Original author: Grayscale Research
Original translation: Felix, PANews
The potential launch of a spot Ethereum ETF will expose more investors to the concepts of smart contracts and decentralized applications, thereby making them understand the potential of public blockchains to transform digital commerce.
Ethereum is the largest blockchain network in terms of users and applications, and is expanding with a modular design concept, with more activities taking place on the Layer 2 network in the future. To maintain its dominance in a highly competitive market segment, Ethereum needs to attract more users and increase fee income.
Based on international precedent, it is expected that the demand for US spot Ethereum ETFs will be approximately 25%-30% of the demand for spot Bitcoin ETFs. It is unlikely that a large portion of Ethereum supply (such as staked ETH) will be used for ETFs.
Given the high initial valuations, further price gains may be limited compared to a Bitcoin ETF launching in January 2024, but Grayscale Research remains optimistic on the prospects for both assets.
Last week, the U.S. Securities and Exchange Commission (SEC) approved Form 19 b-4 for spot Ethereum ETFs submitted by several issuers, making significant progress in listing these products on U.S. exchanges. Like the spot Bitcoin ETF that launched in January, these new products will make crypto assets accessible to a wider range of investors. While both assets are based on the same public blockchain technology, Ethereum is a separate network with different use cases (Table 1), while Bitcoin primarily serves as a store of value and digital alternative to gold. Ethereum is a decentralized computing platform with a rich application ecosystem and is often compared to a decentralized application store. New investors interested in exploring this asset may want to consider Ethereum’s unique fundamentals, competitive positioning, and potential role in the growth of blockchain-based digital commerce.
Figure 1: Ethereum is a smart contract platform blockchain
Smart Contract Basics
Ethereum expanded on the original vision of Bitcoin by adding smart contracts. A smart contract is a pre-programmed, self-executing computer code. When a user engages a smart contract, a predefined action is performed without any additional input. It's like a vending machine: the user inserts a coin and the vending machine dispenses an item. When using a smart contract, the user "inserts" a digital token and the software can perform some type of action, such as trading tokens, issuing loans, and verifying the user's digital identity.
Smart contracts operate through the mechanisms of the Ethereum blockchain. In addition to recording ownership of assets, the blockchain's block-by-block updates can also record any changes in "state" (note: a computer science term meaning the state of data in a database). In this way, coupled with smart contracts, public blockchains can actually operate like computers (software computers rather than hardware computers). With this, Ethereum and other smart contract platform blockchains can host almost any type of application and serve as core infrastructure for the emerging digital economy.
Asset Returns and Fundamentals
Since the beginning of 2023, ETH has performed broadly in line with the overall smart contract platform token segment (Table 2). However, ETH has underperformed BTC and Solana. Since the beginning of 2023, ETH, like BTC, has outperformed certain traditional asset classes on a risk-adjusted basis. Over the long term, both BTC and ETH have achieved risk-adjusted returns comparable to traditional asset classes, despite significantly higher volatility.
Figure 2: ETH’s performance has been consistent with the cryptocurrency sector
Through Ethereum’s modular design, different types of blockchain infrastructure work together to provide a great experience for end users. In particular, the ecosystem expands as Ethereum’s Layer 2 network activity increases. Layer 2 periodically settles and publishes its transaction records to Layer 1, benefiting from its network’s security and decentralization. This approach contrasts with single-layer design-philosophy blockchains such as Solana, where all key operations (execution, settlement, consensus, and data availability) occur in Layer 1.
In March 2024, Ethereum underwent a major upgrade that was expected to facilitate its transition to a modular network architecture. From a blockchain activity perspective, the upgrade was successful: the number of active addresses on the Layer 2 network increased significantly and accounted for approximately two-thirds of the total activity in the Ethereum ecosystem (Figure 3).
Figure 3: Significant growth in Ethereum Layer 2 activity
At the same time, the shift to Layer 2 networks has also affected the token economics of ETH, at least in the short term. Smart contract platform blockchains accumulate value primarily through transaction fees, which are typically paid to validators or used to shrink the token supply. In the Ethereum network, base transaction fees are burned (removed from circulation), while priority fees (“tips”) are paid to validators. When Ethereum’s transaction revenue was relatively high, the number of tokens destroyed exceeded the rate of new issuance, and the total ETH supply fell (deflation). However, as network activity transitioned to Layer 2, fee revenue on the Ethereum mainnet fell, and the ETH supply began to increase again (Figure 4). Although Layer 2 networks also pay fees to publish their data to Layer 1 (so-called “blob fees,” as well as other transaction fees), the amounts tend to be relatively low.
Figure 4: ETH supply has increased recently due to lower mainnet fees
In order for ETH to increase in value over time, the Ethereum mainnet will likely need to increase fee revenue. This could happen in two ways:
Moderately increase Layer 1 activity, paying higher transaction fees
Significantly increase Layer 2 activity and pay lower transaction fees
Grayscale Research predicts that a combination of the two approaches is more likely.
Grayscale believes that growth in Layer 1 activity is most likely to come from low-frequency and high-value transactions, as well as any transactions that require a high degree of decentralization (at least until the Layer 2 network is sufficiently decentralized). This may include many types of tokenized projects, where transaction costs may be relatively low compared to the dollar value of the transaction. Currently, approximately 70% of tokenized U.S. Treasuries are on the Ethereum blockchain (Table 5). In Grayscale's view, relatively high-value NFTs are also likely to remain on the Ethereum mainnet, as they benefit from its high degree of security and decentralization and change hands less frequently (for similar reasons, Bitcoin NFTs are expected to continue to grow).
Figure 5: Ethereum hosts the majority of tokenized Treasury securities
In contrast, relatively high-frequency and/or low-value transactions will occur more frequently on Ethereum’s various Layer 2 networks. For example, social media applications, various recent success stories on Ethereum Layer 2, include friend.tech (Base), Farcaster (OP Mainnet) and Fantasy Top (Blast). In Grayscale’s view, both gaming and retail payments are likely to require very low transaction costs and are more likely to migrate to Layer 2 networks. Importantly, however, given the low transaction costs, these applications would need to attract a large number of users to significantly increase fee revenue on the Ethereum mainnet.
Potential Impact of US Spot Ethereum ETF
In the long run, ETH’s market capitalization should reflect its fee income, as well as other fundamentals. But in the short term, ETH’s market price may be affected by changes in supply and demand. While progress has been made in the approval of a spot Ethereum ETF in the United States, ETF issuers will need to wait for the S-1 registration statement to become effective before they can begin trading. Full approval and launch of trading for these products could bring new demand as the assets will be available to a wider range of investors. Given the supply and demand dynamics, Grayscale Research expects that increased access to Ethereum and the Ethereum protocol through ETF wrappers will help drive increased demand and, in turn, higher prices for the token.
Outside the US, both Bitcoin and Ethereum exchange-traded products (ETPs) are listed, with assets in Ethereum ETPs accounting for about 25%-30% of Bitcoin ETP assets (Table 6). On this basis, Grayscale Research's forecast is that US-listed spot Ethereum ETFs will see net inflows of 25%-30% of spot Bitcoin ETF net inflows to date; or about $3.5 billion to $4 billion in inflows in the first four months or so (accounting for 25%-30% of the $13.7 billion in net inflows to spot Bitcoin ETFs since January). Ethereum's market cap is about one-third of Bitcoin's market cap (33%), so Grayscale's assumption means that Ethereum net inflows as a share of market cap may be slightly smaller. But this is only an assumption, and there is uncertainty about higher and lower net inflows for US-listed spot Ethereum ETFs. It is worth noting that in the US market, ETH futures ETFs only account for about 5% of BTC futures ETF assets, although this is not representative of the possible demand for spot ETH ETFs.
Figure 6: Outside the United States, Ethereum ETP assets under management account for 25%-30% of Bitcoin ETP assets under management
In terms of ETH supply, Grayscale Research believes that approximately 17% of ETH can be classified as idle or relatively illiquid. According to data from data analysis platform Allium, approximately 6% of the ETH supply has not moved for more than five years, and approximately 11% of the ETH supply is "locked" in various smart contracts (e.g., bridges, wrapped ETH, and various other applications). In addition, 27% of the ETH supply is staked. Recently, issuers of spot Ethereum ETFs, including Grayscale, have removed references to staking from public documents, indicating that the U.S. SEC may allow ETFs to trade without staking. Therefore, this part of the supply is unlikely to be available for ETF purchases.
Outside of these categories, $2.8 billion worth of ETH is used for network transactions each year. At current ETH prices, this represents an additional 0.6% of supply. There are also a few protocols that hold large amounts of ETH in their treasuries, including the Ethereum Foundation ($1.2 billion worth of ETH), Mantle (~$879 million ETH), and Golem ($995 million ETH). Overall, ETH in protocol treasuries accounts for about 0.7% of supply. Finally, about 4 million ETH, or 3% of the total supply, is held by ETH ETPs.
Collectively, these categories account for approximately 50% of ETH supply, although there is some overlap (e.g., ETH in protocol libraries may be staked) (Figure 7). Grayscale believes that net purchases of ETH are more likely to come from the remaining circulating supply. Because existing usage limits the available supply for new spot ETF products, any increase in demand is likely to have a large impact on price.
Figure 7: A significant portion of ETH supply is unable to enter new spot ETFs
From a valuation perspective, Ethereum is arguably more highly valued than Bitcoin was when the spot Bitcoin ETF launched in January. For example, one popular valuation metric is the MVRV z-score. This metric is based on the ratio of a token’s total market capitalization to its “realized value”: its market capitalization based on the price at which the token last moved on-chain (as opposed to the price at which it trades on an exchange). When the spot Bitcoin ETF launched in January, its MVRV z-score was relatively low, suggesting that valuations were modest and that there could be more room for price appreciation. Since then, the crypto market has appreciated, with both Bitcoin and Ethereum’s MVRV ratios increasing (Table 8). This could indicate that there is less room for price appreciation following the approval of the spot ETH ETF compared to the approval of the U.S. spot Bitcoin ETF in January.
Figure 8: When the spot Bitcoin ETF was launched, ETH’s valuation indicators were higher than BTC
Finally, crypto native investors may be interested in the impact of a spot Ethereum ETF on smart contract platform tokens, specifically the SOL/ETH price ratio. Solana is the second largest asset in this segment (by market cap). Grayscale Research believes that Solana is currently best positioned to take market share from Ethereum in the long run. Solana has significantly outperformed Ethereum over the past year, with the SOL/ETH price ratio now close to the peak of the last crypto bull run (Figure 9). This may be partly due to the fact that despite the impact of the FTX incident on Solana (in terms of token ownership and development activity), the user and developer community of the Solana network continues to grow the ecosystem. More importantly, Solana has also driven increased trading activity and fee revenue through a "silky" user experience. In the short term, Grayscale expects the SOL/ETH price ratio to stabilize as inflows from the Ethereum ETF will support the price of ETH. However, in the long run, the SOL/ETH price ratio will most likely be determined by the fee revenue of both chains.
Figure 9: SOL/ETH price ratio close to previous cycle high
Looking ahead
While the launch of a spot ETH ETF in the U.S. market could have an immediate impact on ETH valuations, the impact of regulatory approval goes far beyond price. Ethereum provides an alternative framework for digital commerce based on decentralized networks. While the traditional online experience is quite good, public blockchains may offer more possibilities, including near-instant cross-border payments, true digital ownership, and interoperable applications. While other smart contract platforms can also provide such practical functions, the Ethereum ecosystem has the most users, the most decentralized applications, and the deepest pool of funds. Grayscale Research expects that the new spot ETF can popularize this transformative technology to a wider range of investors and other observers and help accelerate the adoption of public blockchains.
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