The Bull Case for ETH
Disclaimer from DeGate:We are thankful to Cliffton for allowing us to reproduce his article. Any opinions expressed do not necessarily represent the views of DeGate.
Disclaimer — I’ve learnt so much from the Bankless team and their podcasts, and have shamelessly plugged their structure and content on ultra scalable ethereum and ultra sound money into this article. Would highly recommend all readers to subscribe to their YouTube channel and start their Bankless journey!
TLDR: I’m a strong advocate that Ethereum will be the only L1 as a settlement layer that matters when the crypto scene matures. With ETH 2.0 (assuming that the merge goes well!), other existing L1 ‘ETH Killers’ will eventually pivot to become L2s focusing on high throughput transactions settling on Ethereum.
Ethereum’s scaling strategy and Ether gradually becoming ultra sound money are the key proponents driving this conviction.
Let’s start with..
The Blockchain Trilemma
The infamous Blockchain Trilemma dictates that you can only optimize for two of the three properties of a blockchain. One must be sacrificed due to technical limitations. Those three properties of a blockchain are:
- Scalability — What’s the data throughput of the system? How many TPS
Scalability is the ability to support high transactional throughput
- Decentralization — How many nodes are there?
Decentralization is the central ethos of blockchain technology. Decentralized networks crowdsource consensus, meaning that no one entity can control or censor the data that transacts through it.
However, achieving optimal decentralization tends to decrease network throughput. As more miners/validators secure the network through consensus, transaction speeds drop because there are more parties involved in syncing and verifying the same transactions.
- Security — How difficult is it to attack?
To increase network throughput on a blockchain, there’s an incentive to reduce the distribution of blockchain nodes — of which increases the degree of centralization, which in turns reduces security. With limited nodal distribution, a 51% attack is more likely to occur as hackers can amass hashing power with greater ease and achieve consensus.
In August 2020, the Ethereum Classic (ETC) blockchain — which is unrelated to Ethereum itself — suffered three 51% attacks that reorganized over 4,000 blocks, thus allowing the perpetrators to manipulate data and double spend its ETC currency, resulting in the loss of millions of dollars in value on the network.
Blockchain security is a critical network aspect that cannot be compromised.
So why is this the case? Why can’t blockchains like Bitcoin, Ethereum (pre-merge), Solana and Avalanche achieve sufficient decentralization, security, and scalability in one go?
Because they are monolithic. They try to achieve all three goals on the mainchain.
- Want more block space available by making faster block-times and bigger blocks? Then decrease the number of nodes that can keep up with the chain’s rate of progress — the slow computers of the world won’t hold back the speed of the chain.
- Want fast transactions? Reduce the number of nodes so fewer total computers actually need to do the computation. That way, we don’t have a bunch of redundant computers all doing the same computation (i.e proof of work consensus); we’ll just trust that the few ones that do the hard work of the computation aren’t malicious.
- Want to optimize for security and decentralization? Decrease the supply of block space and reduce node hardware requirements, so that everyone can be a participant in the network, but expect your transactions to take much longer to clear.
Rather than sacrifice decentralization and security which other ‘hotter’ Layer 1 alternatives like Solana and Avalanche are in pursuit of scalability, Ethereum is looking to invert the blockchain trilemma through its scalability roadmap.
Scaling Ethereum through Modularization
TLDR; Ethereum is going modular. Ethereum will be the settlement layer focusing on decentralization and security, and leave scalability to Layer 2 solutions via rollups to the main chain.
Decentralization, scalability and security in any blockchain network are enabled by 3 components. They are:
- Consensus- Provides security and defines the canonical truth about data stored on the blockchain. What block number are we on? What are the contents of block ‘N’?
- Execution- The computation required to update the blockchain from N to N+1. Taking the old state, add a bunch of transactions, and then transition to the new state.
- Data Availability- Data that the Layer 1 guarantees are available to be referenced. All the data that makes up ‘N’.
Here’s a quick example to illustrate these 3 components at work (all bolded).
- One more day to payday! Your bank balance sits at $40,000, and your incoming salary tomorrow is going to increase your balance to $45,000.
- At the start of this month, your bank balance was at $43,000. Your $3,000 worth of expenses are contained in the ‘data availability’ layer — from your daily morning coffees at Starbucks to your rent and utilities, these are all recorded in your bank’s centralized database. Your balance is at $40,000 — this is the state at Block N.
- It’s payday! You get your salary credited to your bank account — behind the scenes, your company sends this payment to your bank, and the bank’s database ‘executes’ a state transition against the ‘data availability’ layer to update your balance to $45,000 on Block N+1.
- The “N+1” state ($45,000) is now reflected on your banking mobile app, web app, and other branch locations. There is ‘consensus’ because all updates take place on a centralized database that only people with the right credentials can access.
Presently, Ethereum as a Layer 1 houses all 3 components. Moving forward, these are going to be compartmentalized — just like with the division of labor, unbundling each component allows the optimization of each, and produce a far better product in which the whole is greater than the sum of its parts.
Modularized Execution on Layer 2 rollups
Layer 2 (eg: Arbitrum, Optimism, Immutable X, zkSync) rollups can process transactions orders of magnitude faster than the mainchain because they are unburdened from the responsibility of consensus and data availability. These rollups only have one goal — maximizing the quantity of transactions executed. They are cryptographically tied to Ethereum — they will make a transaction with Ethereum’s mainnet and make a cryptographic promise (fraud proof / zero-knowledge proof) that it will follow the rules and that all transactions are legitimate.
If the rollup breaks or becomes malicious, users can simply exit all their money from the rollup via an escape hatch — a broken rollup is like a broken escalator; it just turns into stairs.
The bridge between a rollup and Ethereum exists regardless of whether the rollup is online and functioning, and allows the settlement assurances of Ethereum to extend to the rollups on top of it. This bridge connects the security and decentralization of Ethereum to the transaction execution environment of the rollup.
Rollups cost nearly nothing to maintain, and because decentralization is not in focus, very few nodes are required to be live at any given time. At the same time, they are also not burdened by expensive consensus mechanisms that are needed for security. These are all handled on Ethereum’s settlement layer once the rollups are initialized.
Modularized Security with Proof of Stake (PoS) Validators
A PoS consensus mechanism works with validators using the native currency, ETH, as stake to validate transactions on the network.
Where miners in a Proof of Work (PoW) consensus mechanism use raw computing power and hardware to validate transactions (eg: Bitcoin), anyone who can stake 32 ETH can run a validator node in PoS. No longer are specific ‘supercomputers’ responsible for network security — now, your regular, off the shelf MacBook can also play a part in the network’s security. Bye bye ASICs!
Reducing the economic costs of running a validating node down to the cost of capital (32 ETH) and an off the shelf computer significantly increases the total viable number of possible validators. While 32 ETH is expensive, it is an order of magnitude lower than the smallest viable proof of work mining operation ($10’s of millions of CAPEX). Additionally, decentralized staking protocols like Lido and Rocketpool allow for any amount of ETH to be pooled and staked, making the 32 limit an arbitrary number.
These factors combined open the possibility of validating the network to the maximum number of people. This decreases the likelihood of a 51% attack because a whole lot more capital is required to secure a majority stake in the network. Additionally, punitive measures are in place to disincentivize malicious validator behaviour — a significant part of the validator’s stake is slashed if misbehaviour is picked up on the network.
Maximizing Data Availability through Sharding
Ethereum has a ‘validator pool’ of all validators that are up for random selection to validate a block. When more validators come online and supply their stake of 32 ETH to Ethereum, it makes Ethereum more secure.
However, having ALL validators securing one monolithic chain is an overabundance of security, and is in inefficient allocation of resources. Enter sharding.
In phase 1, Ethereum is looking to have a total of 300,000 validators across 64 shards — this equates to approximately 4,500 validators per shard. This makes Ethereum’s scalability positively correlated with its security. There is higher data availability across these 64 shards because there’s just so much more space created for rollups to deploy their bundles of thousands and thousands of transactions. Because rollups compress transactions into compact bundles (like zip files), any increase of data on Layer 1 Ethereum creates orders of magnitude more space for Layer 2 solutions. Increasing the amount of block space that’s available to consume creates massive fee reductions of the rollups on top of the shards.
Also, Ethereum isn’t stopping at 64 shards — the goal is to reach 1,024 shards.
How it all fits in
The beauty of the modular design is that the optimizations to each module amplifies the optimizations to the others.
- Increasing decentralization via PoS increases the number validators to all the shards added to Ethereum
- More shards on the Ethereum Layer 1 adds orders of magnitude more scale to the rollup Layer 2’s because there’s just more block space per shard to house the bundled, compressed transactions.
- More scale on Layer 2’s unlocks newly viable economic activity because now, transactions are faster and cheaper — this ultimately adds more collective fees paid by the rollups to the L1.
- More collective fees paid to Layer 1 Ethereum increases the incentive to run a validator, making the pool of validators larger, allowing for more shards to be created.
It is a virtuous cycle. Of course, it all boils down to execution, which the Ethereum team has a good track record of. If it pans out, over time, Ethereum scales to the masses, and we will see all Layer 1 blockchains either morph into a modular design structure and continue competing with Ethereum, or they will instead do away with the baggage of consensus and data, and instead simply port their execution environment over to a more decentralized chain (ie become a Layer 2 rollup for Ethereum).
Ethereum has solved the scalability trilemma by increasing decentralization, not sacrificing it. Only by optimizing for decentralization are you able to receive the benefits of modularization illustrated above.
Ether becoming Ultra Sound Money 🔊🦇
Let’s start with the definition of ‘sound money’ — sound money is not liable to sudden appreciation or depreciation in value: stable money… specifically: a currency based on or redeemable in gold.”
Fiat and Bitcoin
Fiat is unsound money — central banks can print as much of it as it wants, and it is inherently inflationary. Keeping your assets purely in fiat is the equivalent of allowing your government to change the amount of value you own, just by creating more of what you already have. That’s unsound.
Bitcoin, in contrast, is sound money. There will only ever be a maximum supply of 21 million bitcoin. This fixed supply means that Bitcoin becomes deflationary once all 21 million have been mined, and as adoption and usage picks up, it creates scarcity, and in turn becomes deflationary. This, in essence, is sound money.
Here’s why Ethereum might be ultra sound money. Ultrasound money becomes more valuable over time. It boils down to 2 key factors which significantly drives down the supply of ether: EIP 1559 and the transition to Proof of Stake.
Reduction in net ETH issuance through EIP-1559
Otherwise known as the London Hard Fork, EIP-1559 changes the reward dynamics for verifying transactions on Ethereum, and is a fundamental change required in the transition from Proof of Work to Proof of Stake.
Under the current Proof of Work consensus mechanism, a simple auction system is used to determine which transactions are included in a block. The more you offer to pay in fees, the more likely a miner will include your transaction in an upcoming block. However, this auction system is arguably inefficient because users must estimate the appropriate fee required to complete their transactions. Consequently, some users pay more than other users whose transactions have been included in the same block.
Under EIP-1559, gas fees are replaced by a mandatory and algorithmically determined fee called the “base fee.” This base fee would be paid in ether and fluctuate according to network congestion. This aims to keep the network close to a 50% usage rate, meaning each confirmed block is 50% full.
- If network usage exceeds 50% capacity, the base fee automatically increases.
- If network usage falls below 50% capacity, the base fee decreases slightly.
This predictable pricing mechanism allows transaction costs to be automatically set by wallet providers like Metamask and Coinbase Wallet, and removes the responsibility from users.
**Additionally, base fees would be burned (watch the burn here), and would not be kept by miners. This is intended to reduce ether’s circulating supply and potentially drive up the value of the coin by increasing scarcity over time. To date, more than 1,000,000 ETH in base fees have been burned and removed from circulation, and the average daily burn rate stands at approximately 12,691 ETH.
As network activity continues to grow with more and more users transacting on Ethereum Layer 1 today (see hash rate below which measures network activity), the daily burn rate picks up, which reduces the net issuance of new ether.
In fact, Ethereum had once seen a consecutive week of deflationary issuance for the network, meaning that more ETH has been removed from supply than created through mining. Deflationary Ethereum was not expected until “the merge” — when the Ethereum blockchain is set to merge with Ethereum 2.0’s Beacon Chain, which is currently expected to occur during the first half of 2022.
Essentially, with EIP-1559 and the burning of the base fee for all transactions, the supply of ETH reduces as a function of the growth of the Ethereum economy.
Transition to Proof of Stake
Proof of Stake (PoS) operates on the assumption that there is a sufficient supply of interested parties who will hold and stake ETH in order to access ETH-denominated rewards through validating network transactions. PoS rewards increase or decrease as a function of the supply of ETH being staked to Ethereum.
- If there is less ETH staked, ETH rewards are higher and vice versa.
- As more and more validators stake ETH to Ethereum, the ETH-denominated rewards are reduced.
This process will wash out the lesser-ETH bulls who are less interested in reduced rewards, leaving those who are willing to receive the least amount of ETH possible. Through this mechanism, Ethereum achieves the optimal balance between Ethereum security and ETH issuance — essentially, Ethereum needs to issue the least amount of new currency to provide adequate security for Ethereum.
Once Proof of Stake is adopted and the Proof of Work system is forked away, yearly ETH issuance drops from ~4.75M ETH (4.1% of outstanding supply; 2,372,500 blocks/year, 2 ETH/block), to a projected 0.6–1M with approximately 0.5–1% issuance (staked ETH projected between 10M and 30M). That’s an approximate 80% reduction in ETH issuance.
ETH being Ultra Sound Money
Ether becomes ultra sound money through the compounding synergies created from EIP-1559 and the transition to Proof of Stake. The power of these components are multiplicative.
- With EIP-1559, yearly ETH burn is limiting net issuance of ETH at 1.9%. More than 1 million ETH has already been burnt — this is just going to increase as network activity on Ethereum picks up.
- With the transition to Proof of Stake, yearly ETH issuance is under 1%. ETH issuance drops from 4.75M ETH per year to between 0.5 million ETH and 1.2 million ETH per year.
All of these factors feed into each other and make each other stronger, creating a positive feedback loop into the value of ETH.
This positive feedback loop is furthered by the fact that ETH is the most trustless asset on Ethereum. As the native asset on Ethereum, ETH has favorable risk parameters as collateral on DeFi. Couple that with the rise of NFT adoption — Opensea.io has consistently led the burn leadership board in terms of ETH burnt, accounting for ~11% of all ETH burnt.
ETH is ultra sound money 🔊🦇.
Ultra Sound ETH meets Ultra Scalable Ethereum
There is an intrinsic relationship between the scalability of Ethereum and the soundness of ETH.
- More validators staking ETH with move to PoS ➡️ More security for more shards
- More data available from more shards ➡️ Much more data available on rollups
- More data available for Layer 2 rollups ➡️ Faster, cheaper rollup transactions
- Faster, cheaper transactions ➡️ More total net economic activity on Ethereum
- More total economic activity ➡️ More total fees paid by rollups to the L1 validators
- More fees paid to validators ➡️ Larger incentive to stake more ETH
- Repeat 🔄
The value of ETH on the secondary markets (DeFi, NFTs, Layer 2’s) impacts the value that is paid to validators for securing the network. If ETH goes up in price, validators revenue grows, and this incentivizes more validator nodes to be created. Increased number of validator nodes and validator revenue increases Ethereum scalability and decentralization, decreases transaction fees which incentivizes more economic activity, and it repeats.
To quote Raoul Pal, this is why I’m so irresponsibly bullish on Ethereum. This is my bull case for ETH.