What are the advantages of storing value on Ethereum compared to Bitcoin?

Original source: Unitimes Unicorn Era

Original author: Michael McGuiness

Original translation: Nanfeng

Original title: "10,000 words to explain ETH will eventually win the battle for value storage"

Thanks to __Justin Drake__ for inspiring many of the ideas in this article and for reading drafts of this article.

For years, I have argued that Bitcoin has the most asymmetric risk-reward of our lifetime. Its unique properties make it the best store of value in the world. Its difficult-to-replicate network effects make it unlikely that another cryptocurrency will replace it.

As of September 2020, Bitcoin is the only cryptocurrency I hold. Its TAM (Total Available Market) as a store of value was so huge that it made little sense to allocate capital anywhere else. The broad store of value market could be as high as $400 trillion, and it used to strike me that Bitcoin was very likely to receive a large percentage of its "monetary premium" from:

• Gold ($10 trillion)

• Bonds ($100 trillion)

• Stocks ($30 trillion)

• Real Estate ($200 trillion)

• Broad money ($100 trillion)

• Art, wine, collectibles ($20 trillion)

I used to think, what could possibly compete with this dominance? Besides, most other cryptocurrencies were scams, and the few legitimate projects just didn’t seem to have found product-market fit yet.

Then, at the urging of a friend, I reluctantly started buying some ETH. Don’t get me wrong, smart contracts and decentralized applications (Dapps) are cool. But at the time, it seemed to me that Bitcoin would win the use case for store of value, and that was the foregone conclusion, the ultimate prize. I was also unsure at the time how Ethereum’s native asset (ETH) would appreciate in value.

A few months ago, this perspective of mine began to change. As almost anyone in crypto can attest, once you own something, you care more about it. (Ethereum) Two developments caught my attention: 1) Ethereum’s move to Proof of Stake (PoS); and 2) changes to the protocol’s monetary policy. I quickly realized that these changes would have a huge impact on ETH’s monetary properties, and could even make it a better store of value than BTC.

Of course, I was skeptical at first. After all, Bitcoin already had such a huge head start. It was a household name, it was the most secure in terms of network hashrate, and large institutions like Tesla, MicroStrategy, and MassMutual had already begun adopting it as a reserve asset. Could Ethereum really catch up?

But the more I read and thought about it, the more I thought ETH had a lot of potential as a store of value. I quickly converted most of my BTC into ETH and decided to write this article to clarify my thoughts.

In my opinion, Ethereum will win the battle for store of value for four main reasons:

1. More scarce

2. More secure

3. Organic demand

4. Actual benefits

I realize that such a suggestion might be considered blasphemy to Bitcoin maximalists. I agree with these maximalists on many fronts, such as the need for a brand new asset that allows people to preserve their wealth over time. However, I am not so dogmatic about how this will be achieved. I will ultimately support the asset that I believe has the best chance. To paraphrase Paul Tudor Jones, Ethereum looks like the fastest horse right now.

01. More scarce

1. Store of Value

I wrote a lot about what makes a good store of value in my previous article, Why Bitcoin Makes Sense,1 so I won’t spend too much time discussing definitions here.

The basic premise is that money is simply technology that allows our wealth today to be spendable tomorrow. Therefore, the "best" money is the one that gives the holder the most purchasing power over time. Several factors influence the suitability of a monetary commodity as a store of value, but the most important one is supply growth or scarcity.

Have you ever wondered why gold has been the dominant store of value throughout human history? Why not silver, copper, or one of the other 118 elements? The main reason is scarcity. The annual growth rate of gold supply has historically hovered around 2%. Only silver has been able to achieve an annual growth rate of 5-10%, and it is currently around 20%. The extremely low supply growth rate allows gold to maintain its purchasing power over time better than anything else, and the world is finally recognizing gold as a store of value.

For thousands of years, gold was the best we had available because it was a monetary commodity with a limited supply that retained its value over time. However, the invention of Bitcoin created the first truly scarce form of money ever. Bitcoin has a precise supply of 21 million bitcoins that can be audited by anyone with their home computer. Bitcoin took something that gold did better than anything else and improved upon it by orders of magnitude. However, Ethereum may be doing the same thing to Bitcoin with its move to Proof of Stake (PoS) and upcoming changes to its gas management.

2. Ethereum’s Monetary Policy & EIP-1559

Ethereum's current annual network issuance (i.e. inflation rate) is about 4.5%, 2 ETH per block, and an additional 1.75 ETH reward per uncle block (plus fees) to miners. Ethereum does not have a fixed supply, because a fixed supply also means a fixed network security budget. Rather than arbitrarily fixing the security of Ethereum, Ethereum's monetary policy is best described as "minimum issuance to ensure network security."

Bitcoiners hate this ambiguity because they believe the underlying financial system should be stable. Bitcoin's development is intentionally cautious and slow, and the total number of bitcoins issued will not exceed 21 million.

But the Ethereum community believes in sacrificing short-term stability for long-term network security, and the fact is that Ethereum does have a history of reducing issuance to estimated minimum levels. Furthermore, moving to PoS will significantly reduce ETH issuance while maintaining the same level of network security. I will elaborate on this later, but Vitalik has a great article on his blog2 explaining how PoS can provide more security at the same cost.

According to the current Eth 2.0 specification, as part of PoS, the issuance rate of Ethereum will be greatly reduced. New ETH issuance will be increased by validators who stake ETH by processing transactions and reaching consensus on the state of the network, rather than being handed over to miners, and there will be a floating ratio between the total amount of ETH staked and the annual interest rate of stakers. The current specification will produce the following annual interest rate and inflation rate based on the total amount of ETH staked on the network:

Basically, we can expect that annual network issuance (i.e. inflation rate) will drop from today’s ~4.5% to less than 1% after the PoS transition. The following chart highlights this dramatic drop:

But that’s still higher than Bitcoin, which is capped at 21 million BTC and has a long-term inflation rate of 0%. So, how exactly will Ethereum become more scarce? Well, there’s more. Ethereum has begun addressing many of the concerns about its monetary policy with the release of Ethereum Improvement Proposal EIP-1559, which has been referred to as “Ethereum’s scarcity engine” or “ETH’s burn mechanism.”

EIP-1559 will be implemented in July of this year as part of Ethereum's upcoming London hard fork. Delving into the details of the proposal is beyond the scope of this article, but the key aspect to note is that in addition to improving the user experience of Ethereum gas fees, EIP-1559 will burn (destroy) a portion of ETH transaction fees. This will permanently remove a portion of the ETH supply from circulation and reduce the net daily issuance of ETH.

An analysis of network transactions last year showed that EIP-1559 would burn nearly 1 million ETH in 365 days, which is almost 1% of the entire network's circulation. As the demand for Ethereum transactions grows, many expect this number to increase over time. Therefore, when this is combined with the lower issuance rate brought by PoS (less than 1%), Ethereum will actually have a deflationary monetary policy.

This has led to the recent emergence of a new meme in the Ethereum community, "ultrasound money", which was coined by Ethereum researcher Justin Drake. The term is a bit silly, but Drake's point is that if Bitcoin is "sound money" because its supply is capped at 21 million, then cryptocurrencies with a gradually decreasing total supply should be better, hence the term "ultrasound money".

In the long run, Ethereum will be a more scarce asset. However, I may be more bullish in the short term. With the removal of PoW, ETH issuance will drop by about 90%. It is estimated that the impact on (Ethereum) miner selling pressure will be equivalent to three Bitcoin "halvings".

3. Stock-to-Flow Ratio & Migration to PoS

The best attempt to quantify Bitcoin’s scarcity and use it to model Bitcoin’s value comes from PlanB’s stock-to-flow model3. Essentially, PlanB argues that scarcity (defined as the supply growth rate) directly drives value, and the scarcer an asset is (i.e., the lower the supply growth rate), the more valuable it is. Here’s the chart he created to prove his point (where “SF” stands for “stock-to-flow,” which is calculated in the opposite way to the supply growth rate):

Note: SF = Stock / Flow; Supply Growth = Flow / Stock. The stock of an asset refers to the total amount of the asset currently circulating in the market; flow refers to the amount of new circulation of the asset each year.

Shockingly, this SF model has held up remarkably well in the two years since it was published. In the chart below, the white line is the BTC forecast price, while the multi-colored dots represent Bitcoin’s price performance as of May 2021.

As we can see, based on this model, the value of Bitcoin jumps significantly every four years. This is because the block reward paid to Bitcoin miners is cut in half every 210,000 blocks (which happens approximately every 4 years. Since block rewards are the only way to mint new Bitcoins, Bitcoin's supply growth is cut in half every four years.

As PlanB explains (and quantifies) in his article, declines in Bitcoin supply growth (i.e. halvings) are highly correlated with spikes in Bitcoin prices. This is likely because halvings directly cut miner selling pressure in half. Because Bitcoin uses a resource-intensive PoW consensus mechanism, miners must sell Bitcoin to cover their hardware and electricity costs. Therefore, when Bitcoin's block reward halved from 12.5 BTC per block to 6.25 BTC in May 2020, miner selling pressure dropped from **1,800 BTC per day to 900 BTC per day. This means that miners are selling an amount of BTC less per year that is equivalent to about 1.6% of Bitcoin's market cap (about $18 billion at today's prices). With such a huge supply shock (drop), we would naturally see BTC prices soar until a new equilibrium level is achieved based on this reduced inflation rate.

Ethereum is also currently using the PoW consensus mechanism. But when it fully transitions to PoS, the current annual issuance of ETH of about 4.5% will drop to less than 1%. This is equivalent to Ethereum miners selling less than 3.5% of the market value of ETH each year (more than $15 billion at today's prices). In addition, I expect selling pressure to be smaller because block rewards will be distributed to stakers (validators) who are not forced to sell (ETH) because hardware and electricity costs are very low. However, it is fair to say that most stakers will still have to sell some ETH to pay income taxes on the rewards, so the new ETH market supply will not become zero.

Of course, there are many other factors that drive the value of an asset besides scarcity. Acceptance by others is one factor. However, scarcity (at least for now) seems to be the most important factor affecting the value of commodity money, as it affects the sales of commodities over time. On the other hand, security is also a crucial factor. Just as gold does not rot, corrode, or undergo other types of deterioration, cryptocurrencies must be designed with appropriate incentives to last. After all, an asset that no longer exists in a few decades cannot be a store of value.

02. More secure

With gold, you don’t have to worry about security. From unforgeability to non-double-spending, the laws of physics apply to it. However, with cryptocurrencies, you have to keep paying costs (i.e. block rewards paid to miners/validators) to ensure network security.

Take the Bitcoin network, for example, where a new block is created every 10 minutes. Each block contains newly minted BTC (the "block subsidy", currently 6.25 BTC per block) and transaction fees, which together make up the "block reward". According to Bitcoin's hard-coded monetary policy, the number of newly minted BTC per block will decrease over time (halving every 4 years), eventually reaching 0% in 2140. When this happens, when no new Bitcoins are issued, the only compensation for miners will be transaction fees.

Many Bitcoiners believe that this will not be a problem because when the block subsidy is exhausted, the dollar value of transaction fees will be high, so the security expenditure will be sufficient to ensure the network is secure. Bitcoin supporter Dan Held wrote in his article “Bitcoin's Security is Fine” 4:

“I would guess that a few hundred billion dollars in current dollars would be enough for the security budget, as it would be hard for a government to justify wasting so much money just to attack the Bitcoin blockchain. They would also have to respond publicly to such an attack, as their citizens (taxpayers), businesses, and banks would all be invested in Bitcoin.”

He goes on to address some of the concerns that are often raised about relying solely on transaction fees to achieve (Bitcoin) network security in the article. I agree with many of Held's points and understand why Satoshi Nakamoto designed Bitcoin in this way. Because of the use of the PoW mechanism, there is always a trade-off between inflation (block subsidy) and security. Bitcoin has made specific trade-offs and will continue to pay less and less fees to its consensus engine (i.e., lower block subsidies) to maintain scarcity and limit the number of Bitcoins to 21 million.

However, I disagree with Held’s view that such USD-denominated security spending is important, and support the view of Vitalik Buterin who wrote in a recent reddit post5:

“The security requirements of a thing must be proportional to its size, because as a thing gets bigger, its enemies get bigger and more motivated. If BTC (market cap) is 100 times what it is today, then the value (cost) of destroying it will increase 100 times, and the attackers who want to destroy it will be bigger and more terrible. This is why the size of the military as a percentage of GDP of all countries is similar. So actually the cost of attack divided by market cap is the right number to measure, and in the long run, PoW that (will eventually) not issue (new coins) does not look that good.”

So let's look at Held's most optimistic scenario, where Bitcoin "survives, thrives, and continues to grow exponentially in market share, as it has done over the past decade." In this hypothetical scenario, Bitcoin's market cap in 2140 is $100 trillion, and transaction demand for Bitcoin block space generates $365 billion in transaction fee revenue per year for miners (which is the security expense of the Bitcoin network by then). See the figure below:

Is $365 billion in security spending really enough to protect the Bitcoin network from attacks? Maybe. I’m really not sure, and I don’t know what the world will look like in 2140. But I’m pretty sure we can do better. In the above hypothetical scenario, Bitcoin’s PoW consensus mechanism would give Bitcoin a value-to-security ratio of about 273 to 1. Ethereum’s PoS consensus mechanism gives it a value-to-security ratio of about 10 to 1. If Ethereum’s market cap is the same as Held’s Bitcoin market cap, the cost of launching a 51% attack on the Ethereum network would be equivalent to about $10 trillion, which is more than 27 times higher than Held’s $365 billion cost for Bitcoin. And the only assumption here is that about 10% of ETH is staked, which seems reasonable; at the same time, Held’s prediction assumes a 500% increase in Bitcoin block size, a 40% increase in efficiency, and a huge transaction demand for Bitcoin block space.

In addition to the much lower value/security ratio (note: the lower the value/security ratio, the higher the cost of attack), Ethereum has a major advantage in how to deal with attacks. After suffering a 51% attack, the only option for the Bitcoin network is to move from the current Double SHA-256 ASICs to a new PoW system. This new system will have to be based on commodity mining hardware, such as GPUs or CPUs, because there is not enough time to manufacture hardware for another ASIC PoW system. The attacker can then only carry out the same 51% attack on ordinary hardware. Vitalik calls this a "spawn camping attack", that is, a coalition of miners who launch a 51% attack will continuously attack, making the chain useless. As far as the PoW system is concerned, there is no way to destroy (or punish) the mining power of the attacker.

Ethereum (and PoS more broadly) is less vulnerable to this attack. This is because the Ethereum network can "slash" or punish the attacker. If the attacker does something bad, the network will punish the attacker by confiscating their staked ETH. This is equivalent to asking Bitcoin to destroy the attacker's mining equipment, but this is obviously impossible for the protocol to do.

Ethereum actually has two slashing mechanisms. The first can be called "Layer 1" slashing, which is triggered if you (the validator) do something obviously wrong in the protocol (such as submitting two conflicting proofs), in which case the Ethereum network will automatically slash at least one-third of your ETH stake. This will deal with most potential attacks and redistribute ETH from dishonest nodes to honest nodes, making the system somewhat anti-fragile. If you look at it from the perspective of what is called an "iterated game" in game theory, the Ethereum system becomes stronger every time it is attacked.

Suppose the attacker wants to attack again. He has to get more ETH, attack again, and then get slashed again. After each attack, the amount of ETH in circulation will decrease, so there is actually an upper limit to the number of times the system can be attacked. Let's say there are currently 100 million ETH in total, of which 10% is staked. For each attack, the attacker will have to buy at least 10 million ETH, and each time he is slashed, he will have to regain another 10 million ETH. In the worst case, the attacker can only attack the system 9 times. In addition, the cost of each attack will become increasingly higher, because the price of ETH on the open market is likely to rise as the supply decreases.

Likewise, this antifragility exists at the level of a single bet. If you want to attack the Ethereum network, you have to acquire 10 million ETH (using the simplified numbers in the example above). Due to simple supply and demand dynamics, the more ETH you have to buy, the more expensive ETH becomes as less ETH is available for sale, creating diseconomies of scale, such as your second purchase of 1% of the ETH supply will cost more than your first purchase, because there is less ETH available for sale after you first purchased 1% of the ETH supply.

To mitigate the fear of a miner or mining pool gaining 51% of the hashrate, a common argument (assumption) is: even if they gain 51% of the hashrate, why would they attack? After all, it is not in their interest to attack the network, destroying the "golden goose that lays eggs". But in reality, we cannot assume this, and this argument not only assumes rationality, but also assumes that there are no outside incentives. The whole point of having a high level of security is to prevent attackers with external incentives from breaking the chain. This is why Vitalik thinks about PoS security in the way that "if they (the attacker) have X amount of dollars, how many times can they break the chain before all their funds are slashed?" This is not an assumption of rationality, but only an assumption that the economic resources of malicious actors are limited.

Perhaps the best argument I've heard for the security of PoW is that its physical hardware-driven nature creates friction for well-capitalized attackers: you need to wait a year for the hardware to be manufactured, the process necessarily involves a lot of people, and you run a high risk of being discovered in the process. This is the real advantage of PoW. That being said, physical hardware also has a key disadvantage: it's hard to mine at scale without being detected, while PoS is much more censorship-resistant.

In terms of security, there is a huge advantage to participating in Ethereum staking without any "footprint": to become an Ethereum validator, all you need is ETH, a Raspberry Pi, an SSD, and an internet connection. This is in stark contrast to Bitcoin, where being a miner will bring a large "footprint": miners need to consume huge amounts of energy and use huge warehouses to store mining equipment. Such a "footprint" makes it relatively easy for governments to discover and shut down mining activities. In the case of Ethereum, you (the validator) can be anywhere in the world (perhaps behind the Tor network, you can even hide your IP address). Even if a country is able to find and confiscate your physical devices that validate Ethereum, these devices do not store your staked ETH: ETH only exists in the digital world and can only be confiscated by making the owner hand over their private keys.

People sometimes forget that when Satoshi Nakamoto created Bitcoin over a decade ago, it was the world’s first successful attempt to create digital scarcity and incentive design for a PoW consensus system. While the pseudonym “Satoshi Nakamoto” is clever, this person (or team) is actually human and could not have reasonably anticipated all the potential problems that Bitcoin’s incentive design would create. Since then, the blockchain field has conducted over 12 years of research and development in network security and scalability.

In my opinion, Ethereum seems to be a more secure network in the long run.

03. Organic demand

In 1944, the Bretton Woods Agreement laid the foundation for the United States to have a near-global lock on the international monetary system. However, just a decade later, the Bretton Woods system began to unravel. The United States began to run large fiscal deficits and mildly rising inflation, first from domestic projects in the late 1960s (the United States vigorously developed its own economy after World War II), and then from the Vietnam War. Soon, the United States' gold reserves began to dwindle as other countries began to doubt the support of the dollar and exchanged their dollars for gold. The continued decline in gold reserves finally forced Richard Nixon to end the dollar's peg to gold in 1971.

After the collapse of the Bretton Woods system, every currency was legal tender. For the first time in human history, all of the world’s currencies were turned into paper money that was not backed by anything. These currencies themselves had no value. They had value because governments declared them to have value and enforced their use as a medium of exchange and unit of account by making all taxes payable only in that currency or by enacting other laws that created barriers to the use of other mediums of exchange and units of account (or in some cases outright prohibited them).

However, outside the United States, foreign businesses and governments still have little reason to accept (dollar) paper money, which can be printed endlessly and has no solid backing. But it turns out that the United States has created a constant international demand for dollars through the petrodollar system, thus forcing global adoption of the dollar.

In 1974, the United States and Saudi Arabia reached an agreement. Saudi Arabia (and other OPEC members) would only sell oil in U.S. dollars in exchange for U.S. protection and cooperation. Even if Germany wanted to buy oil from Saudi Arabia, for example, they could only buy it in U.S. dollars. From that point on, any country that wanted oil needed to pay for it in U.S. dollars. As a result, non-oil producing countries began selling many of their exports in U.S. dollars so that they could get the dollars they needed to buy oil from oil producing countries. All of these countries kept the excess dollars as foreign exchange reserves.

Over time, this system has only grown stronger. As Lyn Alden writes in her brilliant article, “The Fraying of The US Global Currency Reserve System”6:

“Initially, countries needed dollars to get oil. Decades later, with so much international financing done in dollars, countries now need dollars to pay back dollar-denominated debt. So the dollar is backed by oil and dollar-denominated debt, and this is a very powerful self-reinforcing network effect. Importantly, much of this debt is not owed to the United States (although it is denominated in dollars), but to other countries. For example, China makes many of its loans to developing countries in dollars, as do Europe and Japan.”

It’s this “self-reinforcing network effect” that leads everyone in the world to accept worthless paper issued by the U.S. government in exchange for tangible goods and services. It’s absolutely the fundamental reason why the U.S. dollar is the global reserve asset. Why is this important? I think a similar system — and a virtuous cycle — is emerging around the Ethereum network.

For the past decade, the demand side of most crypto networks has been dominated by speculation. There is nothing wrong with that. Speculation has funded the construction of the supply side of these networks (infrastructure, applications, etc.). But this is changing. You need ETH to do things on the Ethereum network, and people are doing a lot of things on this network: they buy domains, trade tokens, borrow, issue bonds, use prediction markets, make payments, buy insurance, buy art, play games, buy virtual land in the metaverse, race horses, and so on. All of these things require ETH to pay transaction fees.

As applications built on Ethereum become more sophisticated and intuitive to users over time, demand for Ethereum will grow. 94 of the top 100 crypto projects are built on Ethereum, over 3,000 Dapps and 200,000 ERC-20 tokens run on Ethereum. Total transaction volume on Ethereum reaches new all-time highs every day, and the average transaction value on Ethereum is more than double that of Bitcoin.

Some of these numbers are truly staggering. (At the time of writing) over $80 billion of ETH is locked in DeFi applications, up from $16 billion in January. Decentralized exchanges (DEXs) like Uniswap and Sushiswap have handled $432 billion in Ethereum trades over the past 12 months as these automated market makers (AMMs) make token trading easier than ever. The supply of stablecoins on Ethereum has increased from $19.5 billion in January to over $48 billion today.

Above: The growth of various stablecoins supplied on Ethereum.

Ethereum is not only the settlement layer for almost all leading Dapps, but also the settlement layer for almost the entire digital dollar (i.e. stablecoin) ecosystem. Even traditional financial services companies like Visa will allow USDC to be used for transaction settlement on Ethereum, which shows that stablecoins now have use cases far beyond traditional cryptocurrencies. Just a few weeks ago, the European Union’s investment arm used Ethereum to issue a two-year digital note worth 100 million euros ($121 million) for the first time.

In addition, the sales of NFTs (non-fungible tokens) on Ethereum have exceeded $600 million, of which 13 NFTs have sold for more than $1 million. The use cases of NFTs are exploding.

Likewise, if you want to interact with the Ethereum network in any of the above use cases, you must pay fees to the miners/validators who process your transactions. Ethereum is essentially a decentralized computer, and computing power costs money. These fees are called "Gas," and the similarities to oil are uncanny.

The more useful applications built on Ethereum, the greater the demand for ETH. It is estimated that the TAM (total available market) of DeFi is $2.7 trillion per year (2%-3% of global GDP) based on cumulative revenue alone. Knowing this, it is easy to see how a system similar to the petrodollar will develop around the Ethereum network. Let's quote Lyn Alden above and modify it:

At first, everyone needed ETH so they could use this global decentralized computer. Decades later, with so much international financing done in ETH, people now need ETH to pay back debt denominated in ETH. ETH is thus doubly backed by demand for computation and debt denominated in ETH, a very powerful self-reinforcing network effect.

Comparing the demand for ETH to the demand for oil may seem far-fetched, but if the world’s financial infrastructure were all on Ethereum, would it still be far-fetched? It seems increasingly likely to me that ETH will benefit from the same self-reinforcing network effects that made the dollar the global reserve currency.

Overall, Ethereum mimics Bitcoin in many ways, but offers a substantial improvement by creating a virtual decentralized computer that greatly expands the potential use cases. These use cases provide an organic, sustainable, and growing demand for Ethereum blockspace. As these use cases flourish and become more widely adopted, demand will only grow.

Since the “best” currency gives holders the greatest purchasing power, this organic demand further increases ETH’s odds of winning the battle for store of value.

04. Actual benefits

Wall Street financial mogul George Soros may go down as the greatest foreign exchange trader of all time. In his book, The Alchemy of Finance, he reveals a lot about his decision-making process. Chapter 3, “Reflexivity in the Currency Market,” describes vicious and virtuous cycles in the currency market. In this chapter, Soros argues that there are mutually reinforcing factors in traditional currency markets that create cycles characterized by large fluctuations in exchange rates, interest rates, inflation, and/or economic activity levels. This chapter is quite technical, but let’s focus on the key drivers of speculative capital: rising exchange rates (convertibility) and interest rates.

We focus on speculative capital because it is one of the three major drivers (fundamentals) of exchange rate movements, the other two being trade and the flow of non-speculative capital. In fact, the "fundamentals" (the "scarcity" and "organic demand" we discussed in the previous chapter are also fundamentals for ETH) are also affected by market participants' expectations of future exchange rate movements (note: the two influence each other). This is just one example of Soros's idea of ​​"reflexivity", which is easy to see in Ethereum: speculation drives many investors and developers to invest their time and money to build network infrastructure and applications on it. In fact, speculative capital is crucial to fundamentals.

“Speculative capital seeks the highest total return. There are three factors that influence total return: interest rate differentials, exchange rate differentials, and appreciation of local currency capital. Since the third factor varies from case to case, we can propose the following general rule: Speculative capital is attracted to rising exchange rates and interest rates. Of these two factors, the exchange rate is the most important. The exchange rate of a currency does not need to fall much for total returns to be negative. Similarly, when an appreciating currency also has an interest rate advantage, the total return exceeds anything that the holder of financial assets could expect under normal circumstances.”

Let's break it down. The exchange rate (conversion rate) is the most important factor. This makes sense. If I stake ETH at 8.5% and the price drops 10%, I lose money. So we really shouldn't focus on the interest rate until we can be sure that the exchange rate will rise. This is why most altcoins with annual returns of over 1000% are bad bets, and Bitcoin has been such a great bet over the past 12 years. This is also why I will focus on the key factors that drive the price of ETH in the first three sections of this article.

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By pledging ETH, you can get an additional 6% risk-free pledge return, which will incentivize some investors to transfer funds from Bitcoin to Ethereum. This is how the market works. For example, foreign investors have flowed into the United States by about $8.5 trillion since 2008, most of which has increased since 2011, as investors sought higher returns in the form of arbitrage (the U.S. bond yields are higher than zero or negative yields in Europe and Japan). Speculative capital will naturally flow to assets with the highest expected real yields.

The virtuous cycle of Ethereum will be a vicious cycle of Bitcoin. As more and more speculative capital flows from Bitcoin to Ethereum in search of higher real returns, the exchange rate expectations between the two currencies will also change. This won’t happen overnight, but over time, I expect the market’s expectations of the appreciation of Ethereum prices will be higher than Bitcoin. When this happens, Bitcoin’s situation may be bad. As Soros wrote:

"The longer the virtuous cycle lasts, the more attractive financial assets holding appreciation currencies are, and the more important the exchange rate is when calculating total returns. Those who tend to fight against trends will gradually be phased out, and eventually only trend followers survive as active participants. As speculation becomes more important, other factors lose their impact. The only thing that guides speculators is the market itself, which is dominated by trend followers. These considerations explain how the US dollar can continue to appreciate in the face of an expanding trade deficit."

I like Bitcoin and everything it represents, but this seems increasingly likely to happen. I wonder what would happen if Ethereum had a market cap surpassed Bitcoin for a period of time. What would it be if Bitcoin wasn't the most liquid asset in cryptocurrency?

Another aspect that I wouldn't spend too much time discussing is that for most large ETH holders, staking (using ETH for) and earning farming (liquidity mining) in DeFi is enough to provide passive daily income. They no longer need and want to sell ETH because they can passively earn 8%+ staking income and higher liquidity mining income. This will further enhance the scarcity of Ethereum and the expected price increase in the future.

05. Risk & Worries

To sum up, these four factors (more scarce, safer, organic demand, real benefits) are the main reasons why I think Ethereum will eventually win the store of value battle. Of course, the conclusion I have drawn above is not certain, and if this article does not discuss some of the risks therein, then this article is incomplete. Because this article is already very long, I will briefly comment on each risk.

1. Scalability Challenge

Currently, when the (Ethereum) network is busy, transaction speeds are affected, which makes the user experience of some types of Dapps poor. As the network becomes busy, the price of Gas is also rising as transaction senders bid against each other. This makes using Ethereum very expensive. A few months ago, Gas for a simple transaction cost as much as $100-200, but as Berlin upgrades, prices have fallen, coincidentally with the new all-time highs of ETH.

This is probably the most critical risk for Ethereum because it opens the door to opportunities for competing projects, such as Solana doing something interesting in this field. But ultimately, Ethereum has many options to improve the speed, efficiency and scalability of the network. Layer 2 solutions and sharding are probably the most notable. But they are not without technical risks, and they are urgently needed.

2. Other Layer 1 Solutions

I can’t help wondering if Ethereum will eventually be replaced by a cryptocurrency that learns from Ethereum’s experiments and improves in some basic aspects. There are many “Ethereum killers” trying to take advantage of Ethereum’s weaknesses to become the boss, including Polkadot, Solana, Cosmos, Cardano, etc.

As Peter Thiel (billionaire venture capitalist) explained in his Stanford Entrepreneurship Lecture, “People often talk about 'first-action advantage'. But focusing on that can be problematic; you may take a step forward and then slowly disappear. More important than a firsthander is a latecomer. You have to be holding.”

Two years before Amazon was born, there was Book Stacks Unlimited. Four years before Google, Yahoo! created the original global search engine. Before Facebook came, MySpace dominated social media. There were countless examples of this. In the history of technology, there are countless examples of what pioneers became interested in a concept or product, and then later took advantage of the opportunity to improve existing products.

But Ethereum has strong protections for this risk of being eliminated. It has many of the same network effects as Bitcoin, and the Ethereum community and protocols are innovation-friendly, which may be just as important. "Bitcoin will absorb all innovations" is a meme that has never been implemented. In fact, Ethereum has the opportunity to do this, in large part because they have "functional escape speed" at the EVM level.

Although I admit that new developments and risks in this area must be constantly adapted to, Ethereum seems to be the best choice at the moment.

3. Stability of monetary policy

Bitcoin is probably the most immutable crypto system ever. Bitcoiners believes that this is where Bitcoin really values ​​it. It is a reliable neutral system based on code (not humans) that you can rely on for decades.

Ethereum’s human-managed hard fork and relatively centralized development team brings risks. How do we believe that Ethereum’s monetary policy will not change again? How can we ensure that there is no adverse (protocol) change? Even if the Ethereum community agrees that it will never change and respect that, it will forever lag behind the trust established by Bitcoin for 12 years.

If Ethereum will become a global store of value, this is an important issue, but as mentioned above, I think Ethereum is sacrificing short-term (currency issuance) stability in exchange for long-term security. Ethereum is already very decentralized, and its relatively centralized aspect allows them (the Ethereum development team) to innovate in terms of security, monetary policy and effectiveness.

4. Increased complexity

As it almost always happens in the (protocol) design world, there is a trade-off to transition from PoW to PoS. First of all, complexity. Bitcoin’s PoW system is very simple, you can write pseudo-code for it with a dozen lines of code. But Ethereum’s PoS is much more complex. The state transition mechanism of beacon chains may be written in about 1000 lines of code, so we will see a complexity increase by about 100 times. This is a very real trade-off – complexity leaves room for bugs and can cause other issues like scaling issues. But the good news is that Ethereum has dealt with this complexity well, that is, it proves that this complexity can be overcome through four production-level (client) implementations that are protecting beacon chains.

5. Fair start

Some people believe that Bitcoin is “in a monopoly position in terms of fairness” because when it is launched, no one knows what it will become. They think it is something that can no longer be copied and gives Bitcoin some of the best attributes. Anything that has pre-sale cannot be considered fair. In addition, Bitcoin’s PoW system is an excellent mandatory feature for the distribution of BTC, because miners have to sell Bitcoin to pay for their hardware and electricity costs. PoS does not have this attribute. Ethereum stakers will only accumulate more ETH and will not be forced to sell ETH because PoS is very effective and the hardware and electricity costs are very low. Therefore, Bitcoiners believe that PoS will establish a permanent system of tycoons.

However, as mentioned above, this is a misunderstanding, because income tax (about 50% in many jurisdictions) will play an economically compulsory role. In addition, Ethereum has been using PoW systems for nearly 6 years, and many Ethereum supporters believe this has enabled ETH to be well distributed. Also, do most of the market participants who are not ethical really care whether the network is fair? I would say that most of them are just acting out of their own interests and buying whatever assets they think will make them the most money. Also, who can decide what is a fair distribution and what is not?

Editor's note: This article only represents the original author's views, and the translation has been slightly deleted.