Ten thousand words long article, the structural analysis of Ethereum

Source: Decentralized Finance Community, author: Lyn Alden

2020 has been a challenging year for the entire world. At the same time, it has proven to be a relatively positive year for Ethereum - the Ethereum ecosystem has not weakened in many ways and has made a big step towards our market capitalization. In this article, we will focus on some trends on the Ethereum blockchain, including:

• Grassroots

• DeFi

• Eth2 and L2

• BTC on Ethereum

• NFT

Bitcoin's anonymous creator, Satoshi Nakamoto, published a white paper in 2008 that solved challenges related to digital scarcity and launched Bitcoin in 2009.

After that invention, many other projects followed. There are now over 8,000 unique digital assets recognized by CoinMarketCap.

Among them, Ethereum is the world’s second-largest digital asset by market capitalization after Bitcoin, and a large ecosystem of other tokens can be built on top of it. This makes it the only other major network effect in the field.

A lot of people ask me what I think about Ethereum and why I personally don’t invest in it even though I do invest in Bitcoin.

Below is my analysis of the Ethereum protocol from an investor’s (not a developer’s) perspective.

Ethereum 1.0 Overview

Ethereum was proposed by Vitalik Buterin in 2013, crowdfunded in 2014, and launched in 2015.

Buterin, then about 19, wanted to create a platform for decentralized applications.

Crippled his in-game character, and set him off on a multi-year quest for technological solutions to correct these horrific injustices:

I happily played World of Warcraft from 2007 to 2010, but one day Blizzard removed the Syphon Life component of my beloved Warlock. I cried myself to sleep, and that day I realized how terrible the consequences of centralized services would be.
-Vitalik Buterin

He described discovering Bitcoin in 2011, which ignited a fire.

Bitcoin uses blockchain as a savings and payment technology, and the underlying layer is very simple. It focuses on doing one thing exceptionally well: storing and settling value. Other layers can be built on top of this base layer, leveraging its ability to store and transfer value for more complex purposes. The Lightning Network is an example of this, extending the scalability of Bitcoin for micropayments.

Ethereum, on the other hand, is Buterin’s attempt to apply blockchain technology to the underlying layer of a wider protocol. It markets itself as a “world computer” that is like an app store that is not controlled by any central entity. It is like a distributed operating system with a built-in token system, and programmers can use this ecosystem to make decentralized applications or “dapps” for short, which also often use their own tokens.

Ethereum's underlying technology is based on smart contracts, which refer to program protocols in the blockchain that are triggered when certain events occur. It requires a small amount of Ethereum tokens to pay miners on the blockchain to execute smart contracts.

Sample Application

Ethereum has been used to create a wide variety of projects. DappRadar is one of several sites that lets you explore decentralized applications across categories for Ethereum and other smart contract protocols.

One of the most popular examples is stablecoins. Institutions can collect fiat currencies, store them as collateral, and issue tokens that run on the Ethereum protocol. These tokens are ostensibly 1-to-1 and redeemable for fiat currencies, and therefore tend to maintain a stable price. These are basically dollars that use blockchain technology to transfer and store tokens. People rely on third parties because they have to trust that the collateral that custodies and backs the tokens is reliable, but the exchange of tokens between counterparties is permissionless.

In 2019 and 2020, a set of applications called "Defi" or "decentralized finance" became very popular. These applications replicate various banking functions, including ways to earn yield, borrow funds, or exchange tokens. One example is Uniswap, a decentralized digital token exchange. It is an exchange that operates in a decentralized manner based on blockchain software and incentive mechanisms, rather than a company as a central trading center. Several other DeFi exchanges also exist.

There are many other protocols that provide liquidity to these exchanges, often referred to as “liquidity mining.” People can deposit tokens and receive interest, and others can borrow tokens and pay interest in a decentralized manner. Because there are no manual or human credit checks or risk analysis in most cases, these systems often rely on a policy of “over-collateralization” to guarantee loans.

Gaming and gambling are also big areas of interest. A big early example is CryptoKitties. The game allows users to buy, collect, raise, and sell virtual cats. Each token represents a cat, and each one is unique. Once a cat token is generated, the user owns it, and no one can take it away or change it, like Blizzar did with Buterin’s beloved Warlock. The app was so popular in late 2017 that it slowed down Ethereum’s network.

There are many crypto-based games out there these days. I’m not as into gaming as I used to be, but if I were, I could definitely see why blockchain could potentially add something valuable to the gaming ecosystem. The idea of ​​letting players own items/pets/characters independent of the game publisher, and even having those items/pets/characters recognized by other games, is certainly cool.

However, it’s worth noting that many crypto-based games run on Ethereum’s competitors, like EOS or TRON.

Broadly speaking, non-fungible tokens, or “NFTs,” are a recently-emerged space. Unlike liquid and standardized units like Bitcoin or Ethereum tokens, non-fungible tokens are unique collectibles, like a one-of-a-kind digital cat, a piece of digital art, an event ticket, or a domain name, that can be traded on a blockchain.

Finally, social networks and other systems are also projects in the dapp ecosystem. In theory, the sky is the limit, but the question is whether they make enough economic sense.

Are decentralized applications really decentralized?

One of my concerns when reviewing the biggest use cases for decentralized applications is that many of them are circular and speculative.

Ethereum is widely used for decentralized trading of crypto tokens, heavily used for crypto stablecoins, which are used as liquid units of account for trading crypto tokens, heavily used for lending and earning interest on crypto tokens, which is a practice that serves as a source of liquidity/borrowing for Ethereum crypto token traders, and also for earning or trading various crypto tokens in a gamified manner.

So, this is a massive operating system powered by crypto tokens, for the purpose of moving… crypto tokens.

In the real world, a healthy banking system consists of people depositing money and banks making various loans for mortgages and business financing to generate real-world utility.

On the other hand, the speculation-based banking system, which consists of a series of banks taking deposits and then lending money to speculators in nearby stock markets, plus technology providers, makes this easier, and then those speculators trade mainly in the stocks of these banks, the stocks of technology companies, and the stocks of stock exchanges, forming a large circular speculation. Ethereum's biggest use case right now is a decentralized version of the circular speculation system.

Some games are fun in their own right and can be collected, but for the most part, Ethereum is currently all about decentralized finance and speculative trading.

In fact, we could argue that the main reason some decentralized financial applications (like exchanges and liquidity mining technologies) have become more popular than their more centralized competitors is that they circumvent Know-Your-Customer (KYC) regulations.

Governments are trying to implement KYC checkpoints on regulated exchanges and custodians in order to track who is buying and selling crypto tokens. They can do analysis on the public blockchain, but for tax fraud or other prosecutions, they want to be able to link blockchain transactions to specific individuals by setting up KYC gateways at as many exit and entry points as possible.

Decentralized applications make this a little harder and more attractive to users who wish to retain their privacy. The increase in government surveillance in recent decades has been a key catalyst for the development of privacy technology or offline transactions. There is a common argument that if cash were invented today, it would be illegal because it is difficult for governments to track and they would not like it.

If centralized crypto exchanges and centralized crypto banks are subject to KYC regulations and decentralized crypto exchanges and decentralized crypto banks are not, then we should certainly expect some growth in the non-KYC decentralized versions until they get some regulatory crackdown.

It’s more expensive to run code on Ethereum than on Amazon Web Services. There are a few games or services that use blockchain technology specifically, such as enforcing digital ownership of non-fungible tokens (representing a unique digital cat, for example), but beyond that many are replicating services, such as crypto exchanges or lenders, that work just as well without blockchain. So a lot of the growth seems to be bypassing KYC and becoming somewhat “permissionless.”

The problem, however, is that the ecosystem is not yet as decentralized as it could be and has many attack surfaces in the event of a regulatory crackdown.

Third-party Ethereum node operators

Bitcoin was designed from the beginning to make running a full node an easy task. In fact, this design task was at the heart of Bitcoin’s infamous “fork war” in 2017, when an easy-to-run version of Bitcoin Node Core won out over its hard fork, which 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, at the underlying level, it focuses on one simple thing: storing and transferring value. It’s an elegantly simple blockchain.

Ethereum is more complex, has more goals at the bottom layer, the node situation is more complicated, and some dapps have significant node requirements.

Since at least 2018, people have been pointing out that the Ethereum dapp ecosystem is fairly dependent on large third-party node operators like Infura. For example, here’s an article from December 2018. This is still going strong. Ironically, Infura uses Amazon Web Services, so there are two layers of centralization.

Here’s how Infura describes their product:

Here’s how another third-party node operator, Alchemy, describes its product:

Applications running on Ethereum are more decentralized than normal applications on other platforms, but if most of what they do is bypass KYC regulations and the government decides to crack down on these practices, then they have a fairly large centralized attack surface to go after. Governments can ban cloud providers from hosting Ethereum nodes, and they can go after companies that provide large-scale node services. They won't necessarily destroy Ethereum itself, but they will make it harder for dapps to run, threatening the use case.

If the government cracks down on third-party node services on Ethereum, dapp operators will scramble to find ways to effectively run their applications without these centralized third parties.

In an August 2020 podcast, Peter McCormack asked Vitalik Buterin a question, “How dependent is Ethereum on Infura?”

Buterin replied:

“I think first of all the Ethereum network is not dependent on Infura. For example, if Infura died tomorrow, the Ethereum network would continue to operate and everyone who has an Ethereum full node or an Ethereum light node would continue to operate normally.

Ethereum applications will certainly become harder to use, although in the meantime it will be possible to use Ethereum applications without relying on Infura.

I think in Metamask you can integrate the end point of your local node, and there are things like Ethereum light clients, for example you can run Geth light, and some other implementations have light mode, which also does block header verification just like Bitcoin, and in fact in Ethereum we even go to great lengths to make light clients more powerful. So, for example, Ethereum has a concept called the state tree, where we work not only on transactions, but also on account balances. So given a block, like given a block header, even a small piece of data at the top of the block, you can create a very short proof that cryptographically proves what the balance of a particular account is. *

These are things that we can do better, and there are a lot of active efforts going on in that regard. There's a lot of ongoing efforts, you know, to try to create a more decentralized backend for things like Metamask. Like, you could connect it to your full node or even a light node if you wanted to."

In a follow-up to Ethereum Bankless in October 2020, Buterin gave further context on the issue:

“You can have different levels of verification, right. For example, in a sharded environment, you’re not going to check everything yourself, but there are techniques like data availability verification where you can verify correctness probabilistically. You can verify chain shard beacons, you can check for fraud proofs, you can run a stateless client, which is better than trusting some server, and I think for more people, I think a healthy ecosystem makes it easier for more people to do these things. For example, I’m very unhappy with Metamask being just a client that talks directly to Infura.*

I mean, I realize the reality is that there’s no better way right now, but it’s definitely an approach we should try, and there are a lot of good projects trying that with engineers working on it, like Eth 2 is designed to have a simpler, better light client than Eth 1, so we’re hoping that things like Metamask will eventually adapt to it over time.”*

In November 2020, the market witnessed some of these risks unfold as Infura’s share price fell. Many exchanges had to temporarily stop withdrawing Ethereum tokens and various tokens built on Ethereum.

Infura linked the issue to a vulnerability in the Ethereum client.

“Earlier today (November 11, 2020), Infura experienced its most significant service outage in our four years of operation. We realize that we are an important part of the infrastructure for many amazing products and projects. I want to apologize to all of our users and ecosystem. We recognize the trust you have placed in us, and we do not take that trust lightly. I am happy to share the details of this incident with you so that there is transparency and so that you can have confidence that our service will be better and more resilient in the future.”*

Security Question

2020 has seen a number of high-profile DeFi hacks and vulnerabilities.

This is different from exchanges/custodian providers being hacked without any issues with the underlying protocol (e.g. someone stealing coins from an exchange). Instead, many of these DeFi hacks/bugs have flaws in the underlying protocol they exploit, resulting in the loss of user funds. In other words, this is a more fundamental problem at the token protocol layer that Ethereum enables.

When multiple protocols are involved in a complex way, and many of them have low security from the beginning in terms of hashrate or other protections (aka network effects and many altcoins have weak security budgets, or high complexity with vulnerabilities), hacks and bugs are more likely to occur.

Solving an unclear problem in a developmental way

In summary, there is a large demand for stablecoins as liquid account units when trading crypto tokens and for other purposes, a large demand for decentralized crypto token exchanges and decentralized crypto token liquidity providers, and a large demand for token-based gaming/social dapps. Ethereum has a large market share in financial dapps, while some smaller competitors have a considerable market share in gaming/social dapps.

These dapps are not as efficient as centralized applications in terms of cost per line of code executed, but there is a lot of demand because people want to bypass KYC regulations and stablecoins are currently very useful in the cryptocurrency trading space.

Ironically, however, the Ethereum solution for this need features semi-centralized clusters. While more decentralized than a purely centralized system, it is not actually as decentralized as some would like, as Buterin acknowledged. These centralized clusters provide a potential attack surface for governments to crack down on these regulated, fully centralized, and KYC-regulated companies.

You could almost say that this is a facade of decentralization for what is actually a centralized system. It is a step towards decentralization, but decentralization in its current form is not a true form of decentralization.

The various tokens used by Ethereum have had security issues, and much of the ecosystem is circular. Rather than primarily providing widely successful services to non-crypto industries, Ethereum dapps to date have primarily been used as a platform for trading, lending, borrowing, and moving various crypto tokens. This circular speculation can drive development and prices up very quickly, but can also quickly unwind if the opposite is true.

Ethereum Competition

Ethereum faces competition from smaller smart contract blockchains such as Cardano, TRON, Polkadot, etc.

Just like other currency tokens cannot take market share from Bitcoin’s expanding network effect, these smart contract protocols are much smaller than Ethereum. They are all smaller than Ethereum’s market cap combined, so Ethereum has achieved network effects and a certain escape velocity relative to them.

However, they are not as far behind Ethereum as some currency tokens are behind Bitcoin, so they are worth keeping an eye on.

Likewise, there are smart contract platforms that tie themselves to Bitcoin. RSK is an early example.

Another example is the release of Stacks 2.0 last week, which is a protocol built on top of Bitcoin that can bring smart contracts and DeFi to Bitcoin's network, using Bitcoin as a settlement layer. The project is well funded (from actual multi-million dollar rounds regulated by the SEC), and they are also issuing grants to dapp developers to potentially kickstart network effects. Whether this project will be successful remains to be seen, but the point is that between this project and some smaller independent protocols, Ethereum will face some competition in the transition.

Ethereum 2.0: The Next Iteration

Ethereum.org describes some of the problems with their current protocol:

“High demand has driven up transaction fees, making Ethereum expensive for regular users. The disk space required to run Ethereum clients is growing rapidly. And the underlying proof-of-work consensus algorithm that keeps Ethereum secure and decentralized has a large impact on the environment.”

In order to solve some problems associated with the Ethereum network, core developers including Buterin have been working for years on Ethereum 2.0, which will make huge changes to the core of the protocol.

First, it will move from a proof-of-work security model to a proof-of-stake security model.

In the proof-of-work model used by Bitcoin, miners put processing power into solving puzzles, and when a puzzle is solved, it adds another block to the blockchain, which means a bunch of transactions get processed. The correct blockchain is the longest blockchain, as determined by the majority of the network. In the proof-of-stake model, transactions are not validated by providing processing power, but by proving that they own units of the cryptocurrency, and whichever chain is validated by more currency holders wins.

If there is a split in the proof-of-work blockchain, meaning there is a dispute over which block is the most recent, then one miner can only work on one of them at a time, and the longest blockchain will eventually be accepted by the majority. In the event that miners disagree on the most recent block, each miner must choose the chain he believes is correct and commit to giving processing power to add more blocks to that chain. Inevitably, one chain will outpace the other, and the majority of miners will base themselves on it, so it will be the winner. The shorter chain will be discarded, and any miners who contributed processing power to it have wasted their money.

The Proof of Stake model uses less energy but is an unproven technology in terms of security and decentralization. In fact, continued research in this area is part of the reason why Ethereum 2.0 has not been completed for many years. An inherent problem with the Proof of Stake model is that there is no cost to verify transactions on multiple chains simultaneously. Instead of contributing to one chain, people with a stake can verify all splits on their tokens simultaneously because it does not require much processing power and therefore there is no cost to be wrong. They do not have to choose just one. So, how are chain disputes resolved?

There are multiple solutions to this, which have been part of research and development in recent years. Proof of Stake models have emerged for many different blockchains. Typically, blockchains need a way to know about splits and "penalize" proof of stake validators for validating any chain that doesn't end up being the longest chain. This increases the cost of making mistakes and incentivizes only validating what stakeholders truly believe is the correct chain, just like proof of work miners have to do. Ethereum 2.0 will have a mechanism to remove Ethereum tokens from validators that fail to perform their jobs correctly, which results in huge losses for errors or attacks on the network.

Ethereum has a much lower hashrate on its current proof-of-work system than Bitcoin’s proof-of-work system, and uses GPUs rather than ASICs like Bitcoin uses. ASICs are specialized hardware with physical supply constraints that are much harder for an attacker to get a large portion of; an attacker would likely need existing miners using existing hardware to participate), whereas GPUs are general purpose and widely used. In theory, someone could buy a large amount of cloud GPU power in a short period of time and attempt a 51% attack on Ethereum 1.0 much cheaper than attempting a 51% attack on Bitcoin, and without specialized hardware or supply chain constraints.

So I can understand why Ethereum developers are interested in proof of stake given their low hashrate and GPU-based mining. Assuming it works as intended and has no hidden attack surface, proof of stake should make Ethereum more expensive to attack than it currently is. However, with any new security model, it will take years to actually prove that it is attack-resistant. The more complex something is, the more surprises there are.

Here is a comparison of Bitcoin and Ethereum’s hash rate proof:

Chart source: BitInfoCharts

The huge difference in hash rate isn’t a “best-case metric” for assessing the difference in the cost of attacking each network (since they have different hardware, GPUs are more expensive per unit of processing power), but it’s still a useful comparison.

Furthermore, looking at the difference in hashrate in logarithmic form, zooming in a little, Ethereum has just recently recovered the same hashrate as it had at its mid-2018 peak, while Bitcoin’s hashrate is currently three times higher than it was at its mid-2018 peak. Therefore, Bitcoin’s security has tripled, while Ethereum’s security has remained the same since then.

Ethereum 2.0 Transfer Out

Ethereum developers have been working on the Ethereum 2.0 update for years, experiencing multiple delays, and aiming for completion in 2022. It may end up being delayed. I don’t blame them; it’s extremely complicated.

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”, whereby Ethereum holders can submit a large number of Ethereum tokens to operate a validator, which will verify transactions. Anyone with 32 Ethereum tokens can operate a validator, and those holding fewer Ethereum tokens can contribute funds to the validator pool. This is the core of the proof-of-stake model.

Secondly, a maximum of 64 "shards" will be created. Ethereum 2.0 will no longer be a single chain, but dozens of parallel chains called shards that process transactions and connect with the beacon chain. This will radically increase the transaction throughput of the system. Each validator operates on only one shard at a time, validating transactions that occur on this specific shard. Sharding may bring security issues. For example, if validators can choose which shard to operate on, it will not cost much to conduct a 51% attack on a specific shard, so the beacon chain must randomly coordinate validators to prevent this possibility.

Third, once all of these are up and running, the current Ethereum 1.0 chain will be "docked" into one of the shards. At this point, Ethereum 2.0 is born and can be considered out of alpha development and into beta development, so that it can be further refined as it runs. Then at a certain stage where there are no major changes for a period of time, it can be considered to be out of beta development.

Additionally, there are “aggregators” and other sidechain solutions, somewhat similar to how the Bitcoin network uses Liquid and Lightning as secondary layers to increase throughput.

With these developments, people are beginning to question whether sharding is necessary, which comes back to the issue of the base layer itself being developed.

Ethereum Monetary Policy

One of the criticisms that Bitcoin enthusiasts level at Ethereum is that Ethereum’s monetary policy is flexible, whereas Bitcoin’s is immutable.

Bitcoin produces a new block every 10 minutes on average, and every time that happens, a certain number of new coins are created. For the first 210,000 blocks, there were 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 is halved, and over time it will gradually approach zero. Bitcoin investors can tell you fairly precisely how many Bitcoins there will be in August 2026, for example.

Bitcoin will not go above 21 million coins or change this exponentially decreasing issuance rate unless the majority of the decentralized network agrees, which is very unlikely unless some security issue in the future forces them to change the issuance model. There is no central development team that can easily change it, and it has never changed in its twelve year history.

In contrast, Ethereum's monetary policy is more arbitrary, with major developers changing it over time and being accepted by the network when needed. It has 72 million pre-mined coins from the beginning (unlike Bitcoin, which has no pre-mined coins), and the current total supply is about 115 million. This chart shows the total supply in blue on the left axis and the annual supply inflation rate in orange on the right axis.

Chart source: EthHub

The annual issuance rate with all those annotations looks like something drawn by Bitcoiners to make fun of Ethereum, but in reality this is where Ethereum comes from. Over time, various Ethereum Improvement Proposals, or “EIPs,” proposed by developers have changed its monetary policy as needed for various reasons.

However, during this transition to Ethereum 2.0, it looks like Ethereum will also change its monetary policy once again through an update called EIP 1559. This will significantly reduce new token issuance.

Within the EIP 1559 framework, Ethereum will have both a deflationary and an inflationary element, which together determine how many Ethereum tokens there are at any given time.

The deflationary factor of EIP 1559 is that the base fee that users pay to validators for validating transactions is burned instead of going to the validator. Users can offer additional "tip" fees to validators to encourage them to get certain transactions through the queue faster, but the base fee is burned every time. Thus a small fraction of Ethereum tokens is permanently removed from the system every day. The higher the total fees in the system, the more tokens are burned every day.

The inflation factor of EIP 1559 is that validators will receive newly generated Ethereum tokens from the network for validating transactions in perpetuity. The total issuance rate depends on how many Ether are used as validators, with returns being higher if there are few validators (thus incentivizing more validators, for better security) and lower if there are many validators (making validation less attractive). The more validators there are on the network, the more tokens will be generated, but the amount generated per validator will decrease, resulting in lower returns for validators.

As mentioned before, validators are at risk. Improper validation or going offline could result in some of their tokens being taken away. Therefore, rewards for newly created Ethereum tokens incentivize them to take up capital, risk generating more tokens for themselves, and provide the necessary transaction validation and security for the network.

In theory, EIP 1559 is a fairly elegant framework. It ensures that validators have an inflationary security budget, while also having a deflationary element in the form of fees.

Many Bitcoiners will object to the fact that there is no hard issuance rate or hard cap on EIP 1559. I actually feel like there is nothing fundamentally wrong with EIP 1559; I think it is a much better monetary policy than the one Ethereum is currently running, and it is well thought out. As long as the monetary policy is rules-based and the issuance is relatively low, I think it can satisfy the goals Ethereum is trying to achieve with its protocol (serving as a dapp enabler for oil, rather than a scarce monetary collateral like gold). Indeed, if transaction throughput is high relative to the number of validators that choose to run on the network, then the highest potential issuance rate in the proposed EIP 1559 system is low, and some potential outcomes are deflationary on the network.

However, my question is, given how many times Ethereum's monetary policy has changed, why would I think EIP 1559 will be permanent? Ethereum developers change monetary policy as frequently as the Federal Reserve, and for similar reasons. Perhaps if EIP 1559 is in place in 5 years, proves itself to work as intended, and has not changed, and Ethereum 2.0 is running smoothly, I agree that there is reason to believe that it will not change again, and the system is working as intended. Until then, all I can do is watch how things develop.

Node characteristics

Let’s look at node characteristics. A node is the client software that a user can run to validate the blockchain and enforce the consensus rules. I will again use Bitcoin as a reference and then compare and contrast Ethereum to it.

Even after 12 years of stable operation, the entire Bitcoin blockchain is less than 350 GB and grows quite slowly at a pre-set limit. The bandwidth requirement to run a full node is only about 500 megabytes per day, which is very low. Over time, the size is small and does not grow faster than the memory growth of a typical computer, and a full Bitcoin node that stores and verifies the entire blockchain can be run on a laptop or similar device with only a basic internet connection, and it will remain so for the foreseeable future.

This makes Bitcoin highly decentralized in terms of validation and consensus. While mining power is concentrated in certain countries, a major source of Bitcoin's decentralization lies in its consensus framework between full nodes. Each full node can reconstruct the entire Bitcoin blockchain, and they operate all over the world. Here is a map that is visible to the network:

Source: Bitnodes

Ethereum currently has nodes of various levels. Although the Ethereum blockchain is much younger than the Bitcoin blockchain, the amount of space required to run a full node is already greater than a Bitcoin full node because it grows faster per unit time. Given a sufficient length of time,

It will become increasingly difficult for regular users to operate a node, meaning full nodes may be restricted to large entities rather than accessible to just any user.

Also, there is a more complete archive node in Ethereum, as it contains various intermediate states. A full node can be expanded and turned into an archive node, but it takes many days and many terabytes of space, so they tend to be run only by larger specialized entities.

Ethereum 2.0 will change this. In order to greatly increase the transaction throughput of the system, validators will only verify transactions on a specific shard (there may be 64 shards), so they only store data and pay attention to a small part of the network.

However, there will also be super full nodes that store all the data for the entire Ethereum 2.0 network; this will require massive amounts of storage and bandwidth, and can only be operated by a few large entities.

The Ethereum Wiki provides an overview of the node types in Ethereum 2.0:

Note that there are now several "levels" of nodes that can exist in such a system:

• Supernode - Downloads the entire data of the beacon chain and each shard block referenced in the beacon chain.

• Top-level nodes — only process beacon chain blocks, including the headers and signatures of shard blocks, but do not download all the data of all shard blocks.

• Single-shard node - acts as a top-level node, but also fully downloads and validates each collation on the specific shard it cares more about.

• Light Node - Only download and validate the block header of the main chain block; unless it needs to read some specific entries in the state of some specific shard, it will not process any sorting headers or transactions, in which case it will download the Merkle branch to the latest collation header for that shard, and then download the Merkle proof of that shard from there. Expected value in the state.

This is the difference between Bitcoin and Ethereum 2.0. The Bitcoin community emphasizes that self-verification is the key principle. Any average user can download open source Bitcoin core software on a basic laptop and the entire Bitcoin blockchain. This allows them to audit the entire currency supply of Bitcoin, view every transaction in all Bitcoin history, and personally verify that the entire network is following consensus rules.

In Ethereum 2.0, average users cannot do this; they will need to trust other network participants, including these supernodes run by large entities, and rely on the protocol to evaluate the probability that they work as expected. Unless they can invest in a major computer/network infrastructure to run a supernode, which will exceed the capabilities of most users, they will only be able to access the network at a given time through a single sharded node, beacon node, or light node.

Again, it is credited that they have put a lot of thought into this design. Ethereum developers want to avoid certain issues with altcoins that try to improve throughput by making each node difficult to run, so they want to create a series of nodes to provide users with different levels of verification, which can almost be accomplished when so much complexity is built into the underlying layer of the protocol.

Token price model

The Ethereum 1.0 blockchain is now quite congested, so the transaction fees the protocol is trying to complete are high. This is good for Ethereum prices; users need Ethereum tokens to pay for the execution of smart contracts, and high fees mean users need more tokens to pay for the execution of the contract.

But in the long run, this is bad for the network, because if dapps are much more expensive than centralized applications, then the reason for their existence is less attractive.

The main purpose of Ethereum 2.0 is to greatly scale the throughput of the system, literally on orders of magnitude. While this is necessary for the protocol to become a "world computer" because it is trying to do so, it raises questions about the structure of Ethereum token pricing incentives.

If the transaction throughput is very high and the fees are very low, users don't need too many Ethereum tokens to run the dapp. There is such an interesting trade-off: high fees make the dapp unattractive, while low fees may reduce the demand for Ethereum tokens.

However, running a validator is a good incentive for Ethereum people to hold Ethereum 2.0 tokens for a long time.

They can stock up on tokens and submit them to validate to earn more. So, as long as the system is still running, there may be a lot of people who want to hold the tokens and get profits from it.

Overall, I have not seen a clear price appreciation model for Ethereum tokens like Bitcoin. In theory, if the usage of Ethereum 2.0 dapps increases significantly over time, the price of Ethereum tokens will also appreciate to a certain extent, thanks to Metcalf's law. However, it is hard to say exactly how much, because high throughput and low fees systems do not directly require high token prices for Ethereum. On the other hand, if the use of Ethereum 2.0 dapps tends to flatten and stagnate (see the aforementioned currently fairly circular problem), then the value of tokens may also stagnate.

Bitcoin vs Ethereum

There is a fierce debate between some Bitcoiners and Ethereum (yes, it does sound like the plot in Star Trek).

First, there are cultural differences.

Bitcoin attracts more groups of liberal and Austrian economists; loyal fans of sound currency, sovereignty, and more. There are also many Silicon Valley financiers, so it’s a bit mixed. Bitcoin enthusiasts like to run a full node on their PC and audit the consensus rules of the entire money supply and the Bitcoin blockchain (“Don’t trust, validation”). The field is slower but more stable, because retaining the core Bitcoin protocol is paramount. Institutions with a lot of funds are starting to get interested in Bitcoin. The surrounding ecosystem is very focused on security, including multi-signature solutions and hardware wallets that only support Bitcoin, which make security a step further than other wallets. The protocol and the surrounding ecosystem have been strengthened, tested and stable.

Ethereum attracts more player culture and more experimentation. As a platform, it can conduct a lot of speculation in small alternatives with high failure rates, but it can also continually reevaluate developments in the technology field to understand how to improve its underlying framework. It is more ambitious at the bottom, some see it as a feature, while others see it as a bug. It relies more on its founder and trusts more in terms of money supply and details. DeFi on Ethereum has been able to catch up with the second layer of Bitcoin, for example, more bitcoin used for decentralized transactions in Ethereum than there is in the Bitcoin Lightning Network, but the growth of DeFi has been essentially speculative so far.

Some Bitcoin enthusiasts believe that any other cryptocurrency or digital asset is essentially a bad idea or scam. Many of them insist that new applications of blockchain technology should be built on proven bitcoins rather than being paralleled as separate protocols. The Bitcoin developer community tends to act slowly and cautiously rather than taking quick action and breaking routines, which they believe many other tokens do.

In fact, the history of digital assets is rather bad, besides Bitcoin. Thousands of tokens, many are outright scams, many lack adequate security, and are hacked at the underlying layer (not only through exchange, but also the actual protocol itself is subject to 51% direct attacks or exploits)

And the others were kind and fun, but were simply unsuccessful. In terms of price or hashrate, the vast majority did not exceed the highs in late 2017,

And Bitcoin has surpassed it.

On the other hand, Ethereum people see a lot of value in the Ethereum network, and in fact, this is another blockchain that has established a certain degree of network effects over time, which also benefits from Metcalf's law. Some of them see Bitcoin as old technology, or confined to digital gold, and believe Ethereum will be the future of many actions. Many of them think that Bitcoin's role is saving technology and store of value, but they are just more interested in Ethereum's potential in decentralized applications.

Buterin coined the term “Bitcoin Maximist”, referring to Bitcoin enthusiasts who believe that no other coin can maintain significant value for the long term.

By contrast, Bitcoiners often point out that most people entering the rabbit hole of cryptocurrencies trading various altcoins end up losing money in an inevitable downward cycle, and many of these protocols simply use the dovetail of Bitcoin to enrich its founders. The money spent by unsuspecting traders without adding lasting value or understanding exactly what made Bitcoin successful over the past 12 years.

The hardest money

In this debate, I don’t think I’m important.

I'm an investor and I want to invest in projects that I think are already done, as well as those with good risk/reward characteristics. For me, this includes Bitcoin, but not Ethereum.

Based on the reasons I mentioned in my July 2020 post, I prefer Bitcoin risk/return opportunities for the digital asset portion of my portfolio. It has a 12-year price history and a consistent monetary policy built around difficult adjustments every 2 weeks and supply halving every 4 years, which has so far algorithmically driven higher prices and adoption:

Chart source: Blockchain.com

The basic layer of Bitcoin has been out of the effective beta model and has been fully put into use for a long time. The ecosystem around it is constantly improving, and the basic layer will receive security updates over time.

But it is still a working system. There has been no major changes at the bottom since 2017 and it has been operating under the same overall framework since its launch in 2009. The bigger changes in the Bitcoin space mostly occur at the secondary level and around the software/hardware/financial ecosystem.

On the other hand, Ethereum’s work on its base layer is still in progress, still in the alpha development stage, as it is still changing the core underlying mechanism. The design of Ethereum 2.0 is smart in many ways, and it is obvious that people have thought a lot about it, but there is a lot of speculation about what it needs, how it functions, and how it will safely maintain itself. To address the current limitations that threaten the network’s capabilities, they have changed many aspects of the protocol that have made it successful in price within the first 5 years of its life.

Some macro investors like to do 90% bitcoin and 10% Ethereum on the digital assets part in the portfolio, or 80% bitcoin and 20% Ethereum. Do I think that's crazy? Not really.

People should do what they think is right for them, evaluate what they have good risk/reward opportunities, etc. Research the best options and identify for themselves what they think is possible to succeed.

Some would think buying some Ethereum tokens, hiding it somewhere, and watching what will happen in five years is a rather asymmetrical speculation. If Ethereum breaks through $1,400 to a new high, it has the potential to make a big profit next year. In fact, as long as the network is congested and the fees are high, it will help Ethereum tokens appreciate.

However, investors should understand that Ethereum is still in the alpha development stage. Perhaps in another 5 years, when Ethereum 2.0 is in place and runs for a while, during which monetary policy remains consistent, it can be considered a basically completed project like Bitcoin. Until then, it is still in the experimental stage.

Bitcoin has considerable volatility and upside potential, so most investors do not need to risk speculation and venture into protocols that are still doing basic development on their base layer.

From the perspective of scarcity and security, value accumulation tends to be concentrated in the scarcest form of currency, which is why gold has been the foundation of the financial field for most of human history. Things that can be used to perform work (such as copper or oil)

Usually not where long-term value is stored in the market. This analogy doesn't necessarily apply to Ethereum because it also has a high stock-to-flow ratio that we'll see in time, but from an investor's point of view, the burden of proof is on any secondary network that is trying to optimise in terms of its attempt to compete with the top network in terms of its main function (storage value).

To what extent the Ethereum ecosystem can support a large number of applications is a separate question of how long its tokens will appreciate in price in a long term, in addition to the natural boom/bust cycle it has experienced. The complexity of the underlying layer proposed by Ethereum 2.0, including a beacon chain and dozens of fragmented chains, may not attract much money to buy and hold tokens compared to the relative simplicity and fully verifiability of the underlying layer of Bitcoin.

The risks of Concorde

In my opinion, the biggest risk to Ethereum is that it may end up being like a Concorde.

The Concorde was the first test flight in 1969, which allowed the public to fly at speeds up to twice the speed of sound. While it was practical, it never became an economically sustainable project. When I wrote this in 2021, over 50 years passed, and the public still had no choice for supersonic commercial flights. People in the 1960s thought we were now in space, or had flying cars like the Jetsons, rather than traveling in a plane that was slower than the fastest commercial aircraft of 1969.

Designing and operating an aircraft that can be safe and repeatedly exceeding the speed of sound is extremely challenging; at this point, many aerodynamic changes in sound barriers have been broken through. This problem has not been addressed in the economic mode of commercial flight in the 50 years since its concept was born.

So while Concorde is cool and can fly from New York to London in 3 hours, it can never compare to other alternatives when it comes to solving large enough customer problems at the right price. The market is already content with first-class passengers paying higher fees to make long-haul flights more comfortable than spending money on shortening flight times.

There are a lot of smart developers working on it, and it is exploring some clever avenues. It drives Bitcoin developers to continue to innovate in the ecosystem around the underlying layer, which is what I hope to see. But compared to Bitcoin, I don’t really believe Ethereum will succeed in the long run. As things change and new facts and developments, I will continue to focus on the development of the situation.

Perhaps Ethereum will iterate until it finds a sustainable place for itself. On the other hand, Ethereum may end up being dragged down by its own complexity and lack of a wide range of economic uses, such as Concorde.

Final Thought

I think monitoring Ethereum is important for all kinds of investors.

Stock investors should probably focus on the development of some dapps to see if something outside of this ecosystem will destroy some of their traditional investments over time. Bitcoin investors should supervise it as some competitors and some collaborators to see what works, what doesn’t, and more importantly why it can inform the development of its own ecosystem.

Stablecoins are particularly important in my opinion. I am optimistic about the amount of funds locked in stablecoins. This is a space worth paying attention to, whether it is good or bad. The US Office of The Comptroller of The Currency now officially allows U.S. banks to use stablecoins. They are a more liquid form of fiat currency that can have various impacts on central bank digital currencies and the existing global monetary system.

While I don't think it's crazy to have a place in Ethereum, I don't have a clear modeling method other than speculation, as it's an unfinished product on the base layer with considerable use cases and therefore far involves trading, liquidity supply, and altcoin gamification. For Bitcoin, I can make a more basic point of view in favor of non-zero positions as macro assets.

In terms of BTC/ETH ratio, 80/20 or 90/10 or 100/0 all make sense to me as the digital asset part of the portfolio. My approach is to support Bitcoin 100/0, and I haven't seen a compelling reason to change that, unless I just want to speculate. I personally need to see Ethereum 2.0 ending alpha development, have consistent monetary policy, and have more use in areas outside of token speculation, so that I can catch my interest in a more structured way.

Some in the digital asset community call Bitcoin gold and Ethereum oil. In other words, one is a store of value and the other is a facilitator of work.

However, I think Bitcoin has an unexpected upward trend and continues in cycles in a way that most other cryptocurrencies don’t have. Ethereum is probably the second largest blockchain network, staying between cycles and cycles in a functional form for a long time, always benefiting from Metcalf’s law, but it must first transform through 2.0.

From an engineering perspective, I prefer the modular design of Bitcoin. The base layer is simple and stable, with almost bulletproof design. Above this layer, the ecosystem can innovate, and while it may not develop as fast as some would have hoped, it will move in the direction the market would want. This is also how the existing financial system works; there is a basic settlement layer and a faster payment layer built on these base layers.

So far, the market in the Bitcoin ecosystem has been looking for security to maximize the storage of the value proposition, so it has obtained a level of multi-signature solutions and hardware wallets that surpass the ecosystem of other digital tokens, including Ethereum.

There is little interest in the second layer of Bitcoin as a medium of exchange in the market, as there is not much need yet, although Lightning Labs and other developers continue to build tools and infrastructure to cope with increased demand (ultimately, higher fees). The basic layer may result), and many application developers are already using these tools.

As a metaphor, martial arts have different philosophies. Some preemptively take action and are more prone to attack. Others emphasize solid foundations and then react more and use the momentum of their opponents to deal with them.

Bitcoin is the latter in my opinion. It doesn’t move and break things as fast as many tokens, but it moves slowly and has a tendency to get things right. The more creativity and innovations emerge in the broader digital asset industry,

The more Bitcoin developers need to cooperate for their protocols and ecosystems.

I will continue to focus on this industry, but in the digital asset part of my portfolio, I prefer to invest exclusively in Bitcoin, although I can also understand why some people like to speculate with Ethereum because it can get higher returns during the bull market. These speculators should understand that the underlying layer is still in the alpha development stage while competition in the smart contract industry cannot be ignored, and its security model, monetary policy and target market are changing rapidly.