Fidelity: A Feasibility Study on Ethereum as a Digital Asset and Potential Income Asset

Original Title: Ethereum Investment Thesis: Ethereum's Potential as Digital Money and a Yield-Bearing Asset

Author: Fidelity Digital Assets Research

Compiled by: Biscuit, bayemon.eth, ChainCatcher

Abstract

Users can gain technical utility from the Ethereum network by accessing various applications within the Ethereum ecosystem.

Some may ask, "How does utility translate into the value of Ethereum tokens?" In other words, why would investors buy and hold Ethereum tokens instead of simply using them to interact with the Ethereum network? In our previous article introducing the Ethereum network, we merely considered how or why Ethereum tokens might generate value. In this article, we will delve deeper into this issue from an investment perspective and briefly introduce some technical aspects.

Key points of this article:

• Ethereum can be understood as a technology platform that uses ETH as a means of payment.
• The perceived value of Ethereum is closely related to the supply and demand dynamics of network applications, which have changed significantly since The Merge.
• The overall platform usage of Ethereum may transfer value to token holders, meaning that the value of the tokens increases with the usage of the Ethereum network and platform.
• The investment philosophy of holding Ethereum is similar to that of Bitcoin, viewing it as an emerging form of currency.
• However, due to Bitcoin's characteristics and network effects, no other digital asset is likely to surpass Bitcoin as a monetary commodity.
• Nonetheless, value is subjective, which does not preclude the existence of other competing forms of currency, including Ethereum, especially in specific markets, use cases, and communities.
• We will examine Ethereum's ability to fulfill two major functions of currency: store of value and means of payment.
• Ethereum is currently not a mature network, and upgrades are expected annually, which brings ongoing technical risks and uncertainties, thereby diminishing its prospects. These unknowns weaken Ethereum's outlook as a store of value asset.
• Although Ethereum can be used for various payment purposes, the volatility of its fees remains a barrier to widespread adoption.
• We studied Ethereum's demand model and found a weak relationship between address growth (a standard measure of adoption) and price. Compared to Bitcoin, the relationship between Ethereum's address growth (a metric of adoption) and price is weaker.
• After Ethereum transitioned from PoW to PoS, token holders can now earn yields, part of which comes from increased network usage. We will explore the sources of this yield and the various driving factors and risks.
• As a yield-generating asset, Ethereum's value can be examined through a cash flow discount model. We constructed a simple model to illustrate the assumptions driving this model.

Ethereum and Ether

There exists a certain relationship between digital asset networks and their native tokens, but the "success" of the two is not always fully correlated.

"Success" is not always fully correlated. In some cases, a network can provide utility to users, settling a certain number of complex transactions daily, but this does not necessarily bring incremental value to native token holders. Other networks may have a closer connection between network usage and token value. A commonly used term to describe the relationship between network design and token value is token economics, which helps explain how the design of a network or application creates economic value for token holders.

The Ethereum network has undergone transformative changes in recent years, leading to changes in Ethereum's token economics. In August 2021, Ethereum Improvement Proposal 1559 (EIP-1559) introduced a mechanism for burning a portion of transaction fees, known as the base fee. Burning Ether is equivalent to destroying it, so executing transactions on Ethereum removes Ether from circulation.

Additionally, the transition from Proof of Work (PoW) to Proof of Stake (PoS) in September 2022 reduced the issuance rate of network tokens and allowed entities to earn yields through tips, issuance, and Maximum Extractable Value (MEV). Previous upgrades to Ethereum fundamentally changed its token economics and altered perceptions of the relationship between the Ethereum network and its tokens.

Token Economics: Accumulation of Ether Value

The token economic model of Ether typically transforms usage into value in three ways. When transacting on Ethereum, all users must pay a base fee, priority fee (tip), and generate additional value for other participants through MEV (Maximum Extractable Value), which is the maximum value validators can obtain by including, excluding, or changing the order of transactions during block production. The base fee is paid in Ether and is burned when included in a block (transaction bundle), thereby reducing the circulating supply of Ether. The priority fee is paid to validators, who are individuals or entities responsible for updating the public ledger and maintaining consensus. When a new block is generated, validators who earn rewards will include the highest priority transactions. Finally, potential MEV opportunities (often arbitrage) are submitted by different users and pass most of the value to validators through the competitive MEV market in the current state.

The value accumulation mechanism can be viewed as the network's "revenue" being used for different purposes. First, the burning of the base fee creates deflationary pressure on the total supply, benefiting existing token holders. Second, priority fees and MEV come from users and are distributed to validators in exchange for their services. Although these relationships are nonlinear, increased platform usage means more burning and higher earnings for validators.

Investment Thesis 1: Becoming a Widely Accepted Digital Currency

The prevailing view is that the best understanding of Ethereum is as an emerging currency product, which raises the question of whether Ethereum's native token can also be viewed as currency. Simply put, Ethereum may face more challenges in becoming a widely accepted form of currency compared to Bitcoin, which has advantages. As shown, Ethereum shares many similar attributes with Bitcoin and other currencies; however, it differs from Bitcoin in terms of scarcity and historical record. Technically, Ether has an infinite supply parameter, which is maintained within a certain range based on the number of validators and the amount burned. Although these parameters are strictly controlled by the Ethereum network, they do not equate to a fixed supply schedule and may experience unpredictable fluctuations based on different underlying components. The historical record of a digital asset is not only related to the duration of "creation" but also to the time of "determination." Since Ethereum undergoes a network upgrade approximately once a year, the updating and auditing of code takes a long time and, more importantly, requires developers' attention to rebuild its historical record. While this concept of probabilistic guarantees of code execution over time is specific to digital assets, it is undoubtedly crucial for gaining the trust of stakeholders.

Many argue that Bitcoin is currently the safest, most decentralized, and most robust digital currency, and any "improvement" requires trade-offs, so few other digital assets can surpass Bitcoin in terms of "currency product." While network effects are critical in the blockchain ecosystem, Bitcoin has a seemingly "unassailable" position as a monetary commodity, but this does not mean that other competing forms of currency cannot exist, especially for different markets, use cases, and communities. More specifically, there are use cases in the Bitcoin ecosystem that cannot be achieved on the Ethereum network, such as facilitating more complex transactions, giving it a unique, currency-like utility that should be included in comprehensive considerations. Although Ethereum is typically used to transfer value between addresses, its role as a user executing smart contract logic is where it differentiates itself as a token.

The physical and digital worlds seem to be converging. As we see from leading tech companies, an application that provides unique services to users can create network effects and demand. The widespread use of mainstream applications on Ethereum will naturally lead to increased demand for Ether, which is why this long-term trend may be one of the most compelling cases for viewing Ether as a potential alternative currency.

In fact, there have been some notable cases of Ethereum integration in the cryptocurrency and traditional finance sectors:

• MakerDAO purchased $500 million worth of Ether.
• The European Investment Bank issued bonds on the blockchain.
• A house sale was completed in the form of an NFT in the U.S.
• Franklin Templeton's money market fund uses Ethereum and Polygon to process transactions and record share ownership.

The integration of the Ethereum ecosystem with real-world assets has already begun. However, for the public to start transacting on Ethereum or competitive platforms, it may take years of improvements, regulatory clarity, education, and time to test. Therefore, until then, Ethereum may still remain a niche form of currency.

Moreover, regulation is the most controversial topic regarding how Ethereum's future may be shaped. Although it is a permissionless blockchain, many centralized exchanges holding and staking Ethereum are located in the U.S., meaning that any guidance provided to validators or investors within that jurisdiction could significantly impact valuations and network conditions. Recently, there have been multiple regulatory enforcement actions and the closure of crypto-related banks and Kraken's staking services in the U.S. Thus, regulatory risk is one of the most serious obstacles Ethereum may face in the short term.

Ethereum as a Store of Value

To qualify as a store of value, a token needs scarcity or a high stock-to-flow ratio. As of July 2023, Ethereum's stock-to-flow ratio is higher than Bitcoin's. Since The Merge, this dynamic has become a focal point, significantly reducing the issuance of Ether, as shown below.

We have elaborated on one of Bitcoin's core value propositions, which is its maximum fixed supply of 21 million Bitcoins, with a supply schedule that has not and is unlikely to change. Bitcoin's supply schedule is written into its code and enforced through social consensus and incentives among network participants. So what does Ethereum's supply schedule rely on? As mentioned above, Ethereum's issuance is less of a "plan" and more like a balance between a set of parameters. In reality, two variables determine Ethereum's total supply, making it difficult to assess future supply:

1. Issuance: The issuance of Ethereum is determined by the number of active validators and their performance. As the issuance of Ethereum increases with the total amount staked, the growth rate gradually decreases. Since Ethereum's issuance is linked to the amount staked, this part is less likely to experience drastic fluctuations. The Ethereum protocol has set limits on the number of validators that can enter and exit staking, aimed at ensuring the protocol's security and stabilizing the issuance rate over time.

2. Burning: Since Ethereum blocks can only perform a limited amount of computational work every 12 seconds, the Ethereum network needs to meet the demand for block space through burning. Burning is a highly unstable operation, making it difficult to accurately predict the future supply of Ether. Burning acts as an incentive pendulum, rarely remaining the same from one block to another. The protocol specifies the Gas Fee that each block should contain. If a block's Gas is above or below the target value, it will lead to a corresponding nonlinear adjustment of the base fee for the next block. When on-chain transactions are very active, it can lead to extreme fluctuations in transaction fees. Therefore, it also serves as a security mechanism designed to prevent malicious actors from flooding the network with spam.

In summary, Ethereum's supply is not based on a fixed plan, and the two components of its monetary policy are likely to change continuously. However, based on Ethereum's current structure, it can be determined that its total supply will allow for an annual inflation rate of about 1.5% at most. This assumes that 100% of the current supply is staked, with no burning, meaning no transactions occur on Ethereum. As shown, maintaining Ethereum's normal issuance or keeping inflation at a low level does not require a large amount of burning. In fact, a higher burning rate typically leads to net contraction or a decrease in the total supply of Ethereum.

It has been suggested that Ethereum's future supply is related to the number of active validators (issuance) and the demand for transaction execution (burning), the latter of which is relatively unpredictable in the longer term. Additionally, upgrades to Ethereum may directly affect the amount of burning or issuance on the base layer, so current metrics may still not effectively predict future supply levels. For example, the Shanghai/Capella upgrade reduced risks associated with staking, which may increase total issuance due to higher staking participation rates. On the other hand, data availability expansions (upgrades aimed at increasing transaction throughput) and the maturity of Layer 2, which are independent blockchains built on Ethereum, may unpredictably alter the supply-demand dynamics of burning.

Furthermore, independent Layer 1 public chains with finality and native tokens still lack the same level of iteration and development time as Ethereum. As dApps migrate to other Layer 1s and inherit from other blockchains, investors should closely monitor the transfer of users and traffic. For NFTs or blockchain games, users may not require the high levels of decentralization and security provided by Ethereum's base layer.

If users are willing to sacrifice certain components of the impossible triangle for scalability, then some user-driven value is likely to accumulate outside of Ethereum. Since the economics of smart contract platforms may inherently be multichain, investors should consider determining which narratives will persist on the Ethereum chain and which will exist outside of it.

Another key factor that distinguishes Ethereum from other on-chain assets is the future upgrades to the supply schedule itself. Parts of the roadmap, such as EIP-1559 and MEV Burn, explicitly indicate the potential impact of burning on the supply mechanism. While the exact effects of these upgrades remain unclear, regardless of the outcome, Ethereum has formed a stark contrast in value proposition compared to Bitcoin, which has a supply schedule that will not change in the long term.

In conclusion, while many viewpoints suggest that Ethereum will be the next "supermodel currency," it is still premature to reach this conclusion under Ethereum's currently unstable supply model. While the usage of the Ethereum platform can transfer value to token holders, the so-called value for Ethereum, which is still in its early life, is a subjective judgment derived from users.

ETH as a Means of Payment

ETH is used as a means of payment, but these payments are limited to digital native assets.

Most Ethereum transaction events are typically finalized within 13 minutes, making Ethereum faster than Bitcoin's six blocks (one hour) probabilistic guarantee settlement. The finality of Ethereum means that a transaction has been included in a block, and that block cannot be changed without burning a significant amount of ETH. This mechanism makes Ethereum an attractive payment asset in terms of final settlement time, but it still needs to overcome barriers to payment usage, largely related to user experience and persistently high transfer fees.

Note: Burning refers to the destruction of a portion of a validator's stake, forcibly removing the validator from the network. This occurs in response to dishonest proposals or block proofs on the network.

Since The Merge, NFT payments have consumed the second-highest network fees, only behind DeFi-related transactions. NFTs are priced in ETH, which inherently experiences price fluctuations. For sellers selling NFTs for 1 ETH, this amount represents a significant difference in purchasing power, depending on the market price of ETH. This discrepancy diminishes the transaction experience (primarily for sellers) and is a common reference case in many digital asset claim payment use cases.

Although Ethereum has a wide range of transaction scenarios, direct value transfers account for a large portion of network usage; since The Merge, peer-to-peer transfers of ETH rank third in consumption. The biggest issue affecting Ethereum's payment use cases is the volatility of transaction fees. Ethereum's dynamic fee model leads to fees that can rise quickly and jump dramatically. The variable pricing of transactions may limit payment use cases, and an unreliable low-cost value transfer network diminishes the user experience on Ethereum.

Users often face the decision of whether to transact at the current high cost or wait until network activity subsides. This variable forces developers to be creative in maximizing transaction speed and efficiency to meet user preferences.

Moreover, if more real-world assets enter the blockchain, payments for these assets may use ETH, stablecoins, or other tokens. If these innovations are combined with the lower fees offered by Layer 2 platforms, it could create an attractive future for payment opportunities on the Ethereum network.

Network data shows that ETH is used as a means of payment; however, due to fees and price fluctuations potentially leading to a poor user experience, Ethereum's potential as a payment network has not yet fully peaked.

As Ethereum developers seek to optimize the network for future use cases, this concept will permeate the analysis of subsequent markets. Whether ETH becomes a mainstream payment method may largely depend on how quickly the community can address barriers such as usability, association with real-world assets, and options for secure, low-fee transfers.

Evaluating ETH from a Demand Perspective

As applications on the Ethereum network require ETH for payments, an increase in the adoption of the Ethereum network may lead to an increase in ETH prices, resulting in value increases for Ethereum token holders due to supply and demand mechanisms. Additionally, as Ethereum's scaling progresses, investors should consider re-evaluating the demand-side model. Understanding where new users come from and the trends in use cases they seek will impact investments.

The following diagram illustrates the process of value accumulation on the base layer (Optimism), where Layer 2 blockchains complete transactions and ultimately convert network usage into ETH value. Arbitrum is built on the network's base layer, handling transaction execution and relying on the base layer for security and transaction confirmation.

Despite being in a bear market, Ethereum's daily transaction volume remains stable at around 1 million, while the price of ETH has dropped by 52% since early 2022. Additionally, Layer 2 transaction volumes have increased, while Layer 1 transaction volumes have remained unchanged. This may indicate a degree of sticky demand on the base layer, with new demand originating from Layer 2. These signs may suggest that even as Layer 2 becomes more mainstream, value will continue to accumulate on the base layer.

Measuring ETH's demand as a monetary asset can be challenging. Metcalfe's Law is a popular economic model that illustrates the relationship between address growth, representing the relationship between Bitcoin demand and price. Compared to Bitcoin, we find a weaker correlation between ETH demand and price.

In summary, if Bitcoin is primarily understood as a sentimental monetary commodity, we reasonably expect a stronger relationship between asset demand measured by address count and price. For ETH, this weaker relationship may imply that its value is derived from other sources, such as network usage, rather than simply the demand for holding the asset itself.

Risks of the Demand-Side Model

1. The core value of Ethereum comes from the usability layer, and the adoption model based on addresses rather than transactions, quantity, or usage does not effectively measure these relationships.

2. While data shows a relationship between address growth and ETH price, there is no guarantee that this relationship will persist in the future.

3. This model is merely a demand-side model, and as discussed earlier, Ethereum's supply schedule may change in the future. Therefore, even if demand increases, if supply also increases, the price of ETH may not change or may even decline.

Investment Thesis 2: ETH as a Yield Asset

How the ETH Yield Model Works

Since the implementation of The Merge, ETH has undergone fundamental changes. This not only significantly reduced the network's energy consumption but also provided yield opportunities for those willing to lock ETH in the consensus layer. This shift involves Proof of Stake, a significant turning point in Ethereum's security model.

Some may argue that compared to the Proof of Work mechanism, Proof of Stake maintains or even enhances network security at a lower cost by penalizing validator misconduct. Validators contribute resources to the network and fulfill assigned duties to help Ethereum achieve consensus, thus earning economic rewards. Below is a brief description of various validator responsibilities and rewards:

Attestations: Each validator submits a proof or vote once per epoch and proposes and validates blocks within 32 time slots. These votes contain key data points that each validator believes represent the correct content (block) for each epoch. By aggregating these votes and applying certain rules to determine their validity, the network can reach consensus on the blockchain and provide economic benefits. The cost of Ethereum's economic finality (i.e., reverting to the finalized chain) accounts for at least one-third of the total staked ETH. As of July 2023, this value exceeds $15 billion. This security threshold increases with the value of ETH and the amount of staked ETH.

Block Proposal Rewards: Each validator proposes blocks relatively infrequently, as only one person performs this task per time slot, resulting in 32 proposers per epoch. The selection of validators is pseudo-random and related to their effective balance. The effective balance refers to the amount of ETH that affects reward accumulation. The more ETH held, the greater the potential returns. The maximum effective balance for all validators is 32 ETH, and any balance exceeding this amount does not increase potential rewards.

In addition to the value received from the protocol, proposing validators also receive fees paid by users for including their transactions in blocks, as well as MEV (Maximum Extractable Value), a mechanism by which validators or others exclude certain transactions from blocks based on sorting, inclusion, and information extraction value. Although potential rewards from the protocol depend on the number of active validators, additional income from fees and MEV is directly related to network congestion and activity.

Attestation and block proposal rewards are incentives for minting new ETH from the protocol. These rewards can be viewed as incentives for the protocol to maintain its security. The Proof of Stake model minimizes the security budget by introducing penalties and significantly reducing deductions. The basic reward equals the average validator reward per epoch, and the calculation of potential protocol rewards can be expressed using the following formula:

Basic Reward = Effective Validator Balance * (16 * sqrt(Total Staked ETH))

The key point of this payment structure is that the basic reward is proportional to the validator's effective balance, incentivizing validators to stake up to 32 ETH, and is inversely proportional to the number of network validators. As the number of validators increases, total issuance also increases, but the average reward per validator decreases. The fundamental principle of this issuance model is to ensure sufficient validator participation, as a too-small validator set may lead to high issuance events, while also ensuring that unexpected high issuance events do not occur when many validators participate.

This specific token economics allows ETH to maintain actual yields. Since The Merge on September 15, 2022, as of July 2023, 53% of validator income has come from this mechanism. Below are some other forms of yield that are not paid by the protocol but by users, providing an interesting connection between network usage and validators.

MEV (Maximum Extractable Value):

MEV directly comes from user transactions, as increased user activity often creates more opportunities for profit from such activities. Due to the various uses of Ethereum, value can be extracted from user transactions in multiple ways. Flashbots (an organization dedicated to reducing the centralization effects of MEV) states that the most common forms of MEV typically come from arbitrage and liquidation, which thrive in highly volatile environments, such as in November 2022.

MEV-Boost is a program designed to outsource the role of block building to specialized participants so that MEV-related rewards can be shared with the entire validator set. Since The Merge, most validators have been using this program. On November 7, 2022, validators using MEV-Boost and Flashbots relays had an average reward of 0.1 ETH per block. Following the multi-level liquidations and intense network activity after that day, the average block reward surged nearly 700% to 0.68 ETH per block by November 9, 2022. This sharp increase indicates a close relationship between network congestion and validator earnings. During periods of high volatility, on-chain activity spikes, incentivizing users to accelerate execution with higher fees and increasing the amount of MEV that can be captured.

Although as of July 2023, the relationship between MEV opportunities and validator earnings is strong, many different applications, organizations, and individuals within the Ethereum community are exploring ways to change how MEV is managed. As proposed by Flashbots in their recently released MEV-Share, many of these capture efforts focus on returning MEV to the users who generated it.

Other solutions include burning user-generated MEV or encrypting transaction data so that MEV becomes more valuable and difficult to capture. Regardless of which route the community chooses, it could have a significant impact on MEV-related earnings, which have accounted for about 24% of validator income since The Merge as of July 2023.

Unlike application-specific chains, Ethereum has a wide variety of available MEV types, which may continue to grow as functionality increases. This disparity suggests that a single solution may not be sufficient to reduce all MEV.

Tips:

Since the introduction of EIP-1559 in Ethereum's "London" upgrade in 2021, the fee market for Ethereum has undergone significant changes. Before the upgrade, Proof of Work miners received all Gas fees from any transactions included in the blocks they mined. Due to changes in the fee market, the network now has two different types of fees: base fees and priority fees (tips). All fees are still paid by users attempting to execute transactions; EIP-1559 affects the distribution of these fees after payment.

Validators only collect priority fees, not all fees paid by users. The base fee is burned or removed from circulation. Tips can incentivize validators to prioritize including transactions in their blocks; otherwise, validators may pack empty blocks (which is economically more viable). For users who urgently need to execute transactions, higher tips than competing transactions in the mempool will incentivize validators to prioritize including them.

Note: The mempool is equivalent to a list of pending transactions that includes upcoming block transaction events.

While MEV plays a significant role in determining which transactions are included in each block, tips still serve as an incentive mechanism, as validators decide which transactions to include in their blocks based on tips. Since the transition to Proof of Stake, as of July 2023, tips have accounted for 22% of all validator income.

ETH Valuation Based on "Discounted Cash Flow" Model:

As the network transitions to Proof of Stake, it becomes easier to derive the value of ETH through modeling calculations. The demand for block space can be measured through transaction fees. These fees are either burned or transferred to validators, thereby accumulating value for ETH holders.

Therefore, in the long run, the growth of fees and Ether value should be intrinsically related. The increase in use cases for Ethereum creates greater demand for block space, leading to higher transaction fees and validator earnings.

We will use a simple discounted cash flow model to demonstrate this relationship. The results of this model vary significantly based on growth assumptions and discount rates, similar to high-growth cash flow models. The purpose of constructing such a model is not to provide an estimate of Ethereum's fair value but to describe the relationship between network usage and value accumulation. Additionally, it can show further modeling analysis of ETH value based on estimates of future fees paid to Ethereum stakeholders.

The chart below displays the average daily fees paid in USD for Ethereum since the implementation of EIP-1559 in August 2021. This chart is calculated using a two-stage discounted cash flow model, where the initial stage sees adoption and fees continue to grow significantly, followed by a decline in the growth rate of fees, suggesting that regardless of the utility gained by Ethereum users, scaling may lower the upper limit of fee growth.

This represents the assumed growth rates for all years after 2030. Such results are common when predicting the future of high-growth companies. It is important to note that discounted cash flow models are only theoretically useful.

The following diagram further describes the sensitivity model, illustrating the relationship between modeled prices and assumed growth rates and discount rates. Understanding the relationship between ETH growth and users' willingness to pay fees is extremely important. However, relying on slight changes in future growth assumptions, highly sensitive models may be less useful.

Risks of the Discounted Cash Flow Model:

If scaling technologies reduce fee income, the relationship between ETH and the value it provides to network users may weaken unless transaction volumes increase to offset the compressed profits.

Modeling the future of any growth-sensitive asset and applying relevant discount rates is highly subjective, so valuations may only be theoretically useful.

The Ethereum community's efforts to minimize the negative impacts of MEV will improve user experience, which may lower yields. This model has not yet adjusted for or considered this, along with other secondary details that may have an impact.

Conclusion

Undoubtedly, Ethereum is a leading blockchain technology platform that enables developers to build decentralized applications. Due to Ethereum's superior programmability, many of these applications can accomplish tasks that cannot be completed on the Bitcoin network. This has allowed the Ethereum ecosystem to host some of the largest and most active applications in the crypto space, and ETH has maintained its position as the second-largest market cap asset for years (after Bitcoin).

However, the question investors raise is, "Will the increase in developer and application activity translate into ETH value?" We believe that current theories and data suggest that increased activity on the Ethereum network drives demand for block space, which in turn generates cash flow for token holders. But it is equally clear that these different drivers are complex, nuanced, and will change over time with the emergence of various protocol upgrades and scaling developments (such as Layer 2), and may change again in the future.