Fidelity: Feasibility study on Ethereum as a digital asset and potential income-generating asset

Author: Fidelity Digital Assets Research Compiled by: Cookies, bayemon.eth, ChainCatcher

Summary

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

Some may ask, how does utility translate into the value of an Ethereum token? In other words, why would an investor buy and hold an Ethereum token instead of just using it to interact with the Ethereum network? In our last article introducing the Ethereum network, we briefly considered how or why Ethereum tokens generate value. In this article, we will explore this issue in more depth from an investment perspective and briefly touch on some of the technical issues.

Main points of this article:

• Ethereum can be understood as a technology platform that uses ETH as a payment method
• Ethereum’s perceived value and network applications are closely tied to supply and demand dynamics, which have changed dramatically since The Merge.
• Ethereum's overall platform usage may pass value to token holders, i.e. token value increases with Ethereum network and platform usage.
• The investment philosophy of holding Ethereum is similar to that of Bitcoin, which is to hold it as an emerging form of currency
• However, due to the characteristics and network effects of Bitcoin, it is impossible for other digital assets to surpass Bitcoin and become a monetary commodity.
• Still, value is subjective, which does not mean that other competing forms of money, including Ethereum, cannot exist, especially in specific markets, use cases, and communities.
• We will examine Ethereum's ability to fulfill the two main functions of money: a store of value and a means of payment. *Ethereum is not currently a full-fledged network and is therefore expected to be upgraded every year, which introduces recurring technical risks and unknowns, reducing its prospects. These unknowns dampen ethereum’s prospects as a store of value asset.
• While Ethereum can be used for a variety of payment purposes, the instability of its fees remains a barrier to widespread adoption.
• We looked at demand models for Ethereum but found that address growth (a measure of adoption) has a small correlation with price. Compared to Bitcoin, Ethereum’s address growth (a measure of adoption) has less of a correlation with price.
• After Ethereum changed from PoW to PoS, token holders can now earn profits, part of which comes from increased network usage. We'll look at the sources of this yield and the various drivers and risks.
• As an income-producing asset, the value of Ethereum can be tested through a discounted cash flow model. We constructed a simple model to illustrate the assumptions driving the model

Ethereum and Ether

**There is a relationship between a digital asset network and its native token, but the success between the two is not always completely correlated. **

Success is not always completely correlated. In some cases, the network can provide utility to users, settling a certain number of complex transactions per day, but this will not provide incremental value to the original token holders. Other networks may have a closer connection between network usage and token value. A common term used to describe the relationship between network design and token value is tokenomics, which helps explain how the design of a network or application creates economic value for token holders.

The Ethereum network has undergone dramatic changes over the past few years, and these changes have also resulted in changes to the economics of Ethereum tokens. In August 2021, Ethereum Proposal 1559 (EIP-1559) introduced a mechanism to destroy part of transaction fees, the so-called base fee. Destroying an ether equals destroying it, so executing a transaction on Ethereum takes the ether out of circulation.

Additionally, the transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS) in September 2022 reduces the network token issuance rate and allows entities to earn revenue in the form of tips, issuance, and maximum extractable value (MEV). Ethereum’s previous upgrades essentially changed its token economics, as well as the perception of the relationship between the Ethereum network and its tokens.

Token Economics: Ether Value Accumulation

There are generally three ways in which Ether's token economic model converts usage into value. When transacting on Ethereum, all users are required to pay a base fee, a priority fee (tip), and generate additional value for other participants through MEV (Maximum Extractable Value), which is what validators do during the block production process The maximum value that can be gained by including, excluding, or changing the order of transactions. The base fee is paid in Ether, which is burned when included in a block (transaction bundle), thereby reducing the circulating supply of Ethereum, and the priority fee is paid to validators, the ones responsible for updating the public ledger and maintaining consensus. person or entity. When a new block is generated, validators who receive benefits will include the highest priority transactions due to the existence of priority transaction fees. Finally, potential MEV opportunities (often arbitrage) are submitted by different users, with most of the value passed to validators through the highly competitive MEV market in its current state.

The value accumulation mechanism can be seen as the network’s “income” being used for different purposes. First, the burning of base fees puts 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 non-linear, increased usage of the platform means more burns and higher rewards for validators.

Investment thesis 1: Become a widely accepted digital currency

The prevailing view that Ethereum is best understood as an emerging monetary product raises the question of whether Ethereum-native tokens can also be considered money. To put it simply, Ethereum may face more challenges in becoming a widely accepted form of currency. In comparison, Bitcoin has more advantages. As shown below, Ethereum shares similar properties with Bitcoin and other currencies in many ways; however, it differs from Bitcoin in terms of scarcity and history. Technically, Ether has unlimited supply parameters that are maintained within a range based on the number of validators and burns. While these parameters are tightly controlled by the Ethereum network, they are not equivalent to a fixed supply schedule and may fluctuate unpredictably in different directions depending on the underlying components. The history of a digital asset is not only related to how long it was "created" but also when it was "determined." Since Ethereum undergoes a network upgrade about once a year, it takes a long time to update and audit the code, and more importantly, it requires the attention of developers to rebuild its historical records. While this concept of probabilistic guarantees of code execution over time is specific to digital assets, it is certainly important for gaining stakeholder trust.

There are many opinions that Bitcoin is by far the safest, most decentralized, and most stable digital currency. Any "improvement" needs to be weighed, so there are few other digital assets that can surpass Bitcoin in terms of "currency products." While network effects are crucial in the blockchain ecosystem, and Bitcoin has a seemingly “unsurpassable” status as a monetary commodity in this regard, this does not mean that other competing forms of currency cannot exist, especially for different markets, use cases and communities. More specifically, there are no use cases in the Bitcoin ecosystem that can be achieved on the Ethereum network, such as facilitating more complex transactions, giving it a unique, currency-like utility, and these should be included in the comprehensive consideration. Inside. 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 appear to be converging. As we've seen from leading tech companies, an app that provides a unique service to users creates network effects and demand. Widespread use of mainstream applications on Ethereum will naturally lead to increased demand for Ethereum, which is why this long-term trend may be one of the most attractive cases for considering Ethereum as a potential alternative currency. .

In fact, there are already some high-profile Ethereum integration cases in the cryptocurrency and traditional finance sectors:

• MakerDAO buys $500 million in Ethereum
• European Investment Bank issues bonds on blockchain
• The United States completed the sale of houses in the form of NFT
• Franklin Templeton Money Market Fund uses Ethereum and Polygon to process transactions and record share ownership

The integration of the Ethereum ecosystem and real assets has already begun. However, getting the masses to start transacting on Ethereum or competing platforms will likely take years of refinement, regulatory clarity, education, and the test of time. So, until then, Ethereum may remain a niche form of money.

Additionally, regulation is the most contentious topic regarding how the future of Ethereum might be shaped. Although it is a permissionless blockchain, many of the centralized exchanges holding and staking Ethereum are based in the United States, meaning any guidance for validators or investors in that jurisdiction may be Significantly affects valuation and network conditions. There have been multiple recent regulatory enforcement actions and the closure of cryptocurrency-related banks and Kraken’s staking services in the United States. As such, regulatory risk is one of the most serious hurdles Ethereum could 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 inventory/circulation ratio. As of July 2023, Ethereum’s inventory-to-flow ratio is higher than Bitcoin’s. This dynamic has come into focus since The Merge, significantly reducing the amount of ether issued, as shown below.

We have elaborated on one of Bitcoin's core value propositions, namely that its maximum fixed supply is 21 million BTC, and the supply schedule has not and is unlikely to change. Bitcoin's supply schedule is codified in its code and enforced through social consensus and incentives among network participants. So what does Ethereum's supply plan rely on? As mentioned above, the Ethereum launch is not so much a "plan" as it is a balance between a set set of parameters. In practice, there are two variables that determine the total supply of Ethereum, making it difficult to assess future supply:

1. Issuance: Ethereum issuance is determined by the number of active validators and their performance. As Ethereum issuance increases with total pledged volume, the growth rate gradually decreases. Since the issuance of Ethereum is linked to the pledged amount, this part is not prone to violent fluctuations. The Ethereum protocol has set limits on the number of validators that can enter and exit staking, designed to ensure the security of the protocol and that issuance rates are stable over time.

2 Destruction: Since Ethereum blocks can only perform a limited amount of computational work every 12 seconds, the Ethereum network needs to be destroyed to meet the requirements for block space. Burning is a very unstable operation and therefore makes it impossible to accurately predict the future supply of ether. Burning acts as an incentive pendulum and is rarely the same from one block to another. The protocol specifies the Gas Fee that each block should contain. If a block's Gas is higher or lower than the target value, it will cause the next block's base fee to adjust non-linearly accordingly. When on-chain transactions are very active, it can cause transaction fees to fluctuate wildly. Therefore, it also acts as a security mechanism designed to prevent malicious actors from spamming the network without restrictions.

In summary, Ethereum’s supply is not based on a fixed plan, and both components of its monetary policy are likely to be constantly changing. However, what is certain based on the current structure of Ethereum is that the total supply of Ethereum will allow annual inflation of about 1.5% at best. This assumes that 100% of the current supply is staked and not burned, meaning no transactions take place on Ethereum. As shown in the figure, maintaining normal issuance of Ethereum or keeping inflation low does not require a large amount of burning activity. In fact, higher burn rates often result in a net squeeze, or decrease in the total Ethereum supply.

It has been suggested that the future supply of Ethereum is related to the number of active validators (issuance) and demand for transaction execution (burn), the latter of which is relatively unpredictable in the longer term. Additionally, upgrades to Ethereum may directly affect the number of burns or issuances on the base layer, so current metrics still cannot effectively predict future supply levels. For example, the Shanghai/Capella upgrade reduces the risks associated with staking and may increase total issuance due to higher staking participation rates. On the other hand, data availability expansion (upgrades designed to increase transaction throughput) and the maturation of Layer 2, the independent blockchain built on top of Ethereum, may change the supply and demand dynamics of burns in unpredictable ways.

In addition, the independent Layer 1 public chain with final rights and native tokens still does not have the same iteration and development time as Ethereum. As dApps migrate to other Layer 1 and inherit with other blockchains, investors should pay close attention to the transfer of users and traffic. For NFT or chain games, users may not need the high level of decentralization and security provided by the Ethereum base layer.

If users are willing to sacrifice certain components of the Impossible Triangle for scalability, then some user-driven value will likely accrue outside of Ethereum. Since smart contract platform economies are likely to be inherently multi-chain, investors should consider determining which narratives will persist on the Ethereum chain and which will exist beyond Ethereum.

Another key factor that differentiates Ethereum from other on-chain assets is future upgrades to the supply plan itself. Sections such as EIP -1559 and MEV Burn in the roadmap clearly point out the impact that destruction may have on supply methods. While it’s unclear what the exact impact of these upgrades may be, regardless of the outcome, Ethereum already stands in stark contrast to Bitcoin on a value proposition level, which will not change its supply plan in the long term.

In short, although there are many opinions that Ethereum will be the next "super model currency", it is still too early to reach this conclusion under the current unstable supply model of Ethereum. **Although the usage of the Ethereum platform can transfer value to token holders, for Ethereum, which is still in its early stages of life, the so-called value is a subjective judgment derived from users. **

ETH as payment method

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

Most Ethereum transaction events are typically finalized within 13 minutes, making Ethereum faster than Bitcoin’s six block (one hour) probabilistically guaranteed settlement. Ethereum's finality means that transactions are included in a block, which cannot be changed without slashing a large amount of ETH. This mechanism makes Ethereum an attractive payment asset in terms of final settlement time, but there are still hurdles to overcome in terms of payment usage. Much of the take-off has to do with user experience and persistently high transfer fees.

Note: Slashing refers to destroying part of the validator's stake and forcing the validator to be removed from the network. This happens when the network responds to dishonest proposals or block proofs.

NFT payments consume the second-highest network fees since The Merge, behind only DeFi-related transactions. NFTs are denominated in ETH, which inherently experience price fluctuations. For sellers selling NFTs for 1 ETH, this amount represents a huge difference in purchasing power, depending on the market price of ETH. This discrepancy degrades the transaction experience (mainly on the seller side) and is a common cited case in many digital asset claim payment use cases.

Although Ethereum has a wide range of transaction scenarios, direct transfers of value account for a large portion of network usage; since the merger, ETH consumed by peer-to-peer transfers ranks third on the ranking list. The biggest issue affecting Ethereum payment use cases is the volatility of transaction fees. Ethereum's dynamic fee model makes fees easy to rise quickly and by leaps and bounds. Variable prices for transactions can limit payment use cases, and therefore, an unreliable cheap value transfer network detracts from the Ethereum user experience.

Users often have to make the decision between trading at current high costs or waiting until network activity subsides. This variable forces developers to get creative in the hope of maximizing transaction speed and efficiency that meets user preferences.

Additionally, if more real-world assets enter the blockchain, payments for these assets may be made using 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, although it is used for native digital asset payments. However, Ethereum’s potential as a payment network has not yet fully reached its peak due to fees and price fluctuations that can lead to a poor user experience.

This concept will be used throughout subsequent market analysis as Ethereum developers seek to optimize the network for future use cases. Whether ETH becomes a mainstream payment method will likely depend heavily on how quickly the community can address obstacles such as ease of use, linking real-world assets, and options for secure, low-fee transfers.

Evaluate ETH from a demand perspective

Since applications on the Ethereum network require ETH for payment, increased adoption of the Ethereum network may result in an increase in the price of ETH and an increase in value for Ethereum token holders due to the supply and demand mechanism. Additionally, investors should consider revisiting the demand-side model as Ethereum scaling progresses. Determine where new users are coming from and the use case trends they seek to influence investment.

The figure below shows the process of value accumulation (Optimism) in the base layer. The Layer 2 blockchain completes transactions and ultimately converts network usage into the value of ETH. Arbitrum is built on the base layer of the network, handles transaction execution and relies on the base layer. Provides security and transaction confirmation.

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

Measuring demand for ETH as a monetary asset can be difficult. Metcalfe's Law is a popular economic model that shows the relationship between address growth and represents the relationship between Bitcoin demand and price. Compared to Bitcoin, we find that ETH demand is less correlated with price.

In summary, if Bitcoin is understood primarily as a sentimental monetary commodity, then we would reasonably expect a stronger relationship between demand for an asset, measured by the number of addresses, and its price. For ETH, this weaker relationship may mean 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 Ethereum’s core value comes from the availability layer, through addresses rather than transactions, volume, or usage, and adoption models do not effectively measure these relationships.

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

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

Investment thesis 2: ETH as an income asset

How the ETH revenue model works

ETH has undergone fundamental changes since the merger was implemented. Not only does this significantly reduce the energy consumption of the network, but it also provides revenue opportunities for those users who are willing to lock ETH on the consensus layer. This shift involves proof-of-stake, a major turning point in Ethereum’s security model.

Some may argue that, compared to the proof-of-work mechanism, proof-of-stake maintains or even improves the security of the network at a lower cost by penalizing validators for misbehavior. Validators contribute resources to the network and perform assigned duties to help Ethereum achieve consensus, and are economically rewarded for doing so. Below is a brief description of the various validator responsibilities and rewards:

Attestations: Each validator submits an attestation or vote in each period and proposes and verifies blocks within 32 time periods. These votes contain key data points of what each validator believes is correct for each epoch (block). These votes are combined and some rules are imposed to determine the validity of the votes, allowing the network to reach consensus on the blockchain and provide economic benefits. The cost of Ethereum’s economic finality (i.e., returning to a finalized chain) is at least one-third of the total ETH staked. As of July 2023, this value exceeds $15 billion. This safety threshold increases with the value of ETH and the amount of ETH staked.

Block proposals: The frequency with which each validator proposes blocks is relatively low because only one person performs this task per time period, which is equivalent to 32 proposers per period. Validators are selected in a pseudo-random manner and are related to their effective balance. The effective balance refers to the amount of ETH that affects reward accumulation. The more ETH you hold, the greater your potential returns. The maximum valid balance for all validators is 32 ETH, any balance above this amount will not increase possible rewards.

In addition to the value received from the protocol, proposed validators receive fees paid by users for including their transactions in blocks, as well as MEV (Maximum Benefit Extraction), which is A mechanism for excluding certain transactions within a block based on the value of , inclusion, and information extraction. While potential rewards from the protocol depend on the number of active validators, additional revenue from fees and MEV is directly related to the congestion and activity of the network.

Proof validity and block proposal rewards are rewards 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 payment security budget by introducing penalties and significantly reducing deductions. The base reward is equal to the average validator reward per epoch, and the protocol’s potential reward can be calculated using the following formula:

Basic reward = valid validator balance* (16 * sqrt (total staked ETH))

The gist of this payment structure is that the base reward is proportional to the validator's effective balance, incentivizes validators to stake up to 32 ETH, and is inversely proportional to the number of network validators. As the number of validators increases, the total issuance increases, but the average reward per validator decreases. The rationale for this issuance model is to ensure that there are enough validators participating, as high issuance events can result if the set of validators is too small, while also ensuring that there are no unexpected high issuance events when many validators participate .

This specific token economics allows ETH to sustain real gains. Since the merger on September 15, 2022, as of July 2023, 53% of validators' income comes from this mechanism. Below are some other forms of rewards that are paid not by the protocol, but by users, which provide an interesting link between network usage and validators.

MEV (Maximum Withdrawal Earnings):

MEV comes directly from user transactions, as increased user activity generally creates more opportunities to profit from such activity. Because Ethereum has so many uses, there are many ways to extract value from user transactions. According to Flashbots, an organization working to reduce the centralization effect of MEV, the most common forms of MEV often come from arbitrage and liquidations, opportunities that thrive in highly volatile environments such as November 2022.

MEV-Boost, a scheme to outsource the role of building blocks to dedicated actors so that MEV-related rewards can be shared with the entire validator set, has been used by the majority of validators since the merger. Validators using MEV-Boost and Flashbots relay will receive an average reward of 0.1 ETH per block on November 7, 2022. Due to the multi-level liquidation and intense network activity that followed this day, the average block reward surged nearly 700% to 0.68 ETH per block by November 9, 2022. This dramatic increase demonstrates the strong relationship between network congestion and validator rewards. During times of high volatility, on-chain activity spikes, which incentivizes users to execute faster with higher fees and increases the amount of MEV that can be captured.

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

Other solutions include destroying user-created MEV or encrypting transaction data so that MEV is more valuable and becomes harder to capture. Whichever route the community chooses, it will likely have a significant impact on MEV-related earnings, which as of July 2023 have accounted for around 24% of validator revenue since the Ethereum merger.

Unlike application-specific chains, Ethereum has a large number of MEV types available, which will likely continue to grow as functionality increases. This difference suggests that one solution may not be sufficient to reduce all MEVs.

Tips:

Since the EIP-1559 launch of the Ethereum "London" upgrade in 2021, the Ethereum fee market has changed dramatically. 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 the user attempting to execute the transaction; EIP 1559 affects distribution after these fees are paid.

Validators only charge priority fees, not all fees paid by users. The base fee is burned or taken out of circulation. Tipping can incentivize validators to prioritize including transactions in their blocks, otherwise validators may pack empty blocks (which is more economically feasible). For users who urgently need to execute a transaction, a higher tip than other competing transactions in the mempool will incentivize validators to prioritize their inclusion.

Note: mempool (memory pool) is equivalent to a pending transaction list, including block transaction events that are about to be executed.

While MEV plays an important role in determining which transactions are included in each block, tips still serve as an incentive mechanism as validators use tips to decide which transactions to include in their blocks. Since the move to Proof of Stake, tips have accounted for 22% of all validator revenue by July 2023.

ETH valuation based on the “discounted cash flow” model:

As the network moves to proof-of-stake, it is easier for us to model and calculate the value of ETH. Demand for block space can be measured by transaction fees. These fees are either burned or transferred to validators, accumulating value for ETH holders.

Therefore, the growth in fees and ether value should be intrinsically correlated in the long run. The increase in Ethereum use cases has created a greater demand for block space, which has resulted in higher transaction fees and benefits for validators.

We will show this relationship using a simple discounted cash flow model. The results of such models vary widely depending on growth assumptions and discount rates, as is the case with high-growth cash flow models. The purpose of constructing such a model is not to provide an estimate of the fair value of Ethereum, but to describe the relationship between network usage and value accumulation. In addition, it can also display further modeling analysis of the value of ETH based on estimates of future fees paid to Ethereum stake holders.

The chart below shows the average daily fees paid on Ethereum in USD since the implementation of EIP-1559 in August 2021. The chart is calculated using a two-stage discounted cash flow model, with an initial period in which adoption and fees continue to grow significantly, followed by a decline in fee growth rates, so scaling is likely to lower the cap on fee growth regardless of the utility gained by Ethereum users.

This is the assumed growth rate for all years after 2030. This outcome is common when predicting the future of high-growth businesses. It is important to note that discounted cash flow models are only useful in theory.

The figure below uses a sensitivity model to further describe the responsiveness of the modeled price. The relationship between the model price and the assumed growth rate and discount rate. It is extremely important to understand the relationship between the growth of ETH and the willingness of users to pay fees. However, models that rely on highly sensitive to small changes in future growth assumptions may be less useful.

Risks of discounted cash flow model:

If scaling techniques cut into fee income, the relationship between ETH and the value it provides to network users could weaken unless transaction volume increases and offsets this compressed margin.

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

The ongoing efforts by the Ethereum community to minimize the negative impact of MEV will improve user experience, which may reduce production. This, along with other minor details that would have an impact, has not been adjusted or accounted for in the model.

in conclusion

There is no doubt that Ethereum is a leading blockchain technology platform that enables developers to build decentralized applications, many of which are able to do things that cannot be done on the Bitcoin network due to Ethereum’s superior programmability matter. This has allowed the Ethereum ecosystem to host the largest and most active applications in crypto, and ETH has maintained its second-largest market capitalization position (after Bitcoin) for many years.

However, the question investors are asking is, "Will increased developer and application activity translate into value for ETH?" In our view, current theory and data suggest that increased activity on the Ethereum network drives interest in blockspace demand, which in turn generates cash flow for token holders. But it's also clear that these different drivers are complex, subtle, and changing over time, with various protocol upgrades and extension developments like Layer 2, and likely again in the future change.