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I’m bearish on Ethereum.

But it may not be for the reason you think.

Transition from single chain to layer 1-layer 2 structure has large implications for ETH token valuation. And most people aren’t yet thinking this through 👇

First off I wrote abt how to value blockchain platform tokens like nation state currencies a while ago. I recommend a read cuz it’ll help you understand what I’m gonna say next, as it’s an application of same framework.

In short, think of L1 platforms like nation state economies. You need native token to pay fees in every transaction on platform just like you need USD in every economic transaction in US. The on-chain economic activities thus form fundamental demand for native token.

That means given any starting equilibrium of economy size & ETH price, if ethereum economic activities grow 10%, ETH token demand’ll grow proportionally (assuming stable token velocity). Since supply is relatively constant, that translates to proportional increase in ETH price.

This dynamic btw growth of economy & increase of token price is mechanical & doesn’t require belief in any revenue-based valuation assumptions, which are mostly memes.

Indeed data shows activity growth is single most important driver in ETH price over long run. Using # of txns as rough proxy for size of eth economy, you can see correlation btw txn growth & price growth is overwhelmingly significant— 10% txn growth implies ~13% price growth.

Note this is fundamental-driven long term relationship. Short-term price volatility is obv much bigger b/c of speculative cycles.

W/ this relationship in mind, is there any wonder why ETH price growth has stalled in last 6 mos? Tnxs have declined since May as high gas costs discourage activities & other alt L1s take off. Activity is now even lower than previous cycle peak.

Active wallets, another way to measure activity level, have also declined since May.

If it weren’t for EIP-1559 introducing token fee burns in August & putting downward pressure on supply, we’d have seen bigger ETH price drop given demand dynamics.

To solve scaling/congestion, ethereum is adding layer 2 rollups— to have eth L1 as security/settlement layer w/ contract & tnx executions done on L2s. It could boost speed & lower cost for end users, by a lot.

But as investor, all you need to care abt is this— is this structural change going to increase or decrease activities on eth L1? (Cuz activities—> demand for eth —> price growth, remember?)

By all considerations the answer is negative, at least in short-to-medium term.

Eth L1 does 1.3 million daily tnxs right now. ZK rollups can have 60k-80k tnxs in a batch before submitting to L1. If we move all end-user tnxs from eth L1 to rollups today & all L2 batches are full, that means # of tnxs on eth L1 could drop to 1/20 of current level.

You say, 1) proof verification is high value-add, complex tnx, which costs way more gas than most other tnxs.

2) there’ll be explosion of activities on L2s given lower cost. That’s the point of scaling. If L2 activities grow exponentially, it’ll boost verification needs, i.e. more activity on eth L1.

For 1), L1 verification cost per batch for zkSync rollup is 600k gas. Simple wallet tnx cost on current eth L1 is 21k gas. If a rollup batch has more than 28 simple wallet tnxs, gas cost on L1 is already lower than current. Batch has capacity for 80k tnxs. Do the math.

For 2), activity levels on popular alt L1s give useful benchmark for how much activity you can realistically expect on a new eth L2. Solana, the alt L1 w/ highest activity level rn, has a realized TPS (tnxs per second) of abt 1000 (not counting consensus voting tnxs).

Other chains have much lower realized TPS. E.g. Polygon, the success example all new eth L2s aspire to, has TPS of abt 85. Mind you, low realized TPS on these chains are not b/c of tech constraints (not yet). They can do much higher but there’s simply no higher demand from activities rn.

If one day web3 economy grows so big that numerous eth L2s operate at high capacity & continue growing at warp speed, yes that’d indeed increase activity on eth L1. But that day is not today & no eth maxi can tell you definitively when that day will be.

Btw today & promised L2 land, ethereum has to cross the no man’s land, where L2 growth is taking existing tnxs away from eth L1, while L2s don’t have enough business yet for their proof verification txns to more than compensate for activities they take away from eth L1.

While eth is crossing this no man’s land, activity growth on eth L1 would likely be stagnant or negative. That means to the left & down on our chart of activity vs price. Rational choice for eth ecosystem investor would be to sell eth & long high growth L2 tokens.

You say, what abt institutional investors? They prefer large caps w/ lower risk. So large waves of institutions coming to crypto in near future would shore up demand for BTC & ETH.

It may. But I wouldn’t keep hope too high for dumping bags on institutions, unless you truly have an abysmal opinion on their IQ.

B/c truth is people–whether institutions or individuals– are in crypto for returns, not safety, & large caps are not “safer”.

Here’s Sortino ratio for major L1s, which measures how much you’ve gained for each unit of downside risk you took. LUNA had the highest score in 2021. ETH & BTC both rank low.

There’s another concern abt ETH valuation that’s less obvious but no less important.

(BTW, like this so far? I write about ideas on investment, macro and human potential. Subscribe to my newsletter for updates .)

The network effect of L1 tokens comes from wide ownership participation of those tokens. BTC & ETH become most popular collaterals in deFi b/c almost everyone in crypto owns them. Exchange volumes are high & liquidities ample.

But 180 mn eth wallet addresses are the result of the fact that for the longest time, to use smart contract you have to own some eth.

W/ alt L1s rising that’s already less true. W/ eth L2s coming you won’t need to own eth even in ethereum’s own ecosystem. You can buy, say, ZK tokens on centralized exchange, transfer to your ZK Metamask wallet & spend ZK in ZK L2 chain, all w/o touching eth token.

In other words, as ethereum transitions from B2C to B2B model, direct interaction w/ end users may drop, which would imply lower ownership coverage, liquidity & volume for eth token. All of those are important parameters supporting token valuation.

You say, as security layer of ethereum eco, importance of eth token is paramount & surely users would value that. Yes you’re right. But if “importance” is the decisive factor for token value, ChainLink & Graph would have higher mkt caps than Doge & Shib.

Truth is “face time” w/ as many end users as possible is a precious advantage for a token. (And you should consider this when thinking of investing in any crypto project that only serves “enterprise use cases”.)

This is not just a phenomenon in crypto. In tech stocks, for example, software companies w/ mass-mkt apps have higher P/E ratio than other IT sub sectors like system software or semiconductor. B/c the former get more eyeballs even w/o necessarily having higher growth prospect.

As average investor, it’s much easier to buy stocks of Zoom or Slack—cuz you know & use them often— than investing in something like, idk…”Paragon Database Solutions”.

For a L2 to compete w/ alt L1s they need native tokens for users to rally behind & share the gains of values created on L2 platform. That means they take eyeballs away from eth just like alt L1 competitors.

You say, but other modular L1 chains have same problem. E.g. an Avalanche subnet token would dilute value accrual on AVAX too.

Yes, but AVAX, ATOM or ALGO is not valued at $400 bn mkt cap. They’re much smaller & still on high growth path of their L1 eco, any L2 add-on is not a structural change of status quo like ethereum situation. The starting equilibrium matters.

Crypto is a fast changing industry & my thinking abt ethereum case will surely continue to evolve. But hope this gives you something to ponder on.

TLDR:

  • Activity growth determines price growth for L1 tokens
  • Shifting to L1-L2 structure may mean stagnant or negative activity growth of Eth L1 in ST/MT
  • Transition from B2C to B2B model reduces exposure of Eth token to end users, negative for liquidity, volume, price

31 Comments

  1. Great read, if you had to invest in coin/token that could preform like solana did in 2021, who would you choose?

    • I think the SHDW token on SOL will outperform. IDO Monday.

      • sarmskinginc Reply

        yea this will be cool, great project, awesome team and community!
        a niche within a niche (SOL)

    • It’s good effort, but you should really ask for someone technical to fact check you before you publish.

      IE: the estimations ZK rollups give is for one transaction, that’s correct, but that transaction would take the whole space block.
      This means that your estimations may be off by a factor of 1000 (21k a single small tx to 20M+ block space)

    • Xdc will be golden boy of 2022 one of the few that has progressed enough to absorb negative speculators panicking.

    • Hands down $DAG
      The most upside
      Unlike anything else in the entire crypto space
      Also the US Air Force is buying it to secure its network

      The only true layer 0 is $DAG

  2. Incredible analysis, you are one of the sharpest minds in the crypto world!! Congratulations and keep sending this outstanding content.

  3. This is helpful, but can you help with giving some ideas of L2 scaling solutions that you think have merit?

  4. Would you extend this analysis to Solana and Cardano too? L1-L2 structure negatively impacting liquidity, volume, price?

  5. Thanks for such a great piece of insight.
    I had a very similar thought but wasn’t able backed it up with data as you did.

  6. Most excellent to educate people on the why’s of value in layers of BlockChain.

    Thank you & please check Fivebalance.com This is help for those that have zero idea about many areas of life. This is massive face time token only 1 year old!

    WKH

  7. While your thesis is intriguing, I believe you have omitted some key variables:
    1. Size of network effect is much larger than alt L1
    2. Growth of crypto will require many L1’s
    3. Cross chain will be important
    4. ETH gas fees are already trending lower.
    5. Usage rates grow for all L1 incl ETH
    6. Institutional investors will be given green light on BTC and ETH due to regulatory environment of other L1’s not defined
    7. Institutional investors know the substructure. Retail may not
    8. No ETH no L2
    9. L2 are not developed fully yet other than Matic
    ZK rollups have their challenges in communicating
    effectively with L1

    I see ETH outpace BTC
    I see L1 take share from ETH esp SOL.
    But I see the whole crypto space grow as well.

  8. I respectfully disagree with this analysis. If l2 eth picks up against eth, then you can make the same argument with every other network. You can’t pick and choose.

    Secondly, your analysis needs to include how other l1 chains are being subsidized. Solana by all accounts is unsustainable – diluting holders with fee subsidies because the fee rate is not sustainable. Solana is a flawed economic model.

  9. Yes, i kind of agree and unsure.

    Agree: When most of the activities is occurring in L2 (execution layer), ETH will not be represent the front-end operation. Most of the value creation will concentrated at L2.

    Guys who disagree please read Vitalik lastest post.
    https://vitalik.ca/general/2021/12/06/endgame.html

    Unsure: Lets assume L2 is committing data to L1. L1 will act as Data availability/censorship resistance layer. Since L2 most likely be centralised (high-end hardware is a must)

    As for fees/tokenomic, L2 low fees is b/c it compress tx and batch summit to ETH, then per tx gas fess will be low. But when many L2 start to compete for block space, fees go up anyway.

    I would imaging ETH will become back-end operation like TPC/IP, L2 as front-end operation. The back-end operation ofcoz wont get as much attention as front-end, same for value creation.

    Maybe only under 1 scenario, ppl value L1 as important as L2.

    Btw, No data commitments L2 will act as competitor to ETH mainnet thats pretty clear.

    • When you have L2s batching 60,000 transactions I don’t think it matters how many l2’s competing you will not have that much demand for blocks. At least not in the short to midterm.

  10. Agree with the crypto analysis, but the stocks analogy is wrong. At fixed growth rates, software companies are valued more highly than hardware companies because they have much higher profit margins, and to a lesser extent, are less susceptible to commoditization.

  11. Heiko van Wyngaarden Reply

    You have some valid points but I disagree with your conclusions for a number of reasons.
    1) Ethereum’s transaction count has stalled in the last six months as it has been running at the limits of its current capacity – the high fees (which are determined by demand vs supply) reflect this and have forced people to use alt L1s, side chains and more recently L2s
    2)The blockchain industry is more limited by capacity than demand – as capacity becomes available it its rapidly filled
    3)The very rapid growth of BSC, Polygon and Avalanche is in large part due to their forking/copying Ethereum (which is open source) and changing the settings around decentralisation. They all use EVM (Ethereal Virtual Machine) and Solidity, making it easy for apps and users to move across. But the same is true in reverse – these users can easily migrate back to Ethereum L2s and the far better security of its network
    4)L2 rollups pay fees in ETH for settlement and data storage. Block space on Ethereum will become increasingly valuable – an analogy is ground in Manhattan with skyscrapers above. The fees on Ethereum are therefore likely to trend higher in time.
    5)the fees paid to Ethereum will also increase substantially as sharding is rolled out, as this will increase the capacity of the base layer
    6)Tascha implicitly puts low value on decentralisation. I think it is essential if a public blockchain is to be viewed as credibly neutral and censorship resistant. While centralised chains may be fine for low value transactions, it is not for storing financial records and personal info
    7)Regulation. While ETH may have been a security (as defined by Gensler’s SEC) at its founding, it almost certainly is no longer. The alt L1s all have CEOs and very high ownership by insiders and VCs, and may well be classified as securities in the months ahead.
    8)The alt L1s all have high net issuance of new tokens. It means their fully diluted values are much higher than at first glance. VCs and insiders have vesting schedules and there will be substantial unlocks in the months ahead.
    9)By contrast, much of the value generated by Ethereum accrues to the network (rather than VCs) as the base fee of every transaction is burnt.
    10)Post the Merge, the number of ETH in circulation will continuously decrease. I think ETH will increasingly accrue a store of value or monetary premium over and above its substantial utility value
    11)ETH may be unique as an asset that combines utility, neutrality, fungibility and a native yield for stakers, perhaps making it the premier store of value asset. A more valuable ETH increases the capacity and security of the network as a whole – it will also be the preferred security for DeFi and NFT transactions.
    12)The ecosystem of rollups and apps on Ethereum : an analogy is companies in a capitalist system, competing amongst themselves but relying on the rules and security provided by the host country. The larger and more vibrant that ecosystem, the more valuable the network as a whole.

  12. Fredrik Schmidt Reply

    Thanks for a great piece Tascha!
    What about the short term price pressure that will come from the transition from PoW to PoS. Currently eth has 7% of total supply stakes, and alt L1s have between 37% to 77% staked. Would it not create demand for Eth if around 30% additional eth of the total supply would be staked?

  13. Fascinating read and mind-opening concept to look at Ethereum in a new angle that most likely have ignored.

  14. Great, read, thanks Tascha!
    Would be great to know what kind of scenarios you can think of with the upcoming ETH 2.0 upgrades. This would basically change the whole story, isn´t it?

  15. Hi Tascha,

    Very well written and thought-provoking article. I’m still not sure you are right. I think there’s an analogy to be found between ETH and L2’s (or Btc and lightning networks) and GOLD and the fiat currencies such as USD, EUR, etc. In total value (transactions x cost of USD unit) there is probably no doubt that USD has left Gold in the dust (pardon the pun). However in monetary value of a single unit, i would much rather hold 1 ounce of Gold than 1000 USD for long term value retention.

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