Author: Zach Pandl, Michael Zhao, Grayscale; Translated by: Deng Tong, Golden Finance
summary
The Ethereum network is the leading smart contract blockchain in terms of market capitalization and total locked value[1], and it hosts a rich set of applications, many of which offer their own investable tokens. However, the Ethereum ecosystem is highly diverse, and each token has unique fundamentals.
When examining the broader ecosystem, one might focus on tokens that exhibit strong fundamental characteristics. These factors might include strong user engagement, transparent value creation mechanisms, and controlled supply growth. In the Ethereum ecosystem, some notable assets that exhibit these characteristics are tokens associated with decentralized finance applications, such as AAVE, MKR, and UNI, as well as LDO associated with staking applications.
The design of the Ethereum network means that most activity on the platform is tied to its native token, Ether (ETH). As such, the value of ETH tends to reflect the overall activity and growth of the Ethereum ecosystem. The relationship between network usage and token value is a notable aspect of Ethereum’s economic model.
ETH beta strategies, which aim to mimic the performance of ETH using alternative tokens, have underperformed compared to holding ETH directly, as we show in this analysis (Figure 4). This is because most alternative tokens lag behind ETH, with only a few outperforming it. An alternative approach is to diversify investments across multiple promising projects rather than focusing on a single alternative token.
At its core, Ethereum is a blockchain-based platform that enables developers to build and deploy smart contracts and decentralized applications (dApps). This functionality has spawned a rich ecosystem of projects covering a variety of areas, including decentralized finance (DeFi), non-fungible tokens (NFTs), and games. Many of these projects have issued their own tokens, expanding the crypto asset ecosystem.
However, investors must be aware that assets in the Ethereum ecosystem are far from uniform. Tokens can vary widely in terms of use cases, supply inflation, historical volatility, and value accrual mechanisms. Some tokens are used as governance tokens for decentralized autonomous organizations (DAOs), some are used as utility tokens in specific applications, and some are used as representations of real-world assets.
Explore the ETH ecosystem
While the Ethereum ecosystem contains tens of thousands of tokens[2], in this report we focus on a group of key assets specified in the Grayscale Crypto Sectors — a framework for systematically categorizing digital assets and related index series. These assets represent various aspects of the Ethereum ecosystem, from DeFi protocols to layer 2 solutions and infrastructure projects (Figure 1)[3].
Chart 1: Ethereum ecosystem tokens and Grayscale cryptocurrency sectors
Given the complexity of the ecosystem, we can categorize the main components based on Grayscale Crypto Sectors data as follows (see the Grayscale Glossary for more background on the terminology):
Layer 2 (L2) solutions, such as Polygon (MATIC), Arbitrum (ARB), and Optimism (OP), aim to improve Ethereum’s scalability by processing transactions off-chain, aiming to increase speed and reduce fees while keeping the network secure.
Financial applications leverage smart contracts to provide financial services without traditional intermediaries. Notable examples include leading decentralized exchange Uniswap (UNI), major lending platform Aave (AAVE), and MakerDAO (MKR), the protocol behind the DAI stablecoin.
Other applications include a wide range of services that support the broader ecosystem. For example, the Ethereum Name Service (ENS) provides a distributed naming system. In the NFT space, marketplaces like Blur have gained traction among traders. Finally, while meme tokens like Shiba Inu (SHIB) are not a core feature of Ethereum, they have become an important part of the ecosystem in terms of market capitalization and community engagement[4].
The “High Beta” Argument
Crypto-native investors sometimes view ecosystem assets as a “high beta” way to invest in Ethereum’s growth. This view is not without merit, as many ecosystem assets do show high short-term correlation with Ethereum’s year-to-date (YTD) returns (Exhibit 2). However, this view oversimplifies the complexity of these assets. Each ecosystem token has unique features and should be evaluated individually.
Figure 2: Ethereum ecosystem tokens tend to remain correlated with ETH YTD
The performance of select assets this year highlights that short-term correlations may not be a good guide to an asset’s medium-term performance. For example, ETH itself has appreciated 14% year-to-date. Meanwhile, ARB and MATIC (two relatively large Layer 2 solutions with high short-term correlations to ETH) have actually fallen 54% and 65% respectively (Chart 3). Although these protocols are deeply integrated and may share many of the same users, the fundamentals of the tokens and therefore the price returns can be very different.
Figure 3: Some notable Ethereum ecosystem tokens have underperformed ETH year-to-date
Token Diversity
The Ethereum ecosystem is diverse, with assets significantly different along multiple dimensions (Figure 4):
Figure 4: Ethereum ecosystem assets vary significantly based on use case and fundamentals
Volatility and risk-adjusted returns for the Ethereum ecosystem show that tokens generally exhibit higher volatility compared to ETH, reflecting ETH’s status as a larger, more mature asset. As a result, only a few ecosystem tokens are able to achieve higher Sharpe ratios than ETH itself[5], highlighting the challenge of outperforming the ecosystem’s underlying assets on a risk-adjusted basis.
Ethereum ecosystem tokens exhibit diverse supply growth patterns, unlike ETH’s (mostly) deflationary model[6]. New projects typically use higher initial inflation to boost adoption and fund development, while mature projects may have reduced or fixed supply schedules. Some tokens implement adaptive mechanisms to adjust supply based on usage or market conditions. These inflation strategies can significantly impact the long-term value of a token. High inflation can depress prices if demand growth is mismatched, while a carefully designed timetable can help support sustainable growth. Token supply growth patterns often reflect a project’s maturity and value creation process.
Trends in specific application activity, as measured by key metrics such as total value locked (TVL), daily active users, transaction volume, and fees generated, can indicate a project’s traction and economic viability. For example, rising TVL in a DeFi protocol may indicate increased user trust and capital efficiency, while an increase in transaction fees may indicate high demand for the service. However, these metrics should be interpreted in context; layer 2 solutions may prioritize low fees and high transaction volume, while lending platforms may focus on TVL growth. Additionally, trends in these metrics can reveal competitive dynamics in specific areas of the Ethereum ecosystem. Strong on-chain metrics do not always directly correlate to token price appreciation, as seen in some cases where protocols with high TVL or fee generation may still experience disappointing token performance due to factors such as token distribution or market sentiment.
Performance Comparison
Figure 5: ETH outperforms the average and median
So far, ETH has outperformed its ecosystem tokens in both average and median cumulative returns through 2024 (Exhibit 5). ETH has also shown better risk-adjusted performance, as reflected in a higher Sharpe ratio. However, looking at long-term historical data, the picture is more nuanced. During certain bull runs, some Ethereum ecosystem tokens outperformed ETH on average. For example, during the 2020-2021 bull run, meme tokens such as SHIB significantly outperformed ETH[7], boosting the average return of the ecosystem token basket.
So far this year, specific tokens such as ConstitutionDAO (which we also consider a memecoin) and ENS have been the main contributors to the outperformance of the Other Applications category. In contrast, Layer 2 solutions and financial applications have underperformed ETH during this period. Grayscale Research believes that the potential for excess returns in ecosystem tokens appears to be concentrated in a small number of outperforming assets.
Year-to-date, ETH has tended to outperform its ecosystem tokens, both on average and median basis. However, a few standout tokens in the ecosystem may outperform ETH (Figure 4). This analysis shows that while ecosystem tokens can offer opportunities for significant gains, these opportunities are not evenly distributed. Historically, ETH has performed more consistently over longer periods of time.
Given the performance distribution of ecosystem tokens, a basket of ecosystem assets can provide exposure to potential outperformers while helping to mitigate the risk of selecting underperformers.
Asset Selection Methodology
While a diversified portfolio of Ethereum ecosystem assets can be a viable investment strategy, a more targeted approach focused on specific asset selection may produce better results - although while introducing more idiosyncratic risks. This approach involves identifying assets with good fundamentals and/or potential positive catalysts. Key considerations for asset selection include strong or improving fundamentals (such as usage metrics, market leadership, and innovative features), reasonable inflation rates, and price trends.
Some tokens demonstrate strong fundamentals but have experienced recent price underperformance, potentially offering attractive entry points. For example, UNI (Uniswap) has demonstrated high usage as a key DeFi primitive but has experienced range-bound price action. Similarly, LDO (Lido) has led in liquidity staking and has a high TVL to market cap ratio despite poor price performance. Other tokens such as MKR (Maker) and AAVE have performed well on both metrics, with MKR accounting for nearly 40% of Ethereum’s DeFi profits[8] and holding the largest portfolio of real-world assets, while AAVE has achieved record user engagement with over $11 billion in TVL across 14 active markets.[9]
Figure 6: Some tokens exhibit strong protocol fundamentals but weak relative price action
It’s also important to be cautious with certain assets. Potential considerations may include tokens with limited utility beyond governance, especially when their market caps significantly exceed the value of the assets they manage. Projects with declining user bases or persistently negative fees may indicate declining relevance or an unsustainable economic model. Large, regular token unlock events can also help generate selling pressure and volatility. Finally, assets with large market caps but relatively small TVL or lack of obvious growth catalysts tend to be overvalued. For Grayscale Research, these characteristics often indicate that a token’s current valuation is inconsistent with its fundamental utility or growth prospects.
When evaluating Ethereum ecosystem token projects that have declined or failed, it’s not just current success that can be important information—in other words, control for survivorship bias. For example, once-popular projects like Augur have seen a significant decline in usage and relevance over time. Many tokens from the 2017-2018 ICO boom have completely lost their relevance. By considering only the current key players, we risk overestimating overall success rates, underestimating risks, and misunderstanding the real factors behind project success or failure.
This strategic approach seeks to identify assets with real utility, a growing user base, and effective token economics that may outperform simple basket strategies. However, it requires ongoing research and regular portfolio rebalancing.
in conclusion
Several key takeaways emerge from our analysis of assets in the Ethereum ecosystem. As a platform for many dApps, Ethereum’s native token, ETH, is perhaps the easiest way to participate in the growth of the entire ecosystem. The Ethereum network is the infrastructure for many dApps, but ETH also offers several specific advantages: low supply growth, especially post-merger, which is good for long-term value preservation; potential for increased demand for exchange-traded products, as seen with recent approvals and launches; and strong network effects, as Ethereum’s dominance among smart contract platforms continues to attract developers and users (see our Grayscale: Why Ethereum Underperforms and What’s Next? report for more details).
The Ethereum ecosystem is full of innovative projects that may offer more potential upside, while also exposing investors to more potential risk. These include DeFi protocols that are revolutionizing financial services, layer 2 solutions that address scalability, and infrastructure projects that support the broader ecosystem. A diversified investment approach (e.g., investing in a basket of assets, such as a selection of top DeFi tokens) can provide broad participation in the growth of the ecosystem while seeking to mitigate certain project-specific risks. Alternatively, a research-based selective approach that carefully selects individual projects based on their fundamentals, utility, and growth prospects may generate higher returns despite higher risk.
References
[1] As of August 27, 2024, Ethereum is the largest smart contract platform by market cap and total locked value. Source: Coingecko, DefiLlama
[2] https://coinmarketcap.com/view/ethereum-ecosystem/
[3] Note: Ethereum (ETH) itself has a market cap of approximately $319 billion, dwarfing other assets in the ecosystem. Source: Artemis, Grayscale Investments. Data as of August 27, 2024.
[4] As of August 27, 2024, Shiba is ranked 13th by market capitalization. Source: Artemis, Grayscale Investments
[5] The Sharpe ratio compares the return of an investment to its risk. The numerator of the Sharpe ratio is the return, and the denominator is the standard deviation of returns over the same period.
[6]https://consensys.io/blog/what-is-eip-1559-how-will-it-change-ethereum
[7]https://decrypt.co/89069/bigger-gains-than-bitcoin-or-ethereum-top-crypto-assets-2021
[8] https://www.syncracy.io/writing/makerdao-thesis
[9] https://defillama.com/protocol/aave#information
