Why ETH may not be able to maintain its monetary premium in the long run?

Original title: "Why will ETH not maintain a monetary premium in the long run?"
Written by Checkmate
Translation: LH

The Ethereum project has long been criticized, especially by Bitcoin enthusiasts, for its design, execution, and failure to deliver on its crowdfunding pitch. Ethereum is currently attempting a monumental engineering challenge, attempting to rebuild its entire blockchain to integrate with existing chains while allowing both chains to run in real time.

It’s not that easy. It highlights irrefutable problems with the original design, and the continued uncertainty investors have about the future.

At the same time, Ethereum has found a new direction, focusing on distributed financial applications. This is supported by the so-called "moat" of developer activity. The underlying spirit of this movement is "open and unstoppable finance" and establishes ETH as the reserve currency asset of the entire ecosystem.

This article takes a different position: despite this development, it is unlikely that the ETH token will develop a credible monetary premium. This is particularly important when ETH is competing with digital currencies with a fixed supply, deterministic issuance, and deep liquidity (such as Bitcoin). The core arguments will revolve around the following themes:

• Uncertainty about monetary policy and centralized governance

• Second System Syndrome and Continuous Project Direction Changes

• Relying on the application layer to accumulate value

• Underestimating the “tortoise and hare” reality of Bitcoin development

(Blue Fox Notes: System 2 Syndrome, also known as System 2 Effect, was proposed by Fred Brooks, the author of The Mythical Man-Month. It means that after completing a small, simple, successful system, people tend to expect a better next plan, but the actual result is often the opposite. They may create a large, complex system with complicated functions, that is, an over-designed system, which ultimately fails.)

Monetary Policy and Governance

The core design of Bitcoin's monetary policy is that it was hard-coded into the software from the beginning, with a pre-defined supply curve and a supply of 21 million coins. Bitcoin's monetary policy has only changed once in history, through the BIP-42 soft fork to remove Satoshi's abnormal undefined behavior in C++ and support the development of alternative clients.

Today, this monetary policy is protected by a solid social contract. It is unlikely that Bitcoin’s monetary policy will be changed without destroying the fundamental value of the project and hard forking the chain. Most Bitcoin supporters agree that if the supply curve is tampered with, it will no longer be Bitcoin.

This provides investors with relative certainty and has attracted impressive value capture over Bitcoin’s 11-year history. Bitcoin’s design allows for confidence in future inflation and supply expectations.

For Ethereum, its 2014 crowdsale was conducted with the understanding that it would move to PoS at some stage in the future. To encourage developers to move towards this goal, the "Ice Age" was incorporated into the protocol, which intentionally increased block times by ending PoW difficulty. This had the effect of disincentivizing miners from supporting PoW chains, making it easier to move to PoS.

The Ice Age was recently delayed for the third time in Ethereum’s history due to hard forking changes to the consensus rules. In all cases, the PoS implementations were not ready for deployment, and the first two hard fork delays were tied to reducing the ETH issuance rate.

Unsound monetary policy

Ethereum bulls often point to the continued reduction in block rewards as a sign of increasing hardness and scarcity of its currency. However, a clear distinction must be made between the rate of issuance of an asset (hardness) and the robustness of an asset, or its resistance to human tampering.

Although the issuance rate has been reduced to date, the choice of inflation rate is the product of developer intervention rather than a deterministic, reliable hard-coded change.

The criticism here is that a small group of people have the power to dictate the inflation rate of what is supposed to be a global monetary asset. Play this game long enough and eventually the people at the helm will abuse that power.

The future inflation rate and token supply are unknown. Even in ETH2.0, who has the power to decide what success will be at the minimum viable issuance? Someone will have the power to adjust the staking ratio until a subjective and dynamic target is reached. If it is left to the algorithm and found vulnerable, someone will enter the protocol and change the inflation. Since the attack vectors never stop evolving, this process will never stop. Therefore, Ethereum can only be considered to have an unsound monetary policy, and its social contract grants monetary authority to a small group.

Centralization of nodes and validators

Bitcoin experienced its most controversial period during the scaling war over Segwit activation. The UASF (User Activated Soft Fork) movement invalidated miners’ capture of the Bitcoin chain through a social contract. User nodes were upgraded so that miners who did not comply could not receive valid rewards.

To achieve this, Bitcoin node software has always been designed to be lightweight, ensuring simple hardware requirements and easy access by the public. Ethereum has historically required more specialized high-performance hardware to run nodes. This is often a result of the increased demand for block space due to larger transaction ranges and Turing completeness.

While node hardware will continue to be optimized, sync times and hardware requirements will only increase. If Ethereum truly reaches a global audience, this could lead to a centralization of nodes, with large-scale participants being able to replace SSD drives and upgrade frequently. Node operators will most likely be concentrated around a collection of Ethereum core developers (such as EF and Consensys), traders, crypto banks, and staking service providers.

Due to the lack of technical capabilities of ordinary users, ETH2.0's staking reduction measures actually promote centralized behavior. Ordinary users will give priority to exchanges and providers of equity staking services for convenience.

As the above centralization takes effect, the ability of users to signal intent and initiate UASF-type defenses against malicious actors will be greatly reduced.

This highlights the gradual concentration of governance power towards core developers, who hold large amounts of ETH to validate PoS and influence the direction of monetary policy experiments.

Monetary Experiment

Monetary policy is under discussion, the latest experiment of which is EIP1559, which introduces an ETH destruction mechanism that completely changes the blockchain mechanism and incentive system.

Ultimately, this burn mechanism will benefit current ETH holders the most, while disadvantage future holders and users. Assuming the network is growing, the burn rate of ETH will increase gas costs (fee inflation) for users in USD. Stakers are largely unaffected because they benefit from non-diluted block rewards, as well as taxes generated through burns.

The author is concerned that this monetary policy experiment was carefully designed by those who benefit the most, in response to the "research predictions" that developers found that the current gas fee mechanism cannot accumulate value. This looks very similar to the central bank experiments and the Cantillon effect in the world today. (Blue Fox Note: The Cantillon effect means that the increase in money does not have the same impact on the prices of all commodities at the same time. The way in which the incremental money affects the economy depends on the way and channel of the injection of the new money. It does not necessarily benefit everyone, and those who get the money first may benefit. The increase in money causes some people to gain and others to lose.)

One can only conclude that Ethereum's monetary policy is relatively flexible and is influenced by people rather than code. This uncertainty reflects an unsound monetary policy (susceptible to human intervention) and instills a notion of defensibility for centralized governance. This has undoubtedly hampered the development of Ethereum's monetary premium and seems only to worsen over time.

Second system syndrome

The Ethereum project was originally designed to extend Bitcoin's feature set by introducing Turing-complete scripting capabilities. The design intent was to create a global computing network, a "world computer". In fact, this is a valid design goal, and Ethereum is very suitable for this goal. If so, it provides CAPTCHA verification code for the new transaction Internet.

The trade-off of this design decision is increased protocol complexity, greater vulnerability and hacker attack surface, and inevitable blockchain bloat. Ethereum's design direction has also responded to market demand and made several turns. Its narrative has shifted from the world computer to unstoppable dApps, to token issuance, and now to open financial applications.

Notably, the original Ethereum design explicitly ruled out the use case of the ETH token as a currency. This has since been revised on the Ethereum.org website and in its project documentation.

While this represents an innovative side and lessons learned, the design trajectory of the Ethereum project shows a continued pull toward Bitcoin’s design as a monetary asset. During this time, Bitcoin continued to build money-like features such as liquidity, network effects, and ultimately financial products that drove a strong reputation and product-market fit.

Ethereum is in many ways a perfect example of second system syndrome, where a simple technology like Bitcoin is deemed incapable of meeting its design goals, and iterates into more complex and “promising” projects, which ultimately leads to an endless cycle of research, discovery of new problems, and then delayed delivery schedules.

As the reconstruction of ETH2.0 becomes the latest solution to this problem, it once again paints an uncertain future for ETH holders. This new blockchain will eventually reset the Lindy effect that has developed on the existing chain, and at the same time, it can reasonably be expected that more research and discovery will appear and more problems will be solved. (Blue Fox Note: The Lindy effect refers to those things that will not die naturally (as opposed to organisms that will die naturally). The longer they exist, the longer they will survive. For example, classic books, cryptocurrencies, etc. Here the author means that since ETH2.0 is a new blockchain, it causes the Lindy effect originally generated by ETH to be reset and new problems to arise)

Additionally, the ETH2.0 beacon chain is very similar to Bitcoin in design, handling only consensus and global state, while pushing applications and expansion to shards (sidechains or Layer 2 in the case of Bitcoin).

Rely on the application layer to accumulate value

Despite the technological and engineering success of the open finance ecosystem, there is still a risk of relying on third-party protocols to accrue value to ETH.

Recently, there have been a lot of high-profile "unstoppable", "non-custodial" and "decentralized" applications... Actually... stoppable, custodial and centralized:

• MakerDAO has a zero-delay churn mechanism, and user funds are also custodial.

• Compound Finance was found to be custodial and have developer backdoors and churn mechanisms.

• The developers shut down 0x after discovering a bug in the 0x V2 upgrade.

These challenge the "unstoppable" narrative and are actually dishonest product marketing because they advertise "decentralization" but actually have backdoored product custodians. Although security protections are effective in the early research and development stages, it sounds a lot like second system syndrome. Perpetual research supports an "almost ready" development timeline.

There is no secure backdoor in cryptography. If it is accessible to developers, then it is also accessible to attackers.

Reliance on centralized oracles

MakerDAO, the core of the DeFi ecosystem, is guided by the MKR governance token. One could argue that without Maker and its DAI/SAI tokens, the DeFi ecosystem would rely on centralized permissioned stablecoin infrastructure such as USDT and USDC. Furthermore, the vast majority of the ecosystem relies on the centrally controlled Maker ETH/USD price oracle.

This problem is not easy to solve in a trustless way. In fact, this article does not believe that trustless oracles are a problem that can be solved in the medium term, and emphasizes that this topic has been studied for decades. Any price flow on the chain (such as Uniswap) is vulnerable to liquidity attacks and requires such a large scale that it will be difficult to achieve for at least decades. (Blue Fox Note: This statement is too subjective)

Therefore, trustless oracles, a key component of DeFi, will likely remain centralized for decades. Attacks on these centralized oracles will be a fundamental risk to investor capital for the foreseeable future. The “house of cards” concept is very applicable to describe DeFi. These centralized oracles are used as primitives for other composable protocols. The entire stack is only as resilient as its weakest link, leading to confusion about the actual risk for users.

This appears to be a source of systemic risk and unmitigated risk.

Dependence on MakerDAO

The main criticism of MKR is that the token is highly concentrated in the hands of well-known venture capitalists and teams. Indeed, a proposal to reduce the “decentralized” bank’s interest rate by 4% was recently passed with 94% of the votes coming from a single entity. This shows the apathy of the voting community, the lack of incentives to participate, and the strong influence of a small number of large token holders.

Now, considering the entire open finance ecosystem and the centralized oracles that rely heavily on Maker, one must ask oneself, what would happen if Maker and its token holders were regulated or hacked? Since the base layer forks can be rebuilt, Maker can only be shut down temporarily. But at what cost to ETH holders?

A hack of the MakerDAO oracle would not only result in CDP/treasury liquidations, but all dependent protocols would allow cheap liquidated ETH to be captured by a savvy attacker.

If all 3% of ETH is transferred by the hacker, will rollback be on the table? What if it is not 3%, but 30%? The attacker is now the largest validator on the PoS network. (Blue Fox Note: 3% is the amount of ETH currently locked in DeFi)

This is a real risk, the outcome of which is unclear.

If the value proposition of locking up ETH to drive open finance is dissolved, then it is reasonable to expect that all value accrued under this assumption will also be dissolved. Ethereum bulls believe that smart contracts native to the protocol can be forked by third parties. This is true, but this article questions how many iterations of the new narrative --> boom --> regulation/hackers/false promises --> bust investors will tolerate before apathy destroys future value accumulation.

The tortoise wins the race

In summary, the Ethereum project is affected by the following factors:

• Relatively centralized governance and unsound monetary policy show signs that this will only worsen over time.

• The latest experiment with EIP1559 seems to contradict the needs of all users except current ETH holders. This creates an unfair system and makes user transactions increasingly unpopular on-chain due to rising fees.

• Ethereum faces a much larger attack surface than Bitcoin due to the complexity of the protocol, Turing completeness, developer backdoors, and centralized oracles.

• The narrative, project direction, and experimental features continue to change over time, gradually anchoring it to a narrative of sound money similar to Bitcoin.

• Over-reliance on third-party applications to increase the value of ETH tokens, these applications can be stopped. Uncapped supply and liquidity of monetary policy requires this mechanism.

• Any centralized pool of ETH (including custodial DeFi applications) is under constant threat, which is not beneficial for PoS validators.

• Second system syndrome reaches its peak when the entire underlying blockchain is rebuilt. This is a massive feat of rolling one chain into another, which can take years.

Ultimately, the reason why Ethereum is having a hard time growing and maintaining a compelling long-term monetary premium is simple.

Investors cannot be sure what they are buying, systemic and unmitigated risks are part of the social contract, and there is no tangible data to suggest that this reality will change.

One cannot expect potential investors, aware of the scale, history and depth of the above-mentioned uncertainties, to be unwilling to exchange part of their capital for ETH tokens.

The original vision of being a world computer was the best narrative for the project and an achievable goal if the direction wasn’t endlessly changed. The problem was that the “world computer” turned out to be a smaller potential market compared to a “monetary asset” like Bitcoin. So the narrative gradually shifted to “ETH is money”.

Bitcoin is achieving its goal of digital, sound, immutable money, while Ethereum has explored numerous dead ends. There is a widespread misunderstanding of the potential of systems like the Lightning Network, sidechains, and various higher layer solutions that could enhance Bitcoin’s ability to serve as a global reserve asset.

This article anticipates that if Bitcoin achieves global currency status, most users will rarely interact on-chain due to high fees. Regular users will primarily interact on higher layers of the technology stack, with final settlement being the primary function of the base layer.

Intuitively, it makes sense to build a very secure and immutable base layer with the sole purpose of transaction settlement. More complex layers with less security and consensus requirements should be isolated to higher layers in the stack.

Indeed, this is exactly what the ETH2.0 beacon chain is designed to do, it is only responsible for finality and settlement. No bloated blocks. 2.0 sharding simply replicates Bitcoin's second, third, and higher layer solutions, but without the liquidity, reputation, and security premium that Bitcoin already has, and will continue to develop.