Hi YXI friends,

Today, we are going to do a deep dive on Ethereum and Ether (ETH).

We begin by breaking down the key concepts central to the Ethereum network without getting too deep in the technical jargons. Next, we look into Ether’s supply model, which significantly differs from Bitcoin’s hard-capped system.

For valuing Ether (ETH), we first compare ETH and BTC in terms of their long-term outlook, as well as their correlation and volatility over time. Unlike Bitcoin, we can actually apply a Discounted Cash Flow (DCF) model ETH’s valuation. It helps us gauge whether ETH is over or undervalued under different growth scenarios.

Finally, we review ETH’s technical charts and present an actionable trade idea based on the current price.

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. A Quick-ish Overview Of Ethereum and Ether

For greater technical details, you could start with Vitalik Buterin’s own explanation at Devcon here. Thenewboston’s short tutorial series on Youtube is also immensely helpful from a developer’s perspective. I also recommend the book “The Infinite Machine” by Camila Russo, which recounted in great detail the fascinating beginning of Ethereum - how the cofounders dreamt up the concept, created the network, fought one another, got hacked, and ultimately with Buterin emerging as the central figure.

Ethereum is a decentralised smart-contract platform using blockchain technology. It was conceptualised and created by a group of developers led by Vitalik Buterin, Charles Hoskinson (Cardano founder), and Gavin Wood (Polkadot creator). Ethereum allows developers to build smart contracts and decentralised applications (“dApps” or “Dapps"), going beyond the limitations of Bitcoin.

A smart contract is a self-executing programme or contract that runs on a blockchain. The contract can run without human intervention, using “if-then” logic (i.e. if this condition is met, then that outcome is automatically triggered). However, it should be noted that smart contracts can be exploited because the human design of the code itself can be flawed. Issues typically arise from complex multi-contract interactions, edge cases, and security vulnerabilities.

Dapps are user interfaces built on top of the smart contracts. They can be thought of as mobile apps but hosted on a peer-to-peer network (in this case, Ethereum) instead of Apple’s centralised servers. Most of the Dapps are open-source. For example, OpenSea, the NFT marketplace, is a top ranked Dapp. NFTs (Non-fungible Tokens) are typically bought and sold using Ether.

Ether (ETH) is the native cryptocurrency used on the Ethereum network. This is the crytocurrency we look to trade alongside Bitcoin (BTC). Whether it’s a simple transfer of ETH or creating a complicated smart contract, users must pay a “gas fee” in ETH for every transaction. No pay no play.

Gas is an incentive fee to compensate the validators for processing transactions, covering both the computational usage and prioritisation of one’s request. Gas is actually set by the requestor, like a bid with a maximum limit, for the transaction they want to do. If the gas is insufficient for the task, the transaction is reverted. Gas price can spike if the network is congested with a lot of transactions happening at the same time.

Proof of Stake (PoS) is the consensus algorithm used by Ethereuem. Bitcoin uses “Proof of work (PoW)” which requires the miners to validate transactions while solving a mathematical puzzle that can be very computationally intensive and energy consuming. ETH previously also used PoW, but switched to PoS in 2022. In Proof of stake, validators stake their ETH as collateral, validate the transaction, and get rewarded for their support (more on this below). The collateral can be deducted (“slashed”) if dishonest behaviour is detected. Proof of stake consumes less energy than proof of work, reduces the environmental concerns that is often associated with Bitcoin mining.

Staking is therefore the act of putting one’s ETH as collateral for the validation process. Typically, the yield on ETH staking is 3-7% p.a (see chart below). The minimal requirement for staking directly on Ethereum is 32 ETH, but users can pool their ETH together to benefit from staking. Liquid Staking gives the staking user an IOU token. The tokens can be used as collateral in DeFi (decentralised finance) or Dapps, so the users don’t get locked out of liquidity while staking their ETH.

The Reward System of Ethereum consists of two sources: Consensus Layer (CL) and Execution Layer (EL).

CL incentivises validators through issuance of new ETH tokens from the block reward. The amount of ETH issued varies, depending on the total amount of ETH staked in the network. Today, around 2,600 new ethers are rewarded each day.

EL includes Priority tips and Maximum Extractable Value (MEV) tips. Priority tips are extra fees paid by users to validators in exchange for prioritising their transactions. MEV tips represent additional rewards validators earn by strategically rearranging the order of transactions in a block to extract the maximum possible reward.

2. There Is No Hard Cap On ETH Supply

Bitcoin has a hard cap of 21 million coins (19.6 million already mined) programmed in its code. Ethereum does not have a similar hard cap. Instead, Ethereum uses a decentralised mechanism to influence its supply.

In 2021, Ethereum implemented the current gas fee system (EIP-1559), in which gas is split into two components, a base fee and a tip (as mentioned in the previous section). The network would burn all the Ether tokens in the base fee. This means that validators only receive the tips from the gas fees. The network adopted this change to make the base fees more predictable, while at the same time putting deflationary pressure on ETH. If the burnt tokens outstrip the block rewards, ETH’s overall supply shrinks. The increasing scarcity could theoretically make ETH more valuable.

As you can see from the chart above, the overall ETH Supply stagnated and at times shrank since September 2022. This date was known as the “Ethereum Merge” on which Ethereum adopted the Proof-of-stake consensus mechanism.

In the past two years, ETH’s supply has rarely changed more than 0.2% month on month.

3. Is Ether A “Property” Or A “Security”?

This is an important distinction, because if ETH is a Security, it would be subject to Security laws. There would also be minimal chance of central bank or government adoption as part of their reserve, just like the US Treasury wouldn’t buy Apple shares.

For a long time, the crypto community had regarded Bitcoin as the only crypto “property” - similar to land or gold in the physical world. Ether was regarded more as a security, alongside other cryptocurrencies.

Ethereum, the network, was born out of an Initial Coin Offering (ICO, like an IPO but for Crypto), in which the founders raised 31,500 BTC ($18.7 million) to start the project. At the beginning of the ICO, 1 BTC was worth 2,000 ETH. The Ethereum platform started with 72 million ETH tokens, with more than 60 million being sold to investors. The ICO pretty much checked all the boxes of Ether being a “security” - an investment of money in a common enterprise, with an expectation of profits through the efforts of others.

The Ethereum Foundation, currently led by Vitalik Buterin, Aya Miyaguchi, and Patrick Storcheneger, also has a big directional influence on the network. While they technically don’t “own” or “control” the network, they are instrumental in many of the Ethereum’s fundamental changes over the years.

For example, the current network is actually a “hard fork” of the original Ethereum network after the DAO (Decentralized Autonomous Organization), a de facto crowdfunding organisation for Ethereum, got hacked and lost $150 million worth of ETH. Buterin was also the major force behind the EIP-1559 upgrade mentioned in the previous section. All of this makes Ether feel less decentralised than Bitcoin, which has not gone through any changes since inception. (Technically, the changes / hard forks have become new networks, like Bitcoin Cash, that are much less popular.)

However, the SEC has formally declared ETH as a non-security and has dropped its secret investigation into Ethereum.

In the US, Ether is regulated by the Commodity Futures Trading Commission (CFTC), who regulates Ether as a commodity, like Bitcoin. And given the decentralised issuance mechanism of Ether today, it does tick all the boxes of being a commodity: it is fungible, can act as a store of value and be traded in markets, without a central issuer. The Ethereum Foundation owns 350,000 ETH ($910 million), or 0.3% of the supply. There is no realistic risk of the Foundation issuing more ETH directly.

4. How Does ETH Compare With BTC?

A key question is whether ETH market cap should over take Bitcoin at some point (“the Flippening”), given it’s “smarter” applications. Currently, ETH’s market cap is only 25% of BTC, down from 55% in 2021-2022.

There are two key issues to consider here. Firstly, from a macro point of view, the money world tends to congregate towards one particular asset for store of value. In the case of precious metals, Gold, with “harder” currency properties, won over Silver in the late 1800s and early 1900s (topic for another time). Today, the Gold/ Silver ratio has increased over six-fold over the past half-century.

For the store of value, or the “Digital Gold”, debate, Bitcoin likely remains as the dominant “store of value” in the long run. By “long run”, I am talking in decade terms. However, Ether may act as a backup choice if the Bitcoin network fails.

When it comes to the store of value, it’s less about the “smartness” of the asset, but more about the certainty that the asset stays exactly the same for the next thousand years. Bitcoin has essentially made no changes since inception, yet ballooned into a $1.2 trillion asset class. In contrast, the Ethereum network has gone through many iterations of big changes that have had drastically different economic outcomes to its stakeholders.

Secondly, in terms of institutional or even central bank / government adoption, Bitcoin is a clear favourite over Ether. This is because governments around the world unlikely want to hold something that can be hugely influenced by a small group of people (even if in the thousands), in this case the developer community around the Ethereum Foundation.

It doesn’t mean Ether isn’t valuable. The value of Ether should largely depend on the growing value of the Ethereum network, i.e. the value created by the smart contract applications across Dapps and Defi etc. The greater the platform activities, the more valuable ETH likely becomes.

Now let’s get into the performance side of things.

Subscribe to YX Premium to read the rest.