Ethereum 2.0
Ethereum, the first and most utilized smart contract platform has begun its most highly anticipated upgrade, ETH 2.0 Staking. This is a big deal for the 5 year old protocol. With nearly $70B in market cap, there’s a lot riding on the team’s ability to execute the transition from its Proof of Work (mining) consensus algorithm to its Proof of Stake (staking) mechanism.
However, this is also a huge moment for every Internet user and investor as they will now, for the first time have direct exposure to the underlying value of the Internet. The rise of the Internet Bond.
source: ethereum.org
Staking
Staking is a type of digital work agreement made between an individual and a protocol via a smart contract - an individual will collateralize value in the form of tokens for the right to do work in exchange for a reward or a yield. In Ethereum’s case, an individual will stake their ETH tokens in order to participate as a validator to process transactions on the network in exchange for the ETH reward. The current transaction process is carried out by computers that validate transactions by solving mathematical puzzles competing for the ETH reward, this is known as mining or Proof of Work (POW) and very similar to bitcoin’s mining algorithm. Now, as we move into the Proof of Stake (POS) epoch, Ethereum’s ETH token takes on a new meaning and a new value. ETH has historically been used as a fuel or '“gas” to power the computation necessary to send a transaction or to run decentralized applications on it’s network - spending ETH to use a dApp creates a transaction which the miners are incentivized to process in order to win the ETH reward and the transaction fees. However, now staking creates a new use case for ETH, collateral for fixed income.
source: ethereum.org
ETH Perpetual Bonds
Before blockchain, the Internet’s value has been locked up in the application layer vs. the protocol layer - Amazon, Facebook, Google, Dropbox, etc. In other words, the valuable data being produced by internet users (content, articles, sharing, analytics, measurement, etc) was being stored, processed and curated by companies running on top of the Internet’s open source protocols.
TCP/IP - Transmission Control Protocol / Internet Protocol launched in 1978 that set the standards for communication between individual computer networks.
SMTP - Simple Mail Transfer Protocol launched in 1982 that set the standards for email communication.
HTTP - Hypertext Transfer Protocol launched in 1989 that set the standards for webpages and data communication for the Internet.
Internet users have depended on trusted 3rd parties for these particular services, and we can all agree that those service providers have benefited financially quite nicely. Now, blockchain provides the data architecture needed to capture that value and decentralize that value amongst the Internet’s participants. This is the idea behind Web3.0 and Ethereum is currently leading the way.
source: ethereum.org
Let’s take a look at an example provided by the Bankless team for how this works by comparing staking to a contractor license bond commonly used by construction professionals.
In many parts of the world, construction professionals are required to purchase a contractor license bond before they are legally allowed to provide construction work. By purchasing the contractor license bond, the construction professional agrees to work in accordance to rules and regulations designed to protect both the government agencies and consumers from potential financial loss.
A contractor license bond is a type of surety bond between:
The Principal: the entity seeking permission to work by offering capital and consenting to set of rules
The Obligee: the entity setting the requirement for the bond in adherence to a set of rules and surety
The Issuer: the entity guaranteeing the obligations of the principal
When comparing this structure to Ethereum’s staking structure we have the following.
The Principal: is the validator who deposits a minimum of 32 ETH into a smart contract to register their node and agree to the validation and consensus rules for operating on the network.
The Obligee and Issuer: is the Ethereum blockchain that sets the rules and requirements necessary for participants to engage with the digital work agreement in order access the financial rewards.
Here the individual is the lender of capital, work and owners of the network all at the same time. This new dynamic creates the financial structure and incentives for the perpetual Internet Bond. Please keep in mind, the financial reward is also denominated in ETH, which is an appreciating digital asset in it’s infancy that’s also the beneficiary of Ethereum’s network effects and ever increasing utility. Currently valued at ~$600 at the time of writing. Below is a chart projecting the estimated yield or validator rewards as more individuals begin staking their ETH. As you can see, ETH2 staking can be quite profitable with a healthy yield even as more ETH is staked on the network.
source: Darma Capital
ETH 2.0 Tokenomics
Ethereum is very different than bitcoin. Bitcoin is a digital asset with an artificially capped supply engineered to be the best sound money and could possibly serve as the world reserve asset or function as pristine collateral. However, bitcoin’s functionality is purposely limited in order to maintain network security at all costs. Ethereum does not have a hard cap and its inflation rate is between 2%-4% annually. However, Ethereum has much more functionality as it can act like “programmable money” for decentralized applications. Think of Ethereum as the smartphone that powers the app marketplace, only without any single one owner and available to all. Ethereum is also an evolving platform and makes improvements on a regular basis, such as EIP-1559 that looks to improve Ethereum’s monetary policy. The Ethereum Improvement Proposal 1559 is widely accepted in the community and recommends burning ETH transaction fees, which ultimately decreases the supply of ETH.
source: ethereum.org
One of the main ways to value bitcoin is via PlanB’s Stock-to-Flow model. Bitcoin’s halving event creates a supply shock and exponentially increases bitcoin’s S2F ratio every four years. This has had a dramatic effect on bitcoin’s price and future price predictions. Ethereum and crypto analyst, Alex Saunders modeled out Ethereum’s S2F using PlanB’s framework and got the below. Ethereum’s S2F is currently close to silver (~22) and has increased to 28.5 in 2020. In Saunder’s hypothetical situation where almost everyone locks up their ETH via staking + EIP-1559’s fee burn, the network dramatically decreases the circulating supply and the inflation rate. His hypothetical ETH S2F more than doubles to 58.5 by 2022. This is on par with gold and bitcoin’s S2F which is ~60. This puts ETH in the monetary commodity category or in other words, money.
White Circle: ETH Current S2F
Black Circle: ETH S2F in 1-2 Years
Conclusion
There’s a big debate in the crypto community about whether ETH is money. We’re not exactly sure why this is such a heated debate as money is a free market social phenomenon that helps facilitate trade at scale. Money is a belief system and tends to have specific monetary properties:
Store of value
Medium of exchange
Unit of account
Without getting into it, ETH checks the boxes across the board. However, ETH is extremely dynamic and can be coded to do just about anything on the Ethereum network. However, ETH2.0 staking along with EIP-1559’s fee burn changes Ethereum’s narrative as it becomes more than Internet money, more than a commodity, but a game changer for institutional investors searching for yield to offset their antiquated 60 / 40, equity / bond portfolios.
source: FRED data base: UST 10Y Yield
As we’ve spoken about this before, the bond market is dead. It no longer functions by offsetting volatility in an investor’s portfolio. As we reach the zero-bound in interest rates with bonds yielding less than 1% nominally with negative real yields, investors are essentially paying to lose money. Especially, as global central banks and governments promise massive monetary and fiscal stimulus devaluing the currency in which the bonds’ interest payments are made. This situation pushes institutional investors with firm liabilities coming due - pension funds, insurance companies, banks, hedge funds, etc - farther out into riskier assets like stocks, emerging markets, private equity and alternative assets in order to find yield to meet their obligations. However, when you look around the market landscape, everything looks extremely risky.
Equity markets are expensive, at all time highs and have dislocated from reality and the real economy held up by stimulus expectations
Emerging markets have ballooning USD & Yuan denominate debts forcing them to hyperinflate their local currencies in order to service those debts
Credit & Debt markets are at all time highs across corporates, households, federal and sovereign nations
source: FRED data base: US Households Debt
source: FRED data base: US Nonfinancial Corporate Debt
source: FRED data base: US Federal Debt
source: Institute of International Finance
Which brings us to the alternative asset class, specifically to crypto. Bitcoin will play a major part to help offset the drag and volatility in investor’s portfolios. Over the past several months, we’ve seen a media and financial analyst frenzy about bitcoin’s new role in asset allocation. Some of the largest banks and financials institutions have stated even more bullish price predictions than your most confident bitcoiners’ - $300k-$500k in the next five years. However, the mainstream has not yet understood the second largest cryptocurrency and its new blossoming role within the investor’s toolkit.
Ethereum’s Internet Bond will provide the fixed income yield to help attract large blocks of capital to join the crypto revolution. Investors will accumulate massive positions in ETH and then stake them on the network to drive a healthy yield that’s currently more than ~20x compared to 10Y treasuries. Keep in mind, Ethereum’s market cap is a fraction of the bond market, 0.07% of the ~$100T bond market, therefore investors are yielding returns in a massively unappreciated asset with 1000x upside. This investment along with the new fee burning mechanism and in combination with the growing number of ETH locked up in DeFi ($7M), will further remove ETH from the circulating supply putting accelerated upward pressure on ETH’s price.
If we do some back-of-the-napkin math, we see a dramatic increase in price compared to where we are now at ~$600 (50% off its ATH). If ETH’s S2F is similar to gold, that would be a market cap of $10T. However, let’s take a much more conservative approach with a $2T market cap. Then let’s remove 10M staked ETH from it’s current supply of ~114M ETH, which brings us to 104M. And, finally let’s remove 4% of ETH that might be burned through the implementation of EIP-1559 bringing us to a total of ~100M ETH. This puts ETH at a $20,000 price point.
$2T market cap / 100M ETH supply = $20,000 per ETH
This is obviously rough math, but regardless Ethereum’s Internet Bond and ETH2.0 staking will have a massive impact on financial markets and how individuals and institutional investors allocate capital.
Welcome to Web3.0.
Cheers,
Verks
**This is not financial advice. Investing in bitcoin and cryptocurrency is extremely risky. Please do your own research. The ideas and news presented in this newsletter are my personal opinions and meant for informational and entertainment purposes only.