Digital Nugget: January 2021
Good News On Ethereum Priced In?
After ether hit an all time high of $1,459.93 and outperformed bitcoin, which itself experienced a tremendous bull run, almost 2.5x from the beginning of last year to the 25 January, it is reasonable to ask whether the revaluation of ether is complete for now, or even whether this is simply a bubble in the ether price.
The rally in ether has been fuelled by very real fundamentals. After previous delays, the backbone of the Ethereum network upgrade (2.0) launched on time on 1 December 2020, ether transaction volume and fees earned surpassed bitcoin by quite some margin in 2020, and the ecosystem building on top of Ethereum grew strongly.
Below we share some thoughts on whether these developments are now discounted in the price of ether, or whether this rally has further to go.
Proof-of-work (PoW) to proof-of-stake (PoS)
Apart from the advantages of PoS networks such as scalability and energy efficiency, it also creates a much more valuable token economy. You require a fraction of the annual transaction fee volume in market capitalisation to support a PoW “economy”. That fraction is the velocity of ether (how fast it changes hands within a year). This is estimated to be between 2-10, implying a market capitalisation of between a half to a tenth of the transaction fee volume. With PoS, the validators need to de facto make an investment to earn the staking rewards, including the transaction fees distributed to them. The income validators accept (let’s say 5-10%) will put a floor under the network’s value. 5% would mean a capitalisation of 20x the annual fee volume, 10% would mean 10x. Whatever your assumptions are about the size of the future transaction fee economy on Ethereum, the PoS model makes it about a hundred times more valuable.
Ether as a store of value
Although the institutional flows into crypto are focused on bitcoin, it is reasonable to expect that some of this will start flowing into ether, too. As new investors become more familiar with the space, they are likely to want to diversify their holdings. The CME ether futures launch is going to increase the name recognition and will put ether on the map for institutional investors.
The upsurge in innovation and activity in the decentralised finance (DeFi) sector has benefited ether as the majority of these projects are built on the Ethereum network. Ethereum has accounted for the vast majority of DeFi transactions to date, and a large chunk of the value locked (outstripping bitcoin by a mutiple). As the DeFi sector is continuing to build, innovate and grow, Ethereum will continue to benefit.
DeFi is of course not the only use case for the protocol: Ethereum is the leading smart contract platform, supporting a large and growing ecosystem. The latest new growth area, albeit still in its early stages, is the creator economy, with artists starting to use the Ethereum network to monetise their work.
Ether as a currency
Ethereum’s founder pitched the project initially as something very different from bitcoin – not “money” but a “world computer”, with no intention of “competing with bitcoin”. But in actual fact, although different blockchain protocols have their strengths and weaknesses and some serve certain purposes better than others, their protocol tokens can all be used as currency if market participants so decide. And they might, as there have been increasing suggestions that ether is not only suitable to be used as money, but it is “a new model for money”.
As much as asset prices are driven by fundamentals over the longer term, narratives make a big difference to sentiment and to the path the prices take. Positive newsflow for ether could come from the successful delivery on the milestones for Ethereum 2.0, the success of the CME contract, possible statements by influential figures about ether, good news about the DeFi ecosystem, or news that Ethereum is continuing on the path to potentially “flipping” bitcoin, having surpassed it already in terms of daily transaction volume since the middle of least year.
The risks to the positive outlook may come from any problems with the new network, including possible delays, negative developments in the DeFi space if any, regulatory risk as although the SEC had ruled that ether was not a security, the launch of Ethereum 2.0 may lead them to revise their view – and of course the ever present possibility in this vibrant space that another protocol overtakes Ethereum.
We believe that the recent price increases in ether are supported by a change in fundamentals as they delivered on the first step of launching the Ethereum 2.0 mainnet, the upcoming CME futures launch providing visibility at the time when institutional money is flowing into crypto, and the excellent growth trends in the Ethereum ecosystem. Our expectation is that the above listed factors supporting further upside are likely to drive the price of ether over the medium term, pushing it to new all time highs.
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