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Can you imagine a $3.2 trillion Ethereum market cap 10 years from now?

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From the S2F model to the Fisher equation, different investors use different models to value different assets

A Guide to Understanding ETH as an Investment

By Kevin Hu and Celia Wan

Original text compiled by 0x88, 0x71

Asset valuation has always been a topic widely discussed by investors. The different attributes of assets determine the selection of appropriate valuation models, while the narrative of asset subject determines the imagination space of assets. Compared with traditional financial assets, the valuation of on-chain assets is more difficult and uncertain. From the S2F model to the Fisher equation, different investors use different models to value different assets.

This article from Dragonfly Research details the current situation and future trends of Ethereum, and evaluates the value of ETH from its multi-dimensional asset properties.

This article is intended to help readers understand the potential impact of investing in Ethereum and its native asset ETH. This article does not attempt to provide precise valuations and price forecasts for ETH, and assumes that readers already have a basic understanding of Bitcoin, Ethereum and crypto systems more broadly. The views expressed in this article are not, and should not be considered, investment advice.

An overview of the

Bitcoin was created in 2009 as the first de-trusted, digital native currency. Because of its scarcity and unforgability, it has the potential to become a global store of non-sovereign value. Bitcoin's status as digital gold solidified as a large number of institutions began accepting it in the second half of 2020. Eleven years after its birth, institutional investors are finally investing in bitcoin as this simple and powerful store of value goes mainstream.

Investors, on the other hand, have struggled to understand Ethereum and its underlying asset, ETH. Smart contracts, decentralized finance, and Web 3.0 remain niche topics. ETH is a complex asset that is hard to define, even for full-time professionals in the crypto industry.

By design, ETH is the gas charge for the Ethereum network, also commonly 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 increase in value?

The unique narrative of ETH has yet to develop. The remainder of this article will explore its different emerging properties around ETH, and hopefully help investors understand what they are betting on when they invest in ETH.

Popular (but actually slightly outdated) ETH economic analysis

The current version of Ethereum resembles a distributed operating system and uses the system's native token, ETH, to pay for computing costs. Miners who contribute computing resources to the system receive block bonuses and transaction fees. Historically, ETH's block rewards have been tailored to specific transactions, making its monetary policy more aggressive than Bitcoin's.

In the current model, Ethereum users pay transaction costs with ETH and ETH holders bear the cost of inflation. Implicitly, in the absence of speculative sentiment, ETH holders are betting that the rate of demand for ETH in Ethereum applications will exceed the inflation rate of Ethereum block awards, which have historically fluctuated wildly.

A popular ETH economic analysis model now treats Ethereum as an economy, thereby representing the total value of the network in terms of GDP. We can then calculate the value of the Ethereum network based on the formula PQ = MV. The result of price multiplied by quantity (total output) must be equal to the money supply multiplied by the money velocity. So the total value of the Ethereum network is equal to the total amount of ETH circulating times the ETH turnover.

A common guess is that in the long run, the GDP of the Ethereum network could be substantial, but not too large, because it is limited by the deflationary nature of computing costs, since the network has to be very cheap to use in order to achieve mass adoption. The turnover rate of ETH can also be very high, as there is no reason for users to hold such a non-resistance payment tool. As a result, the value of ETH can be relatively low and still support a relatively large economy. In this framework, ETH cannot capture significant economic value because it is a completely fungible commodity that does not need to be held for long periods of time.

The core of this argument is: 1. The only function of ETH is to make payments; 2. The open source nature of the public chain makes it impossible to retain IP value; 3. For the application, the cost of the switching chain is close to zero. As a result, Ethereum has a weak network effect, and ETH should be priced like a commodity because users are unwilling to pay more than it costs to produce it.

The latest progress

While the logic behind the PQ = MV argument is sound, the theory has not yet been translated into reality. Ethereum is still way ahead in terms of user adoption and developer acceptance. Its network effect does not seem to have abated, with the market value of ETH being five times larger than that of Layer 1's third item.

Ethereum today is very different than it was two years ago. In 2017 and 2018, the Ethereum network was only useful for projects to release IC0s (the vast majority of which were worthless). Today, Ethereum supports the prosperity of the Decentralized Finance (DEFI) ecosystem, as well as other areas such as NFT, gaming, meta-universe, and Web 3.0.

Average gas costs for Ethereum (to reflect usage, source: Etherscan)

Defi has become the first widely used application in the Ethereum network. Currently, DEFI has an AUM of $60 billion (peaking at over $120 billion in early May 2021), a loan size of over $17 billion, and an average daily transaction volume of $5 billion. Overall, these Defi apps generate more than $4.5 billion in annual revenue (fees paid to agreements over the last 30 days represent revenue) and have built up considerable liquidity to create network effects.

At present, Ethereum ecology has formed a positive feedback loop. Users bring liquidity-based network effects to Defi and benefit from the liquidity of the Defi market. As more and more assets locked in DeFi, based on automated market-makers (AMM) decentralized exchange of slippage, and a decline in lending platform borrowing costs again and again, let the DeFi more attractive to users (although there is no network effect between liquidity pools, but the overall network should be to lock up the dollar amount into a linear relationship).

In addition, the composability and interoperability of the DEFI protocols with each other also creates a lock-in effect for Ethereum, making it difficult for other Layer 1 projects and side chain projects to compete. In order to compete with Ethereum, other chains need to foster a whole ecosystem of dapps, providing liquidity from scratch, which takes a lot of work and requires a lot of token subsidies. In fact, we've seen chains like Polygon and BSC have found success by replicating the Defi app on Ethereum and offering low gas rates and fluid mining activities. Even so, linking these different public chains across chains breaks the composability of the DEFI protocol, thus forcing Layer 1 projects to develop their own separate ecosystems.

Defi Total Lock Capacity (Source: DeBank)

From an architectural point of view, the next biggest changes coming to Ethereum are Ethereum 2.0, Layer 2 and EIP-1559. Without going into technical detail, Ethereum 2.0 will transform the Ethereum network from a proof-of-work consensus to a proof-of-stake consensus. Instead of using computing resources to validate the next block, Ethereum 2.0 will rely on ETH holders (validators) to vote on the next block, building security models based on game theory and economics. Ethereum 2.0 will also split the network into 64 pieces, which will allow the network to run in parallel and leave room for future capacity expansion.

In the short term, Layer 2, especially the Rollup scheme based on proof of fraud and zero knowledge proof, could optimize the scalability and cost of use of the Ethereum network by an order of magnitude. Ethereum currently handles around 15-17 transactions per second (TPS). We expect the following changes to increase Ethereum throughput at Layer 2 to 2000+ TPS (on-chain data) and 9000+ TPS (off-chain data). Layer 2 will also significantly reduce transaction costs. Today, a typical Defi transaction costs between $10 and $100+, which is daunting for most applications and users. Layer 2 will likely compress Defi transaction costs below $1 (and sometimes as low as 10-20 cents), increasing the usability of Defi and Ethereum by a factor of 100.

Recently, Ethereum may adopt a new monetary policy, EIP-1559. EIP-1559 makes some changes to the Ethereum transaction fee algorithm. For the purposes of this analysis, the most important change is that EIP-1559 allows the majority of Ethereum transaction fees to be burned instead of being paid to miners. If Proof of Interest and EIP-1559 are implemented, ETH inflation will be significantly reduced and ETH will become a capital asset in addition to its consumable commodity nature. This will have a profound impact on the value added of ETH. More on that later.

Where are we now?

As fascinating as the Ethereum story we've been telling so far is that Defi has had a lot of appeal to a limited number of users through a brief period of fluid mining and project ID0 mechanics. However, the development of various projects on Ethereum has made the PQ = MV valuation model obsolete, and new methods of valuing ETH need to be constantly adapted to the rapid development of the Ethereum network.

The next three sections describe different approaches to defining both qualitative and quantitative ETH and contribute to the final evaluation of ETH. It is worth reiterating that none of the following mechanisms and final assessments should be taken as the final verdict on ETH. Still, this is an excellent attempt to understand ETH as an asset and Ethereum as a platform.

Ethereum as the financial layer of the future

Ethereum enables contracts to be automatically executed without a trusted third party. The various token standards give value to assets in the network other than ETH. In short, the code determines the value and ownership in the Ethereum network, which makes Ethereum an alternative to trading and settlement in traditional finance. As technology improves and transaction costs fall, Ethereum and Defi will enable many new use cases that are not possible today.

We think Ethereum and DEFI have the potential to disrupt traditional finance for the following reasons:

- Permission-free rate of software innovation: All Defi protocols are open source and composable. Defi innovators can restructure and innovate financially at a phenomenal rate and reach global users at virtually no fixed cost.

- Consistency of incentives: With proper token design, all stakeholders in the ecosystem (protocols, users, liquidity providers, engineers/protocol maintainers) will be incentivized and the cold start of growth will not require excessive up-front costs.

- Cost reduction: Defi has no legal, labor, compliance and infrastructure related costs. Traditional financial transactions are based on a legal system promulgated and enforced by the government. In complex cases such as bankruptcy liquidation, recourse costs can be high and opaque. These costs are not present in DEFI because all values are completely controlled by the code.

- Resistance Free Money and Instant Clearing: Funds within DEFI flow without resistance, programmatically and cleared at the sub-minute level ーー This is a true digital native experience. In the traditional world, by contrast, payment tracks from different jurisdictions don't connect with each other (which has improved since the advent of companies like Stripe and Plaid). These processes need to be done manually, and many systems are decades old.

- Mass Customization vs. Synthetic Assets: Just as the Internet enabled companies to reach different niches, Defi gives users access to almost every asset in the world. Today, through AMMs like Uniswap, anyone can create a new trading pair, as long as they hold the corresponding assets. Synthetic assets are taking this step to another level. 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 neutrality: The financial system built on Ethereum is open for anyone to use. While not very attractive to users in countries with mature financial systems like the United States, it offers unparalleled advantages for those living in inefficient and corrupt local financial systems.

ETH as capital asset

ETH's function as the default form of payment in Ethereum network activity gives it a fairly straightforward value-based pricing model. This will become more pronounced once the network is upgraded to Ethereum 2.0 and EIP-1559. Even though other tokens, such as stablecoins, may replace ETH as an alternative to payment in the future, ETH will still be used by network validators to place bets and receive rewards. Thus, ETH may accumulate value from demand like a consumable, and from cash flow like a capital asset.

Say 10 years from now, the Ethereum network is handling 4 billion transactions a day worth 5 trillion dollars. $5 trillion a day represents a growth rate of 74%. It seems reasonable if you believe that Ethereum will evolve like the early Internet did.

If you look at the growth record of Ethereum, the above numbers actually understate Ethereum. Currently, Ethereum is processing $8 billion of ETH and $10 billion of stablecoin transactions per day (which is an understated total since we exclude other ERC-20 transactions), increasing sixfold and 15-fold, respectively, from 2019 to 2020.

In this case, the number of transactions is a more aggressive assumption (from 1.2 million transactions a day to 4 billion transactions a day, which is a 125% annual growth rate), but it would be reasonable if Ethereum's rates were cheap and scalable to programmable micropayments between contracts. After more than three years, Ethereum is finally on the cusp of releasing its expansion solution. As we have highlighted earlier, the cost of the DEFI transaction could be reduced by 20-50 times over the next 6-12 months, which could lead to exponential growth in the number of transactions.

It is also conceivable that in the future, high-value transactions that are differentiated (not necessarily in dollar value, but possibly in extractable value) should be billed based on transaction value (fees as a percentage of transaction value), and low-value transactions should be billed based on daily usage criteria (fees vary slightly depending on network usage).

High-value transactions should be value-based because transaction sequencing is a critical part of the Ethereum network's blocks, especially when transactions are profitable for users. These days, high-value transactions are often pre-empted, which is nearly impossible to prevent (see Ethereum Dark Forest) unless the transaction is sent to a private mine pool (which may charge a fee based on the value of the transaction). Some teams are working hard to find a solution to establish an orderly market for MEVs, which may be achieved in the medium term.

However, there will always be transactions that are worth far more than the base fee (such as highly competitive arbitrage trades) and therefore require high tips in order to be processed in the first place. These transactions, though, make up only a small fraction of the total network.

In EIP-1559, the value-based transaction rates are normalized (possibly not ETH based) in the form of a tip to the miner/verifier, while the day-to-day transaction based fees will be ETH based and destroyed. Unlike in Ethereum 1.0, where miners get all the fees, the value generated by the base fees and tips will be captured by the ETH holders after the implementation of EIP-1559. Base fees will create a deflationary effect and demand for ETH, while tips (regardless of the asset base) will become the cash flow for the miners/pledge of ETH (who are also the holders of ETH).

Let's do some rough math with the numbers assumed above and assume the following (these numbers apply only to this example) :

- 5% of the $5 trillion will be high-value transactions, with a fee of 0.05% of the transaction value. Most of these transactions are likely to come from the Defi application.

- Base fees average $0.01 per transaction and 4 billion transactions per day.

- At this stage, Ethereum has matured enough that fee increases will be reduced to permanent increases of 5% per year.

- In the long run, the economy's long-term risk-free interest rate is 2%. The ETH pledger would need another 5% to compensate for the forfeiture and technical risk (which would be stable in the long run, so 5% would be sufficient), bringing the required return on ETH to 7% in the long run.

Based on these assumptions, Ethereum will generate $60.2 billion in fees annually. That is only 18 times more than today, while trading volume and number of transactions have increased by 250 times and 3,300 times, respectively. Such is the deflationary power of technology!

Finally, if we price ETH as a capital asset and use the dividend growth model, if the above revenue is $60.2 billion, this would mean that the final value of ETH in 10 years would be $3.2 trillion. While that may seem like a huge number, it's a decade away, and it doesn't take into account any risk factors (such as technology, competition, regulation). The savvy investor needs to make calculations using the appropriate probability or discount rate.

Ethereum as a monetary asset

Ethereum's value comes from two sources. The first is its practical value, as stated in the argument above. The second source of its value is its currency premium, due to its ability to be used as a "quasi-currency" in the Ethereum economy.

As a medium of exchange for value and a unit of account, the ETH is unlikely to succeed. In an extreme ETH bull market, as might be the case, ETH could become a mainstream currency if the Ethernet network becomes ubiquitous and its costs are stable. In general, this is unlikely, and even if Ethereum does emerge as the ultimate dominant platform, stablecoin is inherently a better choice on both fronts. Today, the total on-chain transfer volume of ERC-20 stablecoin exceeds that of ETH ($10 billion per day versus $8 billion per day), even though ETH has 5 times the market capitalization of stablecoin. The difference in transaction volume between stablecoins and ETH chains 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 acting as collateral for DEFI.

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

1. The ETH's monetary policy will stabilize and its inflation rate will be halved (from 4% to 2%, according to &NBSP;Tim RoughgardenPuts it). Of course, there is still a difference between a fixed aggregate supply, but assets with low inflation are good.

2. Ethereum 2.0's security model will eventually be tested on a massive scale like Bitcoin (which in 20 years will only be around 20% longer than Ethereum). In addition, if ETH is valuable enough, Ethereum 2.0 PoS could potentially increase Ethereum's security (we admit that this idea is circular).

3. Similar to BTC, ETH, as the first collateral asset of DEFI, has a strong Lindy effect. History tells us that the adoption of a new technology/asset/product is extremely dependent on its path. Often, having a better distribution channel (distribution ratio) is more important than having a better product/technology. If Ethereum and Defi really do become the financial layer of the future, ETH is likely to remain one of the primary collateral, as it is the first of its kind and the Defi ecosystem is built around it.

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

The potential value of ETH

Ethereum's narrative is complex, and its mapping of ETH's various value growth mechanisms is even more challenging. We believe that the potential value of ETH should be the sum of these categories: 1) consumables, 2) capital assets, and 3) monetary value (broken down by its payment and value store functions).

According to our above projections, the total potential value of ETH in the future will be between $3.7 trillion and $4.7 trillion, based on the following parts:

1. The value of ETH as a consumable is limited by its high flow rate.

2. The value of ETH as a cash-flowing capital asset is probably a little over ten trillion dollars. $3.2 trillion is our extrapolation 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 cease to exist and that all the monetary value of the ETH will come from the non-sovereign store of value driven by DEFI.

An important caveat: these numbers are by no means precise predictions. We use this thought exercise to help readers understand the potential impact of Ethernet and the value of ETH. The aim is to highlight the underlying narrative of Ethereum and to give readers a mental model of the value added of ETH. Many of the risks (such as technology, competition, regulation) are not probabilistically adjusted or properly discounted. A savvy investor needs to take these risks into account in order to ultimately measure the risk and return of ETH as an investment.