Grayscale Research: Reasons for ETH's poor performance in 2023

• Ethereum has performed strongly in 2023, but has underperformed relative to Bitcoin and some other smart contract blockchain tokens. We believe this reflects Bitcoin-specific positive factors this year and a slower recovery in Ethereum on-chain activity.

• Although not as high as Bitcoin, Ethereum has outperformed traditional asset classes on an absolute and risk-adjusted basis this year. The development of the Ethereum L2 ecosystem could attract new users and support the token’s valuation in 2024.

While an asset is up 82%, you could hardly call it “underperforming,” but that’s exactly what’s happening with Ethereum’s Ether (ETH) in 2023. The second-largest crypto asset has generated strong returns this year (and relatively low price volatility), but still has less room to appreciate than Bitcoin (BTC), which is expected to rise 162% this year[2]. The ETH/BTC price ratio has fallen throughout the year, reaching its lowest level since mid-2021 (Chart 1)[3]. Grayscale Research sees several reasons for ETH’s underperformance in 2023.

Chart 1: ETH/BTC price ratio is on a downward trend in 2023

First, this year included several positive Bitcoin-specific factors, including potential progress on a spot Bitcoin ETF and the shaky situation of regional banks in the United States, highlighting Bitcoin’s role as an alternative digital currency system. These developments appear to have driven inflows into Bitcoin-focused crypto investment products throughout the year, which may have helped to drive its larger price returns. For example, Grayscale Research estimates that net inflows into Bitcoin-focused crypto trading products (including futures-based products in the United States and spot products overseas) will total approximately $2 billion in 2023. In contrast, net inflows into Ethereum-focused trading products during the same period were only $24 million (Chart 2) [4].

Chart 2: Bitcoin-specific positives appear to be driving greater ETP inflows

Second, while most smart contract platform tokens have underperformed Bitcoin this year, ETH has largely kept pace with this peer group. As shown in Figure 3, the FTSE Grayscale Smart Contract Platform Crypto Sector Index is up about 94% in 2023, only slightly higher than ETH[5]. Ethereum outperformed other cryptocurrencies in the year to October, but other tokens have recently caught up (notable outperformers include AVAX and SOL). Overall, ETH ranks in the middle of the pack among the 40 tokens in the smart contract platform crypto space[6].

Chart 3: Ethereum performance is consistent with the smart contract platform crypto industry

Third, certain categories of on-chain activity on the Ethereum mainnet have recovered more slowly than on other blockchains. For example, Solana’s NFT transaction volume has grown faster (by about 15x) since the beginning of the quarter, while Ethereum’s NFT transaction volume has only grown by about 2x in comparison[7]. Bitcoin’s digital collectibles transactions have also increased significantly due to the rise of Ordinals (Chart 4); in late December, Bitcoin’s daily fees even surpassed Ethereum’s due to the large number of Ordinals transactions[8]. Although Grayscale Research remains positive about Ethereum’s NFT ecosystem, Solana and Bitcoin have recently taken market share in this area of ​​on-chain activity[9].

Chart 4: NFT activity on Bitcoin and Solana continues to grow

From a broader perspective, while Ethereum has lagged behind Bitcoin and certain other crypto assets this year, it has largely outperformed traditional asset classes both in absolute value and adjusted volatility (Chart 5). Therefore, while its price is “only” up 82% this year, this rebound should be viewed as evidence of a broader crypto market recovery, in our view.

Chart 5: Ethereum’s risk-adjusted returns outperform traditional asset classes

While other blockchains are getting a lot of attention in 2023, Ethereum’s future looks bright. Most importantly, the Ethereum blockchain has historically benefited from the industry’s deepest network effects, with the most decentralized applications (DApps), the most developers, and the highest revenue [10]. Ethereum is pursuing a “modular” approach to development, where an ecosystem of Layer 2 blockchains will be built on top of Layer 1 chains to enable scaling activity. This effort is still ongoing, but will take a step forward next year with EIP-4844[11], which will make it 10-100 times cheaper for Layer 2 scaling solutions to confirm transactions on Ethereum[12]. This will help reduce costs for Ethereum Layer 2 users.

If Ethereum can attract more users to its growing Layer 2 ecosystem, it has the potential to return to center stage in 2024.

Low-cost “monolithic” blockchains like Solana can provide a compelling experience for new users, especially if paired with well-designed wallets and other ecosystem applications. In contrast, Ethereum’s modular landscape may be more difficult to speculate on, as users will need to actively bridge assets between the mainnet and its Layer 2. However, the development of these networks is still in its early stages, and it is unclear which blockchain design choice will find the best product/market fit and accumulate the most value for its native token over time. Once end users primarily interact with applications and the blockchain infrastructure runs in the background, Ethereum’s current user experience challenges will become less relevant, while Ethereum’s other features, such as its reliable decentralization, may attract developers and ultimately support the token’s valuation. For investors who are uncertain about how competition for smart contract platforms will evolve, considering diversification in this crypto sector may be worth exploring.