An Economic Analysis of Ethereum

Originally published: January 2021

The anonymous founder of bitcoin, satoshi nakamoto, solved the difficult problems associated with digital scarcity with a white paper in 2008 and launched bitcoin in 2009.

Reading: Lyn alden ethereum

After that invention, many other projects arose. There are now over 8,000 separate digital assets recognized by coinmarketcap.

Of these, ethereum is the second largest digital asset in the world by market capitalization after bitcoin, and enables a large ecosystem of other tokens as well. this gives you the only other important network effect in space.

Several people have asked my opinion on ethereum and why I don’t personally invest in it at the moment, even though I do invest in bitcoin.

The short answer is that while I’m bullish on a number of utility protocol use cases, I’m more cautious about betting on utility protocol tokens’ long-term price appreciation, as there isn’t necessarily a correlation. between the size of the overall ecosystem and the symbolic appreciation of any particular protocol.

so, here is my analysis of the ethereum protocol from the perspective of an investor (rather than a developer). was originally published on January 17, 2021, and after feedback from the ethereum developer community, including its founder, I finalized this slightly revised version a week later on January 25, 2021, with additional clarifications and details. /p>

ethereum 1.0 overview

ethereum was proposed by vitalik buterin in 2013, crowdfunded in 2014, and launched in 2015.

buterin, then about 19 years old, wanted to create a platform for decentralized applications. As he jokingly describes, the great game creator Blizzard nerfed his game character, sparking a multi-year search for a technological solution to rectify these kinds of terrible injustices:

I happily played world of warcraft during 2007-2010, but one blizzard day removed the damage component of my beloved warlock’s life siphon spell. I cried myself to sleep and that day I realized the horrors that centralized services can bring.

-buterina vitalik

describes finding bitcoin in 2011, and from there, a fire was lit.

Bitcoin uses a blockchain as its savings and payment technology, and the base layer is elegantly simple. it focuses on doing one thing exceptionally well: store and liquidate value. Additional layers can be built on top of this base layer, harnessing its ability to store and transmit value for more complex purposes. An example would be the lightning network, which extends the scalability of bitcoin for small payments.

ethereum, on the other hand, is an attempt by buterin and other developers to apply blockchain technology on a much broader scale within the base layer of the protocol. It has been marketed as a “world computer”, like an app store that is not controlled by any central entity. it’s like a distributed operating system, with a built-in token system, and programmers can use that ecosystem to create decentralized applications, or “dapps” for short, that often use their own tokens as well.

Ethereum’s underlying technology is based on smart contracts, which refer to agreements programmed into the blockchain that are activated when certain events occur. requires fractions of ethereum tokens to pay for a smart contract to be executed by miners on the blockchain.

sample applications

ethereum has been used to create a variety of projects. dappradar is one site among many that allows you to explore decentralized applications in all categories for ethereum and other smart contract protocols. defipulse allows you to track decentralized applications specifically for decentralized finance.

One of the most popular examples is stablecoins. An institution can collect fiat currency, store it as collateral, and launch tokens that run on the Ethereum protocol. these tokens are apparently backed 1-to-1 and are redeemable for fiat currency, and as such tend to maintain a stable price. these are basically dollars that make use of blockchain technology to transmit and store the tokens. people trust a third party in the sense that they have to trust that the custody and collateral backing the tokens is strong, but exchanging tokens between counterparties does not require permission. there are creations that also make decentralized stablecoins, like maker dai.

A suite of apps called “defi” for “decentralized finance” became very popular in 2019 and 2020. These apps replicate various banking functions, including ways to earn yield or borrow funds or trade tokens. one example is uniswap, a decentralized digital token exchange. Instead of a company acting as a central exchange, this is an exchange that is run in a decentralized manner based on blockchain software and incentive mechanisms. There are also other defi exchanges.

Many other protocols exist to provide liquidity to these exchanges, often referred to as “yield farming”. people can deposit tokens and collect interest, and other people can borrow tokens and pay interest, in a decentralized way. Because there are no manual/human credit checks or risk analysis for most of this, these systems often rely on an “over-collateralization” policy to secure loans.

Gaming and betting are also important areas of interest. a great early example was cryptokitties. the game allows users to buy, collect, breed and sell virtual cats. each tile represents a cat, and each one is unique. once generated, users own their cat tokens and no one can take or alter them, like blizzard did with buterin’s beloved warlock. this app was popular enough to slow down the ethereum network in late 2017.


source: cryptokitties

Nowadays, there are a number of games based on crypto. I’m not as much of a gamer as I used to be, but if I was, I could certainly see why blockchain can potentially add some value to the gaming ecosystem. the idea of ​​having items/pets/characters that the user can have regardless of the game publisher, and maybe even having those items/pets/characters recognized by other games, is certainly cool.

Of note, however, is the fact that many crypto games run on ethereum competitors, such as eos or tron.

Generally speaking, non-fungible tokens or “nfts” are an area of ​​recent demand and interest. Unlike a liquid, standardized unit, such as a bitcoin or ethereum token, a non-fungible token is a unique collectible item, such as a unique digital kitten or, more broadly, a piece of digital art, event tickets, or a company name. domain, which can be traded on a blockchain.

lastly, social networks and other systems are also projects that exist in the dapp ecosystem. In theory, the sky is the limit, but the question is whether or not they make enough economic sense.

Are decentralized applications really decentralized?

one of my concerns, when reviewing the most important use cases for decentralized applications, is that much of the use case is circular and speculative.

ethereum is widely used for decentralized crypto token exchanges, crypto stable coins that serve as liquid units of account for trading crypto tokens, and for lending and earning interest on crypto tokens, which is a practice that serves as a source of liquidity/loan for traders. of crypto tokens. To a lesser extent, it is also used for playful ways to earn or trade various crypto tokens.

so, it’s a big operating system powered by crypto tokens, for the purpose of moving… crypto tokens.

A healthy banking system in the real world would consist of people depositing money and banks making various loans for mortgages and business financing, to generate real world profit.

a banking system based on speculation, on the other hand, would consist of a group of banks that take deposit money and then lend it to speculators in the nearby stock market, along with technology providers that make this easier , and then what those speculators are trading primarily in those bank stocks, those tech company stocks, and stock market stocks, resulting in a big circular speculative party. the biggest use case so far for ethereum is a decentralized version of that speculation-based circular system.

There are games that are fun and collectible on their own, but for the most part, ethereum these days is mostly about decentralized finance and speculative trading.

In fact, it can be argued that the main reason why some of these decentralized finance applications, such as exchanges and yield farming techniques, have become popular compared to their more centralized competitors, is that they avoid know your customer “kyc” regulations.

Governments try to enforce kyc checkpoints on regulated exchanges and custodians, so they can track who buys and sells crypto tokens. they can do analytics on public blockchains but for them to be able to enforce tax fraud or other demands they want to be able to tie blockchain transactions to specific people by having kyc gateways at both entry and exit points as possible.

decentralized applications make it a bit more difficult and of course are more attractive to users who want to preserve their privacy. Increases in government surveillance in recent decades have been a key catalyst for the development of privacy technology or off-net transactions. There is a common saying that if cash were invented today it would be illegal as it is hard for the government to trace and they would not like it.

if centralized crypto exchanges and centralized crypto banks are subject to kyc rules, and decentralized crypto exchanges and decentralized crypto banks are not, then of course we should expect some growth in decentralized non-kyc versions, unless or until there is some regulation. repress them.

It’s more expensive to run lines of code on ethereum than, say, amazon web services. there are some games or services that make specific use of blockchain technology, such as enforcing digital ownership of non-fungible tokens (for example, depicting a unique digital cat or a piece of digital art), but other than that, many of them they are replicating services, like crypto exchanges or lenders, that work just as well without using a blockchain. therefore much of the growth seems to bypass kyc, to become permissionless.

The problem, however, is that the ecosystem is not yet as decentralized as expected and has many attack surfaces in the event of a regulatory crackdown.

third party ethereum node operators

bitcoin has been designed to make running a full node relatively small. in fact, that was at the heart of some of bitcoin’s infamous “fork wars” in 2017, and the easy-to-run core node version of bitcoin has so far won over its hard forks which increased block size and lo made it more difficult. to run a full node in exchange for increased network performance.

This works well for bitcoin because at the base layer, it focuses on doing one simple thing very well: storing and transmitting value. it’s an elegantly simple blockchain by design.

ethereum, being more complex and with more targets in the base layer, has a more complicated node situation, and dapps would be significantly more difficult to use if people didn’t have access to third-party node providers.

Since at least 2018, people have been pointing out that the ethereum dapp ecosystem has relied heavily on large-scale third-party node operators like infura. here is an article from December 2018, for example. that situation is still strong. and ironically, infura uses amazon web services, so there are two layers of centralization.

this is how infura describes its offer:


And this is how alchemy, another third party node operator, describes their offering:


applications running on ethereum are more decentralized than normal applications on other platforms but if a large part of what they are doing is circumventing kyc regulations and the government decides to crack down on these practices then they have enough centralized attack surfaces to chase. governments could ban cloud providers from hosting ethereum nodes, and could go after these companies that offer large-scale node services. they may not necessarily bring down ethereum itself, but they may make dapps more difficult to use and thus threaten the use case of the protocol.

If the government were to crack down on third party node services for ethereum, there would be a scramble among users to find ways to efficiently access their dapps without those centralized third parties.

In an August 2020 episode of his podcast, peter mccormack asked vitalik buter: “how dependent is ethereum on infura?”

buterin replied:

so first of all i think the ethereum network doesn’t depend on infura. like if infura died tomorrow you know the ethereum network would still be working and everyone who has an ethereum full node or ethereum light node would still be working normally.

Ethereum applications would definitely be much more difficult to use, although at the same time it is possible to use ethereum applications without relying on infura.

Like, I think in metamask it’s possible to smooth the endpoint to a local node and there is an ethereum light client like you can run geth light, and some of the other implementations also have lightmodes, which also do the same kind of thing. of block header verification that bitcoin does and in fact at ethereum we even put a lot of effort into making light clients more powerful. so for example ethereum has this concept called a state tree where instead of just committing to transactions, we commit to account balances. and so, given a block, like given a header of a block, even this little piece of data that’s at the top of a block, you can create a very short proof that proves cryptographically that you know what the balance is for a particular account. /p>

and definitely these are things that we can try to do better and there are very active efforts to try to do better at this. like, there’s a lot of efforts going on, you know, trying to create a more decentralized backend for something like metamask, for example. like if you want you could definitely connect it to your full node or even your light node.

During an October 2020 follow up on the no-bank pro-ethereum channel, buterin gave more context on this topic:

and there are different levels of validation that you can have, correct. so, for example, in a sharding context, for example, you’re not going to check literally every single thing yourself, but there are techniques like data availability validation, for example, where you can probabilistically validate correctness. you can validate the beacon chain snippet, you can check for fraud proofs, you can run a stateless client, you can even run a light client which is better than relying on a server and I definitely think it’s healthier for the ecosystem the more people to do those things, and the healthier it is for the ecosystem, the easier it is for people to do those things. like, for example, I’m definitely unhappy with the fact that you know that metamask, for example, is just a client that talks directly to infura, whatever.

I want to say that I recognize that the kind of reality is that there is no better way right now, but this is absolutely something that we should be trying to design to overcome, and there are a lot of good projects that are trying to overcome it and even that eth 2, for example, is designed to have a much simpler and better light client than eth 1, so hopefully things like metamask and stuff like that might end up porting over time.

In November 2020, the market saw some of this risk materialize in real time as infura fell. many exchanges had to temporarily stop allowing withdrawals of ethereum tokens and the various tokens that are based on ethereum.

infura linked the problem to a bug within one of the ethereum clients.

Earlier today (2020-11-11) infura experienced the most serious outage in our four years of operation. we realize that we are an important piece of infrastructure for many amazing products and projects. I would like to apologize to all of our users and the ecosystem. We recognize the faith you place in us and never take it lightly. I would like to share the details of the incident with you so that there is transparency into what happened and so that you can be sure that our service will be better and even more resilient in the future.

security concerns

There have been a lot of high profile defi hacks and bugs in 2020.

This is different from an exchange/escrow provider being hacked (such as someone stealing coins from an exchange) without the underlying protocol having a problem. instead, many of these defi hacks/bugs had deficiencies in their underlying protocols exploited, resulting in users losing funds. it’s a more fundamental problem at the token protocol layer that ethereum enables, in other words.

When multiple protocols are involved in a complex way, attacks and bugs can occur more easily.

a development solution for an unclear problem

See also: Heres the truth about the crypto miner that comes with Norton Antivirus – The Verge

To summarize here, there is a substantial demand for stablecoins to use as a liquid unit of account when trading crypto tokens and other purposes, a substantial demand for decentralized crypto token exchanges and decentralized crypto token liquidity providers, and some demand for tokens based on social games/dapps. Ethereum has a large share of the financial dapp market, while some of its smaller competitors have a sizable market share of gaming/social dapps.

These dapps are less efficient than centralized apps, as measured in terms of cost per line of code execution, but because people want to circumvent kyc regulations and because stablecoins are very useful at the current time within of the crypto trading space. , there is a lot of demand.

However, the ethereum solution to serve this demand, ironically, has centralized clusters. while it is a significant step towards decentralization, it is not really the level of decentralization that some were hoping for, and buterin has admitted it as such. it’s much more decentralized/permissionless on the user side, but these centralization groups serve as potential attack surfaces for governments to crack down on these methods of bypassing fully centralized, kyc-regulated companies.

There are security issues in various tokens ethereum is used for, and most of the ecosystem is fairly circular. Instead of ethereum dapps providing a wide range of successful services to non-crypto industries, its primary use case so far is as a platform to trade, lend, borrow, leverage, and move various crypto tokens. this type of circular speculation can drive development and prices very quickly, but can also quickly unravel if things change.

ethereum competition

ethereum faces competition from smaller utility protocols such as cardano, polkadot, tron ​​and others.

Just as other monetary tokens have been unable to take market share from the expanding network effect of bitcoin, these smart contract protocols are much, much smaller than ethereum. all together they are smaller than ethereum’s market cap, so ethereum has achieved a network effect and some degree of escape velocity compared to them.

however, their difference from ethereum is not as big as some currency tokens compared to bitcoin, so they are worth looking at.

Similarly, there are some smart contract platforms that link to bitcoin. rsk was an early example. stacks 2.0 was released last week, as another example, and is a protocol built on top of bitcoin that can bring smart contracts and defi to the bitcoin network, using bitcoin as the settlement layer. The project is well funded (from a real multi-million dollar SEC regulated capital raise) and they also issue grants for dapp developers to power a network effect.

It remains to be seen whether or not any particular project will be successful, but the point is that ethereum has some competition at a time when it is undergoing a transformation.

In the second half of 2020, the ethereum ecosystem encountered high fees due to excessive use of defi and stablecoins. that’s a healthy thing to start with, as ethereum is heavily used and its network effect is vibrant. however, the fees caused problems for small transactions and made them uneconomical. it’s okay to pay $10 to transfer $10,000 worth of tokens, but it’s not okay to pay $10 to move $200 worth of tokens.

and so, as coindesk reported, for example, more connection transactions are happening on tron ​​lately than on ethereum:

Ethereum Analysis Tether Transactions

chart source: coindesk

there was still more connection value settled in ethereum than in tron ​​during this period, as the largest transactions still took place there, but many of the smaller transactions spilled over to competing protocols as rising transaction fees were making them uneconomical on ethereum.

this happened years ago with bitcoin and ethereum. tether used to run over the bitcoin/omni protocol, but increasingly switched to ethereum. it now shows a constant tendency to switch to cheaper chains as needed.

This highlights the relatively low switching costs of these utility protocols; stablecoin entities and their users often create their tokens in multiple protocols and can use whichever one best serves their purposes.

ethereum 2.0: the next iteration describes some of the problems with their current protocol:

high demand is increasing transaction fees making ethereum expensive for the average user. the disk space required to run an ethereum client is growing at a rapid rate. and the underlying proof-of-work consensus algorithm that keeps ethereum secure and decentralized has a huge environmental impact.

To resolve some of these issues associated with the ethereum network, core developers, including buterin, have been working for years on ethereum 2.0, which will make major changes to the protocol right down to its core.

Primarily, you will be moving from a proof-of-work security model to a proof-of-stake security model.

In a proof-of-work model, which is what bitcoin uses, miners devote processing power to solving puzzles, and when one is solved, it adds another block to the blockchain, meaning a new block is processed. lot of transactions. the correct blockchain is whichever is the longest blockchain, as determined by the majority of the network. In a proof-of-stake model, transactions are validated not by contributing processing power, but by proving they hold units of the cryptocurrency, and the chain that is validated by the most coin holders wins.

if a proof-of-work blockchain has a split, meaning there is a dispute over which block is the most recent, a miner can only work on one of them at a time, and the blockchain more long ends up being accepted by the majority. in a scenario where miners disagree on which is the most recent block, each miner has to choose which chain he thinks is the correct one and commit processing power to add more blocks to that chain. inevitably, one chain will outperform the other, depending on which chain contributes the most miners, and will be the winner. the shortest chain will be discarded, and any miners who contributed processing power will have wasted their money.

A proof-of-stake model uses less power, but is a less proven technology in terms of security and decentralization. in fact, the ongoing research in this space is part of what delayed the completion of ethereum 2.0 for years. An inherent problem with a proof-of-stake model is that there is no cost to verify transactions simultaneously on multiple chains. Instead of contributing to a chain, someone with a stake can check all the shards in the chain simultaneously with their tokens, as it doesn’t require a lot of processing power and therefore has no cost to be wrong. you don’t have to choose just one. so how do you resolve chain disputes?

There are various solutions for this, and that was part of the research and development in the last few years. Several different blockchains with proof-of-stake models have appeared. in general, the blockchain needs a way to keep track of splits and “punish” proof-of-stake validators for validating any chain that ends up not being the longest chain. this adds a cost of being wrong and provides an incentive to validate only what stakeholders actually think is the correct chain, as a proof-of-work miner should do. ethereum 2.0 will have mechanisms to remove ethereum tokens from validators that didn’t do their job correctly, which incurs a huge cost for getting it wrong or attacking the network.

ethereum’s proof of work security spend is less than bitcoin’s proof of work system and more importantly it uses gpus instead of asics like bitcoin uses. asics are specialized hardware with physical supply constraints (much harder for an attacker to acquire most – attacker would likely need involvement of existing miners with existing hardware) that cannot be reused for other activities, while gpus are general purpose and abundant. theoretically someone could buy a ton of cloud gpu power for a short period of time and try to do a 51% attack on ethereum 1.0, and this attempt would be much cheaper than trying to do a 51% attack on bitcoin, no specialized hardware or supply chain constraints.

So, I can see why ethereum developers are interested in proof of stake, due to its low hash rate and gpu based mining. Assuming it works as intended with no hidden attack surfaces left unaccounted for, proof-of-stake should make attacking ethereum more expensive than it currently is. however, with any new security model, it takes years to prove resistant to attacks in practice. the more complex something is, the more surprises there can be.

ethereum 2.0 release

Ethereum developers have been working on the ethereum 2.0 update for years, have experienced several delays, and intend to complete it by 2022. It may end up being delayed beyond that. I do not blame them; it is extremely complex.

first, a “beacon chain” was launched that runs in parallel to the existing ethereum blockchain. this was done in december 2020. this allows for “staking”, meaning ethereum holders can pledge a number of ethereum tokens to operate a validator, which will validate transactions. Anyone with 32 ethereum tokens can operate a validator, and those with smaller holdings can contribute to a pool of validators instead. this is the main proof of stake model.

second, up to 64 “shards” will be created. instead of being one chain, there will be dozens of parallel chains called shards that process transactions on ethereum 2.0 and connect with the beacon chain. this will radically increase the transaction performance of the system. each validator will only operate on one shard at a time, verifying the transactions that are performed on that particular shard. sharding potentially opens up security issues, because, for example, if validators can choose which shard to operate on, it wouldn’t take a lot of money to do a 51% attack on a particular shard, so the beacon chain has to coordinate the validators somewhat randomly to prevent this possibility.

Third, once all of this is working, the current ethereum 1.0 chain will be attached to one of the shards. at which point ethereum 2.0 is born, and could be considered out of alpha development and into beta development, to be further refined as it goes live. and then at some stage with no major changes for a while, it can be considered out of beta development.

In addition, there are “rollups” and other sidechain solutions, which are somewhat similar (in terms of end goal) to how the bitcoin network uses liquids and lightning as secondary layers to improve its performance.

And with these developments, there are questions about whether sharding is necessary, which comes back to the point that the base layer is under development. ben edgington’s recent article for the block, for example, describes how the roadmap is changing:

A year ago ethereum 2.0 had a neat and tidy linear roadmap. phase 0 (the chain of beacons) would be followed by phase 1 (sharding for scalability), which would be followed by phase 2 (abstract execution engines), and finally eth1 would merge with eth2 on top of this superstructure . then the design of phase 2 started to look like it would take longer than expected and at the same time the pressure started to mount for eth1 to merge with eth2 as soon as possible. so we inserted a 1.5 phase, where you could directly “lift and shift” eth1 into a shard of eth2.

Also, a completely new scaling paradigm emerged that doesn’t rely on sharding at all. this is “rollups” and in October this year vitalik proposed a new rollup-focused ethereum roadmap as the path to scalability. rollups are a so-called layer 2 technology that removes much of the computing and storage load from the blockchain, and uses the chain enough to benefit from its security guarantees. they come in different forms, zk-rollups and optimistic rollups, with different offsets, and the technology is nascent. but it seems very likely that rollups could provide much of the scalability that ethereum needs, even before ethereum 2.0 is fully delivered.

Also in the mix are stateless ethereum (although rollups may relieve some of the pressure from ethereum’s state bloat) and promising new cryptographic techniques like kate (pronounced “kah-tay”) commits suggesting new and exciting addresses.

with all that’s going on, our nice and tidy three-phase roadmap has now morphed into the web of vitalik’s recent update.

can we weave all these threads into a cohesive tapestry? I think if any community can make this work, it’s the ethereum community.

what will ethereum be like in a few years? it’s hard to say. Investors who believe strongly in the project could be significantly rewarded if all the pieces fit together correctly in the coming years, but there is also significant risk and lack of clarity as technical paths and overall architectural proposals change, right in the base layer.

Somewhat like a bet on the management team of a start-up, a bet on ethereum is a bet that developers will perform a massive transformation in the base layer and successfully maintain their dominant network effect vs. competitors.

ethereum monetary policy

one of the criticisms that bitcoiners have towards ethereum is that its monetary policy has changed several times within its shortest lifetime, while bitcoin’s has not changed yet.

bitcoin generates a new block on average every 10 minutes, and each time this happens, a certain number of new coins are created. for the first 210,000 blocks, it was 50 new coins per block. for the next 210,000 blocks, it was 25 per block. then it was 12.5 per block, and now it is 6.25 per block. every 210,000 blocks, the emission rate is halved, and over time its emission will asymptotically approach zero. bitcoin investors can tell you with a fairly high degree of accuracy how many bitcoins there will be in, say, August 2026.

bitcoin will not exceed 21 million coins or alter this exponentially declining issuance rate unless the majority of the decentralized network agrees, which is highly unlikely unless there is some future security issue that forces them to change their emission model. Here is an article that covers a number of topics related to the long-term security of bitcoin. There is no central development team that can easily change bitcoin’s monetary policy, and in twelve years of history it hasn’t been changed.

by contrast, ethereum has a more flexible monetary policy, changed by key developers over time and accepted by the network whenever necessary. It launched with 72 million coins pre-mined from the start (unlike bitcoin, which had no pre-mined), and currently has a total supply of around 115 million. this chart shows total supply in blue on the left axis and shows the annual supply inflation rate in orange on the right axis.

Ethereum Issuance

chart source: ethhub

It looks like the annual issuance rate with all those annotations was drawn by a bitcoiner mocking ethereum, but instead, it’s from an ethereum source. various ethereum enhancement proposals or “eips” by developers have changed their monetary policy over time as needed for various reasons.

however, along with this transformation process to ethereum 2.0, it seems that ethereum will change its monetary policy again with an update called eip 1559. this should substantially reduce the issuance of new tokens.

Within this eip 1559 framework, ethereum will have both a deflationary element and an inflationary element which together will determine how many ethereum tokens there are at any given time.

The deflationary element of eip 1559 is that the base fees that users pay for validators to verify transactions will be destroyed, rather than given to the validators. users can provide an additional “tip” fee to validators to incentivize certain transactions to get through the queue faster, but the base fee will be destroyed each time. Since these fees are paid exclusively in fractions of ethereum tokens, this permanently removes a small percentage of ethereum tokens from the system every day. the higher the total fees in the system, the more tokens will be destroyed per day.

the inflationary element of eip 1559 is that validators will receive newly generated ethereum tokens from the network to validate transactions in perpetuity. the total issuance rate will depend on how many ether tokens are used as validators, with higher returns if there are few validators (which incentivizes more, to increase security) and lower returns if there are many validators (which makes it less attractive to validate). the more validators there are on the network, the more tokens will be generated, but the amount generated per validator will decrease, resulting in lower returns for validators.

validators have risks, as mentioned above. incorrect validation or being offline may result in some of your tokens being removed. therefore, the rewards of the newly created ethereum tokens incentivize them to tie up capital and take risks to generate more tokens for themselves, and provide the necessary security and transaction validation for the network.

In theory, eip 1559 is a pretty elegant framework. guarantees an inflationary security budget for validators, while also having a deflationary element in the form of fees.

many bitcoiners would frown on the fact that there is no fixed issuance rate or hard cap for ethereum tokens in eip 1559. actually i don’t have a fundamental problem with eip 1559; I think it’s a much better monetary policy than ethereum has been operating so far, and it’s well thought out. As long as the monetary policy is rule-based and results in relatively low issuance, I think it can work for what ethereum is trying to achieve with its protocol (as an enabler of dapps similar to oil, in instead of that as a scarce collateral like gold). in fact, the highest potential issuance rate in the proposed eip 1559 system is quite low, and some potential results are deflationary in the network, if there is high transaction throughput relative to the number of validators choosing to operate on the network .

However, my question is that given the number of times ethereum’s monetary policy has already changed, why would you assume eip 1559 will be permanent? ethereum developers change their monetary policy as often as the federal reserve does, and for similar reasons (to try to optimize aspects of the ecosystem’s economics). if eip 1559 is in place for several years, shows that it works as intended and doesn’t change, and ethereum 2.0 works flawlessly, I’ll have reasonable confidence that it won’t change any more and that the system is working as intended. Until then, all I can do is watch and see how things turn out, unless I feel like speculating based on my assessment of the dev team and the competitive environment.

node characteristics

let’s see the characteristics of the nodes. A node refers to client software that a user can run to verify the blockchain and help enforce consensus rules. I’ll start with bitcoin as a reference again and then compare and contrast it with ethereum.

even after 12 years of constant operation, the entire bitcoin block chain is less than 350 gigabytes and growing quite slowly at a pre-programmed limit. the bandwidth requirements to run a full node are only about 500 megabytes per day, which is very low. being small and not growing faster than memory for a typical computer grows over time, and with only a basic internet connection required, a bitcoin full node that stores and validates the entire blockchain can be run on a laptop or similar device, and that will be true for the foreseeable future.

This makes bitcoin highly decentralized in terms of validation and consensus. Although mining capacity is focused on certain countries (such as China), a large source of bitcoin decentralization is based on its full node consensus framework. each full node can rebuild the entire bitcoin block chain and they are operated all over the world. here is a map of those visible to the network:

Bitcoin Nodes

source: bit nodes

ethereum currently has several tiers of nodes. even though the ethereum blockchain is much younger than the bitcoin blockchain, the amount of space required to run a full node for the ethereum blockchain is already larger than a bitcoin full node, since it grows faster per unit of time. given enough time, it can become increasingly difficult for a regular user to operate one, meaning full nodes could be limited to large entities rather than accessible to any user.

Also, there is something called a file node in ethereum which is more complete as it includes several intermediate states. a full node can be deployed and become an archive node, but it takes many days and many terabytes of space, so they tend to be run only by larger specialized entities.

See also: Does Mining for Cryptocurrency Damage My GPU?

ethereum 2.0 will change this. In order to greatly increase the transaction throughput of the system, validators will only verify transactions on a specific shard (out of 64 potential shards), thus only storing data and paying attention to a small subset of the network.

however, there will also be super full nodes that will store the full data of the entire ethereum 2.0 network; these will require massive storage and bandwidth, and can only be operated by a handful of large entities.

the ethereum wiki provides an overview of the types of nodes that will exist in ethereum 2.0:

Note that there are now several “tiers” of nodes that can exist in such a system:

super full node – Downloads the full data of the beacon chain and each shard block referenced in the beacon chain.

top-level node – Processes only the blocks in the beacon chain, including shard block headers and signatures, but does not download all shard block data.

single shard node: Acts as a top-level node, but also fully downloads and checks every collation in some specific snippet that interests you the most.

light node: downloads and verifies main chain block headers only; does not process any collation headers or transactions unless it needs to read some specific entry in the state of some specific shard, in which case it downloads the merkle branch to the latest collation header for that shard and from there downloads the merkle test from the desired value in the state.

this is a difference between bitcoin and ethereum 2.0. the bitcoin community emphasizes self-verification as a key principle. Any normal user can download the open source bitcoin core software on a basic laptop and the entire bitcoin blockchain. this allows them to audit the entire bitcoin money supply, view every transaction in the entire bitcoin history, and verify for themselves that consensus rules are being followed across the network.

with ethereum 2.0, a normal user won’t be able to do that; they will need to trust other network participants, including these super full nodes run by large entities, and rely on an assessment of probability that the protocol is working as intended. they will only have direct check access to the network with a single shard node or a beacon-only node or a light node at any given time, unless they can invest in significant computer/network infrastructure to run a super node complete, which will be beyond the ability of most users.

again, a lot of thought went into this design to its credit. ethereum developers wanted to avoid some of the problems of altcoins trying to increase performance by making each node hard to run so they wanted to create a spectrum of nodes to give users different levels of validation which is best what can be done. when so much complexity is built into the base layer of the protocol.

a pricing model for tokens

the ethereum 1.0 blockchain is quite congested now so the transaction fees are quite high for what the protocol is trying to achieve. this can be beneficial for the price of ethereum; you need ethereum tokens to pay for smart contract execution, and high fees mean you need more tokens to pay for that execution. however, in the long run, that’s bad for the network, because if dapps are much more expensive than their centralized app counterparts, then their rationale is less compelling and competing utility protocols can take over. market share.

the main purpose of ethereum 2.0 is to dramatically expand system performance, literally by orders of magnitude. while this is necessary for the protocol to become a “world computer”, as it is trying to do, it opens up questions about the incentive structure for the ethereum token price.

if the transaction throughput is very high and the fees are quite low, users don’t need a lot of ethereum tokens to run dapps. there is this interesting trade-off: high fees make dapps less attractive and provide room for competitors to gain market share, while low fees potentially reduce demand for ethereum tokens.

However, running validators is a good incentive for ethereum investors to hold tokens long-term on ethereum 2.0. they can accumulate tokens and take them to validation to get a yield of more tokens. therefore, as long as the system continues to function, there are likely to be many people who want to hold onto the tokens and make a profit on them. Furthermore, ethereum tokens can be used as collateral in defi loans. these functions serve as a liquidity sink for ethereum tokens in the ecosystem, and is part of ethereum’s attempt to be both a utility product and a monetary asset.

In theory, if ethereum 2.0 dapp usage grows substantially over time and the protocol retains significant market share against competitors, ethereum tokens should also increase in price to some extent, benefiting from these sinks. of liquidity, guarantees and metcalfe’s law.

However, it’s hard to say to what extent, as a high-performance, low-cost system doesn’t directly require a high ethereum token price. between the end of 2017 and the end of 2020, for example, the amount of dollar value established on the ethereum network nearly tripled and even surpassed bitcoin, largely due to defi and high-frequency stablecoin trading, while Ethereum’s dollar market cap just retested its previous highs. this phenomenon was predicted by john pfeffer in late 2017.

Once again, an assessment here will depend on an investor’s opinion of the ethereum development team and their ability to transform the base layer of their protocol while maintaining an edge over the competition. Being a utility token does not prevent Ethereum from also being a monetary token, if there is enough demand for Ethereum tokens from investors for staking and collateral. at the same time, ecosystem growth for a utility protocol does not require token appreciation, unlike bitcoin as a primary store of value where adoption and token appreciation mostly go hand in hand.

On the downside, if ethereum 2.0 dapp usage levels off and plateaus (see the aforementioned issue of being fairly circular at the moment, coupled with some competition), then the value of the token would likely plateau as well. .

So, with ethereum, investors have to be right about two outcomes. First, you must be right about ethereum retaining most of the smart contract market share in the long run, even when undergoing a transformation. second, you must be right that, in addition to its utility functions, staking and collateral will suffice to permanently monetize ethereum tokens, rather than serving primarily as fuel for the network.

bitcoin vs ethereum

There is a heated debate going on between some bitcoiners and ethereans (which, yes, sounds like a star trek episode).

First of all, there is a cultural divide.

Bitcoin appeals more to a group of libertarian and Austrian economists; big fans of sound money, self-sovereignty, etc. also a lot of silicon valley financiers so there’s a bit of a mix there. Bitcoin enthusiasts like being able to run a full node on their personal computer and audit the entire money supply and consensus rules of the bitcoin blockchain (“don’t trust, verify”). development in the space is slower, but more stable, because preserving bitcoin’s core protocol is of paramount importance. Institutions are starting to get interested in bitcoin with large pools of capital. the surrounding ecosystem is very focused on security, including multi-signature solutions and bitcoin-only hardware wallets that take security one step further than other wallets. the protocol and surrounding ecosystem is hardened, battle-tested, and stable.

ethereum attracts more experimentation. As a platform, it allows a lot of speculation in small altcoins that have a high failure rate, but it also constantly reassesses developments in the technical landscape to see how to improve its fundamental framework. it’s more ambitious in the base layer, which some see as a feature and others see as a bug. it is more centrally dependent on its founder and more reliable in terms of money supply and details. defi on ethereum has been able to catch up faster than bitcoin’s child layers, but defi’s growth is inherently based on speculation thus far.

some bitcoiners see any other cryptocurrency or digital asset as a bad idea or a scam. many of them insist that new uses of blockchain technology should be built on the proven foundation of bitcoin rather than in parallel as a separate protocol. the bitcoin developer community tends to move slowly and cautiously, rather than take the move fast and break things approach, which they perceive many other tokens to do.

ethereans on the other hand see a lot of value in the ethereum network and indeed that is the only other blockchain that has created some degree of network effect over time besides bitcoin and also benefits from metcalfe’s law some of them see bitcoin as old technology, or just digital gold, and believe that ethereum is where much of the action will take place. many of them see a role for bitcoin as a savings and store of value technology, but are simply more interested in ethereum’s potential for decentralized applications.

buterin coined the term “bitcoin maximalist” to refer to bitcoiners who believe that no currency other than bitcoin will hold significant value in the long term. bitcoiners, by contrast, often point out that most people who go down the rabbit hole of crypto trading of various altcoins end up losing money in the inevitable down cycle, and that many of these protocols simply rely on bitcoin to enrich its founders at the expense of unsuspecting traders, without adding lasting value or understanding what exactly made bitcoin successful for 12 years now.

In general, the history of digital assets other than bitcoin is pretty bad. out of thousands of tokens, many have been outright scams, many lack sufficient security and are hacked at the base layer (not just through an exchange, but the protocol itself gets a direct 51% attack or exploit error ), and others are well-intentioned and interesting, but simply unsuccessful. the vast majority have not broken their late 2017 highs in terms of price or hash rate, while bitcoin has.

However, I believe that some digital assets, such as utility protocols, are useful and here to stay; the questions are how many, which ones and with what market capitalization. Ethereum has so far been the second “blue chip” in the digital asset ecosystem, and remains a major force for more than a cycle.

the hardest money

I don’t consider myself very interested in this debate. I am an investor and I want to invest in things that I consider stable projects and that have good risk/reward characteristics. for me right now that includes bitcoin, but does not include ethereum.

I prefer the risk/reward opportunity in bitcoin for the digital asset portion of my portfolio, for reasons I outlined in my July 2020 article. it has 12 years of price history and consistent monetary policy based on adjustments of difficulty occurring every 2 weeks and supply halvings occurring every 4 years, which have so far algorithmically driven price and adoption:

Bitcoin Supply Cycle

chart source:

The bitcoin base layer has been out of effective beta mode and fully operational for a long time. the ecosystem around it continues to improve, and the base layer gets security updates over time, but it’s a working system as it is today. there have been no major changes to the base layer since 2017, and it has operated with the same general framework since its inception in 2009. the biggest changes in the bitcoin space occur primarily in sub-layers and in the software/hardware/finance ecosystem surrounding .

ethereum, on the other hand, is a work in progress at its base layer, still in alpha development as it is still changing the core underlying mechanics despite being live. many of the design aspects of ethereum 2.0 are clever, and clearly a lot of thought has been put into it, but there is a lot of speculation about what the demand will be, how well it will work, and how secure it will be. it will keep itself. many things are changing about the protocol that made it successful in terms of price for the first 5 years of its life, in an attempt to address current limitations that threaten network functionality.

Some macro investors like to split 90% bitcoin and 10% ethereum, or 80% bitcoin and 20% ethereum, for the digital asset portion of their portfolio. I think it’s crazy? not really.

People should do what they think is right for them, what they assess to have a good risk/reward opportunity, etc. study the main protocols and determine for yourself what you think is likely to be successful. some people would see value in buying some ethereum tokens, putting them away somewhere and seeing what happens in five years, as a pretty lopsided speculation. If ethereum breaks above $1,400 to new highs, it has the potential for a big gain next year. in fact, as long as the network is congested and fees are high, it will help ethereum tokens to increase in price.

However, investors should understand that ethereum is still in alpha development. maybe in another 5 years, when ethereum 2.0 is in place and running for a while, with consistent monetary policy throughout that time, it can be considered very much a finished project like bitcoin. Until then, it’s experimental.

Bitcoin has a significant amount of volatility and upside potential as it is, so most investors do not need to take the speculative risk of venturing into protocols that are still developing fundamentally at their base layer.

the accumulation of value tends to be concentrated in the most difficult form of money in terms of scarcity, security, divisibility and fungibility, which is why gold has been essential for most of human history in the area of finance. things that can be used to get work done, like copper or oil, are often not where the market stores long-term value. that analogy doesn’t apply perfectly to ethereum since ethereum has a high stock-to-flow ratio, but from an investor’s perspective the burden of proof is on any secondary networks that are trying to optimize for many things, in terms of their trying to compete with the main network in the main thing it does (store value). this is not unprecedented, however. silver, for example, has a history of being used for both utility and money, existing in the intermediate state between gold and copper/petroleum.

The extent to which the ethereum ecosystem can enable a host of applications is a somewhat different question than how much its tokens will appreciate in the long term in terms of price, plus the natural boom and bust cycles it goes through. . the complexity of the proposed base layer of ethereum 2.0, with a chain of beacons and dozens of shard chains, may be less attractive to large pools of capital to buy and hold tokens, compared to the relative simplicity and full verifiability of the bitcoin base layer

the risk of concord

in my opinion the biggest risk for ethereum is that it could end up like concorde.


the concorde was an airplane, first flown in 1969, that allowed the public to fly up to twice the speed of sound.

While it was functional and commercially operated for more than 25 years in a limited sense, it never became an economically sustainable project. As I write this in 2021, more than 50 years later, the public still has no options for commercial supersonic flight.

In the 1960s, people thought we’d already be in space or in flying cars, like supersonics, instead of traveling in planes slower than the fastest commercial airliner of 1969.

It is extremely challenging to design and operate an aircraft that can safely and repeatedly exceed the speed of sound; a lot of aerodynamics change at that point where the sound barrier is broken. In five decades since its inception, the problem has yet to be solved economically for commercial flights.

so even though the concorde was great, it could go from new york to london in three hours and stay for a while, it could never work in terms of solving a big enough customer problem at the right price, compared to the alternatives. the market eventually settled for first-class passengers paying higher fares to make a long flight more comfortable, rather than spending money to shorten the flight.

ethereum has a lot of smart developers working on it, and is exploring some interesting avenues. it pushes bitcoin developers to continue to innovate the ecosystem around the base layer, which I like to see. but i have less conviction that ethereum will be successful in the long run compared to bitcoin, in part due to the rise of other utility protocol competitors. I will continue to monitor the situation as things change and new facts and developments emerge.

perhaps ethereum will iterate and find a long-term sustainable place for itself in ethereum 2.0. on the other hand, ethereum could end up overwhelmed by its own complexity and lack of broad economic use, such as concorde, while later generation utility protocols catch up.

final thoughts

I think monitoring ethereum and other utility protocols is important for a variety of different investors.

Equity investors should probably pay attention to some of the dapp developments, to see if something outside of that ecosystem could disrupt some of their traditional investments over time. Bitcoin investors should monitor it as part competitor and part contributor, to see what works, what doesn’t, and more importantly why. can inform the development of its own ecosystem.

In my opinion, stablecoins are especially important. I am optimistic about the amount of money locked up in stablecoins. it is a space to watch, both for good and bad developments. The US Office of the Comptroller of the Currency now officially allows US banks to use stablecoins. they are a much more liquid form of fiat currency and may have several implications for central bank digital currencies and the existing global monetary system.

While I don’t think having a small position in ethereum is crazy, I also don’t have a clear way to model it other than speculation, as it is an unfinished product at the base layer, with a fairly circular usage. case so far revolving around altcoin trading, leverage, liquidity provision and gamification. With bitcoin, I can make a more fundamental argument for a non-zero position as a macro asset.

80/20 or 90/10 or 100/0 in terms of btc/eth ratio make sense to me as the digital asset portion of an investment portfolio. my focus is closer to 100/0 in favor of bitcoin and i haven’t seen a compelling reason to change that other than if i just feel like speculating on the long term success of the developers. personally, i would need to see ethereum 2.0 out of alpha development, with consistent monetary policy and more use in areas outside of token speculation, to catch my interest in a more structural way.

Some people in the digital asset community refer to bitcoin as gold and ethereum as oil. one is a store of value and the other is a job enabler, in other words.

However, I see that bitcoin has a tendency to surprise to the upside and persist from cycle to cycle in a way that most other cryptocurrencies do not. Ethereum could be the second big blockchain network that stays for a long time from cycle to cycle in a functional form, constantly benefiting from metcalfe’s law, but it has to overcome this 2.0 transformation.

From an engineering perspective, I prefer the modular design of bitcoin. the base layer is simple and stable, designed to be nearly bulletproof. on top of that layer, the ecosystem can innovate, and while it may not move as fast as some people prefer, it moves in the direction the market wants. this is how the existing financial system also works; there are underlying settlement layers and then faster payment layers built on top of those base layers.

Until now, the market in the bitcoin ecosystem has sought security to maximize the store of value proposition, thus receiving a level of multi-signature solutions and hardware wallets that outperform other digital token ecosystems, including ethereum. the market has been less interested in the secondary layers of bitcoin as a medium of exchange as there hasn’t been much of a need yet, although lightning labs and other developers continue to build tools and infrastructure for when demand increases (which eventually, higher fees on the base layer will probably cause it), and many application developers are already using those tools.

As an analogy, all martial arts have different philosophies. some strike first and are more prone to offense. others emphasize a solid foundation, patiently absorbing or deflecting initial attacks and then hitting back harder and using their opponent’s momentum against them.

bitcoin, in my opinion, is the latest. It doesn’t move fast and break things (in the silicon valley saying) like many altcoins do, but it moves slowly and has a tendency to do things right. the more ideas and innovations that emerge in the digital asset industry in general, the more bitcoin developers will have to work for their protocol and ecosystem.

I will continue to monitor the industry, but right now I prefer a bitcoin-only investment for most of my digital asset portion of my portfolio. i can see why some people also like to speculate on ethereum as you can have higher percentage gains during bull runs. Those speculators need to understand that the base layer is still in alpha development, with rapid changes in terms of its security model, monetary policy, and addressable market, at a time when competition in the smart contract industry is not insignificant.

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