Dragonfly Capital: Ethereum, how do we value it?

A Guide to Understanding ETH as an Investment

Original source: Kevin Hu& Celia Wan is a Partner and a Junior Partner at Dragonfly Capital, respectively

Original text: Perry Wang, Link to Wen

This article attempts to help readers understand the potential impact of the Ethereum network and the underlying asset ETH as an investment. However, this article does not attempt to arrive at precise valuations or price forecasts. This article assumes that the reader has a basic understanding of Bitcoin, Ethereum, and the broader crypto ecosystem. The views expressed in this article are not and should not be construed as investment advice.

An overview of

Bitcoin was introduced in 2009 as the first digital native currency to require no trust. Because of its rarity and unforgeable nature, Bitcoin has the potential to become a universal, non-sovereign store of value. As traditional financial institutions began to embrace bitcoin in large numbers in the second half of 2020, the narrative of bitcoin as digital gold gained traction. Eleven years after its launch, institutional investors are finally investing in bitcoin as this simple and powerful store of value narrative begins to enter the financial industry mainstream.

On the other hand, investors' understanding of the Ethereum network and its underlying asset, ETH, is mixed. Smart contracts, Decentralized Finance (DEFI), and Web 3.0 remain niche topics. ETH as an asset has a complex value narrative that even full-time cryptographers struggle to articulate.

According to the design of the Ethereum blockchain, ETH is the fuel Gas in the Ethereum network, often referred to as the "world computer". But what is the use of a "world computer"? Is ETH a consumable, a capital asset, or a programmable collateral/currency? How does ETH add value?

So far there has not been a single value narrative for ETH that has materialized.

The rest of this article will explore the different emerging views around ETH and help investors understand what they may really be betting on when investing in ETH.

A popular (but slightly archaic) economic analysis of ETH

The current version of Ethereum is similar to a distributed operating system with the native token ETH, which is used to pay for computing costs, while miners who provide computing resources are rewarded through block rewards and transaction fees. Historically, ETH block awards have undergone adjustments based on specific targets for specific expenditures. It's worth noting that ETH has a more aggressive monetary policy than Bitcoin.

Under the current model, Ethereum users pay their transaction costs in ETH, while ETH holders bear the cost of inflation. Assuming no speculative trading, ETH holders are betting that demand for ETH from users of Etherium-based applications will exceed the inflation rate generated by block rewards, which have fluctuated wildly in Ethereum's history.

A popular economic analysis of ETH treats the Ethereum network as an economy and describes the total value of the network in terms of GDP. We can then calculate the network value of Ethereum based on the exchange equation PQ = mV, where the price times the quantity (total production) must equal the money supply times the velocity of money circulation (turnover rate). Thus, the total value of the Ethereum network is equal to the total number of ETH in circulation multiplied by the number of ETH turnovers.

A common guess is that the network's GDP could be substantial in the long run, but not particularly large, because it is limited by the deflationary nature of computing costs and the fact that Ethereum transaction fees have to be very cheap to be accepted by the masses. ETH turnoffs can also be very high, as there is no reason to hold such a frictionless payment method. So the value of ETH may be relatively low, but it still supports reasonable economies of scale. In this framework, ETH cannot gain significant economic value because it is a completely fungible commodity that does not need to be held.

The core of this theory is: 1) the sole function of ETH is as a means of payment; 2) The open source nature of the public chain makes it impossible to retain IP value; 3) The cost of switching blockchain applications is close to zero. The upshot is that Ethereum will have weak network effects, and ETH should be priced like a commodity because users won't be willing to pay more than it costs to produce.

Recent theoretical developments

Although the logic behind the argument of PQ = MV equation is reasonable, so far, the theory has not been finally perfected. So far, Ethereum is still the leading blockchain in terms of user adoption and developer adoption. Its network effects do not seem to have abated, with ETH being five times bigger than the third largest by market capitalisation, the L1 public chain.

Ethereum is a very different place today than it was two years ago. In 2017 and 2018, the only use case for the Ethereum blockchain was a token offering ICO for projects (the vast majority of which didn't deliver anything meaningful). Today, Ethereum supports the thriving Defi ecosystem, and other uses such as NFT/games/Metaverse and Web 3.0 are starting to take off.

Ethereum Gas Average Price & NBSP; (Can be seen as a bellwether of usage; Source: Etherscan)

Defi became the first widely used Ethereum network application. Currently, DEFI has $60 billion in assets under management (peaking at $120 + billion in early May 2021), over $17 billion in outstanding loans, and generates an average of $5 billion in transactions per day. Together, these Defi apps generate more than $4.5 billion in annual revenue (the amount paid to the agreement over the last 30 days, a metric that can be used as a barometer of revenue) and build up a lot of liquidity to generate network effects.

The Defi ecosystem on Ethereum has now created a positive feedback loop, with users both contributing to Defi's fluid-based network effects and benefiting from the liquid Defi market. As more assets are locked in DEFI, the automated market maker-based (AMM-based) decentralized exchange (DEX) sliding points and lending platforms have lower borrowing costs and become more attractive to users (although there is no network effect across pools and the aggregate network effect is sublinear relative to the total amount locked up).

In addition, the composability and interoperability of the DEFI protocol creates a lock-in effect for Ethereum that makes it difficult for other L1 public and side chains to compete.

To compete with eThefang, other chains need to cultivate an entire dApp ecosystem and gain liquidity from scratch -- not an easy task, usually with a large token subsidy. In fact, we've already seen that. Polygon  Public chains such as Binance Smart Chain (BSC) have found success by replicating the Defi app on Ethereum while offering additional attractions such as low Gas rates and liquid mining projects. However, even so, bridging these different blockchains would still break the composability between the DEFI protocols, thus forcing L1 to develop separate ecosystems.

Defi Total Lock Value Development & NBSP; (Credit: Debank)

From an architectural point of view, the most important changes coming to Ethereum are Ethereum 2.0, Layer 2 (L2), and the EIP-1559 proposal improvements. Without getting into the technical details here, Ethereum 2.0 will transform the Ethereum network from a proof-of-work (PoW) consensus model to a proof-of-stake (POS) consensus model. Instead of using computing resources to validate the next block, Ethereum 2.0 relies on ETH holders (validators) to vote on the next block to build a security model based on game theory and economics. Ethereum 2.0 also splits the network into 64 shards, which will allow the network to operate in parallel, allowing Ethereum to expand in the future.

In the short term, L2, and in particular the Rollup approach based on fraud proof and zero-knowledge proof, could make the Ethereum network more scalable and reduce the cost of fees by several orders of magnitude.

Ethereum today handles around 15-17 transactions per second (TPS). We expect the upcoming Ethereum launch to increase Ethereum throughput to 2,000+ TPS (using on-chain data) and 9,000+ TPS (using off-chain data) in L2. L2 will also significantly reduce transaction costs. A typical Defi interaction today costs between $10 and more than $100, which means most apps and users are priced out of the market. L2 could reduce the cost of Defi transactions below $1 (as low as 10-20c by some estimates), making Defi and Ethereum more accessible by a factor of 100.

Finally, Ethereum may adopt a new monetary policy called the EIP-1559 proposal. EIP-1559 has made some changes to the transaction fee algorithm of Ethereum. The most significant impact to our analysis is that the upgrade will result in most of the Ethereum transaction fees being burned up instead of being paid to miners.

If POS and EIP-1559 are implemented, the rate of ETH inflation is likely to decrease significantly and ETH will become a capital asset in addition to being a consumable good. This should have a profound impact on the value added of ETH. More on that later.

How do we look at Ethereum now?

As impressive as the story we've told about Ethereum so far is that so far, DEFI's momentum has produced a pretty precarious life among a limited number of users who are keen to take advantage of the ephemeral liquidity of mining schemes and projects IDO. However, the various developments in Ethereum do make the PQ = MV model for evaluating the value of ETH obsolete and new ways to conceptualize ETH are needed to fully cover the rapid development of the Ethereum network.

The following three chapters describe different approaches to conceptualizing ETH, both qualitatively and quantitatively. These conceptualizations will ultimately work together to influence the final evaluation of ETH. It is worth reiterating that neither the following mechanism nor the final assessment should be taken as the final word on ETH. Nonetheless, it has made an honest attempt to understand ETH as an asset and Ethereum as a platform.

Ethereum as the financial layer of the future

Ethereum enables smart contracts to be executed automatically without a trusted third party. Its various token standards make it possible to represent values other than ETH on the web. In short, Ethereum enables value and ownership to be managed by code, which could serve as an alternative to the existing trading and settlement tracks of traditional finance. As technology advances and transaction costs fall, Ethereum and Defi will enable new use cases that are unimaginable today.

We believe that Ethereum and Defi have the potential to disrupt traditional finance and therefore deserve to be valued accordingly for the following reasons:

• Permission-free innovation dictated by software speed: All DEFI protocols are open source and composable. Defi entrepreneurs can reinvent financial portfolios and innovations with incredible speed and reach a global audience with virtually no fixed costs.

• Incentives consensus: With the right token mechanism design, all stakeholders in the ecosystem, including protocols, users, liquidity providers "LP", engineers/protocol maintainer, etc., can get the right consensus of interests and can start cold with almost no upfront costs.

• Cost reduction: DEFI eliminates costs associated with law, labor, compliance, and fixed infrastructure. Financial transactions in the traditional world are based on legal structures and enforced by governments, and in complex situations such as bankruptcy, the cost of recourse can be high and opaque. These costs do not exist in Defi because the value is completely controlled by the code.

• Frictionless capital and near-instant settlement: Capital in Defi can be settled in subminutes, flowing frictionless and programmatically -- a true digital native experience. In the traditional world, by contrast, payment channels from different jurisdictions are blocked from each other (a slight improvement now with companies like Stripe and Plaid). In traditional finance, the process is done manually, and many systems are decades old.

• Mass customization and synthetic assets: Just as the Internet enabled companies to reach different niches, Defi will give users access to virtually any asset in the world. Today, through an AMM like Uniswap, anyone can create a new trading pair as long as they have the trading assets in stock. Synthetic assets take this process a step further. In theory, anyone with a trusted data source can create a synthetic asset by providing on-chain collateral. Synthetix, UMA, Mirror, and many other teams are exploring in this direction.

• Government-neutral: The financial system built on Ethereum is open and accessible to all. While this may not sound appealing to users in countries with mature financial markets such as the United States, it offers unparalleled advantages for people living in countries with inefficient or corrupt local financial systems.

ETH as capital asset

The utility of ETH as the default form of payment for Ethereum network activity endorses a fairly straightforward value-based pricing model for assessing asset valuations. This was especially true once Ethereum adopted the Ethereum 2.0 network and the EIP-1559 upgrade. Even though other tokens (such as stablecoins) may replace Ethereum as an alternative form of payment in the future, network validators will still use ETH for pledge and reward. Thus, ETH may generate value from demand (such as consumer goods) and cash flows (such as capital assets).

Let's say 10 years from now, Ethereum facilitates $5 trillion of transactions per day out of 4 billion transactions. Five trillion dollars a day represents a 74 percent annual growth rate. That number seems reasonable if you believe Ethereum will reproduce the early development of the Internet.

If you look at the track record of Ethereum's growth, it's even an underestimate. Ethereum is currently processing $8 billion of ETH and $10 billion of stablecoin transactions per day (these numbers are underestimates in terms of total transaction volume, since we exclude other ERC-20 tokens), representing a 6-fold and 15-fold growth rate from 2019 to 2020, respectively.

Volume is a more aggressive assumption in this scenario (a jump from 1.2m to 4bn transactions a day implies a 125% annual growth rate), but it is entirely reasonable to assume that Ethereum is cheap and successfully scaled up to enable programmable micropayments between smart contracts. After more than three years of development, Ethereum has finally arrived at the moment when a scalable solution will be launched. As we emphasized earlier, the cost of DEFI transactions could be reduced by 20-50 times over the next 6-12 months, which would mean an exponential increase in the number of transactions.

Also as you can imagine, high value transactions (not necessarily is the transfer of the value of the dollar, but may be miners MEV) can extract value between the difference, it should be according to the transaction value of costs (cost percentage of turnover) and low value transactions, which should be based on the mechanism of commodities (a slightly different fees according to the network utilization).

High-value transactions may be value-based, as the sequencing of transactions within the Ethereum block is important, especially if the transactions allow users to make a financial profit. Today's high-value trades are routinely attacked by bots preempting trades, which are nearly impossible to stop unless the trades are sent to private mining pools (which may charge fees based on the value of the trades) (see  Real Ethereum Defi "Dark Forest"). Several teams are currently working on solutions to establish an orderly MEV market, which could be implemented in the medium term.

However, it is likely that there will always be trades (such as arbitrage, which is often highly competitive) that are worth much more than the base fee, so it is profitable to pay an extra tip for priority certainty. These transactions, though, account for only a small fraction of all online transactions.

In the EIP-1559 upgrade, value-based fees are formalized in the form of a tip to the miner/verifier (probably not in ETH), while commodity based fees will be based in ETH and destroyed. Unlike in Ethereum 1.0, where miners took part of the fees, the base fees and tips in EIP-1559 will go to the ETH holder if Ethereum transitions to the POS consensus model. Base fees are deflationary and create demand for ETH, while tips (regardless of currency) are like cash flow to the miner/pawner.

Ethereum Daily Transaction Fees (7-day average) & NBSP; (Credit: The Block)

Daily ETH transfer amount & NBSP; (7-day average; Source: The Block)

Number of ETH transactions including ERC20 and 721 tokens (7-day average; Source: The Block)

Let's do some basic math using the above hypothetical numbers and assume the following (these numbers are purely for demonstration purposes) :

• 5% of the $5 trillion would be high-value transactions, priced at 0.05% of the transaction value. Most of it probably came from DEFI.

• Base fees for $4 billion of transactions per day average $0.01 per transaction At this stage, Ethereum will have matured enough that fee growth will be permanently reduced to 5% per year.

• The long-term risk-free rate for the economy in the distant future is 2%. ETH pledgers would need another 5% to compensate for the risk of cuts and technical risks (which would stabilize over the long term, so 5% would be sufficient), giving ETH a required yield of 7% over the long term.

Using these assumptions, Ethereum would generate $6.02 billion in annual fee revenue. That is only 18 times more than today, while the turnover and volume will increase by 250 times and 3300 times respectively. Such is the deflationary power of technology!

Finally, using the dividend growth model with the $6.02 billion figure above to price ETH as a capital asset, this implies that the token's ultimate value after 10 years is $3.2 trillion. While that may seem like a huge number, that's ten years later, and it doesn't account for any risks (such as technology, competition, regulation). Sophisticated investors need to introduce appropriate probabilities or discount rates.

ETH as a monetary asset

The value of ETH comes from two sources: first, its utility value, as stated in the argument above. But the second part of its value comes from its currency premium, which comes from ETH's preference for being a "money-like" asset in the Ethereum economy.

As a medium of exchange and a unit of account, the ETH is unlikely to succeed. If the Ethereum network becomes ubiquitous and costs are stable, ETH can become a popular currency, and then the super-ETH bull market can take hold. Overall, this is highly unlikely, and even if Ethereum does become a dominant platform, stablecoins generally perform much better on both of these functions. Today the total on-chain transaction volume of ERC-20 stablecoins exceeds that of ETH ($1 billion vs $800 million per day), even though the market value of ETH is four times higher. The difference between stablecoin and ETH off-chain transactions is even greater.

However, as a non-sovereign store of value, there may still be opportunities for ETH to gain some potential market share by using it as collateral in DEFI.

In the long run, it is conceivable that ETH could even compete with Bitcoin on the dimensions of scarcity, durability, and unforgability for the following reasons:

1. With the EIP-1559 upgrade, ETH monetary policy would stabilize and inflation would likely halve (according to Columbia University computer science professor & NBSP;Tim Roughgarden, from 4% to 2%). This is not the same as capping supply, of course, but well-advertised, low-inflation assets may be the second-best option.

2. Ethereum 2.0's security model will eventually be almost as field-tested as Bitcoin (after 20 years, Bitcoin will only be around 20% longer than Ethereum); Furthermore, if ETH is sufficiently valuable, Ethereum 2.0 and PoS may add to Ethereum's security guarantees (we admit that this idea is circular self-validation).

3. Similar to Bitcoin, ETH has a very strong Lindy effect as the first collateral of DEFI. History tells us that adoption of new technologies/assets/products is highly path-dependent. Often, having a better distribution channel is more important than having a better product/technology. If Ethereum and Defi do become the financial layer of the future, ETH is likely to remain one of the primary collateral, since it was the first collateral to scale and the Defi ecosystem is built around it.

Still, if Ethereum and Defi continue to grow, it's credible that ETH could capture 10% of Bitcoin's market share. If we assume that Bitcoin's potential market value is about  $4.7 to $14.6 trillion, the potential monetary value of ETH could be $0.5 trillion to $1.5 trillion.

The potential value of ETH

Ethereum has a complex value narrative, making it more challenging to map out the various value-adding mechanisms for ETH. We believe that the potential value of ETH should be the sum of its value as a 1) consumer commodity, 2) capital asset, and 3) monetary value (broken down into payment and value store functions).

The total potential value of ETH in the distant future is between $3.7 and $4.7 trillion, based on the following considerations:

1. Given its rapid growth, the value of ETH as a consumer product is likely to be limited.

2. The value of ETH, as a capital asset with cash flow, may reach the trillions of dollars, in the low single digits. $3.2 trillion is the point at which we extrapolate from a plausible success story.

3. The monetary value of ETH may be between $0.5 and $1.5 trillion. We assume that the value of the ETH payment function will not exist and that all the monetary value of the ETH comes from: it is a non-sovereign store of value driven by DeFi.

Important note: these numbers are by no means precise estimates. We use this thought exercise to help readers understand the potential impact of the Ethereum network and the value of ETH. It aims to highlight the underlying narrative of Ethereum and to provide readers with a mental model of the growth of ETH's value. Nor do we adjust probabilities or introduce a discount rate to account for many risks (e.g., technology, competition, regulation). Skilled investors need to consider these risks to ultimately measure ETH as the risk/return of the investment.

Thanks to Haseeb Qreshi, Ashwin Ramachandran, Tom Schmidt, and the rest of the Dragonfly team for their feedback.

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