Original author: David Han
Original translation: TechFlow
The multiple role categorizations for ETH raise questions about its place in a portfolio, and this article will clarify some of these narratives and potential tailwinds for the asset in the coming months.
Article Summary
Despite ETH’s poor performance year-to-date, we believe its market positioning remains strong in the long term.
We believe ETH has the potential to deliver unexpected upside in the late cycle. We also believe ETH has the strongest sustained demand momentum in the crypto market and maintains its unique scaling roadmap advantage.
ETH’s historical trading patterns suggest that it benefits from the dual narratives of “store of value” and “tech token”.
text
The approval of a BTC spot ETF in the US strengthens BTC’s store of value narrative and its position as a macro asset. On the other hand, questions remain to be answered around ETH’s fundamental positioning in the crypto space. Competing layer-1 networks such as Solana weaken ETH’s position as the preferred network for decentralized application (dApp) deployment. ETH’s L2 expansion and the reduction of ETH destruction also seem to affect the asset’s value accumulation mechanism at a high level.
Nonetheless, we continue to believe that ETH’s long-term positioning remains strong, with important advantages that other smart contract networks lack. These advantages include the maturity of the Solidity developer ecosystem, the popularity of its EVM platform, ETH’s utility as DeFi collateral, and the decentralization and security of its mainnet. Additionally, we believe that advances in tokenization could have a more positive impact on ETH relative to other layer-1 networks in the near term.
We find that ETH’s ability to capture both the “store of value” and “tech token” narratives is reflected in its historical trading patterns. ETH’s high correlation with BTC shows behavior consistent with BTC’s store of value model. At the same time, it also decouples from BTC during long-term BTC price increases, behaving more like a technology-oriented cryptocurrency like other altcoins. We believe ETH will continue to fulfill these roles and is poised to outperform in the second half of 2024 despite its poor performance year-to-date.
Response to the ETH controversy
ETH has been categorized in a variety of ways, from being considered an “ultrasonic currency” named for its supply reduction mechanism to being called an “internet bond” for the non-inflationary nature of its staking returns, with the development of second-layer networks (L2s) and the addition of re-staking capabilities, new descriptions such as “settlement layer assets” or more complex “general objective work tokens” have emerged. However, we believe that these descriptions do not fully capture the vitality of Ethereum. In fact, as Ethereum’s application scenarios continue to enrich and complicate, it has become increasingly difficult to fully assess its value through a single value metric. What’s more, these different descriptions may conflict with each other, which can have a negative effect because they may offset each other - distracting market participants from the positive drivers of the token.
Spot ETH ETF
Spot ETFs are extremely important for BTC as they provide regulatory clarity and a pathway for new capital inflows. These ETFs structurally change the industry and challenge the previous model of capital circulation, which was capital moving from BTC to ETH to higher beta altcoins. There is a barrier between capital allocated to ETFs and capital allocated to centralized exchanges (CEXs), which only have access to the broader crypto asset space. The potential approval of a spot ETH ETF would remove this barrier, allowing ETH to access the same pool of capital currently only enjoyed by BTC. In our view, this may be the biggest unresolved issue for ETH in the near term, especially given the current challenging regulatory environment.
While the SEC’s silence on issuers has made timely approval uncertain, we believe the existence of a US spot ETH ETF is a matter of when, not if. In fact, the main rationale for approving a spot BTC ETF also applies to a spot ETH ETF. That is, the correlation between the CME futures product and the spot rate is high enough that “CME’s monitoring can reasonably be expected to detect improper behavior in the spot market.” The correlation study period in the spot BTC approval notice began in March 2021, one month after the launch of CME ETH futures. We believe this evaluation period was deliberately chosen in order to apply similar logic to the ETH market. In fact, analysis previously presented by Coinbase and Grayscale shows that the spot and futures correlations in the ETH market are similar to those of BTC.
Assuming this correlation analysis holds, the remaining possible reasons for disapproval could stem from fundamental differences between ETH and BTC. In the past, we have discussed some of the differences in the size and depth of the ETH vs. BTC futures markets, which could be a factor in the SEC’s decision. But among the other fundamental differences between ETH and BTC, we believe the most relevant approval issue is ETH’s Proof of Stake (PoS) mechanism.
In the absence of clear regulatory guidance on the treatment of staking in the asset, we believe it is unlikely that a spot ETH ETF supporting staking will be approved in the near term. Potentially ambiguous fee structures from third-party staking providers, differences between validator clients, complexity of slashing conditions, and liquidity risks (and exit queue congestion) of unstaking are materially different from BTC. (It is worth noting that some European ETH ETFs include staking, but generally, European exchange-traded products differ from those offered in the US.) Nonetheless, we believe this should not impact the status of unstaked ETH.
We think this decision could be a surprise. Polymarket predicts a 16% chance of approval on May 31, 2024, while Grayscale Ethereum Trust (ETHE) trades at a 24% discount to net asset value (NAV). We think the odds of approval are closer to 30-40%. As crypto becomes an election issue, we are also unsure whether the SEC is willing to invest the necessary political capital to support a decision to reject crypto. Even if the first deadline of May 23, 2024 is rejected, we think there is a high probability that the decision can be overturned through litigation. It is worth noting that not all applications for spot ETH ETFs must be approved at the same time. In fact, Commissioner Uyeda’s approval statement on the spot BTC ETF criticized the disguised motivation of accelerating the approval of applications, namely to prevent the emergence of a first-mover advantage.
Challenges of alternative L1s
In terms of adoption, highly scalable integrations, especially Solana, appear to be eroding ETH’s market share. High throughput and low-fee transactions have shifted the center of trading activity away from the ETH mainnet. Notably, the Solana ecosystem has grown from accounting for only 2% of decentralized exchange (DEX) trading volume to 21% today over the past year.
We believe alternative L1s also offer more meaningful differentiation now than during the last bull run. The move away from the ETH Virtual Machine (EVM) and redesigning dApps from the ground up has resulted in unique user experiences (UX) across different ecosystems. Additionally, the integrated/monolithic approach to scaling enhances composability across applications, avoiding issues with bridge UX and liquidity fragmentation.
While these value propositions are important, we believe it is premature to use incentivized activity metrics as confirmation of success. For example, the number of transacting users on some ETH L2s has dropped by more than 80% from the peak of the airdrop. Meanwhile, Solana’s share of total DEX volume grew from 6% to 17% from Jupiter’s airdrop announcement on November 16, 2023, to the first claim date on January 31, 2024. (Jupiter is the leading DEX aggregator on Solana.) Jupiter has three more airdrops to go, so we expect activity on the Solana DEX to continue for some time. In the interim, assumptions about long-term activity retention remain speculative.
That being said, trading activity on leading ETH L2s like Arbitrum, Optimism, and Base now accounts for 17% of total DEX volume (combined with ETH’s 33%). This may provide a more appropriate comparison for ETH demand drivers vs. alternative L1 solutions, as ETH is used as the native fuel token for these three L2s. Other additional demand drivers for ETH are untapped in these networks, providing room for future demand catalysts. We believe this is a more equivalent comparison of integrated vs. modular scaling approaches in terms of DEX activity.
Another, more “sticky” measure of adoption is stablecoin supply. Stablecoin distribution tends to change more slowly due to frictions in bridging and issuance/redemption. (See Exhibit 2. The color scheme and arrangement are the same as Exhibit 1, with Thorchain replaced by Tron.) Activity, as measured by stablecoin issuance, is still dominated by ETH. In our view, this is because the trust assumptions and reliability of many new chains are not yet strong enough to support large amounts of capital, especially capital locked in smart contracts. Large capital holders are generally indifferent to ETH’s higher transaction costs (relative to scale) and prefer to reduce risk by reducing liquidity pause times and minimizing bridging trust assumptions.
Even so, among high-throughput chains, ETH L2s are seeing faster stablecoin supply growth than Solana. Arbitrum’s stablecoin supply has surpassed Solana’s at the start of 2024 ($3.6 billion vs. $3.2 billion currently), while Base’s stablecoin supply has grown to $2.4 billion from $160 million at the start of the year. While the final verdict on the scaling debate is unclear, early signs of stablecoin growth may actually favor ETH L2s over alternative L1s.
The growth of L2s has raised concerns about the actual threat they may pose to ETH - they reduce the demand for L1 block space (and therefore reduce transaction fee burns) and may support non-ETH gas tokens in their ecosystems (further reducing ETH burns). In fact, ETH has seen its highest annualized inflation rate since its switch to a proof-of-stake (PoS) mechanism in 2022. While inflation is often understood as a structurally important component of BTC supply, we do not believe this applies to ETH. All ETH issuance is owned by stakers, and the collective balance of stakers far exceeds cumulative ETH issuance since the merger (see Figure 4). This is in stark contrast to BTC's proof-of-work (PoW) miner economics, where the competitive hashrate environment means miners need to sell a large portion of newly issued BTC to fund operations. While miners' BTC holdings are tracked across cycles to account for their inevitable selling, ETH's minimal staking operating costs mean stakers can continue to increase their holdings. In fact, staking has become a convergence point for ETH liquidity - the growth of ETH in stake is more than 20x the growth of ETH issuance (even excluding destruction).
L2s themselves are also a significant demand driver for ETH. Over 3.5M ETH has been moved to the L2 ecosystem, serving as another liquidity aggregation point for ETH. Furthermore, even if the ETH moved to L2s is not directly destroyed, the remaining balance of native tokens held by new wallets to pay transaction fees constitutes a soft lockup of an ever-growing portion of ETH tokens.
Furthermore, we believe that some core activity will always remain on the ETH mainnet, even as their L2s scale. Things like EigenLayer’s restaking activity or governance actions of major protocols like Aave, Maker, and Uniswap remain firmly rooted in L1. Users with the highest security concerns (typically those with the largest capitalization) may also want to keep funds on L1 until fully decentralized sorters and permissionless fraud proofs are deployed and tested — a process that could take years. Even as L2s innovate in different directions, ETH will always be a component of their treasuries (used to pay L1 “rent”) and their native unit of account. We firmly believe that the growth of L2s is not only good for the ETH ecosystem, but also for ETH as an asset.
Advantages of ETH
Beyond the commonly covered metrics-based narratives, we believe ETH has other, harder to quantify but equally important strengths. These may not be short-term tradable narratives, but rather represent a set of long-term strengths that could sustain its current dominance.
Original collateral and account units
One of the most important uses of ETH in DeFi is as collateral. ETH can be leveraged in the ETH and its L2 ecosystem with minimal counterparty risk. It acts as a collateral in money markets like Maker and Aave, and is also the base trading unit for many on-chain DEX pairings. The expansion of DeFi on ETH and its L2s has led to additional liquidity aggregation on ETH.
While BTC remains the dominant store of value asset more broadly, using wrapped BTC on ETH introduces cross-chain bridges and trust assumptions. We do not believe WBTC will replace ETH for DeFi-based ETH usage — WBTC supply has remained flat for over a year and is over 40% below its previous high. Instead, ETH can benefit from the diversity of its L2 ecosystem.
Continuous innovation and decentralization
An often overlooked component of the ETH community is its ability to continue to innovate even as it decentralizes. ETH has been criticized for its extended release timeline and development delays, but few acknowledge the complexity of balancing the goals and objectives of diverse stakeholders to achieve technological progress. Developers of more than five execution clients and more than four consensus clients need to coordinate design, testing, and deployment of changes without causing disruption to mainnet execution.
Since BTC’s last major Taproot upgrade in November 2021, ETH has enabled dynamic transaction burning (August 2021), transitioned to PoS (September 2022), enabled staking withdrawals (March 2023), and created blob storage for L2 scaling (March 2024), among a host of other ETH Improvement Proposals (EIPs). While many other L1s appear to be able to evolve faster, their single clients make them more fragile and centralized. The path toward decentralization inevitably leads to a degree of rigidity, and it is unclear whether other ecosystems are capable of creating similarly effective development processes if and when they begin this process.
Rapid innovation at L2
This is not to say that ETH is innovating slower than other ecosystems. On the contrary, we believe that ETH’s innovation around execution environments and developer tooling is actually outpacing its competitors. ETH benefits from the rapid, centralized development of L2s, all of which pay settlement fees to L1. The ability to create diverse platforms with different execution environments (such as Web Assembly, Move, or the Solana Virtual Machine) or other features (such as privacy or enhanced staking rewards) means that the slow development timeline of L1 does not prevent ETH from gaining acceptance in more technologically comprehensive use cases.
Meanwhile, the ETH community’s efforts to define different trust assumptions and definitions around sidechains, Validium, Rollup, etc. have led to greater transparency in the space. For example, similar efforts in the BTC L2 ecosystem (such as L2 Beat) have yet to emerge, where trust assumptions for L2 vary widely and are generally not well communicated or understood by the broader community.
EVM Popularity
Innovation around the new execution environment does not mean that Solidity and the EVM will become obsolete in the near future. On the contrary, the EVM has been widely popularized to other chains. For example, many BTC L2s have adopted the research results of ETH L2. Some shortcomings of Solidity (such as the easy introduction of reentrancy vulnerabilities) now have static tool checkers to prevent basic vulnerabilities. In addition, the popularity of the language has also created a mature audit sector, a large number of open source code samples, and detailed best practice guides. All of these are essential to building a large development talent pool.
While the use of the EVM does not directly lead to the demand for ETH, changes to the EVM are rooted in the development process of ETH. These changes are then adopted by other chains to maintain compatibility with the EVM. We believe that it is likely that core innovations in the EVM will remain rooted in ETH - or soon preempted by L2 - which will focus developer attention and thus breed new protocols within the ETH ecosystem.
Tokenization and the Lindy Effect
The push for tokenized projects and increased global regulatory clarity may also benefit ETH (among public blockchains) first. In our view, financial products are often more focused on technical risk mitigation than optimization and feature richness, and ETH has the advantage of being the longest-running smart contract platform. We believe that higher transaction fees (dollars instead of cents) and longer confirmation times (seconds instead of milliseconds) are secondary issues for many large tokenized projects.
Additionally, for more traditional companies looking to scale on-chain, recruiting enough developer talent becomes a key factor. Here, Solidity becomes the obvious choice as it constitutes the largest subset of smart contract developers, which echoes the previous point about EVM popularity. Blackrock’s BUIDL fund on ETH and JPM’s proposed ERC-20-compatible Onyx Digital Assets Fungible Asset Contract (ODA-FACT) token standard are early signs of the importance of this talent pool.
Structural supply mechanisms
Active ETH supply changes significantly differently than BTC. Despite price increases since Q4 2023, ETH’s three-month circulating supply has not increased significantly. In comparison, we observed an increase of almost 75% in active BTC supply during the same time frame. Unlike what was seen in the 2021/22 cycle when ETH was still running using Proof of Work (PoW), long-term ETH holders are not leading to an increase in circulating supply, but instead a growing supply of ETH is being staked. This reaffirms our view that staking is a key liquidity convergence point for ETH, minimizing structural seller pressure on the asset.
Evolving trading system
Historically, ETH has traded more in line with BTC than any other altcoin. At the same time, it has also decoupled from BTC during bull market peaks or specific ecosystem events - a similar pattern observed in other altcoins, albeit to a lesser extent. We believe that this trading behavior reflects the market's relative valuation of ETH as a store of value token and a technical utility token.
In 2023, ETH's correlation with BTC is inversely related to changes in BTC's price. That is, as BTC's value increases, ETH's correlation with it decreases, and vice versa. In fact, changes in BTC's price appear to be a leading indicator of changes in ETH's correlation. We believe this is a reflection of market enthusiasm led by BTC's price in altcoins, which in turn drives their speculative performance in bull markets (i.e. altcoins trade differently in bull markets than they do in bear markets relative to BTC).
However, this trend has weakened following the approval of the US spot BTC ETF. We believe this highlights the structural impact of ETF-based inflows, where an entirely new capital base has only exposure to BTC. New markets, such as registered investment advisors (RIAs), wealth management advisors, and securities firms, may view BTC differently in a portfolio than many crypto-native or retail traders. While BTC is the least volatile asset in a pure crypto portfolio, it is often viewed as a small diversifier in more traditional fixed income and equity portfolios. We believe this shift in BTC’s utility has impacted its trading patterns relative to ETH, and that ETH may see a similar shift (and a recalibration of trading patterns) if a US spot ETH ETF is approved.
Summarize
We believe that ETH may still have upside potential in the coming months. ETH does not appear to be under significant supply-side pressures such as token unlocking or miner selling pressure. Instead, the growth of staking and L2 has proven to be a meaningful and growing convergence point for ETH liquidity. We believe that ETH's position as the center of DeFi is unlikely to be replaced due to the widespread adoption of the EVM and its L2 innovations.
Additionally, the importance of a potential US spot ETH ETF cannot be ignored. We believe the market may be underestimating the timing and likelihood of a potential approval, which provides upside. In the meantime, we believe ETH’s structural demand drivers and technological innovation within its ecosystem will allow it to continue to juggle multiple narratives.
