DeFi recession, the market is being eroded by L2, where is the cure for sick ETH?

Original Title: “Ethereum's Identity Crisis?: What You Need to Know”

Author: The Daily Bolt by Revelo Intel

Translation: Deep Tide TechFlow

In this issue, we will explore Vitalik Buterin's recent comments on his waning interest in DeFi, the current performance of $ETH compared to $BTC and other competitors, and the question of whether $ETH is facing an identity crisis, such as whether it is seen as "ultrasound money" or being eroded by certain L2s. As of now, $ETH has dropped 5% year-to-date, highlighting this issue. There are often semantic disagreements among the community supporting ETH and others in the crypto space about what constitutes Ethereum. Whether L2s are considered part of Ethereum or not, the development of L2s like Arbitrum and Base has not brought significant benefits to $ETH as an asset. In the cryptocurrency space, narratives are often validated by price, as this directly relates to their profitability.

Vitalik's Waning Interest in DeFi

Vitalik Buterin's recent comments on DeFi have sparked heated discussions in the cryptocurrency and Ethereum communities. Vitalik believes that the current form of DeFi is unsustainable, likening it to an "Ouroboros," a self-consuming state. This situation highlights leadership issues within the Ethereum ecosystem. Unlike other competitors with clear leaders, Ethereum faces unique challenges due to its decentralized nature. In competing with other blockchains, it lacks a clear market spokesperson. While Vitalik is a thought leader with a real identity, he does not advocate as aggressively as Do Kwon did in the Terra community (perhaps for good reason), nor is he as forceful as Anatoli in Solana (which has outperformed $ETH and attracted a large number of retail investors).

Some community members believe that DeFi is a crucial part of Ethereum's value and are concerned about the apparent lack of support from key figures like Vitalik and the Ethereum Foundation (most members merely held or sold $ETH during periods like DeFi summer). Overall, those closer to Ethereum's development roadmap and technical implementations seem more inclined to prioritize other use cases, such as public goods, encrypted messaging, and quadratic voting—quite different from the 24/7 "infinite casino."

Despite Vitalik Buterin's skepticism about DeFi, it is worth noting that the current DeFi ecosystem, while cyclical, has proven the viability of on-chain financial systems. The infrastructure built for payments, exchanges, lending, and derivatives demonstrates the potential to reduce counterparty risk, increase transparency, and lower transaction costs. Even if the initial applications were mostly speculative, these achievements in market efficiency and financial fundamentals should not be overlooked.

Meanwhile, the current on-chain DeFi seems to have reached a stagnation point, with little change in the core functionality of exchanges since Bancor and Uniswap. The user experience has not become simpler; in fact, it has become more complex. Users now have to deal with new blockchains and Layer 2 technologies, understand the complexities of cross-chain assets, manage different gas tokens, and handle various representations of tokens. True innovation may lie in the introduction of intents and solvers, which effectively centralize order flow into a few mature market makers—contrary to the original vision of allowing anyone to become a market maker in a permissionless manner, although relying on professionals does provide users with better prices.

However, Ethereum's identity crisis is not limited to Vitalik's comments on DeFi; it touches on core issues of value accumulation and network economics. Over the past few months, Ethereum's gas fees have remained low, around 2-4 gwei—no longer reflecting the deflationary scenarios seen on ultrasound.money. This situation has led to an increase in Ethereum's supply, challenging the "ultrasound money" theory that was popular during the last bull market cycle. EIP-1559 was introduced in August 2021 to make Ethereum deflationary by burning transaction fees. However, in the current low-fee environment, combined with the emergence of a large (possibly excessive and growing) number of Layer 2s, its effects have not met expectations, resulting in net inflation rather than the anticipated deflation.

Ethereum's focus on Layer-2 solutions and the upcoming EIP-4844 upgrade complicates the issue further. Venture capitalist and Solana supporter Kyle Samani believes there are problems with this strategy. He points out that Layer 2s may act like parasites, siphoning value from the Ethereum main network. Samani argues that Ethereum's decision to outsource transaction and smart contract execution to these Layer-2 networks is "extremely poor." He notes that the primary value of blockchain networks comes from MEV (Miner Extractable Value, or the profits validators gain from reordering transactions), and Ethereum may be sacrificing this due to its Layer 2-centric roadmap. This viewpoint was initially raised by his Multicoin partner Tushar Jain, who proposed an MEV-based asset ledger valuation framework about two years ago. Multiple Layer 2s lead to the decentralization of liquidity and user activity, resulting in a poor user experience, contrasting sharply with a Layer 1 chain like Solana. Samani believes this decentralization is a significant reason for Ethereum's recent poor performance and poses challenges to its future growth and adoption.

The disclosure of the Ethereum Foundation's annual budget of approximately $100 million has intensified this discussion. It has sparked controversy over resource allocation and transparency within the ecosystem. Supporters argue that Ethereum's scale and influence justify such funding, but others question whether this is an effective use of resources. The Foundation's decision to sell large amounts of $ETH on exchanges like Kraken has raised concerns, as selling $ETH even during market downturns exacerbates selling pressure.

Here are the Ethereum Foundation's expenditures categorized by type in 2023:

In a recent Steady Lads podcast, Justin Bram mentioned that decision-making power at the Ethereum Foundation is primarily concentrated in the hands of three individuals, including Vitalik Buterin, a core member, and a hired regulatory expert. This organizational structure raises concerns about transparency and accountability. As the crypto industry matures, there is an increasing expectation for foundations and other centralized entities to clearly explain how their financial resources are allocated. This demand for transparency also extends to governance structures, decision-making processes, and how these align with the platform's overall goals.

Despite the challenges facing Ethereum and the entire DeFi ecosystem, a potential direction for development is emerging. The key question now is: What will drive the next wave of cryptocurrency adoption, potentially leading to 10 to 100 times growth? While Vitalik's concerns about the sustainability of DeFi are noteworthy, they do not negate the potential of blockchain technology in the financial sector. The answer may not lie in improving existing DeFi models or extending the current speculative cycle, but rather in a more fundamental shift: the tokenization of traditional financial assets or RWAs. This represents the largest untapped market in cryptocurrency, with the potential to bring trillions of dollars in capital into the blockchain. By introducing a large number of "real-world" assets, this shift could alleviate some of Vitalik's concerns about the cyclicality of DeFi.

Given the enormous scale of traditional financial markets: the assets managed by BlackRock alone are nearly five times the entire market capitalization of crypto. By tokenizing assets such as bank deposits, commercial paper, government bonds, mutual funds, money market funds, stocks, and derivatives, we can bring unprecedented capital inflows into the crypto ecosystem. These funds can be integrated into DeFi infrastructure, which has already demonstrated utility in creating more transparent, accessible, and liquid markets. This potential for tokenization aligns with Larry Fink's views on Ethereum, potentially creating an enticing future for the platform.

As Ethereum continues to mature, the platform stands at a critical crossroads of innovation and widespread application. Discussions around the future direction of Ethereum—whether to continue focusing on DeFi or expand into other application areas—will determine its technological development, market position, and regulatory strategy. While Vitalik's skepticism about the current DeFi model may drive the ecosystem toward more sustainable and innovative solutions, the potential for tokenizing traditional assets could position Ethereum as a leader in the on-chain financial market.

While focusing on the future, it is crucial to maintain a balance with the present. The emergence of financial derivatives is meant to manage risk and speculate on real assets, such as commodities, commodity contracts, and corporate shares. However, cryptocurrencies have almost directly entered the derivatives phase, lacking sufficient underlying assets. This is not the fault of the industry itself, as regulatory issues have hindered the tokenization of many important real-world assets (RWAs). Many top crypto assets actually represent a platform for trading and speculation, and the assets being traded are themselves highly speculative.

Cryptocurrencies are not unique in this regard: how many of America's most valuable companies pay dividends? Dividends were once a core attraction for companies going public, but now they are mostly replaced by strategies akin to the "greater fool theory." Even gold, which is inherently highly speculative, has minimal practical use in semiconductors and other devices relative to its market value. Therefore, the role of speculation in the market, especially under inflationary fiat regimes, should not be underestimated. Regardless of perspective, the recent price performance of $ETH can only be described as disappointing. This is not only true in the cryptocurrency space, but also in recent years, many large-cap U.S. stocks have outperformed Ethereum.

Moreover, some critics point out that an increasing number of protocols like DePIN are choosing to build on Solana and other blockchains rather than Ethereum. As previously mentioned, BlackRock has clearly expressed its intent to use Ethereum; however, whether other traditional financial institutions will also choose Ethereum over other blockchains, and whether this value can truly and effectively accumulate to $ETH, remains to be seen.

Criticism can sometimes be the motivation that protocols, companies, communities, or foundations need. As the regulatory environment may gradually loosen, coupled with some interesting new developments in the RWA and DePIN fields, those hoping for a more "real" DeFi ecosystem may get their wish, and hopefully, that day will come soon.