Research Summary: Ethereum
A benchmark for blockchain investments
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By Mahomed Ibrahim
This is a summary of our in-depth investment research report which can be found here.
Ethereum is foundational technology playing a critical role in blockchain. It has spawned innovations such as DeFi, NFTs, DAOs, Dapps and rollups. It has 400,000 daily active addresses, dominates DeFi with an almost 2/3rd share by TVL (US$29bn), dominates NFTs with an 80% share of weekly volumes, has US$26bn staked on it, US$96bn of Pegged Stablecoins running on it, and comprises 17% of the total crypto market cap. And with the potential to act as the Layer 1 for web3, its opportunity set is exponentially larger. As an example, Ethereum’s revenue from DeFi last year was less than 0.01%of global financial services revenue of c.$26tn.
It is worked on by more than 4,000 monthly active developers. That is more than 2x the next biggest blockchain protocol. The founder Vitalik’s skillset & personality are rare and well-suited to crypto. He is amongst the top three developers in blockchain, is a brilliant strategist, exceptional leader and is altuistic. And the overall team has vision, ability, and an unmatched track record of execution. They are transparent, honest, and well-funded.
Ethereum’s development culture has a good balance; embracing innovation without compromising security. It has prioritised decentralisation – insisting that regular users should be able to run a node. While this has come at the cost of scalability and resulted in network congestion and poor user experience, decentralisation is critical to blockchains and is the right property to be non-negotiable on.
If it solves its scalability challenge, it will be the most decentralised & secure scalable Layer 1 chain, solidifying its dominance. And Ethereum has a clear path to solving this challenge. It has embraced Layer 2s as a scaling solution, in the process pivoting to a semi-modular structure. This gives it optionality over the future paths of blockchain. Over the next 12-24 months, it is implementing proto-danksharding, statelessness & state expiry, using cryptography to reduce computational intensity & optimise for rollups. This will result in a 10-100x increase in scalability.
In crypto, community matters as much as, if not more than, technology. While Ethereum does not lead in terms of activity, it does have a sizeable, high-quality, and organically acquired community. This is not surprising given Ethereum’s properties – poor usability but the best security & decentralisation – which serious users value.
Ethereum’s governance model is well-balanced between developer and community control to ensure sufficient levels of decentralisation and execution.
And its tokenomics are the best amongst Layer 1s, well designed to meet the needs of all its various stakeholders. Value in blockchain inherently accrues to users and participants. Proof of Stake allows active investors to participate via staking. And Ethereum’s monetary policy allows passive investors to participate via deflation. These give Ethereum capital asset characteristics with sustainable, positive real yield. At the same time, its monetary policy cements ETH as the only way to pay for its use, underpinning its value as a consumable asset.
Its value as a capital asset can, in theory, be determined by a DCF model. However, trying to forecast cashflows is a futile exercise. Cashflows depend on activity, which in the short term, depends on narratives and macroeconomics – both unpredictable. At the same time, Ethereum’s roadmap will shift execution to Layer 2s – resulting in a significant fall in fees. How this is countered by the resultant rise in volumes is difficult to predict.
And given Ethereum’s current market cap, such an exercise is unnecessary. At $210b, Ethereum is trading c.15 – 20 x normalised free cashflow. This is extremely attractive. And if fee income does fall by 20x, we think it is very reasonable to expect at least a 20x increase in volumes as this is consistent with what we’ve seen in the past. At the same time, being more scalable will attract many more users – and Ethereum has lots of white space here.
Ethereum has a network effect advantage. High volumes & resultant liquidity drive innovation & vice versa. This is bolstered by the Lindy effect and the fact that there is a low incentive for users to switch away.
Compared to its peers, the multi-chain ecosystems like Avalanche and Cosmos or its monolithic peer, Solana, are not as decentralised or secure as Ethereum. And none have clear value accrual mechanisms or attractive monetary policy. At the same time, their scalability performance relative to Ethereum on a like-for-like basis is not as high as advertised. Rollups will catch Ethereum up quickly. And finally, with so much white space and a good argument for different blockchains serving different purposes, competition is less concerning at the moment.
The biggest risk Ethereum faces is from taking long to solve scalability. One part of this risk is within its control – optimising for rollups and the other is outside its control – rollups being successful mechanisms. The other risk is from regulation. While Ethereum’s decentralisation is sufficient to protect it from being shut down by regulators or governments, regulation could still significantly hurt activity and revenues.