Will Ethereum 2.0 upgrade make ETH the largest cryptocurrency by market capitalization?

The world’s second-largest cryptocurrency is implementing a network upgrade that completely changes its value proposition as a financial asset.

The term Flippening was colloquially coined in 2017 to refer to the possibility of Ethereum (ETH) surpassing Bitcoin (BTC) in market capitalization. As such, the term describes a hypothetical future moment when Ethereum becomes the largest cryptocurrency by market capitalization.

Although BTC has long been the top cryptocurrency by market cap, its market dominance has declined significantly in recent years. This decline was particularly pronounced in mid-2017 and early 2018. During this period, many Ethereum supporters hoped that the Flippening would occur.

Speculators said greater flexibility and the ability to write smart contracts would push Ethereum ahead of Bitcoin in these rankings, but the flip never really happened.

One of the main criticisms of cryptocurrencies in the investment community has long been that they do not generate any future cash flows and therefore cannot be considered an investment.

Due to their deflationary design, most cryptocurrencies are not suitable as a currency to denominate income-generating assets (i.e. no one wants to borrow in a currency that is designed to appreciate in value, and no company wants to pay employees/denominate contracts in this currency).

If cryptocurrencies could generate future cash flows, would some of these criticisms disappear?

So far, this issue has not received widespread attention from the investment community, but it is worth considering because it may indeed be happening.

To understand why things change, we need to look at the following aspects.

Let's review how cryptocurrencies work. Cryptocurrencies are digital assets recorded on the blockchain, a distributed ledger that keeps an unchangeable record of these assets. The accuracy of the distributed ledger is maintained by the consensus mechanism in the blockchain, which requires that every transaction on the chain be verified by a distributed group of validators.

Bitcoin uses the consensus mechanism of Proof of Work (PoW). In this mechanism, validators (called "miners") spend their energy to solve mathematical problems (the solution to the hash function SHA256 cannot be calculated by the human brain). They prove that they are real entities by investing resources (mining machines). Miners who successfully record accounts (the answer to this math problem) will receive Bitcoin rewards. This is the most commonly used consensus mechanism in today's public chains.

The POW mechanism is widely criticized for over-consuming electricity, "a secondary energy source," and not using it productively. According to a CBS report, the Bitcoin network consumes more electricity than the average annual consumption of 159 countries (Figure 1), "including Ireland and most African countries."

Figure 1: The Bitcoin network consumes more electricity than these countries

“The yellow areas are countries and regions that consume less electricity than the Bitcoin network.”

However, Ethereum, the smart contract platform and the second largest cryptocurrency by market value, has been working on a revision of its consensus mechanism. This version, called Eth 2.0 or Casper, intends to introduce a proof-of-stake (“POS”) consensus mechanism.

In the Proof of Stake (PoS) mechanism, the validator needs to hold some relevant cryptocurrency and then stake it to become a validator.

In return, they are rewarded in ether, the Ethereum network’s cryptocurrency, equal to a percentage of their stake. Both mechanisms presuppose that validators invest in helping to secure the network and receive rewards to compensate them for their investment.

In PoW, investors invest in mining equipment and pay for the equipment’s consumption and fees; in PoS, they are using their own financial resources to purchase cryptocurrencies and stake them.

Financially speaking, the interesting thing is that this makes collateralized cryptocurrencies look more like financial assets with fixed income capabilities, which can change the way such assets are valued in economics as a whole.

The rewards distributed by nodes increase the existing supply of Ethereum, so it is called the inflation rate. If we assume that the final stage is that the entire network is running under the PoS mechanism, then the inflation rate will be equal to the rewards distributed by all nodes.

So if we make the simplified assumption that any Ethereum purchased will be staked forever, then this looks like a financial asset with future cash flows, all in its native currency, the native currency of the Ethereum network.

It’s no accident that Ethereum’s designers used traditional economic terms. It is a digital ecosystem that has similarities to the traditional economy.

Ethereum is a distributed world computer, and Ether ("ETH") can be used to buy Gas, which is the necessary fuel to run this computer. Therefore, Ethereum is like an emerging economy, and economic activity measured by the amount of currency used has been growing (Figure 2).

Figure 2: Ethereum network gas usage

Source: Etherscan.io

Like all other traditional currencies, this currency also has an inflation rate.

Once PoS goes live, it will generate its own interest rate in the form of staking rewards. Having a currency with an interest rate curve makes it possible to have a forward market established against other currencies, so hedging is also possible.

However, there are also big differences with emerging currencies. In fiat currency, when you generate a fixed return, that is through the purchase of interest-bearing instruments such as bonds or lending cash, which inherently carries credit risk. In the case of staking, since the returns are generated by an algorithmic mechanism rather than through the risky economic activities of the trading parties, there is no credit risk on the trading parties.

Therefore, the rate of return in the crypto economy is the risk-free rate. However, there may be some other technical risks, such as slashing, attacks, and hacking, at least in the initial stages. However, technical risks are also inherent in the existing financial infrastructure, so we should assume that as financial institutions become active in this space, they will build the necessary technical defenses.

Another important factor to consider is the relationship between this return and inflation. Staking rewards are directly tied to Ethereum’s inflation rate. This direct relationship does not exist for any traditional cash instrument other than inflation-linked bonds, and historical data shows that the actual return on cash can be negative over extended periods of time.

Therefore, ETH will be a unique currency that can offer a risk-free interest rate with the security of being protected against inflation. In addition, it will not be possible to stake all the currencies in existence, as part of the currency will be used for its utility, such as paying network fees to run smart contracts.

This means that in this hypothetical scenario, the returns earned on staked coins will be higher, thus ensuring that the actual rate of return exceeds the inflation rate. This is not possible with any other asset class at present.

All things considered, this could be considered an asset with no credit risk and offers the potential for real inflation-adjusted returns.

This makes it possible to view it as a common financial asset with financial characteristics, rather than a worthless "tulip" phenomenon. For financial investors, this is a complete game-changer, and the time is ripe.

The world’s primary reserve currency, the U.S. dollar, is under intense pressure as holders are financing trillions of dollars of government debt at virtually zero return, an increasingly difficult position to defend. Moreover, holders are increasingly subject to the unpredictable actions of the U.S. government.

Alternative currencies like the euro and yen have negative interest rates and are supported by economies that are charging various political and demographic time bombs.

Whereas Bitcoin requires a radical leap forward from the “digital gold” narrative, Ethereum represents a currency for a rapidly evolving, decentralized, open economy that has extremely attractive and understandable attributes for financial managers.

As the economy based on the Ethereum network grows, in the long term one can expect to see ETH gain a place as a unique asset in institutional portfolios and even central bank reserves.

Finally, there are many technical hurdles on the road to a full transition to PoS, leaving aside the uncertainty of the final state of the ecosystem using PoS. As a financial asset, this potential risk means that Ethereum is becoming too dangerous to ignore.