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Betting It All On Ethereum

The Merge Creates the World’s First Economically Viable Blockchain

Image credit: Adobe Stock

Key Takeaways:

  • There isn’t yet any major blockchain protocol that is economically viable long term, in terms of revenue exceeding the cost of running the blockchain.
  • The real superpower of crypto technology is decentralization. If you want to decentralize a network, you can’t just turn on the “blockchain switch”. In order for it to work, a powerful social force called legitimacy is needed.
  • In blockchain ecosystems, legitimacy grows and is maintained within the community. Community maintains legitimacy and distributes responsibility.
  • Without regular community members being able to run a node, a blockchain can’t be decentralized.
  • The Ethereum Merge is a historic upgrade and will most likely make Ethereum the first long-term economically viable blockchain.

Ether (ETH), Ethereum’s native currency, is many things at once — it is a commodity (used to pay for transactions) that powers the world’s largest decentralized computer, a yield-generating “bond” (used for proof-of-stake consensus mechanism), and a store of value (used as money in DeFi) — all complementing each other.

The cryptocurrency ecosystem contains assets that, in the past decade, have been the best performing assets in the world and with the best risk/reward ratio out there (e.g. BTC and DOGE). For many of us, this is the primary reason we begin being interested in crypto. From an investor’s perspective, however, I think ETH is now the asset with the best risk/reward ratio out there, which explains why ETH is the biggest bag in our portfolio at Faraday (a small investment company I help run).

This piece is written in a way that crypto beginners can read it without feeling intimidated, but at the same time it should help inform readers who are looking to get a more in-depth understanding of Ethereum.

…[Ethereum] it’s much harder to grok than bitcoin, and because of that, it hasn’t gotten the mainstream or institutional attention that bitcoin has.” — Packy McCormick in “Own the Internet”.

These are the main five reasons I’m bullish on ETH:

  1. Solving the Scalability Trilemma
  2. Network Effects
  3. “The Most Important Scarce Resource is Legitimacy”
  4. Befriending Moloch
  5. The World Computer Goes Green

Solving the Scalability Trilemma

Scalability Trilemma Diagram: Decentralized, Scalable & Secure as vertices
Scalability Trilemma Diagram. Source: vitalik.ca.

The Scalability Trilemma is explained by Vitalik in this post. The trilemma states that, if you stick to “simple” techniques, you can only get two of the three main properties that a blockchain tries to achieve (scalability, decentralization, and security). Let’s take a look at three classes of “easy solutions” that only get two of the three:

Blockchain comparison table showing which property of the Scalability Trilemma they are missing.
Blockchain properties comparison. Source: vitalik.ca

It seems pretty obvious to me now, but it took me a while to realize that the real superpower of crypto technology is decentralization.

If you think about it, the “pure gold mathematics” in blockchain technology doesn’t really serve its purpose without proper decentralization, but Satoshi showed us how to get it. Before Satoshi, we already knew how to communicate in a secure and scalable way, that’s not the hard part (high-TPS chain fans really need to understand this); what we didn’t know was how to do it in a decentralized way. It is similar to the way Michael Faraday showed us how to get electricity with the world’s first electric generator, which created a domino effect, with many other innovations built on top of electricity revolutionizing the way we live.

Have we solved the Scalability Trilemma yet?

Currently, there isn’t a single blockchain that has solved the Scalability Trilemma, but this shouldn’t disappoint you. It would be similar to expecting to be able to download a movie in less than a minute in the 1990s; the technology and adoption simply wasn’t ready back then (I recommend reading “The Limits to Blockchain Scalability” and “WTF is Data Availability?” for a deeper dive on scalability).

People invest time or money into internet projects because it is profitable to do so. I don’t see a scenario where devs continue leveraging the available technology, for long periods of time, if the technology itself isn’t economically viable. Shockingly, there isn’t any major blockchain protocol that is economically viable, meaning that the fee revenue is greater than the cost of running the blockchain. That should give us some idea of how difficult it is to build a proper blockchain. Don’t believe me? Let’s take a look at some of the most successful blockchains :

Blockchain profitability comparison showing some popular blockchains running at a loss
Blockchain profitability comparison. Source: cryptofees.info, moneyprinter.info (July 2022).

Bitcoin is the best in its main purpose: being a store of value; but it needs to “print” BTC to pay for security. It “prints” ~$31 million USD worth of BTC daily and only produces ~$300,000 USD of BTC in transaction fees (July 2022). What will happen after several halvings or when all 21 million BTC have been mined (estimated to be in year 2,140), will Bitcoin be economically viable? Nobody knows for sure. I think most people would agree that there will definitely be forces pushing towards reduced economic viability as more halvings occur (if everything else stays the same).

After Ethereum’s upgrade to proof-of-stake, it will most likely become the first long-term economically viable blockchain because the cost of maintaining the network is projected to be less than the fee earned through block creation. In fact, post EIP 1559 (BASEFEE burn), Ethereum has already produced some deflationary blocks.

Ethereum is the blockchain closest to solving the Scalability Trilemma, and it has the best scalability strategy by building a unified settlement and data availability layer. Ethereum has been the only ecosystem in which community efforts (proper R&D, public goods, and grants) have been able to bring it to this point.

Network Effects

On the Ethereum network, several players such as the core team, investors, validators, devs, and users interact with each other using the same currency, creating a beautiful, positive feedback flywheel and building a bigger and stronger community.

Why did the “crypto-use-case explosion” happen in Ethereum? DAOs, NFTs and DeFi didn’t magically appear in 2016–2018; they have been envisioned since the Ethereum whitepaper and built by the most innovative brains in the industry. These brains have been tirelessly building for years, updating the network and developing dApps (decentralized apps). dApps attract users (and money), which attracts more devs, who build more dApps, which attracts more users, and so on — creating a positive feedback loop called the “Two-Sided Platform Network Effect”.

“…the real distinguishing characteristic of a two-sided network is that there are two different classes of users: supply-side and demand-side users. They each come to the network for different reasons, and they produce complementary value for the other side”. — James Currier in “The Network Effects Manual”.

The “Two-Sided Platform Network Effect” is the same reason you wouldn’t develop a billion-dollar app idea for the Blackberry ecosystem; you would most likely develop it for the Apple or Android ecosystems. And it is the same reason why many “Ethereum Killers” have failed, despite the fact that many of them have a bad approach (e.g. leaning towards gains for insiders, not giving priority to decentralization, cutting corners, or not adding real innovation).

Ethereum Ecosystem Pyramid
Ethereum Ecosystem. Source: Bankless.

Is it too late to invest in Ethereum?

Do other, newer, cheaper chains have a better risk/reward ratio?

I can’t think of a better answer to those questions than the one provided in Arthur Hayes’ article Five Fucking Digits. In his article, Hayes explains that ETH, despite having a much bigger market capitalization than its competitors, is still cheap on a network fundamentals valuation basis. Hayes supports this by comparing ETH’s valuation to that of its main competitors’, relative to the developer count, number of addresses, and value locked in DeFi (TVL). Considering ETH is cheaper on a fundamentals valuation basis compared to the alternatives, I think it is safe to say, from an investment perspective, that ETH offers the most attractive risk/reward ratio out there.

“The Most Important Scarce Resource is Legitimacy”

Blockchain technology is not like many other technologies in the sense that, if you want to decentralize a network, you can’t just turn on the “blockchain switch”. In order for it to properly function, a powerful social force called legitimacy is needed.

Legitimacy is defined in Vitalik’s post as:

“Legitimacy is a pattern of higher-order acceptance. An outcome in some social context is legitimate if the people in that social context broadly accept and play their part in enacting that outcome, and each individual person does so because they expect everyone else to do the same”.

To understand this idea of legitimacy, ask yourself:

  • Why is Ethereum capable of paying considerably more for security than any other smart contract blockchain?
  • Why can blockchains recover from a 51% attack?
  • Why are some hard forks much more valuable than the practically technologically identical forked blockchain (eg. Ethereum vs Ethereum Classic, Hive vs Steem, etc.)?
  • Why are some NFTs more valuable than others, despite use of the exact same image to represent them?

The answer to all those questions is legitimacy.

It has been challenging for me to understand the concept of legitimacy in blockchain ecosystems, but something I have found helpful is to think about the relationship between legitimacy and community.

Why is community so important?

In blockchain ecosystems, legitimacy grows and is maintained within the community. Community not only hosts legitimacy, it is also where the power and responsibility of maintaining the blockchain are actually disbursed to its members, thus making the network more distributed and decentralized.

“For a blockchain to be decentralized, it’s crucially important for regular users to be able to run a node, and to have a culture where running nodes is a common activity”. — Vitalik Buterin in “The Limits to Blockchain Scalability”.

The stronger the community, the more legitimate it can be, and considering Ethereum has a proven, powerful network effect feeding users, devs, investors, and validators, I think Ethereum has the strongest community among smart contract blockchains.

It’s all about community meme
It’s all about community meme.

Befriending Moloch

Early on in my crypto journey, I realized that you don’t fully grasp the value of blockchain technology until you truly understand how it can help solve big problems.

One big problem that took me quite a lot more time to understand is coordination failures — the scourge of Moloch.

An illustration from Charles Foster’s 1897, Bible Pictures and What They Teach Us, depicting an offering to Moloch
An illustration from Charles Foster’s 1897, Bible Pictures and What They Teach Us, depicting an offering to Moloch.

What is Moloch?

My definition of choice is this: Moloch is the answer to the question “why can’t we have nice things”?

The name “Molech or Molek” (depends on translation) appears several times in the Bible referring to a pagan god; it is the same god some have referred to when mentioning the 40-foot-owl statue in the Bohemian Grove ceremonies. Surprisingly, Moloch is also mentioned in Wikileaks’s Hillary Clinton Email Archive. For the purpose of this piece, we will refer to Moloch as the “God of human coordination failure”.

I think the essence of Moloch is best described in this fish farming coordination failure story:

“As a thought experiment, let’s consider aquaculture (fish farming) in a lake. Imagine a lake with a thousand identical fish farms owned by a thousand competing companies. Each fish farm earns a profit of $1000/month. For a while, all is well. But each fish farm produces waste, which fouls the water in the lake. Let’s say each fish farm produces enough pollution to lower productivity in the lake by $1/month.

A thousand fish farms produce enough waste to lower productivity by $1000/month, meaning none of the fish farms are making any money. Capitalism to the rescue: someone invents a complex filtering system that removes waste products. It costs $300/month to operate. All fish farms voluntarily install it, the pollution ends, and the fish farms are now making a profit of $700/month — still a respectable sum.

But one farmer (let’s call him Steve) gets tired of spending the money to operate his filter. Now one fish farm worth of waste is polluting the lake, lowering productivity by $1. Steve earns $999 profit, and everyone else earns $699 profit.

Everyone else sees Steve is much more profitable than they are, because he’s not spending the maintenance costs on his filter. They disconnect their filters too.

Once four hundred people disconnect their filters, Steve is earning $600/month — less than he would be if he and everyone else had kept their filters on! And the poor virtuous filter users are only making $300. Steve goes around to everyone, saying “Wait! We all need to make a voluntary pact to use filters! Otherwise, everyone’s productivity goes down.”

Everyone agrees with him, and they all sign the Filter Pact, except one person who is sort of a jerk. Let’s call him Mike. Now everyone is back using filters again, except Mike. Mike earns $999/month, and everyone else earns $699/month. Slowly, people start thinking they too should be getting big bucks like Mike, and disconnect their filter for $300 extra profit…

A self-interested person never has any incentive to use a filter. A self-interested person has some incentive to sign a pact to make everyone use a filter, but in many cases has a stronger incentive to wait for everyone else to sign such a pact but opt out himself. This can lead to an undesirable equilibrium in which no one will sign such a pact.”

Why is this a big problem?

One way to measure human progress is by our ability to develop better ways to coordinate with each other. Language, religion, governments, nations, constitutions, monetary systems, the scientific method, and the internet are all fruits born from the tree of human coordination. Each one of these inventions is a small battle won against Moloch (though they come with their own sacrifices). But there are many more battles we haven’t won yet: corruption, censorship, privacy, fair trade, economic justice — the list goes on.

“Finding, discovering, and building systems that enable unstoppable human coordination is SO INSANELY BULLISH FOR HUMANITY, that even the most grandiose sci-fi authors CAN’T DREAM of the future we’re about to build with this technology.” — David Hoffman in Ethereum: Slayer of Moloch

How is Ethereum related to all of this?

I think David explains it best:

“Unstoppable code, immutable transactions, and unprintable money is the ultimate coordination toolkit that humans have never had before…Ethereum is a platform for the production of coordination mechanisms…means the world is about to become a lot more coordinated”.

The World Computer Goes Green

The Merge is the most anticipated crypto event of the year, and a historic upgrade for Ethereum. According to the latest estimates, the Merge is expected to happen between September 14–15, 2022. In brief, the Merge represents the switch from proof-of-work to proof-of-stake as the engine for block production.

The Merge diagram
The Merge diagram. Source: ethereum.org.

There is so much going on around the Merge, but I want to focus on why ETH’s value will appreciate in the coming months, and it all has to do with the concept of Ultrasound Money.

Ultrasound Money is a meme focusing on the likely ETH supply reduction due to the combination of EIP 1559 (BASEFEE burn) and the Merge. After the Merge, ETH issuance will be reduced ~60–90% (depending on staking participation), which is equivalent to at least two Bitcoin halvings in one shot.

Hal Press, a crypto analyst from North Capital, wrote a very compelling case for Ethereum as a generational investment. In that piece, Hal explains why the Merge will be the most powerful structural flow catalyst to ever occur in blockchain ecosystems. My main takeaway of his is:

“From a price action perspective, it will switch from an environment that needs ~$5mm of new money entering the asset on a daily basis just to maintain current prices to an environment that will require ~$30mm of existing holders to sell their tokens every day just to maintain a level price without going up”.

That is a hell of a lot of perpetual buying pressure for ETH.

After the Merge, ETH will be ESG compliant (no more energy-hungry miners), enabling new institutional investors to invest in ETH. And we are already seeing this taking place with the Swiss bank SEBA.

Many are framing staked ETH as an internet bond, because, with proof-of-stake, you can stake ETH to perpetually generate yield.

“If we can convince the fiduciaries that the classification of ETH is a bond rather than a currency, then a whole new set of fiduciary clowns can be mentally primed to allocate into the ecosystem”. — Arthur Hayes in “Five Fucking Digits”.

Now that we have discussed the bullish case for Ethereum, we should also talk about the main risks and challenges to the Ethereum ecosystem. I like the way altcoinmonk has helped me make the Ethereum case stronger by casually asking the hard questions and always testing the thesis (as we should). The following analysis is based on our conversations.

Risks

Based on the last cycle performance, I think ETH doesn’t represent a much higher risk than BTC (the current ‘less risky’ cryptocurrency). Yes, ETH is currently more volatile, and yes, it normally doesn’t perform as well as BTC in bear markets (although ETH/BTC is currently making new local highs). That being said, many of the risks involved in BTC would probably also hit the entire cryptocurrency market, including ETH.

What are some of the extra risks involved in ETH?

What happens if more stablecoins blow up? What if regulators crack down on Ethereum for being unstoppable (e.g. Tornado Cash case) or suddenly decide to label it as a security? What if the Merge doesn’t work as planned? What if Ethereum’s complexity creates more problems than improvements? What if DeFi is not as resilient as we thought it was?

Challenges

Is it environmentally friendly? It doesn’t have a limited supply, so is it sound money? Security is too costly, is it efficient enough? All these challenges have an easy response now, they will most likely be solved after the Merge.

Is it too expensive for retail users? Will it be suitable for mass use? What if retail users don’t care much about decentralization? These are more challenging matters, and solving the scalability trilemma is definitely not an easy task. But the roadmap is clear and if there is a team/community that is most suitable for these challenges, it would be the Ethereum devs, in my opinion, as most of the innovation in the blockchain ecosystem comes from them.

Ending with Positive Tailwinds

ETH has one of the best risk/reward ratios out there. It is arguably the best candidate to solve the scalability trilemma; it is the smart contract chain with the biggest network effect and greatest legitimacy; its coordination mechanisms can help solve some of the biggest problems in the world; and it may well become a deflationary asset. All of these properties create a steady gust of protocol-supporting tailwinds for ETH. We must not forget that most of the value that blockchain ecosystems will create, by potentially solving all sorts of human coordination failures, is still ahead of us.

Thanks to altcoinmonk for input and editing.

Also to:

packyM for the art of making not boring articles.

TrustlessState for explaining amazing concepts.

NorthRockLP for betting the fund on the Merge.

VitalikButerin for the valuable knowledge posted on the “official EF travel blog”.

yuan_han_li for the meme idea.

CryptoHayes for the awesome writing style.

Bios

Author:

Alphadegen.eth is a crypto fund manager, scout nansen_ai, and a DeFi enthusiast. He is interested in finding ways to leverage decentralization technology to improve human coordination.

Editor:

Hiro Kennelly is a writer, editor, and coordinator at BanklessDAO and the Editor-in-Chief at Good Morning News. He is also helping to build a grants-focused organization at DAOpunks.

BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.

Bankless Publishing is always accepting submissions for publication. We’d love to read your work, so please submit your article here!

This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.

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Alphadegen.eth

Alphadegen.eth

Scout @nansen_ai 🧢, #DeFi enthusiast