The Value Capture Dilemma of Ethereum

Author: 0xEdwardyw Source: tokeninsight

Over the past year, the price performance of Ethereum has been disappointing. Despite overall development in the Ethereum ecosystem, ETH has struggled to keep pace with its competitors in terms of price appreciation. The indicator reflecting the relative strength of ETH, the ETH/BTC ratio, has significantly decreased, falling by over 32% in the past year.

Disappointing price performance has raised concerns among investors, especially considering Ethereum’s core position in Decentralized Finance (DeFi) and Smart Contract fields. The slowing rise in price has sparked debates about the long-term value capture potential of ETH, particularly in the face of increasingly fierce competition from other Layer 1 blockchains and the complexity brought by second-layer scaling solutions.

This article will introduce several key issues facing Ethereum, which may have contributed to its recent poor performance.

Layer 2 solutions cause a drop in ETH demand

Layer 2 solutions for Ethereum, such as rollups, have emerged as a way to alleviate congestion on the Ethereum Mainnet. By processing transactions off-chain and then uploading them back to the mainchain in batches, these solutions offer faster and cheaper transactions, significantly improving the user experience. However, this transition poses potential challenges to capturing the value of Ethereum.

As more and more transactions are being processed on layer two solutions, the fees and economic activity that would have benefited the Ethereum mainnet are being redirected. This shift could result in a decreased demand for ETH as users interact more with layer two networks like Arbitrum and Optimism instead of using the Ethereum base layer. The economic incentives that drive the value of ETH may weaken, potentially impacting its price and utility as a primary asset within the ecosystem.

Although Ethereum can serve as the data availability (DA) layer for these Layer-2 protocols, the fees and value captured by ETH are still significantly lower than if these transactions were directly occurring on Layer-1. While the DA role is critical, it does not fully compensate for the reduced value of direct transactions on the Ethereum mainnet.

Gas fees significantly decreased

In July and August 2024, the Ethereum network experienced a significant drop in gas fees, reaching levels not seen in over five years. This trend is mainly attributed to the continued impact of the Dencun upgrade and increased activity on second-layer solutions.

By mid-August, gas fees on the Ethereum network had dropped to as low as 0.6 gwei, with low-priority transaction records as low as 1 gwei or lower. This is a decrease of over 95% from the peak of 83 gwei observed during the network’s high activity period in March 2024.

The Dencun upgrade implemented in March 2024 played a key role in dropping Transaction Cost on the second-layer network of the drop. The most significant aspect of the Dencun upgrade is the introduction of proto-danksharding. This mechanism allows Ethereum to more efficiently process second-layer (L2) transaction data using a new type of temporary data called “blobs”. These blobs are cleared from the Blockchain after a set period of time, significantly dropping the storage cost associated with L2 transactions.

ETH supply increase

The significant decrease in Gas fees has also affected the burning of ETH, which is determined by the EIP-1559 mechanism. EIP-1559 establishes a base fee for each transaction, which is the minimum gas price required for a transaction to be included in a Block. This base fee is dynamically adjusted based on the network’s demand for Block space, increasing when the Block is full and decreasing when the Block is underutilized. The base fee is burned and permanently removed from circulation, reducing the total supply of ETH over time. This mechanism introduces deflationary pressure on ETH, and if the burning exceeds the issuance of stake rewards, the total supply will decrease over time. However, if there is insufficient demand for paying gas fees with ETH, the issuance from stake rewards may increase the total supply of ETH.

Due to the decreasing burn of ETH, the total supply of ETH on the Ethereum platform has been increasing over the past few months, rising from approximately 120 million ETH in March to approximately 120.3 million ETH in August. If demand fails to keep up, the increase in supply may exert downward pressure on the price of ETH.

Interoperability and Complexity Issues on Layer 2

The advancement of ETH towards layer 2 solutions has caused interoperability issues and increased developer complexity, making it harder for users to achieve a seamless experience compared to other layer 1 networks such as Solana.

Each Layer 2 solution, such as Arbitrum, Optimism, and zkSync, operates as an independent environment with its own rules and standards. This decentralization means that assets and data cannot move seamlessly between these different Layer 2 networks, creating islands within the ETH ecosystem. Developers must build or integrate complex Cross-Chain Interaction mechanisms to achieve interoperability between these layers, which can be time-consuming and error-prone.

There are currently 64 Layer 2 and 18 Layer 3 scaling projects, as well as 81 Layer 2 and Layer 3 projects that are about to enter Ethereum. Since different L2s operate in isolated environments, it has become difficult for decentralized applications (dApps) and users to seamlessly interact across these networks.

In addition, multiple Layer 2 solutions have significantly increased the complexity of building and deploying decentralized applications (dApps). Developers must decide which Layer 2 network to build on, weighing factors such as user base, transaction cost, and technical specifications. Moreover, maintaining dApps on multiple Layer 2s increases development and maintenance workload, as each Layer 2 may have different tools, APIs, and performance characteristics.

These interoperability and complexity issues not only affect developers, but also have a ripple effect on user experience. Users may find it confusing to navigate between different Layer 2 networks, each with its own Wallet, transaction process, and fees. This fragmented experience will hinder adoption, and dropETH aims to provide a seamless experience.

Does ETH have a currency premium?

Currency premium refers to the additional value of an asset beyond its intrinsic value or utility value, usually because it is seen as a store of value, medium of exchange, or unit of account. Over the years, Ethereum (ETH) has been considered to have a currency premium, which has contributed to its position as the second-largest cryptocurrency by market capitalization.

For Ethereum, its currency premium comes from several factors:

• The utility in the ecosystem: ETH is the cornerstone of a large number of decentralized applications (dApps), decentralized finance (DeFi) platforms, and non-fungible tokens (NFTs). The demand for using ETH to pay gas fees and participate in on-chain activities has made its value more than just technical functionality.
• Understanding of store of value: Due to the widespread use of Ethereum, its large market capitalization, and the belief in the long-term rise of the Ethereum network, some investors regard ETH as a store of value similar to BTC. This understanding has added a monetary premium to ETH.
• Staking and earning potential: ETH holders can earn rewards by staking their tokens, which further enhances their value proposition and increases their currency premium.

However, unlike BTC with a hard cap of 21 million, Ether (ETH) does not have a fixed supply limit. Critics argue that this lack of limit weakens ETH’s ability to be a reliable store of value, as its supply may increase over time, leading to value dilution. According to EIP-1559, when demand for ETH is high, it becomes a deflationary asset as a portion of gas fees is burned. However, when demand decreases, ETH becomes an inflationary asset, which undermines its value proposition as a store of value.

In addition, Ethereum is often seen as more focused on becoming a “world computer” rather than just a monetary asset. While this versatility provides utility, it may weaken its perception as a simple and reliable store of value compared to Bitcoin, which is more focused on becoming “digital gold”.

The core issue revolves around what exactly is the value proposition of Ethereum. If Ethereum’s primary goal is to operate as a world computer, it needs to move transactions to second-layer solutions to achieve faster processing and lower Transaction Cost. However, this transition inevitably shifts some value to the second-layer protocol, weakening the value accumulation of ETH as an asset. The challenge lies in balancing the demand for scalability with the desire to maintain and enhance the value of ETH.

To maintain its ‘Ultra Sound Money’ status, Ethereum must ensure that the second-layer solution provides users with low-cost transactions without compromising the value of its native assets. This delicate balance is crucial for ETH to continue to maintain its monetary premium.