Coinbase in-depth analysis: Finance 2.0, the driving force behind the rise of the Ethereum economy

As the second largest cryptocurrency after Bitcoin, Ethereum is more than just a digital currency, it is the foundation of a multi-billion dollar economy. From DeFi to digital art, we need to understand the driving force behind Ethereum's rise.

On February 22, a whimsical headline appeared in the business section of the New York Times:

Why a pie-shaped animated cat sold for $600,000.

If you were online much in 2011, you knew this cat. Chris Torres, creator of the internet’s wildly popular “nyan cat” gif (a pixelated kitten glittering on a rainbow), sold his decade-old meme for nearly $600,000.

And Torres isn’t the only one finding ways to sell digital content that was previously considered nearly worthless, in part because anyone could copy and paste digital files endlessly. In recent weeks, it seems that has changed:

• Christie’s has revealed plans to auction its first “all-digital” work, a series of images by an artist named Beeples, with a starting bid of $100.

• A cool-looking lo-fi monkey from the Cryptopunks collection sold for $1.5 million.

• A series of 3D models of "weird furniture," such as a table made of bubblegum, fetched $450,000.

• A tweet from Dallas Mavericks owner and entrepreneur Mark Cuban sold for $952.

All of these stories actually tell the same story, which is that people are starting to buy virtual digital properties with real-world money.

This booming market is enabled by a class of crypto assets known as NFTs. Short for “non-fungible token,” NFTs are essentially certificates of authenticity, showing that the version of a digital piece of content you hold in your hands—be it an image, video, song, or anything else—is the real deal.

NFTs are mostly issued on the Ethereum blockchain, which uses the power of "smart contracts" and allows users to buy or sell them on a dedicated NFT market. (Although NFTs are popular now, they are not actually the latest to emerge. You may remember the craze around the digital cat trading game Cryptokitties in 2017.)

Sales volume of different Ethereum NFT projects

NFTs are tokens, just like Bitcoin is a token, that users can usually buy or sell through special exchanges that support sales. Unlike Bitcoin, which has almost identical characteristics, each NFT represents a specific digital property. Therefore, each NFT is "non-fungible." They are used to sell everything from celebrity paintings, NBA "digital collectibles", virtual real estate and live videos of dance music star Deadmau5.

As NFTs become a staggering business, with sales exceeding $100 million, a debate has begun over ownership: Is collecting digital art any different from collecting rare sneakers, vinyl records, or Picassos?

These are fascinating questions, but they don’t even begin to speak to a bigger story. Smart contract technology, which enables artists, meme makers, and musicians to sell their virtual goods, is also furthering the need for a new, decentralized alternative to the current financial system. In this alternative system, designed to empower individuals financially, capital will flow through open-source protocols that are faster, cheaper, more transparent, and open to everyone.

We call it Finance 2.0.

Ethereum has had a breakthrough year

Before the NFT craze, Bitcoin had dominated the headlines in non-cryptocurrency media recently. When the topic of Ethereum came up, people in the field were even more excited. This is not because Ethereum is the second largest cryptocurrency by market capitalization after Bitcoin.

People who don’t know Ethereum well often fail to understand that Ethereum is more than just another form of digital currency. The Ethereum blockchain was created to be a diverse decentralized computing platform that allows developers to build digital art markets while running tools like Compound and Uniswap, which have hundreds of billions of dollars in value flowing through “decentralized finance” (DefI).

Ethereum’s price and popularity, like Bitcoin’s, have climbed from $300 to a high of over $2,000 in February of this year.

Ethereum Price

Global user interest in Ethereum has also experienced a record surge in recent months. (Bitcoin searches still lag behind their peak in late 2017 and early 2018.)

Ethereum global search volume

Another indicator of rising mainstream engagement is the Reddit subreddit dedicated to Ethereum (and other cryptocurrencies), which has also seen a surge in new subscribers in recent days:

Reddit Cryptocurrency Subscriptions

A big reason for these rising numbers is the price of ETH. You might be surprised to learn that ETH's price has actually grown faster than Bitcoin's since the beginning of 2021 (partly due to the spread of the coronavirus, which has led to a large number of retail investors with extra time and disposable income trying new investment strategies). Since the beginning of the year, Bitcoin's price has risen by about 65%, while ETH's increase has exceeded 112%, and its market value has surpassed Morgan Stanley and Square to reach $177 billion.

Understanding the wider Ethereum economy

But the soaring market cap is only part of the Ethereum story. The real appeal of Ethereum is the broader economy that the Ethereum blockchain makes possible.

We can think of the price of ETH as the tip of the iceberg. Since the Ethereum blockchain is very flexible, a large amount of economic activities are running on the Ethereum blockchain, and the categories of cryptocurrencies based on Ethereum include DeFi, stablecoins, wrapped tokens, and NFTs.

The market capitalization of the Ethereum economy (defined by the total market value of the largest ERC-20 tokens issued on top of the Ethereum blockchain) has surged to over $250 billion in recent weeks, not including NFTs.

Ethereum economic total market value

Stablecoins reduce volatility by pegging their value to a reserve asset such as the US dollar, and they are one of the most promising and fastest-growing areas of the Ethereum economy. They have been widely adopted as a stable medium for payments between exchanges.

As of February 2021, the total value of stablecoins on the Ethereum blockchain has exceeded $30 billion:

Ethereum Stablecoin Market Cap

A smaller but rapidly growing component of the Ethereum economy is “wrapped tokens,” which allow non-Ethereum native cryptocurrencies (especially Bitcoin) to be used on the Ethereum blockchain and easily interact with DeFi applications. As a result, the value of tokenized Bitcoin has risen significantly.

Market capitalization of tokenized Bitcoin

When Reddit meets DeFi

So what’s driving the recent excitement around Ethereum? While much of this has to do with the broader cryptocurrency boom, one interesting group worth taking a closer look at is Reddit’s “memstock” investors, who are looking for decentralized alternatives because they are frustrated with traditional finance.

These decentralized tools (also known as “DeFi” or “Finance 2.0”) allow for investing, trading, savings with yield, new types of “flash loans,” and more. According to Fabian Schär, a professor and researcher at the University of Basel, Ethereum-powered DeFi applications have “the potential to create a truly open, transparent, and immutable financial infrastructure.”

If you haven’t found your bearings in the DeFi space yet, let’s take a look at three categories of DeFi applications — their common goal is to become a faster and more efficient alternative to the inefficient, slow, and often expensive capital flow pipelines in the current financial system.

• Decentralized Exchanges: Decentralized exchanges such as Uniswap and Sushiswap allow users to trade tokens without an intermediary.

• Lending protocols: Lending protocols like Compound and Aave allow users to lend and borrow tokens without an intermediary.

• Oracles: Oracles like Chainlink are designed to provide real-world data to DeFi applications.

DeFi is a natural playground for Reddit traders whose trust in Finance 1.0 has been shaken — since these very online investors are already fiercely exchanging tips and strategies, they can help each other navigate complex new protocols. (It doesn’t hurt that this group is willing to take risks, either, given the volatility of DeFi markets.)

At least one persuasive voice has begun to promote DeFi directly to Reddit’s most active stock traders. Mark Cuban shared his views on DeFi in an AMA: DeFi will make “markets more efficient, more transparent, and more effective for small investors.”

Not only Cuban thinks so, but even Reddit co-founder Alexis Ohanian expressed his views on DeFi in an exchange with U.S. Congressman Alexandra Ocasio-Cortez: No one will wake up a week later and say, let's all go back to the way we were before. The public can't ignore this, so I think there will be more and more energy to find decentralized solutions. People have so much energy to support things that can't be manipulated. "

As of February 2021, the total DeFi market has exceeded $40 billion. The largest decentralized exchange platform, Uniswap, has traded $100 billion since its launch in May 2020, which strongly illustrates the speed of popularity of these tools.

Ethereum DeFi Market Cap

Monthly trading volume across all decentralized exchanges surpassed the $50 billion mark in January:

Monthly trading volume of decentralized exchanges

Institutional adoption of Ethereum

The Ethereum economy has also attracted the attention of major financial institutions. Due in large part to the role of stablecoins as a non-volatile method of sending value between exchanges and DeFi protocols, the Ethereum blockchain has become one of the most popular vehicles for U.S. dollar payments.

In 2020, Ethereum processed $874 billion worth of payments, competing with major consumer-facing systems like Zelle ($307 billion) and PayPal ($983 billion), although it is still far below the amount processed by central bank payment systems like FedEx ($840 billion).

In December 2020, Visa announced that it would connect its global payment network of 60 million merchants to the U.S. stablecoin USDC. (USDC is supported by consortiums such as Coinbase and Circle.)

PayPal also recently enabled limited ETH transactions for its large U.S. user base, and plans to expand the feature to 325 million users worldwide. The company's CEO Daniel Schulman said in a 2021 earnings call: "We all know that the current financial system is outdated, and we can foresee that transactions will be completed in seconds instead of days in the future. We are investing heavily in our new cryptocurrency blockchain and digital currency business units to help shape this more inclusive future."

At the same time, institutional investors are also beginning to enter Ethereum. Grayscale Ethereum Trust, which helps investors obtain Ethereum through traditional brokerages, has seen significant growth over the past year. The fund currently holds 3 million ETH, worth more than $4 billion.

Grayscale Ethereum Trust Holdings

Another Ethereum institutional exposure platform, CME Futures, recently went live, with more than $33 million in trading on its first day. In December 2020, Connecticut-based hedge fund One River Asset Management announced a commitment that "its holdings of Bitcoin and Ethereum will reach approximately $1 billion by early 2021."

Ethereum Development

When Ethereum was created in 2014, it was clear to the founding team that the blockchain had a fundamental flaw that would eventually need to be fixed. Because it used a “consensus mechanism” called proof-of-work, transaction times would slow and fees would increase when blockchain traffic increased.

The sheer volume of transactions handled by DeFi and other smart contract tools we cover in this article has led to a scalability bottleneck for Ethereum. As a result, the Ethereum network has become increasingly expensive to use. As of February 2021, ETH “gas” fees are around $10 per transaction.

Median Ethereum network fee

But major solutions are on the horizon. The nonprofit Ethereum Foundation is officially working with Reddit to seek solutions and new use cases for the technology. In August 2020, nearly two dozen development teams submitted Ethereum scaling proposals to Reddit. Projects like Optimism and Rollups could potentially help blockchains process hundreds of thousands of transactions per second (although each solution has unique challenges).

Meanwhile, the ethereum community has begun its long-planned transition to the faster, cheaper and theoretically more secure ethereum 2.0 blockchain.

The theoretically more secure Ethereum 2.0 blockchain uses a consensus mechanism called proof-of-stake, which should increase block capacity. The project began rolling out in December 2020, and as of February 2021, more than 3 million ETH are participating in ETH 2.0 contracts. After years of upgrades, the Ethereum economy is a big step closer to realizing its potential and making all kinds of financial transactions faster, cheaper, and easier to conduct.

Author: Coinbase

Compiled by Captain Hiro