Coinbase Monthly Report: Why Do We Still Believe in the Value of Ethereum?

Original Title: “Monthly Outlook: Expectations on Ethereum”

Author: David Han

Compiled by: Deep Tide TechFlow

Note: This article was published before the sudden readiness for the approval of the Ethereum ETF, at which time the market believed that the Ethereum ETF could not be approved.

The multiple role classifications of ETH have raised questions about its position in investment portfolios. This article will clarify some of these claims and the potential positive factors for this asset in the coming months.

Article Summary

● Despite ETH's poor performance year-to-date, we believe its market positioning remains strong in the long term.

● We believe ETH has the potential for unexpected upside in the later stages of the cycle. We also believe that ETH has the strongest sustained demand dynamics in the crypto market and maintains its unique scalability roadmap advantages.

● Historical trading patterns of ETH indicate that it benefits from the dual narratives of "store of value" and "technology token."

Main Text

The approval of the BTC spot ETF has enhanced BTC's narrative as a store of value and its status as a macro asset. On the other hand, questions remain regarding ETH's fundamental positioning in the crypto space. Competing layer one networks like Solana have weakened ETH's status as the preferred network for decentralized application (dApp) deployment. The L2 scaling of ETH and the reduction in ETH burn also seem to affect the asset's value accumulation mechanism at a high level.

Nevertheless, we continue to believe that ETH's long-term positioning remains strong, as it possesses important advantages that other smart contract networks do not. These advantages include the maturity of the Solidity developer ecosystem, the popularity of its EVM platform, the utility of ETH as collateral in DeFi, and the decentralization and security of its mainnet. Additionally, we believe that advancements in tokenization may have a more positive impact on ETH in the short term compared to other layer one networks.

We find that ETH's ability to capture the narratives of "store of value" and "technology token" is reflected in its historical trading patterns. The high correlation between ETH and BTC shows behavior consistent with BTC's store of value narrative. At the same time, during long-term price increases of BTC, it can decouple from BTC and behave more like a technology-oriented cryptocurrency, similar to other altcoins. We believe that ETH will continue to play these roles and is expected to perform well in the second half of 2024, despite its poor performance year-to-date.

Response to ETH Controversies

ETH has been classified in various ways, from being referred to as "ultrasound money" due to its supply reduction mechanism to being called "internet bonds" because of its non-inflationary staking yields. With the development of layer two networks (L2s) and the increase in restaking functionality, new descriptors such as "settlement layer asset" or more complex "general-purpose objective work tokens" have emerged. However, we believe these descriptions do not fully capture the vitality of Ethereum. In fact, as Ethereum's use cases continue to diversify and complicate, it has become increasingly difficult to comprehensively assess its value through a single metric. More importantly, these different descriptions may conflict with each other, leading to negative effects as they may distract market participants from the positive drivers of the token.

Spot ETH ETF

Spot ETFs are extremely important for BTC as they provide a pathway for regulatory clarity and new capital inflows. These ETFs structurally change the industry and challenge the previous capital cycle model, where capital flows from BTC to ETH and then to higher beta altcoins. There is a barrier between the capital allocated to ETFs and that allocated to centralized exchanges (CEXs), with only the latter having access to a broader crypto asset space. The potential approval of a spot ETH ETF would eliminate this barrier, allowing ETH to access the same capital pool currently enjoyed only by BTC. In our view, this may be the biggest pending issue for ETH in the near term, especially considering the current challenging regulatory environment.

Although the SEC has remained silent on issuers, creating uncertainty about timely approvals, we believe the existence of a U.S. spot ETH ETF is merely a matter of time, not whether it will happen. In fact, the main rationale for approving the spot BTC ETF also applies to the spot ETH ETF. That is, the correlation between CME futures products and spot prices is sufficiently high to "reasonably expect that CME's oversight can detect misconduct in the spot market." The correlation study period mentioned in the spot BTC approval notice began in March 2021, one month after the launch of CME ETH futures. We believe this evaluation period was intentionally chosen to apply similar logic to the ETH market. In fact, analyses previously presented by Coinbase and Grayscale indicate that the correlation between the spot and futures markets for ETH is similar to that of BTC.

Assuming this correlation analysis holds, the remaining possible reasons for not approving may stem from the fundamental differences between ETH and BTC. In the past, we have discussed some differences in the scale and depth of the ETH and BTC futures markets, which may be a factor in the SEC's decision-making. However, among other fundamental differences between ETH and BTC, we believe the most relevant approval issue is ETH's proof-of-stake (PoS) mechanism.

Due to the lack of clear regulatory guidance on asset staking, we believe it is unlikely that a spot ETH ETF supporting staking will be approved in the short term. The potentially ambiguous fee structures from third-party staking providers, differences between validator clients, complexities of slashing conditions, and liquidity risks associated with unstaking (and exit queue congestion) are substantively different from BTC. (It is worth noting that some ETH ETFs in Europe include staking, but generally, European exchange-traded products differ from those offered in the U.S.) Nevertheless, we believe this should not affect the status of unstaked ETH.

We think this decision could bring surprises. Polymarket predicts a 16% chance of approval by May 31, 2024, while the trading discount rate of Grayscale Ethereum Trust (ETHE) is 24% of net asset value (NAV). We believe the chances of approval are closer to 30-40%. As cryptocurrencies begin to become election issues, we are also uncertain whether the SEC is willing to invest the necessary political capital to support a decision to reject cryptocurrencies. Even if the first deadline of May 23, 2024, encounters rejection, we believe the likelihood of overturning that decision through litigation is high. It is worth noting that not all applications for spot ETH ETFs need to be approved simultaneously. In fact, the approval statement from Commissioner Uyeda regarding the spot BTC ETF criticized the implicit "motivation to accelerate approval applications to prevent first-mover advantages."

Challenges from Alternative L1s

At the adoption level, highly scalable integrated chains, particularly Solana, seem to be eroding ETH's market share. High throughput and low-fee transactions have shifted the center of trading activity away from the ETH mainnet. Notably, over the past year, Solana's ecosystem has grown from accounting for only 2% of decentralized exchange (DEX) trading volume to now 21%.

We believe alternative L1s now offer more meaningful distinctions than during the last bull market. The shift from the ETH virtual machine (EVM) and the redesign of dApps at the base layer have brought unique user experiences (UX) across different ecosystems. Additionally, the integrated/single-chain scaling approach enhances cross-application composability, avoiding issues of bridging UX and liquidity fragmentation.

While these value propositions are important, we believe it is still too early to confirm success by using activity incentive metrics. For example, the number of trading users on some ETH L2s has dropped by over 80% since the peak of airdrops. Meanwhile, from the airdrop announcement of Jupiter on November 16, 2023, to the first claim date on January 31, 2024, Solana's DEX total trading volume share has grown from 6% to 17%. (Jupiter is the leading DEX aggregator on Solana.) Jupiter still has three rounds of airdrops yet to be completed, so we expect Solana DEX activity to continue for some time. During this period, the assumption of long-term activity retention remains speculative.

That said, trading activity on leading ETH L2s like Arbitrum, Optimism, and Base now accounts for 17% of total DEX trading volume (plus 33% for ETH). This may provide a more appropriate comparison for ETH demand drivers against alternative L1 solutions, as ETH is used as the native fuel token for these three L2s. Other additional demand drivers for ETH in these networks have yet to be developed, leaving room for future demand catalysts. We believe that in terms of DEX activity, this is a more equivalent comparison of integrated versus modular scaling approaches.

Another more "sticky" measure of adoption is stablecoin supply. Due to the friction of bridging and issuing/redemption, the tendency for stablecoin distribution changes is slower. (See Chart 2. The color scheme and arrangement are the same as Chart 1, with Thorchain replaced by Tron.) Measured by stablecoin issuance, activity is still dominated by ETH. In our view, this is because many new chains' trust assumptions and reliability are still insufficient to support large amounts of capital, especially capital locked in smart contracts. Large capital holders are typically indifferent to ETH's higher transaction costs (relative to scale) and tend to reduce risk by minimizing liquidity stall times and minimizing bridging trust assumptions.

Even so, in high-throughput chains, the growth rate of stablecoin supply in ETH L2s has outpaced that of Solana. At the beginning of 2024, Arbitrum's stablecoin supply surpassed Solana's (currently $3.6 billion compared to $3.2 billion), while Base's stablecoin supply grew from $160 million at the beginning of the year to $2.4 billion. Although the final verdict on the scaling debate remains unclear, early signs of stablecoin growth may actually favor ETH L2s over alternative L1s.

The growth of L2s has raised concerns about the potential real threat they pose to ETH—reducing the demand for L1 block space (and thus reducing the destruction of transaction fees) and potentially supporting non-ETH gas tokens within their ecosystems (further reducing ETH's destruction). In fact, since the shift to the proof-of-stake (PoS) mechanism in 2022, ETH's annual inflation rate has reached its highest level. While inflation is generally understood as a structurally important component of BTC supply, we believe this does not apply to ETH. All ETH issuance belongs to stakers, and since the merge, the collective balance of stakers has far exceeded the cumulative ETH issuance (see Chart 4). This starkly contrasts with the proof-of-work (PoW) miner economy of BTC, where a competitive hash rate environment means miners need to sell most of the newly issued BTC to fund operations. Miners' BTC holdings are tracked across cycles to cope with their inevitable sell-offs, while ETH's staking operating costs are minimal, allowing stakers to continuously increase their holdings. In fact, staking has become a convergence point for ETH liquidity—growth in staked ETH has exceeded 20 times the ETH issuance (even excluding destruction).

L2s themselves are also an important demand driver for ETH. Over 3.5 million ETH have been transferred to the L2 ecosystem, becoming another liquidity convergence point for ETH. Furthermore, even if ETH transferred to L2s is not directly destroyed, the remaining balance of native tokens held in new wallets for paying transaction fees constitutes a soft lock on the increasingly growing portion of ETH tokens.

Additionally, we believe that even with its L2 expansions, some core activities will always remain on the ETH mainnet. Activities such as restaking on EigenLayer or governance actions of major protocols like Aave, Maker, and Uniswap are still firmly rooted in L1. For users with the highest security considerations (often the largest capital holders), funds may also be kept on L1 until fully decentralized orderers and permissionless fraud-proof deployments are tested and proven—this process may take years. Even if L2s innovate in different directions, ETH will always be a part of their treasury (to pay L1 "rent") and the local pricing unit. We firmly believe that the growth of L2s benefits not only the ETH ecosystem but also the asset ETH itself.

Advantages of ETH

In addition to the typically covered metric-based narratives, we believe ETH has other difficult-to-quantify but equally important advantages. These may not be short-term tradable narratives but represent a set of long-term strengths that can sustain its current dominance.

Original Collateral and Account Unit

One of the most important uses of ETH in DeFi is as collateral. ETH can be leveraged with minimal counterparty risk within the ETH and its L2 ecosystem. It serves as a form of collateral in money markets like Maker and Aave and is also the base trading unit for many on-chain DEX pairs. The expansion of DeFi on ETH and its L2s has led to additional liquidity convergence for ETH.

While BTC remains the primary store of value asset on a broader scale, using wrapped BTC on ETH introduces cross-chain bridges and trust assumptions. We believe WBTC will not replace ETH's DeFi-based use of ETH—WBTC's supply has remained stable for over a year, more than 40% lower than previous peaks. Instead, ETH can benefit from the diversity of its L2 ecosystem.

Continuous Innovation and Decentralization

A frequently overlooked component of the ETH community is its ability to continue innovating even while being decentralized. Criticism has been directed at ETH for extending release timelines and development delays, but few acknowledge the complexity of achieving technological advancements while balancing the goals and objectives of diverse stakeholders. Developers of more than five execution clients and over four consensus clients need to coordinate design, testing, and deployment changes without causing disruptions to mainnet execution.

Since the last major Taproot upgrade of BTC in November 2021, ETH has enabled dynamic transaction burning (August 2021), transitioned to PoS (September 2022), enabled staking withdrawals (March 2023), and created blob storage for L2 scaling (March 2024), which includes a series of other Ethereum Improvement Proposals (EIPs). While many other L1s seem to be able to evolve more quickly, their single-client nature makes them more vulnerable and centralized. The path toward decentralization inevitably leads to a degree of rigidity, and it remains unclear whether other ecosystems have the capability to create similarly effective development processes when and if they begin this process.

Rapid Innovation of L2s

This is not to say that ETH's pace of innovation is slower than that of other ecosystems. On the contrary, we believe that ETH's innovation around execution environments and development tools actually exceeds that of its competitors. ETH benefits from the rapid concentrated development of L2s, all of which pay settlement fees to L1. The ability to create diversified platforms with different execution environments (such as Web Assembly, Move, or Solana virtual machine) or other features (such as privacy or enhanced staking rewards) means that L1's slow development timeline does not hinder ETH's recognition in more technically integrated use cases.

At the same time, the ETH community's efforts to define different trust assumptions and definitions around sidechains, Validium, Rollup, etc., have facilitated greater transparency in the field. For example, similar efforts in the BTC L2 ecosystem (such as L2Beat) have yet to materialize, where the trust assumption differences among L2s are significant and often fail to be well communicated or understood by the broader community.

Popularity of EVM

Innovation around new execution environments does not mean that Solidity and EVM will become obsolete in the near future. On the contrary, the EVM has been widely adopted across other chains. For instance, many BTC L2s have adopted the research outcomes of ETH L2. Some flaws in Solidity (such as susceptibility to reentrancy vulnerabilities) now have static tool checkers to prevent basic vulnerabilities. Additionally, the popularity of the language has created a mature auditing sector, a wealth of open-source code samples, and detailed best practice guides. All of these are crucial for building a large pool of development talent.

While the use of EVM does not directly drive ETH demand, changes to the EVM are rooted in ETH's development process. These changes are then adopted by other chains to maintain compatibility with the EVM. We believe that core innovations of the EVM are likely to remain rooted in ETH—or quickly be seized by L2s—which will focus developers' attention and foster new protocols within the ETH ecosystem.

Tokenization and Lindy Effect

The push for tokenization projects and increased global regulatory clarity may also first benefit ETH (in public blockchains). In our view, financial products often prioritize technological risk mitigation over optimization and feature richness, and ETH has the advantage of being the longest-running smart contract platform. We believe that higher transaction fees (in dollars rather than cents) and longer confirmation times (in seconds rather than milliseconds) are secondary issues for many large tokenization projects.

Moreover, for more traditional companies looking to scale their businesses on-chain, recruiting sufficient development talent has become a key factor. Here, Solidity becomes the obvious choice, as it constitutes the largest subset of smart contract developers, which also responds to the earlier point about the popularity of EVM. Blackrock's BUIDL fund on ETH and JPM's proposed ERC-20 compatible Onyx Digital Assets Fungible Asset Contract (ODA-FACT) token standard are early signs of the importance of this talent pool.

Structural Supply Mechanism

The changes in active ETH supply are significantly different from BTC. Despite price increases since Q4 2023, the three-month circulating supply of ETH has not significantly increased. In contrast, we observed that the active BTC supply increased by nearly 75% within the same timeframe. Unlike the increase in circulating supply seen during the 2021/22 cycle when ETH was still operating on proof-of-work (PoW), long-term ETH holders have not led to an increase in circulating supply; rather, the growing ETH supply is being staked. This reaffirms our view that staking is a key liquidity convergence point for ETH, minimizing the structural selling pressure on the asset.

Evolving Trading Regime

Historically, ETH's trading has aligned more closely with BTC than with any other altcoin. At the same time, during bull market peaks or specific ecosystem events, it can decouple from BTC—similar patterns observed in other altcoins, albeit to a lesser extent. We believe this trading behavior reflects the market's relative valuation of ETH as both a store of value token and a utility token.

In 2023, the correlation between ETH and BTC exhibited an inverse relationship with changes in BTC prices. That is, as BTC's value increased, the correlation of ETH with it decreased, and vice versa. In fact, changes in BTC prices seem to be a leading indicator of changes in ETH's correlation. We believe this reflects the market enthusiasm led by BTC prices manifesting in altcoins, subsequently driving their speculative performance during bull markets (i.e., altcoins trading differently in bull markets compared to bear markets relative to BTC).

However, this trend has weakened following the approval of the U.S. spot BTC ETF. We believe this highlights the structural impact of ETF-based capital inflows, where a whole new capital base can only access BTC. New markets, such as registered investment advisors (RIAs), wealth management advisors, and brokerage firms, may view BTC in their portfolios differently than many crypto-native or retail traders. While BTC is the least volatile asset in pure crypto portfolios, it is often seen as a small diversification asset in more traditional fixed-income and equity portfolios. We believe this shift in the utility of BTC has influenced its trading patterns relative to ETH, and if the U.S. spot ETH ETF is approved, ETH may see a similar shift (and adjustment in trading patterns).

Conclusion

We believe that ETH may still have upside potential in the coming months. ETH does not appear to face significant supply-side pressures, such as token unlocks or miner sell-offs. Instead, the growth of staking and L2 has proven to be a meaningful and growing convergence point for ETH liquidity. We believe that due to the widespread adoption of EVM and its L2 innovations, ETH's position as the center of DeFi is unlikely to be replaced.

Furthermore, the potential importance of a U.S. spot ETH ETF cannot be overlooked. We believe the market may underestimate the timing and likelihood of potential approvals, which creates room for upside. During this period, we believe that ETH's structural demand drivers and the technological innovations within its ecosystem will enable it to continue balancing multiple narratives.