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Monthly Market Review - April 2021

Updated: Mar 8

In this note, we will look at Ethereum and some of its competitors in more detail. April was Bitcoin’s first negative month in 2021 - however, the talk of the town at the moment is Ethereum.


In early May, ETH (the token of Ethereum) passed $3,000 - 10,000 times its 2014 sale price of ± $0.3 per ETH. Its recent move has the broader market scrambling to work out what Ethereum is, how large its long-term potential is, and who its competitors are.


So, how does one begin to think about Ethereum? In comparison to Bitcoin (i.e., the "digital gold"), Ethereum is a smart contract platform (SCP), so investing in Ethereum is investing in the underlying technology of the blockchain versus Bitcoin's "sound money" thesis.


The above difference means that many people believe these two assets complement each other and that there is room for both to thrive. The challenge for investors is that ETH’s value is based on new technology with little precedence. For the sake of this note, I will compare Ethereum with Solana (a competing smart contract blockchain). However, I could have easily used Cardano, Tezos, EOS, Tron or Binance Smart Chain. These are just a few of Ethereum's significant competitors.


So, how does one compare these different smart contracting platforms (SCPs)? There are three dimensions in which they compete on a high level – technical, marketing and value capture. We will discuss all these briefly. Technical: All blockchains make trade-offs between scalability, security and decentralisation. SCPs aim to process thousands of transactions per second so that a new financial system can exist. To reach this goal, SCPs must scale drastically compared to today's versions, which can only do 7-15 transactions per second. Scaling means decreasing decentralisation or security. Typically, blockchains reduce decentralisation or security by minimising the nodes in the network or using a different consensus algorithm. Proof of Work (PoW) is the most trusted and well-known consensus mechanism, so utilising another type increases the unknown risks and decreases security. As an illustration, Ethereum is migrating to Proof of Stake (PoS) from PoW, while Solana uses Proof of History.


The above tweet shows the decentralisation nature (or lack thereof) of some of Ethereum's challengers in term of the number of validators. For comparison, Ethereum as 8000 validators. Note that if an attacker controlled 51% of these nodes, they could control the network.


Marketing:

These networks all compete for attention, both from the broader public as well as potential investors and developers. As the oldest SCP, Ethereum has a dominant lead in many developer communities; however, other SCPs are gaining and aggressively trying to move projects away from Ethereum. To some extent, Ethereum has been a victim of its own success, with current transaction fees of up to $15 for simple transfer operations. Any decentralised system that enables low-value transactions (such as video games), cannot afford Ethereum's current high fees. Some of these have migrated away to other platforms that prioritise speed and cost (versus decentralisation). In time, migration to competitor protocols will become more complex as infrastructure developers create bespoke tools for leading SCPs meaning the technical work required for migration increases.


The below chart is a google trend chart that is a useful proxy for the popularity of these projects over time. It shows Ethereum’s healthy lead, but how others are growing.

However, Ethereum is not standing still; it reacted in two ways. Firstly, Ethereum developers have built many 'layer two' solutions. At the risk of oversimplifying, a layer two solution allows the reconciliation of batches of smaller transactions to the original blockchain, sharing the cost across the batch. Secondly, it is migrating to PoS as described above.

These technical battles are reminiscent of the Operating System wars of the 1980s and 1990s between Mac, Windows. Linux and IBM, where the different OS providers, each with passionate supporters, competed to win the desktop battle.


Value Capture:

Investors wonder even if an SCP dominates, where will its value accrue? The value that Ethereum enables could accrue to ETH, the projects built on top of it, or a separate digital asset. The systems that use ETH could store value in BTC as an example. Currently, for Ethereum, $393 billion worth of digital tokens use Ethereum as their underlying blockchain, and ETH is worth $400 billion, so the total Ethereum ecosystem is c. $800 billion, with ETH 'capturing' 50% of the value. Many SCPs monitor this, and some have altered their economics to improve the value of the base currency. For example, Ethereum is drastically reducing the issuance of ETH after approving EIP-1559, which many believe was one of the main catalysts for this latest price increase.

Information networks experience powerful feedback loops, and crypto networks are no different. Strong price action causes speculation and attention to the big SCPs, which draws in developers and users of their products (which, in turn, causes price action). These feedback loops can help the dominant SCPs stay ahead. Currently, Ethereum has a strong lead, but it is still too early to be entirely confident that it will dominate the SCP market. Its 3.65x price growth is impressive, but it is significantly smaller than Solana, which has appreciated 30x this year. Time will tell if these competing platforms keep outgrowing Ethereum and become serious challenges or if they will become meme coins like Dogecoin (having grown > 100x this year) while never serving a serious purpose. We expect a lot of volatility around the different SCPs while the market decides.