Weekly Onchain Insights: EIP-1559 & The Flippening
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One common argument for Bitcoin’s advantage over Ether is its predictable, limited maximum supply of 21 million. Although EIP-1559 is not expected to make Ether deflationary near-term, it does start to reduce its net issuance as ETH will start to be burned through the introduction of the base fee. This fundamentally restructures Ether’s monetary policy and raises several questions about Bitcoin’s premium over Ethereum. (For those unfamiliar with EIP-1559, we covered it a few weeks back in an edition of the newsletter which you can find here.)
With EIP-1559 in mind, it is worth taking a step back and analyze key indicators for Bitcoin and Ethereum. This week we’ll assess on-chain data pointing to the value being generated by the two largest crypto-assets in terms of utility, network effects and monetary premia. Finally, we’ll consider these to assess the possibility of the flippening following the upcoming Ethereum upgrades.
Number of Transactions
The number of transactions taking place on a blockchain provide a sense of the utility being created from using it. Since it costs users to execute a transaction on the blockchain, they are presumably obtaining value from them. Tracking on-chain activity over time, we see that Ethereum transactions have outnumbered those in Bitcoin since the summer of 2017.
Although ICOs are no longer the primary use-case for Ethereum as they were in 2017, hundreds more have emerged from finance to gaming to digital art. The creation of these decentralized applications has led to a constant increase in ETH transactions since 2020, with the 7-day average number of transactions growing 120% over that time. On-chain transactions for Bitcoin, on the other hand, have dropped by 20% since January 2020.
This trend points to increased activity on Ethereum, but relatively stagnant on Bitcoin. Ultimately, this suggests a greater and increasing amount of utility being generated by Ethereum.
As we will dive into further on, Ethereum being a smart contract platform is currently valued more closely in relation to its transaction activity than Bitcoin.
Fees Generated
While transactions give an idea of a network’s utility, the fees it generates provides a better gauge for its demand. Given the limited blockspace of Bitcoin and Ethereum, fees can amount to relatively high amounts to end-users. Although these may price out some users, the total amount paid in fees allow us to quantify the aggregate willingness to pay for usage of blockchains. In this case, Ethereum has recently surpassed Bitcoin and held above it throughout most of 2021.
The first time Ethereum’s fees became greater than Bitcoin’s for a sustained amount of time was during DeFi summer. As financial use-cases and opportunities for yield blossomed on Ethereum, demand to transact on its blockchain reached over $10 million per day for the first time.
Ethereum’s high fees have since become a highly-contested subject. Although EIP-1559 is not expected to decrease fees, it better aligns Ethereum users and Ether holders. This is the case as increased usage of the network will result in a higher amount of ETH being burned, directly benefitting holders from network activity. Moreover, by introducing block size adjustments EIP-1559 is expected to result in smoother, more predictable fees for end-users.
With the base fee being burnt, higher Ethereum demand can potentially result in lower supply. This in turn disincentivizes spending ETH in the short-term, allowing fees to cool down and supply to increase up to equilibrium. By doing so, EIP-1559 establishes a dynamic monetary policy. Although this may not be as predictable as Bitcoin’s fixed supply schedule, this shift in issuance enables Ether holders to benefit more clearly from demand for the fees it generates.
Number of Holders
Another key piece to evaluate with regards to the flippening is the network effects created by Bitcoin and Ethereum. Being digitally-native protocols, both Bitcoin and Ethereum make up networks connecting users globally in a permissionless and decentralized way.
Metcalfe’s Law states that the value of a network is proportional to the squared number of users. In crypto, where there is no concrete number for users, the number of addresses with a balance acts as a proxy. Even though users can have multiple addresses, often times one address managed by a central entity (such as exchanges) manages funds for multiple users.
As the number of holders of Bitcoin and Ethereum, their networks become more valuable as there are more potential ways for their users to transact or connect with one another. In this end, Ethereum has also managed to surpass Bitcoin.
Despite its first-mover advantage, Bitcoin has lagged behind Ethereum in terms of its growth in number of addresses with a balance. Currently, there are approximately 20 million more Ether holders than Bitcoin holders.
This is likely to be the case as Ethereum supports broader use-cases than Bitcoin. Ecosystems around NFTs and DeFi have attracted several users for Ethereum and amplified its network effects. That being said, though, Bitcoin does continue to lead over Ethereum in its core functionality.
Transaction Volume
Since Bitcoin’s inception peer-to-peer finance has been at its core. The size of the financial activity taking place on top of blockchains is perhaps best demonstrated by the transaction volume they process. In this indicator, Bitcoin continues to outpace Ethereum, at least when considering their native assets only.
Bitcoin still regularly manages the most trading volume both on-chain and off-chain. Although transaction volume for BTC and ETH have converged recently, Bitcoin is still processing $2 to $4 billion more per day.
This additional liquidity — along with its predictable supply schedule — is likely playing a role in Bitcoin’s higher valuation and monetary premium.
Market Cap & Monetary Premia
We would be remiss not discussing market cap when analyzing the flippening. Despite most of key indicators pointing to greater utility and network effects being created by Ethereum, Bitcoin continues to be the king in terms of valuation.
Ethereum, however, has significantly caught up with Bitcoin. Since 2020, Ethereum’s market cap has grown by 1,600% while Bitcoin’s market cap has increased 400%. In terms of their relative market caps, Ethereum is currently about a third of the size of Bitcoin.
While Ethereum has become in many ways more used than Bitcoin, it makes up a smaller percentage of its market cap than it did in 2017. As previously mentioned, Bitcoin’s fixed decreasing inflation is arguably a major factor leading to its higher valuation. This is the case as Bitcoin’s predictable supply sets the base for it being a store of value.
Moreover, having been around for longer Bitcoin has a greater lindy effect, giving greater confidence to investors that it will continue to be around the longer time passes. These two characteristics create a monetary premium for Bitcoin, where indicators like the number of transactions are evidently less relevant when valuing it than in Ethereum’s case, where the network’s utility plays a larger role.
In light of the implementation of EIP-1559, however, it is worth asking — will Ethereum develop a similar monetary premium as ETH supply starts being burned? And would this be a threat for Bitcoin’s existing monetary premium?
Although the answer to these questions will be answered with time, EIP-1559 is likely to play a key role in the way the relationship between Bitcoin and Ethereum advances. Being the first step towards decreasing Ether’s inflation, it is feasible to believe that more and more investors will start seeing its potential as a store of value. Ultimately, this would influence the way Ethereum is valued and bring forth higher chances for the flippening.
