The cryptocurrency market is inefficiently priced because of information asymmetry and pervasive cognitive bias such that black swan-type events are possible and already occurring. In the last few years, nearly any investment in low market capitalization cryptocurrencies has been, to varying degrees, a high beta call option for the cryptocurrency market as a whole. This price action reinforces retail investors, and even institutional confidence in non-productive assets without fundamental value and seemingly validates their illogical narratives.
Big Players, False Narratives
The most common misconception is the belief that superior technology is the ultimate driver of value. In actuality, network effect and security are more fundamental to cryptocurrency value than transaction rates and low fees; Bitcoin being the prime example. Network effect is the requisite foundation on which technology is built for crypto assets. The most advanced cryptocurrency in the world is useless without users. And yet, even the most influential players are confused. Elon Musk, with his 58 million followers, recently tweeted:
Elon utilized a superior technology strategy across all of his successful ventures from Paypal to Tesla to SpaceX because usually, and intuitively, superior technology wins. But part of what makes crypto so misunderstood is the unintuitive concept of decentralized blockchains and their complexity. Elon, and the broader market, are blind to several “moats” that make bootstrapping a blockchain to the level of Ethereum nearly impossible.
Foremost, Elon’s Dogecoin premise implies that crypto asset value is equivalent to superior technology. The short history of crypto has repeatedly refuted this in the form of EOS, TRON, and several others, both of which made decentralization sacrifices in favor of transaction rate and are now effectively failed projects.
Why is this? No logical actor wants to risk their money on an unproven platform. This is evident as millions of dollars are spent on the Ethereum blockchain daily in fees alone. Other protocols may have the ability to transact quicker and cheaper, but those protocols can’t effectively (or theoretically) prevent censorship or protocol-breaking attacks because they have too little securing their networks. The point of cryptocurrency, as people so often overlook, is freedom from any centralized entity influencing your funds — a feature nascent protocols can’t reliably offer.
The Code Moat
The Ethereum Virtual Machine has massive developer and codebase momentum that took years to create. Consider the success of Binance Smart Chain (BSC), for example. Binance, the gargantuan Chinese cryptocurrency exchange, literally copied nearly every aspect of Ethereum from its protocol code to user experience (UX) clients like Metamask, to the Etherscan.io block explorer. Binance had to rely on fundamental interoperability with the Ethereum Virtual Machine (EVM) because the code is well established, trusted, and is already familiar to cryptocurrency users. BSC’s success is a testament to the network effect of Ethereum and the fact that Ethereum’s demand remained despite BSC’s existence is antithetical to the idea that Ethereum is readily replaceable.
A major critique of the EVM is the complexity of smart contracts that have led to many well-known hacks and millions of dollars stolen throughout the life of Ethereum. This complexity, while at times detrimental, is also a major moat for Ethereum. An immense amount of developer time, auditing, testing, and persistent attacks contributed to the natural evolution and ongoing strengthening of the Ethereum ecosystem. It cannot be understated that security and the confidence built over years of battle-tested product iteration are impossible to replicate overnight.
Equally difficult to replicate is the composability of the Ethereum ecosystem. The fact that tokens and protocols interoperate, that wallets and decentralized exchanges work together and build off one another and that the user experience between many protocols is continually improving, is a result of a massive, unified (but decentralized) development effort.
Another common misconception is that the Ethereum ecosystem can easily be replaced as though all the users, applications, developers, security, and investor confidence are fungible; as if this is a simple situation like MySpace and Facebook. Unlike cryptocurrency users, MySpace users have nothing at stake — no “skin in the game”. To move from MySpace to Facebook, there are no entrenched economic incentives, no emotional attachment to wealth (imagined or real), and no major questions of security or censorship resistance. The only barrier to setting up a Facebook account for a MySpace user was thirty seconds of setup time in a relatively familiar and more aesthetically pleasing interface. In other words, MySpace had no meaningful moats.
Another tech mogul’s latest business venture is evidence that the market is severely confused:
The counterfactual to Jack Dorsey’s thesis is that nearly 13 years after inception, decentralized finance (DeFi) does not already exist on Bitcoin in any meaningful way — likely because it is infeasible to create a competitive DeFi ecosystem on Bitcoin’s protocol. It is no surprise Jack is as caught up as anyone in all the same narratives about Bitcoin: he and his company, Square, is heavily invested in the success of Bitcoin. These narratives attempt to give Bitcoin a special reverence based on attributes considered unique to Bitcoin alone. The chief narrative among them being that Bitcoin is the original chain and has never split from the original chain and therefore maintains perfect immutability. Subsequent to this characteristic of perfect immutability, Bitcoin maximalists believe the original chain should never be altered and consider steadfastly maintaining the original cryptocurrency technology and arbitrary monetary policy of 13 years ago a feature, not a bug.
All the while, the DeFi phenomenon (and arguably anything interesting you can do with crypto) is happening almost entirely on Ethereum. The chart of DeFi growth this year is up and to the right. In the midst of all the demand, Ethereum had trouble keeping up with transaction throughput. Fees were high in peak usage and remain high in the competition for block space. Despite this, Jack wants to attempt to create DeFi on Bitcoin (and likely spend millions trying)?
Michael Saylor should be an example to both Elon and Jack since he came to the conclusion about the utility of Bitcoin as a store-of-value well before them. Most notably, having spent months pounding the table about Bitcoin, Saylor has transitioned from calling all other cryptocurrencies worthless to admitting, “Ethereum is attempting to dematerialize the JP Morgan building.” However, Saylor’s capacity for Bayesian inferencing — updating his worldview based on new information — is a rare trait indeed and even rarer when large sums of money are involved.
A Confluence of Bias
If big-brain business leaders are confused, you can be assured retail investors are even more lost. One need only take close look at a few of the crypto assets in the top 10 to realize how mispriced the market is. Namely, Cardano (ADA) has an unexplainable $38 billion fully diluted market capitalization as a smart contract platform yet to process a single smart contract. You read that right. Nearly four years since its creation and a smart contract platform with no smart contracts is the 5th most valuable crypto asset available. Sliding in at number 8, Dogecoin has a market cap of $24 billion and is nothing more than a meme propped up by Elon (probably as a joke at first).
Coinbase and Grayscale to name a few, as ironic intermediaries antithetical to the fundamental tenets of decentralization, only serve to further obfuscate asset prices in crypto by rushing to list memecoins (DOGE) and continuing to support failed projects (EOS, ETC, TRON, LTC, BCH). Retail investors who, on top of failing to do basic due diligence, are easily persuaded by memecoins and unit bias — bias induced by the unit cost of an asset that affects their analysis of the potential investment value (1 BTC = $31K ∴ expensive, 1 ADA = $1.2 ∴ cheap).
As heretofore stated, most crypto pricing inefficiency exists due to information asymmetry and cognitive bias. Information asymmetry arises from the fact that cryptocurrency, blockchain, and economics are complex, abstract concepts. Bias and human nature obscure truth-seeking and facts in cryptocurrency. It is only natural for people to assume they missed an opportunity when an asset increases by hundreds of percent. So, they look elsewhere for new opportunities with high potential. If or when an asset they own increases by orders of magnitude their biases are confirmed and their emotional attachment to tangible wealth is a non-negligible (and an often insurmountable) influence on their assessment of reality.
Perhaps the most important factor of human psychology in the pricing of the crypto market over the last few years is patience, or rather, the lack thereof. Intertwined with patience is the human tendency to poorly assess time, for which Bill Gates rightly commented, “Most people overestimate what they can do in one year and underestimate what they can do in ten years.” The demand for high-speed, highly secure, decentralized blockchains to process smart contracts and host a decentralized ecosystem arrived faster than the technology could progress. Often overlooked, once a protocol like Ethereum gains network effect and significant monetary value, it has a certain responsibility to move slowly and methodically so as to protect the growing ecosystem and countless development hours. But people are impatient, impatience leads to pessimism, and pessimism leads to hyperbolic narratives that claim Ethereum will never scale to support millions of users at once.
The Future of Scaling
It has taken longer than expected. At one point I thought proof-of-stake (PoS) was imminent in 2018. Only a few months ago, I was certain the roll-up-based scaling solutions of Optimism, zkSync, and Arbitrum would be launched by the end of May. It is now mid-July and Optimism has launched in an alpha-stage with Uniswap V3. The GIF below displays the real-time user experience of Uniswap utilizing Optimistic rollups. Note how the experience is nearly instantaneous and extremely cheap (see https://optimism.io/gas-comparison for fee comparison).
Importantly, rollup scaling inherits the Layer 1 security of the Ethereum blockchain. As a result, rollups allow popular trading protocols for tokens and even non-fungible tokens (NFT’s) to be traded at speeds normally associated with centralized protocols like Binance Smart Chain. Now, one need not give up immutability and decentralization to transact at light speeds and with low fees. The trade-off? Composability. Rollup systems require you to deposit Ether into their protocols for use which means separate protocols that have not adopted the same rollup solution require you to return to the Layer 1 chain to interoperate — for now. Bridges and other interoperating solutions are in the works to mitigate fragmented layer 2 protocols. Ultimately, as rollups develop and gain traction over the next few months, the burden on the Layer 1 protocol of Ethereum should be greatly reduced.
Likely by early 2022, a second boost to Ethereum’s transaction throughput will come as a result of what is now called the “merge” between the Ethereum Proof-of-Stake (PoS) beacon chain and the current Ethereum protocol. Whereas Ethereum currently supports approximately 30 transactions per second (TPS), the expected TPS in concert with rollup solutions could approach 100,000. (Visa does approximately 60,000 TPS.)
The “Ethereum is too slow” and “Ethereum will never scale” narratives being imminently invalidated by rollup solutions, the obvious question becomes what of competition smart contract platforms such as BSC, ADA, Polkadot, and Solana? As I discussed in the case of previous Ethereum competitors, the market has demonstrated a preference and demand for decentralized transactions on a secure blockchain observable through the high fees on Ethereum. Without demand, fees are low. If investors were only interested in low fees and high transaction rates, EOS and TRON would have killed Ethereum long ago and BSC would be annihilating Ether demand currently. Therefore, it seems improbable other smart contract platforms will exhibit major growth without differentiating themselves through specialization and niche use-cases.
Store-of-Value
In concert with EIP-1559 fee burning, the lower issuance rate of PoS will decrease ETH issuance per day dramatically, if not make Ether issuance negative. An Ethereum core developer, Tim Beiko, tweeted:
At the current gas limit, the PoW chain would be deflationary with a baes fee of ~150 gwei (133 for block rewards, and some buffer for uncle rewards). On PoS, with the current daily issuance (~1100 ETH), the chain would be deflationary at ~11 gwei.
For context, 11 “gwei” is approximately $0.0002 and Ethereum fees have not been that low since early 2020.
EIP-1559 makes Ethereum a productive asset. This means that demand to use the blockchain equates directly to value for the Ether holder. Transaction fees are “burned” after EIP-1559 such that high demand equates to less Ether issuance per day.
Some call the combination of Proof of Stake and EIP-1559 the “triple halving” in reference to the Bitcoin monetary policy that reduces issuance every 4 years by half. To use an analogy, imagine every oil producer in the world were to reduce their production by half. The price of oil would skyrocket in a short time. This was the cause of Bitcoin’s price surge from May of 2020. Now imagine decreasing the number of barrels produced by 90% or stopping production altogether — this is what is about to happen with Ethereum (planned for December 2021). This is on top of other mechanics such as Ether staking and locked value in smart contracts that makes Ether even more scarce. (Check out SquishChaos’s paper for an in-depth review on the coming “supply shock.”)
The issuance and sell pressure on Ethereum are set to decrease dramatically. In PoS, staked ETH is collateralized by “validators” as an assurance that they will be truthful actors and come to a consensus on the state of the blockchain. Malicious validators risk being “slashed” or, in other words, lose their collateral. The more monetary value at stake the more money is required to maliciously attack the PoS system. Therefore, Ether value equals more security in PoS and Ether likely becomes more secure than even Bitcoin after the merge. Already there is nearly 6.2 million ETH (~$15B) locked as validators on the beacon chain.
Finally, it cannot be understated how environmentally conscious the West is becoming. In effect, Proof-of-Work is reducible to a consensus mechanism based on electricity usage. One can argue the renewability and environmental impact of such a system, but the same arguments cannot be levered against Proof-of-Stake.
Long-term Bullish (6–12 Months)
Institutions and retail investors alike have entrenched themselves in a Bitcoin future and either purposefully ignore, or are too biased to understand, the Ethereum developments I have outlined in this report. We know big influencers such as Elon Musk, Jack Dorsey, Michael Saylor, and others readily dismiss Ethereum without fully understanding it. If they do not understand Ethereum and the impact of PoS, a large percentage of investors are equally unable to accurately price the future of the crypto market. For all these reasons, Ether is still heavily undervalued by most market participants.
It appears that Bitcoin has found support around $30,000. A bearish trend is likely to continue as Grayscale Bitcoin Trust shares (GBTC) unlock through the end of this month. However, GBTC is trading at a 12% discount to the BTC market which means any sellers of GBTC from December and January 6 month lock-up period would be selling at break-even or at a loss. Additionally, accumulation is visible across on-chain metrics, a reversal from a bearish trend of long-term holders at these levels.
With the China Bitcoin mining ban and tightening regulation behind us, the fundamentals of Ethereum and DeFi are continuing, business as usual. DeFi users are up, total-value-locked (TVL) in DeFi is steadily trending up over the last 30 days. Meanwhile, Ethereum development and meaningful upgrades to the protocol are proceeding as planned.
In summary, there is a lot to look forward to over the next 6–12 months for the cryptocurrency market in general and Ethereum particularly. Ethereum will become a disinflationary asset and arguably a better store of value asset than Bitcoin after the merge.