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How I Learned to Stop Worrying and Love ETH
As we continue to explore DeFi, we have been getting a lot of questions on how to value a crypto network and its token. Should it be valued like a social network like Facebook? A computing resource like AWS? A payment network like Visa or Mastercard? A commodity – like digital gold or oil? Coming from the world of ‘real’ finance, ETH can be confusing. That is because depending on how you slice it, the answer could be any or all of the above. In this article we lay out a framework to think about valuing ETH.
What is Ethereum?
Ethereum is a protocol that enables decentralised, peer-to-peer transactions to occur on a global network, powered by its native digital currency, ETH. Ethereum is often referred to as the "world computer" because it allows for the execution of smart contracts and decentralised applications (dApps) on its blockchain. Unlike traditional centralised servers or cloud platforms, Ethereum is maintained and secured by thousands of nodes distributed worldwide.
At the base level, Ethereum is like a global database that lets you perform arbitrary computations. For a fee (paid in ETH), you can store, write and change data. What does this mean in practice? In practice, this means that every week 1.5mn accounts perform 17mn transactions paying $5bn in annualised fees to the Ethereum network.
These people trade assets, send payments, take leverage positions on margin and perpetual futures, execute fixed and variable term loans, exchange art and collectibles, play games and more. Further, Ethereum now is the default data storage for a wide network of other blockchains and applications (i.e. it ‘rents out’ its network space). Some of these, like the Layer 2 networks, leverage Ethereum’s security to run their own faster, cheaper blockchains. Others, like Lens, are running entire social networks with ETH as a backend database.
The network is no longer a tiny startup, it’s a running system used by users all over the globe.
ETH as a Network
Owning a piece of App Store
When thinking of Ethereum as a network we can consider a kind of "network effect" seen in social media companies, where the value of the network increases as more users join. Similarly, the more users and developers Ethereum has, the more valuable the platform becomes. Being highly decentralised, Ethereum is credibly neutral and users can always know how the network will behave and process transactions. This has meant that the vast majority of asset value sits on the Ethereum network ($40bn). The money attracts users, developers and investors. Metrics like number of active addresses, transaction volume, and gas usage can be used to estimate network value.
On top of this Ethereum ‘rents out’ its network space to other blockchains who choose to build on top of Ethereum.
ETH as a Commodity
Digital oil that powers the blockchain economy
When using the Ethereum network, users pay transaction fees in ETH. To store data on the network and make use of the distributed compute, users spend ETH. A part of this fee is “burned” and taken out of circulation, making it possible that ETH is a deflationary asset with diminishing supply. Similar to a finite commodity like oil, ETH is removed from circulation and can be considered a scarce asset as more is used for fees in the network. Every day, users spend millions of dollars in ETH to process their transactions. Annualised the current run rate is over $4b.
ETH is also stored in various DeFi protocols, used as pairs in liquidity pools and held by users as a store of value. These use cases gave ETH additional utility, and just like gold, silver or other hard commodities, ETH has value because it is a useful and necessary asset to conduct business. The utility of the asset, both to process transactions, and to use as a monetary asset in DeFi, gives ETH a level of money premium above and beyond that of a simple network valuation.
ETH as a Bond
A perpetual bond paying out a share of transaction fees
Two of the most important upgrades in Ethereum’s history are now finished. Together they moved Ethereum from a proof-of-work network to a proof-of-stake network.
Valuing ETH as a bond is a concept that has gained popularity with the launch of Ethereum 2.0 and the introduction of staking. Staking is essentially a process where holders of ETH can "lock up" their ETH in a smart contract to help secure the Ethereum network, and in return, they receive rewards in the form of additional ETH. This yield has remained at a steady 5% since the merge. Some portion of these rewards come from transaction fees, but another part is "inflationary" - new coins that are printed and given to stakers as a reward for their work.
To value ETH as a bond, we can look at the current and projected future staking rewards, the total amount of ETH staked, the duration of the lock-up period, and the associated slashing risks.
ETH as Equity
Token buyback & dividend yield
Ethereum as a business has a primary product: the decentralised platform that enables the creation and execution of smart contracts and decentralised applications. This platform is used by a variety of users including software developers, businesses, and individual users.
Its "revenue" can be considered as transaction fees (gas fees) paid by users to execute transactions and smart contracts on the network. With the implementation of EIP-1559, a portion of these fees are burnt (removed from circulation). Staking rewards in Ethereum 2.0 can also be considered a form of revenue for the network. During times of high demand, these fees can reach the double digit annualised return.
Profitability in the traditional sense can be a bit tricky to define for Ethereum. For validators, profitability could be considered the difference between the rewards they receive (in the form of block rewards and transaction fees) and their costs. For ETH holders, profitability could be viewed as the appreciation in the value of ETH due to ETH’s ‘burn’, or the staking rewards received for staking their ETH. For the entire network, we can look at money earned in fees above and beyond what was paid to stakers for securing the network. But as a staker, we could look at all rewards and fees as going to our bottom line.
The layer cake of ETH Value
When we take a step back and consider all these elements, we find that the value of ETH is not one-dimensional. Instead, it's more like a layer cake, with each layer representing a different aspect of Ethereum's utility and potential.
The bottom layer of this cake is Ethereum's foundational technology, its blockchain and the protocol that governs it. This is the layer that makes everything else possible, and its value is derived from the security, transparency, and decentralisation it provides.
The next layer up is Ethereum as a network. The value here is found in the ever-growing community of developers, users, and applications that form the Ethereum ecosystem. This value grows with each new participant and transaction, creating a powerful network effect. Ethereum also rents out its network effect and security to a host of applications like Layer 2s and as a data store for other blockchains.
The third layer is Ethereum as a commodity. Here, the value lies in the utility of ETH as "fuel" for transactions and smart contracts, as well as its role as a store of value and a form of collateral within the DeFi ecosystem.
The fourth layer is Ethereum as a bond. This is where the value of staking comes into play. By locking up their ETH to secure the network, stakers can earn consistent returns, adding another element to Ethereum's value proposition.
The top layer of the cake is Ethereum as an equity. Just like a business, Ethereum generates revenue in the form of transaction fees and has costs associated with maintaining the network. The profitability of Ethereum as a "business" contributes yet another dimension to the value of ETH.
Each of these layers contributes to the overall value of ETH, and they are all interdependent. The health and growth of the Ethereum network support the utility of ETH as a commodity, which in turn drives the value of staking, and so on. It's this multi-layered, dynamic nature that makes Ethereum such a unique and exciting platform, and ETH such a compelling asset.
So what’s ETH worth?
Data below helps put this into perspective:
Network Value: Transactions are up 2.6x y-oy
Commodity Value: 1% burn and 17% of supply out of circulation vs 3% inflation a year ago
Bond Value: 5-10% yield vs 0 a year ago
Equity Value: “Net Profit” of $362mn in 2Q23 vs -$1.9bn in 2Q22
In the meantime the price is down 60%+ from ATH.
Only time will tell which of these frameworks is most precise but fundamental metrics look pretty interesting from all angles.
Re7 Capital - DeFi liquidity providers