatory crackdown on them.
It is more expensive to run lines of code on Ethereum than on, say, Amazon Web Services. There are some games or services that make specific use of blockchain technology, like enforcing digital ownership of non-fungible tokens (e.g. representing a unique digital cat or piece of digital art), but other than that, many of them are replicating services, like crypto exchanges or lenders, that work similarly well without using a blockchain. So, a lot of the growth seems to get around KYC, to become somewhat “permission-less”.
The problem, however, is that the ecosystem isn’t yet as decentralized as it was envisioned to be, and has a lot of attack surfaces in the event of a regulatory crackdown.
Third-Party Ethereum Node Operators
Bitcoin has been designed to make running a full node take up relatively little space. In fact, that was at the heart of some of Bitcoin’s infamous “fork wars” in 2017, and the easy-to-run node core version of Bitcoin has so far won out over its hard forks that increased the block size and made it harder to run a full node in exchange for higher network throughput.
This works well for Bitcoin because on the base layer, it focuses on doing one simple thing very well: storing and transmitting value. It’s an elegantly simple blockchain by design.
Ethereum, being more complex and with more goals on the base layer, has a more complicated node situation, and dapps would become significantly harder to use if people didn’t have access to third-party node providers.
Since at least 2018, folks have been pointing out that the Ethereum dapp ecosystem has been rather reliant on third-party large-scale node operators like Infura. Here’s an article from back in December 2018, for example. That situation is still going strong. And ironically, Infura uses Amazon Web Services, so there are two layers of centralization.
Here’s how Infura describes their offering:
And here’s how Alchemy, another third-party node operator, describes their offering:
Apps that run on Ethereum are more decentralized than normal apps on other platforms, but if a large portion of what they are doing is getting around KYC regulations, and the government decides to crack down on these practices, then they have pretty big centralized attack surfaces to go after. Governments could disallow cloud providers from hosting Ethereum nodes, and they could go after these companies that offer large scale node services. They can’t necessarily bring down Ethereum itself but they can make dapps harder to use and therefore threaten the use-case of the protocol.
If there were to be some government crackdown on third-party node services for Ethereum, there would be a scramble among users to find ways to efficiently access their dapps without those centralized third-parties.
In an August 2020 episode of his podcast, Peter McCormack asked Vitalik Buterin the question, “How reliant is Ethereum on Infura?”
So I think first of all the Ethereum network is not reliant on Infura. Like if Infura died tomorrow you know the Ethereum network would keep going and everyone who does have either an Ethereum full node or an Ethereum light node would still continue kind of functioning normally.
Ethereum applications would definitely get significantly harder to use, though at the same time like it is possible to use Ethereum applications without relying on Infura.
Like, I think in Metamask it’s possible to kind of smoosh the end point to a local node and there is such a thing as an Ethereum light client like you can run Geth light, and some of the other implementations have light modes too, which also do the same kind of you know block header verification that Bitcoin does and actually in Ethereum we even try really hard to make light clients more powerful. So, for example, Ethereum has this concept called a state tree where instead of just committing to transactions, we commit to account balances. And so, given a block, like given a header of a block, even this small piece of data that’s at the top of a block, you can create a very short proof that cryptographically proves that you know, what is the balance of a particular account.
And, these are definitely things that we can try to do better and there’s very active efforts at trying to do better at this. Like, there is a lot of ongoing efforts at, you know, trying to create a more decentralized back end for something like Metamask for example. Like, if you want to, you could definitely hook it up to your full node or even your light node.
During an October 2020 follow-up on the pro-Ethereum channel Bankless, Buterin gave further context on this issue:
And there’s different levels of validation that you can have, right. So for example in a sharding context for example, you’re not going to be literally checking every single thing yourself but there’s techniques like you know data availability validation for example where you can probabilistically validate correctness. You can validate the beacon chain shard, you can be checking fraud proofs, you can run a stateless client, you can even run a light client which is better than to trust some server and it definitely I think is healthier for the ecosystem the more people do those things, and the healthier it is for the ecosystem that we make it easier for people to do to those things. Like, I for example am definitely unhappy with the fact you know Metamask for example is just a client that direct talks to Infura, whatever.
I mean I recognize that kind of the reality is that there isn’t much a better way right now but this is absolutely something that we should be trying to kind of engineer our way past, and there’s a lot of good projects that are trying to engineer their way past it and even that Eth 2 for example is designed to have a much simpler and better light client than Eth 1 does, so we hope things like Metamask and things like that can end up adapting it over time.
In November 2020, the market saw some of this risk play out in real time as Infura went down. Many exchanges had to temporarily stop allowing withdrawals of Ethereum tokens and the various tokens that are built on Ethereum.
Infura linked the issue to a bug within one of the Ethereum clients.
Earlier today (2020-11-11) Infura experienced its most severe service interruption in our four years of operation. We realize that we are an important piece of infrastructure for many amazing products and projects. I’d like to apologize to all of our users and to the ecosystem. We recognize the faith that you place in us and we don’t ever take that lightly. I’d like to share the details of the incident with you so that there is transparency in what occurred and so that you can feel confident that our service will be better and even more resilient going forward.
There have been a lot of high-profile DeFi hacks and bugs in 2020.
This is different than an exchange/custody provider being hacked (like, say, someone stealing coins from an exchange) without the underlying protocol having any issues. Instead, many of these DeFi hacks/bugs had shortcomings in their underlying protocols exploited, resulting in loss of funds by users. It’s a more fundamental issue at the protocol layer of tokens that Ethereum enables, in other words.
When multiple protocols are involved in a complex way, hacks and bugs can happen more easily.
A Developmental Solution to an Unclear Problem
To summarize here, there is substantial demand for stablecoins to use as a liquid unit of account when trading crypto tokens and other purposes, substantial demand for decentralized crypto token exchanges and decentralized crypto token liquidity providers, and some demand for token-based gaming/social dapps. Ethereum has a big market share of financial dapps while some of their smaller competitors have sizable market share of gaming/social dapps.
These dapps are less efficient than centralized apps, as measured in terms of cost per line of code execution, but because people want to go around KYC regulations, and because stablecoins are very useful at the current time within the crypto-trading space, there is plenty of demand.
The Ethereum solution to serve this demand, however, ironically has centralized clusters. While it’s a significant step towards decentralization, it’s not really the level of decentralization that some were hoping for, and Buterin has admitted as such. It’s far more decentralized/permissionless on the user side, but these clusters of centralization serve as potential attack surfaces for governments to crack down on these methods of going around KYC-regulated and fully centralized firms.
There are security issues in various tokens that Ethereum is used for, and most of the ecosystem is rather circular. Rather than Ethereum dapps providing a broad array of successful services to non-crypto industries, its primary use-case so far is as a platform for trading, lending, borrowing, leveraging, and moving various crypto tokens. This sort of circular speculation can drive development and prices up very quickly, but can also unravel quickly if things turn the other way.
Ethereum faces competition from smaller utility protocols, such as Cardano, Polkadot, Tron, and others.
Much like how other monetary tokens have not been able to take market share from Bitcoin’s expansive network effect, these smart contract protocols are much, much smaller than Ethereum. All of them together are smaller than Ethereum’s market capitalization, so Ethereum has achieved a network effect and some degree of escape velocity compared to them.
However, their gap to Ethereum is not quite as big as some of the monetary tokens are compared to Bitcoin, so they are worth watching.
Similarly, there are some smart contract platforms that tie themselves to Bitcoin. RSK was an early example. Stacks 2.0 launched last week, as another example, and is a protocol built on top of Bitcoin that can bring smart contracts and DeFi to Bitcoin’s network, using Bitcoin as the settlement layer. The project is well financed (from an actual SEC-regulated multi-million dollar capital raise) and they also issue grants for dapp developers to potentially kickstart a network effect.
It remains to be seen whether any particular projects will be successful or not, but the point is, Ethereum has some competition at a time when it is undergoing transformation.
In the second half of 2020, Ethereum’s ecosystem encountered high fees, due to so much DeFi and stablecoin usage. That’s a healthy thing at first, since Ethereum is being heavily used and its network effect is vibrant. However, the fees caused problems for small transactions and made them non-economical. It’s fine to pay $1o to transfer $10,000 worth of tokens, but not fine to pay $10 to move $200 worth of tokens.
And so, as CoinDesk reported for example, lately more Tether transactions are occurring on Tron than on Ethereum:
Chart Source: CoinDesk
More Tether value was still settled on Ethereum than Tron during this period, since the larger transactions still took place there, but many of the smaller transactions spilled over onto competing protocols since the rising transaction fees were making them uneconomic on Ethereum.
This happened years ago with Bitcoin and Ethereum. Tether used to be run via the Bitcoin/Omni protocol, but increasingly switched to Ethereum. Now it’s showing an ongoing tendency to switch to cheaper chains as needed.
This highlights the relatively low switching costs of these utility protocols; stablecoin entities and their users often create their tokens on multiple protocols and can use whichever ones serve their purposes the best.
Ethereum 2.0: The Next Iteration
Ethereum.org describes some of the problems with their current protocol:
High demand is driving up transaction fees that make Ethereum expensive for the average user. The disk space needed to run an Ethereum client is growing at a fast rate. And the underlying proof-of-work consensus algorithm that keeps Ethereum secure and decentralized has a big environmental impact.
To solve some of these issues associated with the Ethereum network, the core developers including Buterin have been working for years on Ethereum 2.0, which will make huge changes to the protocol down to its core.
Primarily, it will change from a proof-of-work security model to a proof-of-stake security model.
In a proof-of-work model, which is what Bitcoin uses, miners dedicate processing power to solving puzzles, and when one is solved, it adds another block to the blockchain, which means a bunch of transactions get processed. The correct blockchain is whatever the longest chain of blocks is, as determined by the network majority. In a proof-of-stake model, transactions are validated not by contributing processing power, but instead by proving they own units of the cryptocurrency, and whichever chain is validated by more holders of the currency, wins.
If a proof-of-work blockchain has a split, meaning that there is a dispute about which block is the latest, a miner can only work on one of them at a time, and the longest blockchain ends up getting accepted by the majority. In a scenario where miners disagree about what the most recent block is, each miner has to choose which chain it thinks is correct, and commit processing power to add more blocks to that chain. Inevitably, one chain will outpace the other, based on which one the majority of miners contribute to, and it will be the winner. The shorter chain will be discarded, and any miner that contributed processing power to it has wasted their money.
A proof-of-stake model uses less energy, but is less-proven technology in terms of security and decentralization. In fact, ongoing research into this space is part of what delayed Ethereum 2.0 from being finished for years. An inherent problem with a proof-of-stake model is that there is no cost for simultaneously verifying transactions on multiple chains. Rather than contributing to one chain, someone with a stake can verify all splits on the chain simultaneously with their tokens, since it doesn’t require much processing power and thus has no cost for being wrong. They don’t have to just pick one. So, how are chain disputes resolved?
There are various solutions to this, and that was part of the research and development in recent years. A number of different blockchains with proof of stake models have popped up. In general, the blockchain needs a way to be aware of splits and “punish” proof-of-stake validators for validating any chain that ends up not being the longest chain. This adds a cost for being wrong, and gives an incentive to only validate what stakeholders really think is the correct chain, like a proof-of-work miner has to do. Ethereum 2.0 will have mechanisms to remove Ethereum tokens from validators that didn’t do their job properly, which creates a big cost for being wrong or attacking the network.
Ethereum’s proof of work security spend is lower than Bitcoin’s proof of work system, and more importantly uses GPUs rather than ASICs like Bitcoin uses. ASICs are specialized hardware with physical supply limitations (much harder for an attacker to acquire the majority of; the attacker would likely need involvement from existing miners with existing hardware) that can’t be repurposed for other activities, whereas GPUs are general purpose and abundant. Theoretically, someone could buy a ton of cloud GPU power for a brief period of time and try to do a 51% attack on Ethereum 1.0, and this attempt would be much cheaper than trying to do a 51% attack on Bitcoin, without specialized hardware or supply chain limitations.
So, I can see why Ethereum’s developers are interested in proof of stake instead, due to their low hash rate and GPU-based mining. Assuming it works as intended with no hidden attack surfaces that were not accounted for, proof of stake should make Ethereum more costly to attack than it currently is. However, with any new security model, it takes years to prove that it’s attack-resistant in practice. The more complex something is, the more surprises there can be.
Ethereum 2.0 Roll-Out
The Ethereum developers have been working on the Ethereum 2.0 update for years, have experienced multiple delays, and are intending to complete it by 2022. It may end up being delayed beyond that. I don’t blame them; it’s extremely complex.
First, a “beacon chain” was released that runs in parallel to the existing Ethereum blockchain. This was done in December 2020. This allows for “staking”, meaning that Ethereum holders can commit an amount of Ethereum tokens to operate a validator, which will validate transactions. Anyone with 32 Ethereum tokens can operate a validator, and those with smaller holdings can contribute to a validator pool instead. This is the core proof-of-stake model.
Second, up to 64 “shards” will be created. Rather than being one chain, there will be dozens of parallel chains called shards that process transactions on Ethereum 2.0 and connect with the beacon chain. This will radically increase the transaction throughput of the system. Each validator will only operate on one shard at a time, verifying transactions that are taking place on that particular shard. Sharding potentially opens up security issues, because for example if validators can choose which shard to operate on, it wouldn’t take much money to do a 51% attack on one particular shard, and so the beacon chain has to coordinate validators somewhat randomly to prevent this possibility.
Third, once all of this is running, the current Ethereum 1.0 chain will be docked into one of the shards. At that point, Ethereum 2.0 is born, and could be considered out of alpha development and in beta development, for further refining as it operates. And then at some stage of no major changes for a while, it can be considered to be out of beta development.
In addition, there are “rollups” and other side-chain solutions, which are somewhat similar (in terms of the end goal) to how the Bitcoin network uses Liquid and Lightning as secondary layers to enhance its throughput.
And with these developments, there are questions as to whether sharding is even necessary, which gets back to the point of the base layer itself being in development. Ben Edgington’s recent article for The Block, for example, outlines how the roadmap is shifting:
A year ago, Ethereum 2.0 had a neat and tidy, linear roadmap. Phase 0 (the beacon chain) was to be followed by Phase 1 (sharding for scalability), which was to be followed by Phase 2 (abstract execution engines), and finally, Eth1 would be merged into Eth2 on top of this superstructure. Then the Phase 2 design began to look like it would take longer than expected, and, at the same time, pressure started growing to get Eth1 merged into Eth2 as early as possible. So we inserted a Phase 1.5, in which a “lift and shift” of Eth1 into an Eth2 shard could be performed directly.
Alongside that, a whole new scaling paradigm emerged that doesn’t rely on sharding at all. This is “rollups”, and, in October this year, Vitalik proposed a new rollup-centric Ethereum roadmap, as the route to scalability. Rollups are a so-called Layer 2 technology that take much of the burden of computation and storage out of the blockchain, and use the chain just enough to benefit from its security guarantees. They come in different forms — zk-rollups and optimistic rollups—with different trade-offs, and the technology is nascent. But it is looking very likely that rollups could provide much of the scalability Ethereum needs, even before Ethereum 2.0 is fully delivered.
Also in the mix are stateless Ethereum (although rollups might relieve some of the pressure of Ethereum’s state bloat), and promising new cryptographic techniques like Kate commitments (pronounced “kah-tay”) that suggest exciting new directions.
With all this going on, our nice, neat, three-phase roadmap has now morphed into the spider’s web from Vitalik’s recent update.
Can we weave all these threads into a coherent tapestry? I believe that if any community can make this work, it’s the Ethereum community.
What will Ethereum look like in a few years? It’s hard to say. Investors that strongly believe in the project could be rewarded significantly if all the pieces fall into line properly in the years ahead, but there is also significant risk and lack of clarity as technical paths and overall architecture proposals change, right on the base layer.
Kind of like a bet on a startup company management team, a bet on Ethereum is a bet that the developers will perform a massive transformation on the base layer and successfully maintain its dominant network effect against competitors.
Ethereum Monetary Policy
One of the criticisms that Bitcoiners have towards Ethereum is that its monetary policy has changed multiple times within its shorter lifespan, while Bitcoin’s has yet to change.
Bitcoin generates a new block on average every 10 minutes, and every time this happens, a certain number of new coins are created. For the first 210,000 blocks, it was 50 new coins per block. For the next 210,000 blocks, it was 25 per block. Then it was 12.5 per block, and currently it is 6.25 per block. Every 210,000 blocks, the issuance rate gets cut in half, and over time its issuance will asymptotically approach zero. Bitcoin investors can tell you with a rather high degree of precision how many Bitcoins there will be in, say, August 2026.
Bitcoin will not exceed 21 million coins or alter this exponentially decreasing issuance rate unless a majority of the decentralized network agrees to, which is very unlikely unless there is some security issue in the future that forces them to change their issuance model. Here’s an article that covers a number of topics related to long-term Bitcoin security. There is no central development team that can easily change Bitcoin’s monetary policy, and in twelve years of history it has not been changed.
In contrast, Ethereum has a more flexible monetary policy, changed by key developers over time and accepted by the network whenever needed. It was launched with 72 million pre-mined coins from the start (unlike Bitcoin which had no pre-mine), and currently has about 115 million in total supply. This chart shows the total supply in blue on the left axis and shows the annual supply inflation rate in orange on the right axis.
Chart Source: EthHub
The annual issuance rate with all those annotations kind of looks like it was drawn by a Bitcoiner making fun of Ethereum, but instead that’s from an Ethereum source. Various Ethereum Improvement Proposals or “EIPs” by developers have changed its monetary policy over time as needed for various reasons.
However, alongside this transformation process to Ethereum 2.0, Ethereum seems set to change its monetary policy again with an update called EIP 1559. This should substantially reduce new token issuance.
Within this EIP 1559 framework, Ethereum will have both a deflationary element and an inflationary element that together will determine how many Ethereum tokens there are at any given time.
The deflationary element of EIP 1559 is that the base fees that users pay for validators to verify transactions will be destroyed, rather than given to the validators. Users can provide an extra “tip” fee to validators to incentivize getting certain transactions through the queue quicker, but the base fee will be destroyed each time. Since these fees are exclusively paid in fractions of Ethereum tokens, this permanently removes a small percentage of Ethereum tokens from the system every day. The higher the total fees are in the system, the more tokens that will be destroyed per day.
The inflationary element of EIP 1559 is that validators will receive newly-generated Ethereum tokens from the network for validating transactions in perpetuity. The total rate of issuance will depend on how many ether tokens are being used as validators, with higher yields if there are few validators (thus incentivizing more, to boost security) and lower yields if there are many validators (which makes it less attractive to validate). The more validators there are on the network, the more tokens that will be generated, but the amount generated per validator will decrease, resulting in lower yields for validators.
Validators have risks, as previously mentioned. Improper validation or being offline can result in some of their tokens being taken away. So, rewards of newly-created Ethereum tokens incentivize them to tie up capital and take risk to generate more tokens for themselves, and provide necessary transaction validation and security for the network.
In theory, EIP 1559 is a rather elegant framework. It ensures an inflationary security budget for validators, while also having a deflationary element in the form of fees.
Many Bitcoiners would disapprove of the fact that there’s no hard issuance rate or hard cap for Ethereum tokens on EIP 1559. I actually don’t have a fundamental problem with EIP 1559; I think it’s a much better monetary policy than Ethereum has been operating with so far, and is well thought out. As long as the monetary policy is rules-based and results in relatively low issuance, I think that can work for what Ethereum is trying to accomplish with its protocol (as an oil-like enabler of dapps, rather than as a gold-like scarce collateral). Indeed, the highest potential rate of issuance in the proposed EIP 1559 system is quite low, and some potential outcomes are deflationary on net, if there is high transaction throughput relative to the number of validators choosing to operate on the network.
However, my question is that given how many times Ethereum’s monetary policy has changed already, why would I assume EIP 1559 will be permanent? Ethereum developers change their monetary policy as often as the Federal Reserve does, and for similar reasons (to try to optimize aspects of the ecosystem’s economy). If EIP 1559 is in place for a number of years, proves itself to work as intended, and doesn’t change, and Ethereum 2.0 is operating smoothly, I’ll have reasonable confidence that it won’t change anymore and that the system is working as intended. Until then, all I can do is watch and see how things turn out, unless I feel like making a speculation based on my assessment of the developer team and the competitive environment.
Let’s take a look at node characteristics. A node refers to client software that a user can run to verify the blockchain and help enforce consensus rules. I’ll start with Bitcoin for reference again and then compare and contrast Ethereum to it.
Even after 12 years of consistent operation, the entire Bitcoin blockchain is less than 350 gigabytes, and is growing rather slowly at a pre-programmed limit. Bandwidth requirements to run a full node are only about 500 megabytes per day, which is super low. By being small and not growing faster than memory grows for a typical computer over time, and with only a basic internet connection required, a full Bitcoin node that stores and validates the entire blockchain can be run on a laptop or similar device, and that will be true for the foreseeable future.
This makes Bitcoin highly decentralized in terms of validation and consensus. Although mining capacity is centered in certain countries (like China), a big source of Bitcoin’s decentralization rests with its consensus framework among full nodes. Each full node can reconstruct the entire Bitcoin blockchain, and they are operated around the world. Here’s a map of ones that are visible to the network:
Ethereum currently has various levels of nodes. Despite the Ethereum blockchain being far younger than the Bitcoin blockchain, the amount of space required to run a full node for the Ethereum blockchain is already larger than a Bitcoin full node, since it grows more rapidly per unit of time. Given a sufficient length of time, it can become harder and harder for a regular user to operate one, which means full nodes could be limited to large entities rather than accessible to any user.
Plus, there is something called an archive node in Ethereum that is more complete, since it includes various intermediate states. A full node can unfold and turn into an archive node, but it takes many days and many terabytes of space, so they tend to be run only by larger specialist entities.
Ethereum 2.0 will change this. In order to greatly increase the transaction throughput of the system, validators will only be verifying transactions on a specific shard (out of potentially 64 shards), so they are only storing data for and paying attention to a small subset of the network.
However, there will also be super-full nodes that store the full data of the entire Ethereum 2.0 network; these will require massive storage and bandwidth, and will only be operable by a handful of large entities.
Ethereum wiki provides an overview of the types of nodes that will exist in Ethereum 2.0:
Note that there are now several “levels” of nodes that can exist in such a system:
Super-full node – downloads the full data of the beacon chain and every shard block referenced in the beacon chain.
Top-level node – processes the beacon chain blocks only, including the headers and signatures of the shard blocks, but does not download all the data of the shard blocks.
Single-shard node – acts as a top-level node, but also fully downloads and verifies every collation on some specific shard that it cares more about.
Light node – downloads and verifies the block headers of main chain blocks only; does not process any collation headers or transactions unless it needs to read some specific entry in the state of some specific shard, in which case it downloads the Merkle branch to the most recent collation header for that shard and from there downloads the Merkle proof of the desired value in the state.
This is a difference between Bitcoin and Ethereum 2.0. The Bitcoin community emphasizes self-verification as a key principle. Any normal user can download the open source Bitcoin Core software on a basic laptop and the entire Bitcoin blockchain. This allows them to audit the entire money supply of Bitcoin, see every transaction in all of Bitcoin history, and verify for themselves that the consensus rules are being followed across the network.
With Ethereum 2.0, a regular user won’t be able to do that; they will need to trust other network participants, including these super-full nodes run by large entities, and rely on a probability assessment that the protocol is working as intended. They will only have direct verification access to the network with a single-shard node or beacon-only node or light node at a given time, unless they can invest into major computer/network infrastructure to run a super-full node, which will be outside of the capacity of most users.
Again, to their credit a ton of thought was put into this design. Ethereum developers wanted to avoid some of the issues of altcoins that try to increase throughput by making every node hard to run, so they wanted to make a spectrum of nodes to give users different levels of validation, which is about as good as can be done when this much complexity is being built into the base layer of the protocol.
A Price Model for Tokens
The Ethereum 1.0 blockchain is rather congested now, so transaction fees are pretty high for what the protocol is trying to accomplish. This can be beneficial for Ethereum price; you need Ethereum tokens to pay for smart contracts to execute, and high fees mean you need more tokens to pay for that execution. In the long run that’s bad for the network though, because if dapps are way more expensive than their centralized app counterparts, then their reason for existence is less compelling and competing utility protocols can take market share.
The main purpose of Ethereum 2.0 is to dramatically expand throughput of the system, literally by orders of magnitude. While this is necessary for the protocol to become a “world computer” as it is attempting to do, it opens up questions about the incentive structure for Ethereum token pricing.
If transaction throughput is super high, and fees are pretty low, users don’t need much Ethereum tokens to run dapps. There’s this interesting trade-off: high fees make dapps less attractive and provide room for competitors to take market share, while low fees potentially decrease the demand for Ethereum tokens.
However, running validators is a good incentive for Ethereum investors to hold the tokens for the long-term on Ethereum 2.0. They can hoard tokens and take them to validation to earn a yield of more tokens. So, for as long as the system remains functional, there will likely be plenty of people that want to hold the tokens and earn yield on them. In addition, Ethereum tokens can be used for collateral in DeFi borrowing. These functions serve as a liquidity sink for Ethereum tokens in the ecosystem, and is part of Ethereum’s attempt to be both a utility commodity and a monetary asset.
In theory, if Ethereum 2.0 dapp usage grows substantially over time, and the protocol retains significant market share against competitors, Ethereum tokens should appreciate in price to some extent as well, benefiting from these liquidity sinks, collateralization, and Metcalfe’s law.
By what degree, however, is hard to say, since a high-throughput low-fee system doesn’t directly necessitate a high Ethereum token price. Between late 2017 and late 2020, for example, the amount of USD value settled on the Ethereum network nearly tripled and even outpaced Bitcoin, largely due to high frequency stablecoin trading and DeFi, while Ethereum’s USD market cap merely re-tested its previous highs. This phenomenon was predicted by John Pfeffer back in late 2017.
Once again, an assessment here will depend on the investor’s view of the Ethereum development team and their ability to transform the base layer of their protocol while maintaining a lead over competition. Being a utility token does not preclude Ethereum from also being a monetary token, if sufficient investor demand for Ethereum tokens exists for staking and collateral. At the same time, ecosystem growth for a utility protocol does not necessitate token appreciation, unlike with Bitcoin as a primary store of value where adoption and token appreciation go mostly hand-in-hand.
To the downside, if Ethereum 2.0 dapp usage flattens out and stagnates (see the aforementioned problem of being rather circular at the moment, along with some competition), then the token value would also likely stagnate.
So, with Ethereum, investors have to be correct about two outcomes. First, you need to be correct about Ethereum retaining most of the smart contract market share for the long run, even as it undergoes a transformation. Second, you need to be correct that in addition to its utility functions, staking and collateral will be enough to permanently monetize Ethereum tokens themselves, rather than them serving primarily as fuel for the network.
Bitcoin vs Ethereum
There is a heated ongoing debate between some Bitcoiners and Ethereans (which, yes, does sound like a Star Trek episode).
First of all, there’s a cultural divide.
Bitcoin attracts more of a libertarian and Austrian economists group; big fans of sound money, self-sovereignty, etc. Also plenty of Silicon Valley financiers, so a bit of a mix there. Bitcoin enthusiasts like being able to run a full node on their personal computer and audit the entire money supply and consensus rules of the Bitcoin blockchain (“don’t trust, verify”). Development in the space is slower, but more stable, because preserving the core Bitcoin protocol is of upmost importance. Institutions are starting to get interested in Bitcoin with big pools of capital. The surrounding ecosystem is very security-focused, including multi-signature solutions and Bitcoin-only hardware wallets that take security a step further than other wallets. The protocol and surrounding ecosystem are hardened, battle-tested, and stable.
Ethereum attracts more experimentation. As a platform, it enables plenty of speculation in small altcoins that have a high failure rate, but also constantly re-assesses developments in the technical landscape to see how to improve its foundational framework. It’s more ambitious on the base layer, which some see as a feature, and others see as a bug. It’s more centrally-reliant on its founder, and more trusting in terms of money supply and details. DeFi on Ethereum has been able to catch on faster than Bitcoin secondary layers, but DeFi’s growth is inherently based on speculation so far.
Some Bitcoiners view any other cryptocurrency or digital asset as inherently a bad idea or scam. New uses of blockchain technology, many of them insist, should be built on Bitcoin’s proven foundation rather than in parallel to it as separate protocol. The Bitcoin developer community tends to move slowly and cautiously, rather than adopting the approach of moving fast and breaking things, which they perceive many other tokens as doing.
Ethereans, on the other hand, see a lot of value in the Ethereum network, and indeed that is the one other blockchain that has built some degree of network effect over time besides Bitcoin, and it’s also benefiting from Metcalfe’s law. Some of them view Bitcoin as old technology, or limited to being digital gold, and believe Ethereum is where a lot of the action will be going forward. Many of them see a role for Bitcoin as a savings technology and store of value, but are simply more interested in Ethereum’s potential for decentralized apps.
Buterin coined the term “Bitcoin maximalist” to refer to Bitcoiners that believe no other coin besides Bitcoin will retain significant value in the long-term. Bitcoiners in contrast, often point out that most folks who go into the rabbit hole of crypto-trading various altcoins end up losing money in the inevitable down cycle, and that many of these protocols just ride on the coattails of Bitcoin to enrich their founders at the expense of unsuspecting traders, without adding long-lasting value or understanding what exactly made Bitcoin successful for 12 years so far.
Overall, the track record for digital assets other than Bitcoin is pretty bad. Out of thousands of tokens, many have been outright scams, many lack sufficient security and get hacked at the base layer (not just through an exchange, but the actual protocol itself receives a 51% direct attack or a bug exploit), and others are well-intentioned and interesting but simply not successful. The vast majority have not surpassed their late-2017 highs in terms of price or hash rate, whereas Bitcoin has.
However, I do think some digital assets such as utility protocols are useful and are here to stay; the questions are how many, which ones, and at what market capitalization. Ethereum has so far been the second “blue chip” in the digital asset ecosystem, remaining a large force through more than one cycle.
The Hardest Money
I don’t consider myself to have much of a stake in this debate. I’m an investor, and want to invest in things that I consider to be stable projects and that have good risk/reward characteristics. For me at this time that includes Bitcoin, but does not include Ethereum.
I prefer the risk/reward opportunity in Bitcoin for the digital asset portion of my portfolio, based on reasons I described in my July 2020 article. It has 12 years of price history, and consistent monetary policy built around difficulty-adjustments that occur every 2 weeks and supply-halvings that occur every 4 years, which so far has algorithmically driven the price and adoption up:
Chart Source: Blockchain.com
Bitcoin’s base layer has been out of effective beta mode and in full operation for a long time. The ecosystem around it continues to improve, and the base layer gets security updates over time, but it’s a working system as it currently is. There have been no major changes on the base layer since 2017, and it has operated with the same overall framework since inception in 2009. The bigger changes in the Bitcoin space are mostly happening on secondary layers and in the surrounding software/hardware/finance ecosystem.
Ethereum, on the other hand, is a work in progress on its base layer, still in alpha development since it’s still changing core underlying mechanics despite being in operation. Many of the aspects for Ethereum 2.0’s design are clever, and it’s clear that a lot of thought has been put into it, but there’s plenty of speculation about what demand for it will be, how well it will function, and how securely it will maintain itself. They’re changing many things about the protocol that made it successful in terms of price for the first 5 years of its life, in an attempt to address current limitations that threaten the functionality of the network.
Some macro investors like to do a split of 90% Bitcoin and 10% Ethereum, or 80% Bitcoin and 20% Ethereum, for the digital asset portion of their portfolio. Do I think that’s crazy? Not really.
People should do what they think is right for them, what they assess to have a good risk/reward opportunity, etc. Study the top protocols, and determine for yourself what you think is likely to be successful. Some people would see value in buying some Ethereum tokens, stashing them away somewhere, and seeing what happens in five years, as a rather asymmetric speculation. If Ethereum breaks over $1,400 to new highs, it has the potential for a major gain next year. Indeed, as long as the network is congested and fees are high, it helps Ethereum tokens appreciate in price.
However, investors should understand that Ethereum is still in alpha development. Maybe in another 5 years when Ethereum 2.0 is in place and functioning for a while, with consistent monetary policy for that whole time, it can be considered largely a finished project like Bitcoin. Until then, it’s experimental.
Bitcoin has a significant amount of volatility and upside potential as it is, so most investors do not need to take the speculative risk of venturing into protocols that are still doing fundamental development on their base layer.
Value accrual tends to concentrate in the hardest form of money in terms of scarcity, security, divisibility, and fungibility, which is why gold has been foundational for most of human history in the area of finance. Things that can be used to perform work, like copper or oil, are not typically where the market stores long-term value. That analogy doesn’t apply perfectly to Ethereum since Ethereum has a high stock-to-flow ratio, but from an investor perspective, the burden of proof is on any secondary network that tries to optimize for many things, in terms of its attempt to rival the top network at the main thing that it does (store value). This is not without precedent, however. Silver for example has a history of being used for both utility and money, existing in the intermediate state between gold and copper/oil.
The extent to which the Ethereum ecosystem can enable a host of applications is a somewhat separate question from how much its tokens will appreciate for the long-term in terms of price, apart from the natural boom/bust cycles that it goes through. The complexity of Ethereum 2.0’s proposed base layer, with a beacon chain and dozens of shard chains, may be less appealing for large pools of capital to buy and hold tokens of, compared to the relative simplicity and complete verifiability of Bitcoin’s base layer.
The Concorde Risk
In my view, the biggest risk for Ethereum is that it could end up like the Concorde.
The Concorde was an airplane, first flown in 1969, that would let the public fly at up to 2x the speed of sound.
While it was functional, and operated commercially for over 25 years in a limited sense, it never became an economically sustainable project. As I write this in 2021, over 50 years later, the public still has no supersonic commercial flight options.
People in the 1960s thought we’d be in space by now or with flying cars, like the Jetsons, rather than traveling in planes that are slower than the fastest commercial plane of 1969.
It’s extremely challenging to design and operate an aircraft that can safely and repeatedly surpass the speed of sound; lots of aerodynamics change at that point where the sound barrier is breached. In five decades since its conception, the problem has still never been solved in an economic way for commercial flight.
So, while the Concorde was really cool, could go from New York to London in three hours, and stuck around for a while, it never could quite work in terms of solving a big enough customer problem at an appropriate price, compared to alternatives. The market eventually settled for first-class flyers paying higher fees to make a long flight more comfortable, rather than money going towards shortening the time of the flight.
Ethereum has a ton of smart developers working on it, and it’s exploring some neat avenues. It pushes Bitcoin developers to continue to innovate in the ecosystem around the base layer, which I like to see. But I have lower conviction that Ethereum will be successful in the long run compared to Bitcoin, in part because of the rise of other utility protocol competitors. I’ll continue to monitor the situation as things change and new facts and developments come in.
Maybe Ethereum will iterate and find a long-term sustainable place for itself in Ethereum 2.0. On the other hand, Ethereum could end up being weighed down by its own complexity and lack of broad economic use, like the Concorde, while later generation utility protocols catch up.
I think monitoring Ethereum and other utility protocols is important for a variety of different investors.
Stock investors should probably pay attention to some of the dapp development, to see if anything out of that ecosystem could disrupt some of their traditional investments over time. Bitcoin investors should monitor it as a partial competitor and partial collaborator, to see what works, what doesn’t, and more importantly, why. It can inform the development of their own ecosystem.
Stablecoins are particularly important, in my view. I’m bullish on the amount of money locked up in stablecoins. It’s a space to watch, for both good developments and bad developments. The US Office of the Comptroller of the Currency now officially permits US banks to use stablecoins. They’re a much more liquid form of fiat currency, and can have various implications for central bank digital currencies and the existing global monetary system.
While I don’t think having a small position in Ethereum is crazy, I also don’t have a clear way to model it other than speculation, since it’s an unfinished product on the base layer, with a rather circular use-case so far that revolves around the trading, leveraging, liquidity provision, and gamification of altcoins. With Bitcoin, I can present a more fundamental-based argument in favor of a nonzero position as a macro asset.
80/20 or 90/10 or 100/0 in terms of BTC/ETH ratio all make sense to me as the digital asset portion of an investment portfolio. My approach is closer to 100/0 in favor of Bitcoin and I haven’t seen a compelling reason to change that, other than if I just feel like speculating on the long-term success of the developers. I’d personally need to see Ethereum 2.0 out of alpha development, with consistent monetary policy, and with more usage in areas outside of token speculation, for it to grab my interest in a more structural way.
Some people in the digital asset community refer to Bitcoin as gold and Ethereum as oil. One is a store of value, and the other is an enabler of work, in other words.
However, I see Bitcoin as having a tendency to surprise to the upside, and persist from cycle to cycle in a way that most other cryptocurrencies don’t. Ethereum might be the second large blockchain network that stays around for a long time from cycle to cycle in a functional form, consistently benefiting from Metcalfe’s law, but it has to get past this 2.0 transformation.
From an engineering perspective, I prefer Bitcoin’s modular design. The base layer is simple and stable, designed to be nearly bulletproof. On top of that layer, the ecosystem can innovate, and while it may not move as fast as some people prefer, it moves in the direction that the market wants. That’s also how the existing financial system works; there are underlying settlement layers and then faster payment layers built on top of those base layers.
So far, the market in the Bitcoin ecosystem has wanted security to maximize the store of value proposition, so it has received a level of multi-signature solutions and hardware wallets that exceed the ecosystems of other digital tokens including Ethereum. The market has been less interested in Bitcoin’s secondary layers as a medium of exchange since there hasn’t been a lot of necessity yet, although Lightning Labs and other developers continue to build tools and infrastructure for when demand increases (which eventually, higher fees on the base layer will likely cause), and many app developers are already using those tools.
As an analogy, martial arts all have different philosophies. Some strike first, and are more prone to offense. Others emphasize a strong foundation, patiently absorb or deflect initial attacks, and then respond harder and use their opponent’s momentum against them.
Bitcoin, in my assessment, is the latter. It doesn’t move fast and break things (as per the Silicon Valley saying) like many altcoins do, but it moves slowly and has a tendency to get things right. The more ideas and innovations that pop up in the broader digital asset industry, the more Bitcoin developers have to work with for their protocol and ecosystem.
I’ll continue to monitor the industry, but at this time I prefer an exclusive Bitcoin investment for the bulk of my digital asset portion of my portfolio. I can see why some people like to speculate with Ethereum as well, since it can have higher percentage gains during bull runs. Those speculators should understand that the base layer is still in alpha development, with rapid change in terms of its security model, monetary policy, and addressable market, at a time when competition in the smart contract industry is not insignificant.