Dragonfly Capital: Reorganizing the Value Narrative and Investment Logic of Ethereum for Its Rough Valuation

This article is sourced from medium, authored by Kevin Hu, partner at Dragonfly Capital, and Celia Wan, junior partner at Dragonfly Capital, and compiled by Perry Wang from ChainNews.

This article attempts to help readers understand the potential implications of the Ethereum network and its native asset ETH as an investment target. However, it does not aim to derive precise valuations or price predictions. This article assumes that readers have a basic understanding of Bitcoin, Ethereum, and the broader crypto ecosystem. The views expressed in this article are not, and should not be considered, investment advice.

Overview

Bitcoin emerged in 2009 as the first trustless digital native currency. Due to its scarcity and non-falsifiability, Bitcoin has the potential to become a universal non-sovereign store of value. As traditional financial institutions began to adopt Bitcoin in large quantities in the second half of 2020, the narrative of Bitcoin as digital gold was solidified. Eleven years after Bitcoin's inception, institutional investors finally began investing in Bitcoin, as this simple yet powerful narrative of value storage started to penetrate the mainstream of the financial industry.

On the other hand, investors' understanding of the Ethereum network and its native asset ETH is complex. Smart contracts, decentralized finance (DeFi), and Web 3.0 remain niche topics. ETH, as an asset, has a complicated value narrative that even full-time professionals in the crypto space find difficult to articulate.

According to the design of the Ethereum blockchain, ETH serves as the fuel (Gas) for the Ethereum network (often referred to as the "world computer"). But what is the use of the "world computer"? Is ETH a consumable, a capital asset, or a programmable collateral/currency? How does ETH accumulate value?

So far, there has not been a concrete single value narrative for ETH.

The remainder of this article will explore the different emerging perspectives surrounding ETH and help investors understand what they might be truly betting on when investing in ETH.

Popular (but somewhat outdated) Economic Analysis of ETH

The current version of Ethereum resembles a distributed operating system with a native token, ETH, used to pay for computational costs, while miners providing computational resources are rewarded through block rewards and transaction fees. Historically, ETH block rewards have been adjusted based on explicit targets for specific expenditures. Notably, compared to Bitcoin, ETH's monetary policy is more aggressive.

In the current model, Ethereum users pay transaction costs in ETH, and ETH holders bear the inflation costs. Assuming no speculative trading, ETH holders are betting that the demand for ETH from users of Ethereum-based applications will exceed the inflation rate brought about by block rewards (which have fluctuated significantly throughout Ethereum's history).

A popular economic analysis of ETH is to view the Ethereum network as an economy and then describe the network's total value using GDP. We can then calculate Ethereum's network value based on the exchange equation PQ = MV, where price multiplied by quantity (total output) must equal the money supply multiplied by the velocity of money (turnover rate). Therefore, the total value of the Ethereum network equals the total amount of ETH in circulation multiplied by the turnover of ETH.

A common conjecture is that, in the long run, the GDP of the Ethereum network could be quite substantial but not particularly enormous, as it is constrained by the deflationary nature of computational costs and the fact that Ethereum transaction fees must be very cheap to be accepted by the masses. The turnover of ETH could also be very high, as there is no reason to hold this frictionless payment method. Thus, ETH's valuation may be relatively low but still capable of supporting a reasonable economic scale. Within this framework, ETH cannot achieve significant economic value because it is a completely substitutable commodity that does not need to be held.

The core of this theory is: 1) the only function of ETH is as a means of payment; 2) the open-source nature of public chains prevents them from retaining IP value; 3) the cost of switching applications to another blockchain is nearly zero. The result is that Ethereum will have weak network effects, and ETH should be priced like a commodity, as users would not be willing to pay more than the cost of production.

Recent Theoretical Developments

While the logic behind the PQ = MV equation is reasonable, this theory has yet to be fully refined. So far, Ethereum remains in a leading position among all blockchains in terms of user usage and developer adoption. Its network effects do not seem to have weakened, and ETH's market capitalization is five times larger than that of the third-ranked layer 1 (L1) public chain.

Compared to two years ago, today's Ethereum is vastly different. In 2017 and 2018, the only use case for the Ethereum blockchain was to conduct token sales (ICOs) for projects, most of which delivered nothing meaningful. Today, Ethereum supports a thriving DeFi ecosystem, and other use cases such as non-fungible tokens (NFTs), gaming, the metaverse, and Web 3.0 are also beginning to take shape.

Average Ethereum Gas Price (can be seen as a barometer of usage; Source: Etherscan)

DeFi has become the first widely used application on the Ethereum network. Currently, DeFi has an asset management scale of $60 billion (peaking at over $120 billion in early May 2021), with over $17 billion in outstanding loans and an average daily transaction volume of $5 billion. These DeFi applications collectively generate over $4.5 billion in annual revenue (this is the fee paid to the protocols over the past 30 days, which can be seen as a revenue barometer) and accumulate significant liquidity, creating network effects.

The current DeFi ecosystem on Ethereum has formed a positive feedback loop, where users bring network effects based on liquidity to DeFi while benefiting from the liquidity-driven DeFi market. As more assets are locked in DeFi, the slippage of decentralized exchanges (DEXs) based on automated market makers (AMMs) and the borrowing costs of lending platforms decrease, making them more attractive to users (although cross-pool does not have network effects, the aggregated network effect is a sub-linear relationship relative to the total locked amount).

Moreover, the composability and interoperability of DeFi protocols create a locking effect for Ethereum, making it difficult for other L1 public chains and sidechains to compete.

Other chains need to cultivate a complete DApp ecosystem and acquire liquidity from scratch to compete with Ethereum—this is no easy task and typically requires substantial token subsidies. In fact, we have seen public chains like Polygon and Binance Smart Chain (BSC) achieve success by replicating DeFi applications on Ethereum while offering low Gas fees and liquidity mining projects as additional incentives. However, even so, bridging these different blockchains will undermine the composability between DeFi protocols, forcing L1 public chains to develop their independent ecosystems.

Total Locked Value in DeFi Development (Source: DeBank)

From an architectural perspective, the most significant upcoming changes to Ethereum are Ethereum 2.0, layer 2 (L2), and the EIP-1559 proposal improvements. We do not need to delve into technical details here; Ethereum 2.0 will transition the Ethereum network from a proof-of-work (PoW) consensus model to a proof-of-stake (PoS) consensus model. Ethereum 2.0 will no longer use computational resources to validate the next block but will rely on ETH holders (validators) to vote on the next block, establishing a security model based on game theory and economics. Ethereum 2.0 will also split the network into 64 shards, allowing for parallel operation, enabling Ethereum to scale in the future.

In the short term, L2, especially rollup methods based on fraud proofs and zero-knowledge proofs, may make the Ethereum network more scalable and reduce fee costs by several orders of magnitude.

Today's Ethereum processes about 15-17 transactions per second (tps). We expect the upcoming Ethereum on L2 to increase Ethereum's throughput to over 2,000 tps (using on-chain data) and over 9,000 tps (using off-chain data). L2 will also significantly reduce transaction costs. Currently, the typical cost of DeFi interactions ranges from $10 to over $100, which means most applications and users are being pushed out of the market. L2 could potentially reduce the cost of DeFi transactions to below $1 (some estimates as low as 10-20 cents), increasing the accessibility of DeFi and Ethereum by 100 times.

Finally, Ethereum may adopt a new monetary policy called the EIP-1559 proposal. EIP-1559 makes some changes to Ethereum's transaction fee algorithm. The most significant impact on our analysis is that this upgrade will result in most Ethereum transaction fees being burned rather than paid to miners.

If the PoS mechanism and EIP-1559 are implemented, the inflation rate of ETH may significantly decrease, and ETH will become a capital asset in addition to being a consumable. This should have profound implications for the appreciation of ETH's value, which will be detailed later.

How Do We View Ethereum Now?

As impressive as the story we have told about Ethereum so far is, the development momentum of DeFi has so far produced a rather unstable existence among a limited user base eager to capitalize on fleeting liquidity mining schemes and project IDOs. However, the various developments in Ethereum have indeed rendered the PQ = MV model for assessing ETH's value outdated, necessitating new methods to conceptualize ETH to fully capture the rapid evolution of the Ethereum network.

The following three chapters introduce different approaches to conceptualizing ETH from both qualitative and quantitative perspectives. These conceptualizations will ultimately jointly influence the final assessment of ETH. It is worth reiterating that the following mechanisms and final assessments should not be seen as definitive conclusions about ETH. Nevertheless, it honestly attempts to understand ETH as an asset and Ethereum as a platform.

Ethereum as the Future Financial Layer

Ethereum enables smart contracts to execute automatically without a trusted third party. Its various token standards allow for the representation of value other than ETH on the network. In summary, Ethereum allows value and ownership to be managed by code, which can serve as an alternative to the existing transaction and settlement rails of traditional finance. As technology advances and transaction costs decrease, Ethereum and DeFi will make previously unimaginable new use cases a reality.

We believe that Ethereum and DeFi have the potential to disrupt traditional finance and should be valued accordingly for the following reasons:

• Permissionless innovation driven by software speed: All DeFi protocols are open-source and composable. DeFi entrepreneurs can reimagine financial products and innovations at an incredible pace and can reach a global audience with almost no fixed costs.
• Incentive consensus: With the right token mechanism design, all stakeholders in the ecosystem, including protocols, users, liquidity providers (LPs), engineers/protocol maintainers, etc., can achieve a correct consensus of benefits and can cold-start with almost no upfront costs.
• Cost reduction: DeFi eliminates costs associated with legal, labor, compliance, and fixed infrastructure. Financial transactions in the traditional world are based on legal frameworks and enforced by governments, facing complex situations like bankruptcy, where recovery costs can be high and opaque. These costs do not exist in DeFi, as value is entirely controlled by code.
• Frictionless capital and near-instant settlement: Capital in DeFi can achieve sub-minute settlements, flowing in a frictionless and programmable manner—this is a truly digital-native experience. In contrast, in the traditional world, payment channels from different jurisdictions do not flow freely between each other (though companies like Stripe and Plaid have slightly improved the situation). In traditional finance, the aforementioned processes are manually executed, with many systems being outdated and decades old.
• Mass customization and synthetic assets: Just as the internet allows businesses to reach different niche users, DeFi will enable users to access almost any asset in the world. Today, anyone can create a new trading pair through AMMs like Uniswap, as long as they have the trading assets in stock. Synthetic assets take this process a step further. Theoretically, as long as there is a trusted data source, anyone can create synthetic assets by providing on-chain collateral. Teams like Synthetix, UMA, Mirror, and many others are exploring this direction.
• Government neutrality: Financial systems built on Ethereum are open and accessible to everyone. While this may not sound particularly appealing to users in mature financial markets like the United States, it offers unparalleled advantages to those living in countries with inefficient or corrupt local financial systems.

ETH as a Capital Asset

The utility of ETH as the default payment form for activities on the Ethereum network recognizes a fairly straightforward, value-based pricing model for assessing asset valuation. This is especially evident once Ethereum adopts the Ethereum 2.0 network and the EIP-1559 upgrade. Even if other tokens (like stablecoins) may replace Ethereum as alternative payment forms in the future, network validators will still use ETH for staking and earning rewards. Therefore, ETH may derive value from demand (like consumables) and cash flow (like capital assets).

Assuming that ten years from now, Ethereum facilitates $5 trillion in transaction volume across 4 billion transactions daily. $5 trillion daily means a 74% annual growth rate. If you believe Ethereum will replicate the early growth of the internet, this figure seems reasonable.

Looking back at Ethereum's growth record, this number could even be considered an underestimate. Ethereum currently processes $8 billion in ETH and $10 billion in stablecoin transactions daily (these numbers are likely underestimates for total transaction volume, as we exclude transactions of other ERC-20 tokens), representing a growth rate of 6 times and 15 times, respectively, from 2019 to 2020.

In this hypothetical scenario, the transaction volume is a more aggressive assumption (jumping from 1.2 million transactions per day to 4 billion transactions per day, implying a 125% annual growth rate), but if Ethereum's transaction costs are cheap and it successfully scales to allow programmable micropayments between smart contracts, the above assumption is entirely reasonable. After more than three years of development, Ethereum is finally approaching the moment when scalable solutions will be implemented. As we emphasized earlier, the cost of DeFi transactions could decrease by 20-50 times in the next 6-12 months, which would mean an exponential increase in transaction volume.

It is also conceivable that there will be distinctions between high-value transactions (not necessarily the transfer of dollar value but possibly miner-extractable value, MEV) that should incur fees based on transaction value (fees as a percentage of transaction volume) and low-value transactions, which should be based on a commodity mechanism (fees varying slightly based on network utilization).

High-value transactions may be value-based because the ordering of transactions within an Ethereum block is crucial, especially when transactions allow users to gain economic profits. Today, high-value transactions often encounter front-running attacks unless sent to private mining pools (which may charge fees based on transaction value), making it nearly impossible to prevent otherwise. Several teams are currently researching solutions to establish an orderly MEV market that may be implemented in the medium term.

However, it is likely that there will always be transactions (such as arbitrage, which is usually highly competitive) where the value far exceeds the basic fees, making it profitable to pay extra tips for priority certainty. Although these transactions represent only a small fraction of total network transactions.

In the EIP-1559 upgrade, fees paid based on value will be formalized in the form of tips to miners/validators (possibly not denominated in ETH), while commodity-based fees will be the base fees denominated in ETH and burned. Unlike Ethereum 1.0, where miners took a portion of the fees, if Ethereum transitions to a PoS consensus model, both the base fees and tips in EIP-1559 will belong to ETH holders. The base fees will create deflation and generate demand for ETH, while tips (regardless of denomination) will act like cash flow to miners/stakers.

Daily Ethereum Transaction Fees (7-day average) (Source: The Block)

Daily ETH Transfer Volume (7-day average; Source: The Block)

Number of ETH Transactions Including ERC20 and 721 Tokens (7-day average; Source: The Block)

Let’s do some basic math using the hypothetical numbers above and assume the following (these numbers are purely for demonstration purposes):

• 5% of $5 trillion will be high-value transactions, priced at 0.05% of transaction value. Most of this may come from DeFi.
• The base fee for $4 billion in daily transactions averages $0.01 per transaction.
• At this stage, Ethereum will have developed quite maturely, and fee growth will permanently reduce to 5% per year.
• The long-term risk-free rate of return for the economy in the distant future is 2%. ETH stakers will need an additional 5% to compensate for the risk of slashing and technical risks (these risks will stabilize in the long term, so 5% is sufficient), making the long-term required return for ETH 7%.

Using the above assumptions, Ethereum will generate $6.02 billion in fee revenue annually. This is only 18 times more than today, while transaction volume and quantity will increase by 250 times and 3,300 times, respectively. This is the deflationary power of technology!

Finally, using the above $6.02 billion figure in a dividend growth model, pricing ETH as a capital asset means that the token's ultimate value in 10 years would be $3.2 trillion. While this may seem like a huge number, it is ten years out and does not account for any risks (such as technology, competition, regulation). Experienced investors need to introduce appropriate probabilities or discount rates.

ETH as a Monetary Asset

The value of ETH comes from two sources: first, its utility value, as discussed in the above arguments. But the second part of its value comes from its monetary premium, which arises from ETH's preference as a "quasi-currency" asset in the Ethereum economy.

As a medium of exchange and unit of account, ETH is unlikely to succeed. If the Ethereum network becomes ubiquitous and fees stabilize, ETH could become a popular currency, at which point a super ETH bull market might be plausible. Overall, this possibility is very slim, even if Ethereum does become a dominant platform, as stablecoins perform significantly better in both of the aforementioned functions. Today, the total on-chain transaction volume of ERC-20 stablecoins has already surpassed that of ETH ($1 billion daily vs. $800 million), despite ETH's market cap being four times higher. The disparity between stablecoin and ETH off-chain transaction volumes is even greater.

However, as a non-sovereign store of value, ETH may still have the opportunity to capture some potential market share by serving as collateral in DeFi.

In the long run, it is conceivable that ETH could even compete with Bitcoin in dimensions such as scarcity, durability, and non-falsifiability for the following reasons:

• Due to the EIP-1559 upgrade, ETH's monetary policy will tend to stabilize, and inflation may be halved (according to Tim Roughgarden, a professor of computer science at Columbia University, from 4% to 2%). Of course, this is different from a capped supply, but a well-publicized low-inflation asset may be a suboptimal choice.
• The security model of Ethereum 2.0 will ultimately withstand real-world testing almost as well as Bitcoin (20 years from now, Bitcoin's existence will only be 20% longer than Ethereum's); moreover, if ETH is valuable enough, Ethereum 2.0 and PoS may enhance Ethereum's security assurances (we acknowledge that this idea is circular and self-referential).
• Like Bitcoin, ETH, as the first collateral in DeFi, has a very strong Lindy effect. History tells us that the adoption of new technologies/assets/products is highly path-dependent. Generally, having better distribution channels is more important than having better products/technologies. If Ethereum and DeFi truly become the future financial layer, ETH is likely to remain one of the primary collateral assets, as it is the first scalable collateral and the DeFi ecosystem is built around it.

Nevertheless, if Ethereum and DeFi continue to grow, it is credible that ETH could capture 10% of Bitcoin's market share. If we assume Bitcoin's potential market cap is around $4.7 to $14.6 trillion, then ETH's potential monetary value could be $0.5 trillion to $1.5 trillion.

Potential Valuation of ETH

Ethereum has a complex value narrative, and mapping out the various value appreciation mechanisms for ETH is more challenging. We believe that ETH's potential value should be the sum of its 1) consumable commodity value, 2) capital asset value, and 3) monetary value (specifically broken down into payment and store of value functions).

In the thought process above, we conclude that in the distant future, ETH's total potential valuation lies between $3.7 trillion and $4.7 trillion for the following reasons:

• Given its rapid development, the valuation of ETH as a consumable may be limited.
• The valuation of ETH as a capital asset with cash flow could reach the trillion-dollar level, specifically in the low single digits. $3.2 trillion is an estimated point derived from a conceivable successful scenario.
• The monetary value of ETH could range from $0.5 trillion to $1.5 trillion. We assume that the value of ETH's payment function will not exist, and all of ETH's monetary value comes from: it is a non-sovereign store of value driven by DeFi.

Important note: These numbers are by no means precise estimates. Through this thought exercise, we aim to help readers grasp the potential implications of the Ethereum network and the corresponding value of ETH. It is intended to highlight Ethereum's potential narrative and provide readers with a mental model for ETH's value growth. We have also not adjusted for probabilities or introduced discount rates to account for numerous risks (such as technology, competition, regulation). Experienced investors need to consider these risks to ultimately assess the risk/reward of ETH as an investment.

Thanks to Haseeb Qreshi, Ashwin Ramachandran, Tom Schmidt, and other members of the Dragonfly team for their feedback.

Disclosure: Dragonfly Capital is an investor in BTC, ETH, Matter Labs, and many DeFi assets discussed in this article.