Valuing Ether: Proof-of-Stake and the Birth of a Digital Bond
Though Ether began its’ history as a commodity, with the rise of proof-of-stake, it appears to be evolving to other areas as well. Here we introduce Ether’s future value proposition in a Proof-of-Stake-based environment.
It’s the world computer. It’s the backbone for the future, blockchain-driven internet. Over the course of Ethereum’s short history, it’s been called all of the above and more, though in times of particular network-congestion, crypto’s leading host for decentralized apps has consistently fallen short. Now, with EIP-1559 on the horizon, it’s never been more important to understand where Ethereum’s, and by extension, Ether’s, value lies today. For that reason, we’ve compiled an analysis of our thoughts on the subject, below.
What makes Ethereum stand out?
If you’ve already read our first post on Ethereum’s developing value, then you know that currently, it’s a platform that could serve as the backbone for both the future of finance and the future of the internet at-large. Now, however, with the implementation of EIP-1559 on the horizon, we’d like to hone in further on Ethereum and Ether’s value propositions to help you better understand why both are key to the future of the entire crypto space.
“Ethereum has replaced the fairly limited scripting mechanism that’s available on Bitcoin with a fully expressive, full-featured programming language or set of programming languages in a virtual machine that runs the programs directly on the network. And so, we can build arbitrarily complex behavior directly into money tokens or equity tokens.”
The above quote from Joe Lubin perfectly encapsulates what Ethereum was meant to be. With Bitcoin’s perceived shortcomings in-mind, Ethereum’s founders intended their new network to be a blockchain-based supercomputer that could, at least in theory, underpin a future, crypto-driven internet. Though many elements of the Ethereum network have evolved since its early days, this central aspect has stayed constant.
What is Ether and how is it used?
From the outset, Ether has always worked as the Ethereum network’s native currency, though in reality, it presents itself more as a commodity. If you consider commodities as they are typically defined, then it’s difficult to understand why this is the case.
Instead, it’s likely better to extrapolate the idea of a commodity to the crypto world.
Through doing so, you’ll discover that Ether is a raw material that’s produced by the Ethereum network and used to pay for access to it. Add in the fact that “access” refers to “access to block space,” and you’ve got the gist of where Ether’s value comes from. When there’s more demand for block space, i.e., more people/organizations trying to access the Ethereum network, then “gas fees,” and by extension, “Ether,” get more expensive.
Gas fees, in case you weren’t already aware, are the payments each Ethereum user has to make to access Ethereum’s computing capabilities. That means that they are similar to payments to Amazon Web Services or any sort of cloud computing provider, except the computing resources in question aren’t owned by a single organization. Instead, they’re owned by the Ethereum community, which will become even more clear once the network makes its’ full transition to Proof-of-Stake-based consensus.
With all of this in mind, suffice it to say for now that Ether is a decentralized commodity that gives anyone access to the sharing economy for any and all decentralized services. At the same time, because a block is added to the Ethereum blockchain once its’ Ether-based fees are paid, it’s also the fuel that keeps the Ethereum network going.
What is Proof-of-Stake Consensus?
If you already know what Proof-of-Stake Consensus is, then you can easily move on to the next section. If not, stick with us for a moment here. Bitcoin, which was the first cryptocurrency to launch, runs on what is called a Proof-of-Work network. Proof-of-work networks depend on specialized users called miners to make sure transactions are legitimate and push them through to Bitcoin’s decentralized database, i.e., “blockchain” in the form of blocks. Generally, a block is nothing more than a group of transactions that have been encrypted into randomized strings of letters and numbers with a unique id in a similar format that references the most recently added block before it.
A key criticism of Proof-of-Work-based networks like Bitcoin is that as they grow, it becomes so expensive to be a miner that only deep-pocketed organizations with easy access to specialized computers can do so. Critics of such networks use this to conclude that the possibility of decentralized governance, or leadership by the network’s community, eventually becomes lost due to such a high barrier to entry.
Proof-of-Stake addresses this through moving away from mining altogether and towards block validation that’s based on ownership of the network’s native cryptocurrency. In Ethereum’s case, with the launch of the Beacon Chain last year, it’s already clear that the threshold will be 32 Ether to become a validator. This doesn’t mean, however, that less wealthy users can’t take part as well. Stake delegation services exist specifically to allow anyone to delegate almost any amount of Ether to an approved validator and in return, receive a percentage of the profits said validator generates.
Let’s take a step back for a moment before we get too far into the weeds.
On paper, Proof-of-Stake networks are supposed to be more decentralized because anyone can buy the minimum threshold of coins to become a validator or simply join a delegation service with the Ether they have. Still, networks like Bitcoin allow for the same capability, through cloud-mining services.
Therefore, in the end, further decentralization isn’t necessary the key to Proof-of-Stake’s potential.
Why Proof-of-Stake Matters for Ethereum
So, why adopt it then? Why move away from mining at all?
Essentially, it all comes down to speed. Proof-of-Work networks are slow by design because they depend on miners.
Bitcoin, for example, processes an average of 3–5 transactions per second, which you can see plotted out in the graph above. If you ascribe to the thesis that Bitcoin is digital gold, then this likely doesn’t matter to you. A store of value, on the most basic level, only needs to be moved around when it’s initially bought and when part or all of it is sold. Consequently, it isn’t meant to be trading vehicle.
Ether, on the other hand, needs to frequently change hands, since it works as a settlement mechanism for the developers and users of decentralized applications, which we’ve previously discussed in our introduction to its’ value. As the Ethereum network has grown, however, it’s become harder and harder to move Ether due to progressively more prohibitive gas fees. Currently, for example, the Ethereum blockchain is only processing just above 8 transactions per second on average, having undergone a sharp-drop in performance at the start of this month, which you can see below.
When this present data is compared to Ethereum’s long-term performance, it’s easier to make an educated guess on which trends are likely the key culprits here. Consider, for example, the data below, which zooms out to the network’s all-time performance.
Here we see that Ethereum’s TPS(transactions per second) began to climb with the rise of the DeFi movement over the course of 2020, showing no signs of stopping until this month. One way of accounting for this seemingly sudden roadblock would be to say that the network simply reached its capacity in terms of the transactional growth it could take on. In other words, perhaps, Ethereum can’t currently handle any more increases in overall transaction volume like launches of new DeFi-lending services, without losing a major step.
Even if this isn’t exactly the case, a strong argument remains that by the numbers, Proof-of-Work networks weren’t meant to host applications or do anything that requires frequent transactions. Their security model, i.e., mining forms the major foundation for such a conclusion.
Where Proof-of-Stake’s Value Comes in
Through shifting its’ security-model from being dependent on miners to being dependent on validators who work in microcosms of its’ blockchain called “shards,” Ethereum is theoretically supposed to be able to achieve far more transactions per second than it can now and consequently, rise above the roadblocks that a Proof-of-Work security model creates.
What are shards and how do they work?
At face value, shards are mini-blockchains that function on their own, but effectively make-up “one network,” as opposed to how the single blockchain that Ethereum uses now.
In such an architecture, miners aren’t needed because anyone who qualifies as a staker and meets certain hardware specifications gains the responsibility of both verifying and confirming all of the transactions a shard receives. In Ethereum’s case, stakers(validators) will be randomly assigned to different shards to “minimize any chance of collusion,” such as validators working together to take over a shard.
It’s this system of staker assignment plus the fact that each and every Ethereum-based service will be assigned to a specific shard that makes “Eth2” so unique. Anyone who is interested in accessing a Dapp or any other product living on the Ethereum network will have to make a specific connection from their wallet to the Dapp’s shard, as opposed to all connections being made to one Ethereum blockchain at once. Consequently, with the full-launch of Ethereum’s sharded-architecture (Eth2), the network’s potential congestion will be split into as many parts as there are shards. As a result, it is anticipated that its’ transaction speed will greatly increase and its’ fees will greatly decrease as long as enough shards are created to handle the transactions that come in as Ethereum continues to scale.
What about Ether?: The Future Value of Ethereum’s Native Coin
All of the above analysis has been in the interest of setting the scene for Ether’s future value. Now that you understand the bare-minimum of how “Eth2” will work, it’s possible to bring Ether back into the picture.
Provided that all goes well with Eth2’s full launch, it appears that Ether will function not as “digital gold,” but more like a “digital bond,” which will be the focal point of our next post in this series.
Even so, to set the scene, imagine a bond as it is in the traditional financial markets.
At its’ most basic level, it’s a loan of capital in exchange for interest on that capital(yield) until it’s paid back. Ether, once it’s fully-functional as a staked-asset, should be the crypto equivalent of a bond because, like a bond, the earlier in the network’s life you invest your capital, the higher of a yield you should receive.
With this in mind, you can think of Ether as analogous to a treasury-bond, except instead of betting on the future ability of a particular government to pay you back, you’re betting on the ability of a decentralized network to do the same.
Through standing this value proposition up to Bitcoin’s, it’s possible that Ether will evolve into crypto’s leading debt instrument, while Bitcoin remains its’ leading commodity, with both in turn functioning as stores of value in their own respective spheres.
There’s room for digital gold and a digital bond to live on together, hand-in-hand.
The Road Ahead:
In the end, due to the fact that the roads of the crypto industry are still very much being built, only time will tell whether these value propositions persist.
Still, with the above analysis in mind, you now have a further framework for where both Ethereum and Ether’s values lie today as well as where they’re likely going. In our next post in this series, we’ll zoom in and analyze key metrics for valuing Ether now and down the road, and take a close look at EIP-1559 to help you develop a solid understanding of why it’s likely key to the survival of the Ethereum network over time.
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