Fidelity's major report: Will Ethereum become deflationary?

While users gain technical utility from the Ethereum network by accessing various applications in the ecosystem, one might ask, “How does utility translate into value for the ETH token?” In other words, why would an investor buy and hold ETH, rather than just use it to interact with the Ethereum network? This article will delve into this question, including some technical aspects related to various investment themes.

This article mainly discusses:

The best way to understand Ethereum is that it is a technology platform that uses ETH as a means of payment.

Ethereum’s perceived value is tied to the network’s use cases and supply and demand dynamics, which has changed since the Merge.

Ethereum’s overall platform usage is likely to pass value on to token holders, leading to an appreciation in the value of the ETH token.

One investment thesis for holding ETH is to use it as an emerging form of currency, similar to Bitcoin.

However, it seems impossible for any other digital asset to surpass Bitcoin as a monetary good because Bitcoin has its own characteristics and network effects.

That said, the fact that value is subjective does not mean that other competing forms of money (like ETH) cannot exist, especially in specific markets, use cases, and communities.

We examined ETH’s ability to fulfill the two main functions of money: store of value and means of payment.

Ethereum is still imperfect and is expected to be upgraded every year, which brings constant technical risks and unknown factors, reducing its prospects as a store of value asset.

While ETH is used for a variety of payment purposes, fee instability remains a barrier to widespread adoption.

We studied demand-side models for ETH but found that the correlation between ETH address growth and price was weak compared to BTC.

Ethereum is now transitioning to PoS, allowing token holders to earn returns, some of which comes from increasing network use cases; we look at where this return comes from and what the various drivers and risks are.

As a yield-producing asset, the value of ETH can be examined using a discounted cash flow model; we construct a simple model to illustrate the assumptions driving the model.

Ethereum vs. Ether

There is a relationship between a digital asset network and its native token, but the "success" of the two is not always perfectly correlated. In some cases, a network can provide utility to users, settling a fair number of complex transactions every day, but not generate much value for its native token holders. Other networks may have a stronger connection between network usage and token value.

A common term used to describe the relationship between network design and token value is Tokenomics. Tokenomics is short for Token Economics and is used to explain how the design of a network or application creates economic value for token holders.

The Ethereum network has undergone significant changes in the past few years that have affected its token economics. The introduction of burning a portion of transaction fees (base fees) was implemented in August 2021 through Ethereum Improvement Proposal 1559 (EIP 1559). Burning ETH is equivalent to destroying it; therefore, the execution of a transaction on Ethereum takes part of ETH out of circulation.

In addition, the transition from PoW to PoS in September 2022 reduced the ETH token issuance rate and enabled staking, which allows entities to earn returns in the form of tips, issuance, and maximum extractable value (MEV). Ethereum's previous upgrades fundamentally changed ETH's token economics and changed people's perception of the relationship between the Ethereum network and the ETH token.

Token Economics: How ETH Accumulates Value

ETH's token economics consists of three functions, where use cases are converted into value. When trading on Ethereum, all users pay a base fee (Base Fee), a priority fee (tip), and may generate additional value for other participants through MEV, which refers to the maximum value that a validator can obtain from a user's transaction by adding/excluding transactions or changing the order of transactions in a block during the block production process.

The base fee paid in ETH is destroyed when a block is added (transactions are packaged), thus reducing the supply of ETH. Priority fees are paid to validators, the individuals or entities responsible for updating the public ledger and maintaining consensus. When a new block is created, validators are incentivized to add the highest priority transactions, as this may be their main way of directly earning income. Finally, potential MEV opportunities (usually arbitrage) are provided by different users and most of the value is passed to validators through the competitive MEV market in its current state.

The value accumulation mechanisms can be thought of as different uses of network “revenue”. First, base fees that are burned are deflationary to the total supply, benefiting existing token holders. Second, priority fees and MEV come from users and are distributed to validators who provide services. While the relationship between them is non-linear, increasing platform use cases equals increased burns and increases validators’ earnings.

Investment Theme 1: Aspiring Currencies

A common narrative theory holds that Bitcoin is best understood as an emerging monetary commodity, which has led to the discussion of whether the ETH token can also be considered money. The short answer is yes, some people may think so; however, ETH may face more resistance than BTC in terms of being widely accepted as a currency.

ETH shares many monetary properties with Bitcoin and other tokens; however, it differs from Bitcoin in scarcity and history. ETH technically has infinite supply parameters that are kept within certain bounds based on validators and burns. These parameters, while strictly enforced by the network, are not equivalent to a fixed supply schedule and can fluctuate in unexpected directions.

Since Ethereum undergoes network upgrades approximately once a year, the new code requires time to be updated and audited, and more importantly, requires developer attention to rebuild its performance history.

It seems unlikely that any other digital asset will surpass Bitcoin's status as a monetary commodity, as Bitcoin is regarded by some as the most secure, decentralized, and sound digital currency to date, and any "surpassing" needs to be thought twice. While network effects are crucial in the blockchain ecosystem, and Bitcoin as a monetary commodity is in the best position in this regard, this does not mean that other competing forms of currency cannot exist, especially for different markets, use cases, and communities.

More specifically, Ethereum’s alternative uses that Bitcoin does not have, such as facilitating more complex transactions, have led people to wonder if ETH has unique uses similar to Bitcoin. While ETH is typically transferred between addresses to transmit value, like Bitcoin, ETH’s additional role as a currency for users to execute smart contract logic is its real differentiation.

Everyday goods are not traded on Ethereum in any significant form yet, but the physical and digital worlds appear to be merging. As we have seen from leading tech companies, applications that provide unique services to users drive network effects and demand. By default, mainstream applications used on Ethereum will lead to demand for ETH, which is why this long-term trend may be one of the most compelling reasons for ETH as an aspiring alternative currency.

In fact, Ethereum has already made some notable fusions between the physical world and traditional finance:

MakerDAO purchased $500 million in Treasury bonds.

The first real estate sale in the United States on Ethereum was completed in the form of an NFT.

European Investment Bank issues bonds on-chain.

Franklin Templeton’s money market fund uses the Ethereum and Polygon networks to process transactions and record equity.

The convergence of the Ethereum ecosystem and real-world assets has begun. However, it will likely take years of improvement, regulatory clarity, education, and time before the general public begins transacting on Ethereum or competing platforms. Until then, ETH will likely remain a niche form of currency.

Among the many difficulties, regulation is the most controversial topic in terms of how it will shape the future of Ethereum. Although Ethereum is a global, permissionless blockchain, many of the largest centralized exchanges, which hold and stake Ethereum, are located in the United States. This means that any guidelines issued by the United States for validators or investors could have a significant impact on Ethereum's valuation and network health. With the recent multiple regulatory enforcement actions in the United States and the closure of cryptocurrency-related banks and Kraken's staking services, regulatory risk has become one of the biggest obstacles Ethereum may face in the near future.

Below we will discuss ETH from the two major functions of currency:

ETH as a Store of Value

For something to be a good store of value, it must be scarce or have a high stock-to-flow ratio. As of July 2023, ETH has a higher stock-to-flow ratio than Bitcoin. This dynamic has gained traction since the merger, significantly reducing ETH issuance, as shown below.

One of Bitcoin's core value propositions is its maximum fixed supply of 21 million coins, and the supply schedule has not and is unlikely to change. Bitcoin's supply schedule is programmed into the code and executed through social consensus and incentives from network participants. But what underlies the scarcity and supply schedule of ETH? As can be seen from the above figure, the issuance of ETH is not like a strict schedule, but more like a process of balancing between a set of set parameters. In fact, there are two variables that determine the total supply of ETH, which makes it difficult to assess future supply:

The first is issuance: issuance is determined by the number of active validators and their performance. An important trend in the model is that as the total number of ETH staked increases, the total amount of ETH issued will also increase, but the issuance rate will decrease. Because the issuance of ETH is related to the number of stakes, this part of the formula is not prone to drastic fluctuations. The Ethereum protocol sets limits on the number of validators who can enter and exit staking, which is intended to support the security of the protocol and keep the issuance rate stable over time.

The second is destruction: destruction is determined by the demand for block space. Block space computing resources are limited, and a new block is produced every 12 seconds. The volatility of destruction is extremely high, which makes it impossible to predict the exact future supply of ETH.

Burning acts like an incentive pendulum that is rarely the same from block to block. The protocol specifies a target gas fee that each block should contain, and if a block's gas fee is above or below the target, it causes the base fee of the next block to adjust accordingly. This adjustment is non-linear and can cause transaction fees to rise sharply when on-chain activity is high. It also acts as a safety mechanism, making it uneconomical for bad actors to spam the network from time to time.

Ultimately, ETH supply is not based on a fixed schedule. Both components of ETH monetary policy may still change. The current mechanism ensures that the total supply of ETH inflates by a maximum of about 1.5% per year. This assumes that 100% of the current supply is staked and no tokens are burned, i.e. no transactions occur on Ethereum. As shown in the figure, keeping ETH issuance or inflation low does not require increasing burns. In fact, increases in burns generally lead to net deflation or a decrease in total supply.

It has been pointed out that the future supply of ETH is related to the number of active validators (issuance) and transaction execution demand (destruction), the latter of which is relatively unpredictable in the long run. Ethereum upgrades may directly affect the destruction or issuance of the base layer, which increases the uncertainty of supply dynamics. For example, the Shanghai/Capella upgrade reduces staking risk and may increase total issuance due to higher staking participation. On the other hand, data availability expansion (increased transaction throughput) and the maturity of 2-layer platforms may change the supply and demand dynamics of destruction in unpredictable ways and further disrupt the future supply of ETH.

Additionally, competing L1 networks are independent blockchains with native tokens responsible for completing transactions, but do not have the same iteration and development time as Ethereum. As dApps develop and integrate with other blockchains, investors should be aware that this may drive user growth. For some use cases, such as NFTs or games, users may not need the decentralization and security provided by the Ethereum base layer.

If users are willing to sacrifice decentralization or security of the blockchain trilemma in order to prioritize L1 scalability, some user value may be generated outside of Ethereum. Since the smart contract platform economy is likely to be multi-chain anyway, investors should consider which use cases Ethereum will retain in the long term and which will happen elsewhere.

Another clear and crucial difference between ETH and other store-of-value assets is the possibility of future upgrades to the supply schedule. In the latest release, developers noted Endgame EIP 1559 and MEV Burn. These roadmap components make it clear that changes are coming to the way burns affect supply, but it is not yet clear what the changes will be. Whatever these changes lead to, it stands in stark contrast to Bitcoin's value proposition, which claims that its fixed supply schedule will not change for a long time to come.

In summary, while Ethereum's narrative of ultra-sound money is gaining traction among community members, there are many hurdles to prove that ETH's supply is stable like other store-of-value assets. ETH's overall platform use case can deliver value to token holders. However, value is subjective, and any description of an asset may be merely semantic, especially early in its life cycle.

ETH as a means of payment

ETH is used as a means of payment, but these payments are limited to digital native assets. For most transactions, Ethereum typically completes final confirmation within 13 minutes, which makes it faster than BTC's 6 blocks (1 hour) probability guaranteed settlement. Final confirmation means that the transaction has been included in a block, and the block cannot be changed without slashing a large amount of ETH. (WEEX Note: Slashing means that when a dishonest proposal or block proof appears, part of the validator's equity is destroyed and the validator is forcibly removed from the network.) This mechanism makes Ethereum an attractive payment asset in terms of final settlement time, but there are still many obstacles to overcome for payment applications to take off, most of which are related to user experience and high gas fees.

Since the merger, NFT payments have consumed the second-highest gas fees, second only to DeFi-related transactions. NFTs are denominated in ETH, which by their nature will experience price fluctuations. For a merchant selling an NFT for 1 ETH, the purchasing power represented by this amount varies greatly depending on the market price of ETH. This variability degrades the experience (primarily for sellers) and is a common problem in many digital asset claim payment cases.

While the Ethereum network has a wide range of transaction options, directly transferring value makes up a large portion of the network’s use cases; peer-to-peer transfers have consumed the third-largest amount of ETH since the merge.

The biggest issue affecting Ethereum’s payment use case is fee volatility. Ethereum’s dynamic fee model causes fees to rise quickly and sporadically. The variable cost of transactions can limit payment use cases while reducing Ethereum’s user experience by making it an unreliable and inexpensive value transfer network. Users often have to make a decision: do you transact now at a high cost, or wait until network activity drops? This variable forces developers to get creative in hopes of maximizing speed and efficiency to meet user preferences.

In addition, if more real-world assets enter the blockchain, payments for these assets may use ETH, stablecoins, or other tokens. Combining these innovations with the lower fees provided by Layer 2 platforms can give us an exciting prospect for payments on the Ethereum network.

Network data shows that ETH is mainly used for digital asset native payments when used as a means of payment. However, due to poor user experience, Ethereum's potential as a payment network has not yet fully reached its peak. Whether Ethereum can become a mainstream payment method depends largely on whether the community can overcome various obstacles such as ease of use, real-world transactions, security, and low-cost transactions as soon as possible.

Evaluate ETH based on demand

Since applications on the Ethereum network require ETH, an increase in use cases for the Ethereum network could lead to an increase in the price of ETH and, due to supply and demand mechanisms, increase the value of ETH token holders.

The following figure shows the prospects for value accumulation in the base layer (Optimism), which ultimately converts network usage into the value of ETH. The L2 network (Arbitrum) is built on top of the base layer, which handles transaction execution and relies on the base layer to provide security and transaction confirmation.

Despite the bear market, Ethereum layer 1 transaction volume has remained fairly stable at around 1 million transactions per day, while the price of ETH has fallen 52% since the beginning of 2022. In addition, we have seen an increase in L2 layer transactions, while L1 layer transactions have remained unchanged, which may indicate that there is a certain degree of sticky demand in the base layer, while new demand comes from the L2 layer. This trajectory may indicate that even if L2 becomes more mainstream, the value of the base layer will continue to grow reliably.

The demand for ETH as a monetary asset is difficult to measure. Metcalfe's Law is a popular economic principle that shows the relationship between address growth and Bitcoin demand and price. Compared to Bitcoin, we find less evidence of this demand-price relationship when studying Ethereum.

After all, if Bitcoin is primarily viewed as an aspirational monetary commodity, then the relationship between expected demand for the asset and price as measured by the number of addresses makes more sense. For ETH, this significantly weaker relationship could mean that its value is derived from other sources, such as network use cases, rather than simple demand to hold ETH itself.

Risks of the demand-side model:

1. It can be said that the core value of Ethereum comes from the usability layer, and models that measure use cases by addresses rather than transfer volume, transaction volume, or usage cannot effectively capture this.

2. Although the data shows that there is a relationship between address growth and ETH price, there is no guarantee that this relationship will continue in the future.

3. This model is only a demand-side model, and as discussed earlier, the supply schedule of Ethereum may change in the future. Therefore, even if demand increases, if the supply also increases, the price of ETH may not change, and may even decrease.

Investment Theme 2: ETH as a Yield Asset

Why and how does ETH provide yield?

Since the merger, ETH is a completely different asset. Not only does it consume significantly less energy, it also provides returns to those willing to lock ETH in the consensus layer. The move to PoS is a turning point in Ethereum's security model. Compared to PoW, which introduced penalties for validator misbehavior, PoS maintains or even improves network security at lower fees.

Validators contribute resources to the network and perform assigned duties to help Ethereum reach consensus, and are therefore financially rewarded. The following is a brief description of the various validator responsibilities and rewards:

Since the merger on September 15, 2022, as of July 2023, 53% of validator income comes from Ethereum (referring to block rewards, WEEX note). Here are some other forms of income that are not paid by the protocol but come from users, which provide an interesting connection between network usage and validator income.

MEV:

It is clear that MEV comes directly from user transactions, as increased user activity typically leads to more arbitrage opportunities. Since Ethereum has multiple use cases, there are multiple ways to extract value from user transactions. According to Flashbots, an organization dedicated to counteracting the centralization effects of MEV, the most common forms of MEV typically come from arbitrage and liquidations, which thrive in highly volatile environments like the one in November 2022.

tip:

Ethereum's fee market has changed dramatically since the 2021 Ethereum London upgrade introduced EIP-1559. Before the upgrade, PoW miners received all gas fees from the blocks they mined. After the upgrade, the network has two separate fee types: base fees and priority fees (tips). All fees are still paid by users trying to execute transactions; once these fees are paid, EIP-1559 affects how they are distributed.

Instead of collecting all fees paid by users, validators only charge a priority fee. The base fee is destroyed or taken out of circulation. Tips can incentivize validators to prioritize transactions in their blocks, otherwise validators may pack empty blocks (which is more economically feasible). For users who are eager to execute transactions, a higher tip than other competing transactions in the memory pool (Mempool, pending transaction list, WEEX note) will incentivize validators to prioritize their transactions to be added to the block.

While MEV plays an important role in determining which transactions are included in each block, tips still act as an incentive mechanism as validators use them to decide which transactions to include in their blocks. Since the switch to PoS, tips have accounted for 22% of total validator revenue as of July 2023.

ETH valuation based on discounted cash flow model

After moving to PoS, the value assigned to ETH is easier to model. The demand for block space can be measured by transaction fees. These fees are either burned or rewarded to validators, thereby accumulating value for ETH holders.

Therefore, in the long run, the growth of fees and ETH value should be intrinsically correlated. The figure below shows this relationship using a simple discounted cash flow model. The results of such a model vary greatly depending on the growth assumptions and discount rate. The purpose of constructing such a model is not to provide a forecast of the fair value of ETH, but to describe the relationship between network use cases and value accumulation.

As a starting point, the chart below shows the average daily fees paid on Ethereum in USD since the implementation of EIP 1559 in August 2021. The chart is calculated using a two-stage discounted cash flow model, with an initial phase of continued large growth in adoption and fees, followed by a decline in the fee growth rate, so that regardless of the utility gained by Ethereum users, scaling may lower the upper limit of fee growth.

More than 70% of the token value associated with this model comes from terminal perpetual growth, which is the assumed growth rate (5% per year, WEEX note) for the years after 2030. This result is common when forecasting the future of high-growth companies and is part of the reason why using a discounted cash flow model is theoretically effective.

The sensitivity model shown in the figure below further describes the impact of modeled prices on assumed growth rates and discount rates. Understanding the relationship between ETH and user willingness to pay is extremely important. However, relying on a model that is highly sensitive to small changes in future growth assumptions may not be that useful.

Risks of discounted cash flow model:

1. If scaling technology reduces gas fee revenue, the relationship between ETH and the value provided by the Ethereum network to users may weaken, unless the increase in transaction volume offsets the reduction in revenue caused by the decrease in gas fees.

2. Modeling the future of any growth-sensitive asset and applying the relevant discount rate is highly subjective, and therefore the valuation may only be useful in theory.

3. Current efforts to minimize the negative impact of MEV will improve user experience, but may reduce returns. In this simple model, we have not adjusted for or taken into account this and many other important small details.

in conclusion

Ethereum is undoubtedly a leading blockchain technology platform that enables developers to build decentralized applications, many of which are able to do things that cannot be done on the Bitcoin network due to Ethereum's superior programmability. This has led to some of the largest and most active applications in the digital asset ecosystem being built on Ethereum, and ETH has continued to maintain its position as the second largest market capitalization for many years.

However, the question investors ask is, “Does an increase in developers and applications translate into value for ETH?” We have shown, both theoretically and data-wise to date, that increased activity on the Ethereum network drives demand for block space, which in turn generates cash flows that drive value for token holders. But it is also clear that these different drivers are complex, nuanced, and have changed over time as various protocol upgrades and scaling developments (like L2) emerge, and will likely continue to change in the future.