This investment memo articulates Address Capital’s price target for Ether. This memo is written for informational purposes only, and does not constitute investment advice or a solicitation to buy any Address Capital services or products.

Executive Summary

We live in the era of digital feudalism.

Buoyed by unlimited capital and anti-competitive public policy, a handful of technology giants (“Big Tech”) monitor, police, and capitalize on our online existence.

As life became exclusively virtual during the COVID-19 pandemic, Big Tech’s market capitalizations exploded while unemployment rose. [1]

Fortunately, a technical advancement called Web 3.0 has enabled the path to digital self-sovereignty.

Through its reevaluation of resources and widely adopted decentralized architecture, Ethereum is Web 3.0’s dominant economic infrastructure.

Whereas the current crony capitalism regime treats our time like a public utility, Ethereum enables applications where we are simultaneously owners, workers and governors.

In Ethereum’s open, trustless ecosystem, labor becomes more valuable than capital.

This paradigm shift has given way to a radical new social structure where organizations compete on value distribution versus value retention, sweeping away the old conditions of production as capital is no longer a barrier for innovation.

As a result, Ethereum has emerged as the world’s fastest growing platform across valuation, adoption,

and revenue, enabling a compounding ecosystem of cross-border applications and business models.

With a market capitalization of $362 billion as of September 23, 2021, Ethereum’s native crypto asset Ether (“ETH”) will increase from $3,077 to $32,468 in the next five years, representing an ROI and IRR of 10.6x and 61%, respectively.

Given the multifaceted nature of the Ethereum platform, we considered three valuation methodologies to arrive at this price target: 1) Dividend Discount Method 2) Payment Network Comparables and 3) Network Participants Growth.

The rest of this piece expands on Address Capital’s investment thesis for Ethereum and ETH.

Ethereum Overview

Background

Launched in July 2015, Ethereum (the “Platform” or “Network”) is the leading decentralized application protocol (“L1” or “Blockchain”) in the token economy.

Ethereum enables the development of decentralized solutions by providing an application framework similar to Apple’s iOS alongside network services to manage those applications.

Among those services includes a virtual ledger of real-time facts related to Platform activity with an embedded assurance that all Network participants are in agreement with those facts, which range from asset ownership to the means to run specific applications.

In simplistic terms, the reason Ethereum has such a large advantage relative to competitors is because it has the ledger with by far the most valuable amount of agreed facts.

Ecosystem Snapshot

The Ethereum Network has four main network participants, all of whom have different economic, personal and ideological incentives. [2]

While all actors commercially benefit from Network adoption due to holding ETH or tokens associated with Ethereum applications, many derive deep fulfillment from supporting the Platform and its projects through improvement proposals, funding, evangelism and moral support, in addition to helping create a new system outside the control of Big Tech and authoritarian regimes.

Any first time observer of Platform hotspots such as Discord or GitHub would conclude they’ve stumbled upon a new universe.

Ethereum’s Historical Performance

Ethereum has set record-paces for market capitalization growth, adoption and revenue generated since inception.

We evaluate its performance across three categories: 1) Pricing Data, 2) Network Utilization, and 3) Network Revenue.

ETH Pricing Data

Historical Snapshot

General Commentary

Ethereum is the fastest platform to realize a $500 billion market capitalization, achieving this milestone four times faster than Amazon.

And this has occurred largely without traditional financial products providing easy access to purchase ETH (e.g. Exchange Traded Funds) or user experiences targeting non-crypto natives.

Ethereum Network Utilization

Historical Snapshot

General Commentary

Pricing aside, Ethereum has also boasted tremendous adoption across Network Participants, Network Transactions and Value Settled.

Network Participants

At 60.7 million addresses with non-zero ETH balances since inception, Ethereum’s growth is outpacing Internet user adoption after Tim Berners-Lee developed the web browser. [3] [4]

Network Transactions

While Network Participation has increased every year since inception, Network Transactions have experienced similar (albeit slightly lower) growth.

The year-on-year decline from YE Aug-31–2018 to YE Aug-31–2019 doesn’t concern us as the YE Aug-31–2018 period experienced unsustainable overzealousness in the token economy, and has since rebounded.

Network Transactions growing at a slower pace than Participant Adoption, though, can be attributed to the “hodl” attitude of ETH holders with more than 63% holding their ETH tokens for more than a year [5], and Ethereum’s largest weakness: costly transaction fees from Network congestion.

Fortunately, Ethereum is in the process of addressing this congestion challenge in an upcoming Platform upgrade (“ETH 2.0”), targeted for February 28, 2022, though the Ethereum community reports ETH 2.0 may be delivered as soon as December 2021. [6]

Ethereum Network Volumes

A useful metric in gauging on-chain utilization is the dollar amount of volume settled given the Platform’s similarities to leading payment networks such as Visa and Mastercard.

What happened in 2019 and 2020? And ditto for 2021?

YE Aug-31–2019 and Aug-31–2020 represent the hangover following YE Aug-31–2018’s speculative mania — many lost interest given the lack of useful applications with adoption.

But in the token economy, bear markets cause bull development, which came to fruition in YE Aug-31–2021 with the rise of numerous value-generating applications such as decentralized finance solutions. [7] [8]

Notwithstanding the 2019 and 2020 dip, Ethereum still reached $4 trillion in annual volume settled on its Network nine times faster than it took Visa. [9] [10]

Ethereum Network Revenues

Historical Snapshot

General Commentary

Revenue Overview

Whereas Google represents the fastest growing business in US history by hitting $10 billion in annual revenue in eight years, Ethereum reached this milestone in six years. [11]

Due to its importance in modeling ETH’s future valuation, we’ve provided additional detail below regarding Ethereum’s Revenue Model.

Ethereum’s Revenue Model

Ethereum’s revenue model is tied to updates of its ledger (“transactions”), where Network participants proposing updates to Ethereum’s record of facts must pay the Network a one-time fee denominated in ETH.

This manifests itself two ways: 1) Transaction Fees and 2) ETH Issuance.

Both of these actions occur in Ethereum through processing batches of proposed transactions ( “blocks”). Blocks simultaneously validate transactions on the waitlist, as well as create new ETH for the Miners/Validators doing the work of validation (“proof of work”), all while being linked to every previously mined block.

So if Alice wanted to send Bob ETH to his Ethereum address:

1. Alice would have to pay the Network Miners/Validators a secondary amount of ETH that she already owns ("gas") to validate her transfer to Bob and;

2) the Network would further compensate the Network Miners/Validators involved in validating Alice's proposed transaction with new ETH.

Initially, the concept of issuing ETH to compensate Network Miners/Validators for processing transactions sounds like a fraudulent scheme.

But in reality, it is a hidden transaction cost (e.g. monetary base expansion) designed to encourage Network participation in the absence of widespread ETH adoption.

Over time, Transaction Fees have grown as a percentage of overall Network revenue, and we expect this trend to continue as the Network gains more adoption.

Ethereum Network Revenue: ETH Issuance

As explained above, the ETH Issuance component of Network revenue is programmatically distributed based on every block.

Over the course of Ethereum’s existence, ETH’s monetary policy has evolved three times, and the overarching theme has been to limit monetary base expansion.

Initially, the Network Miners/Validators were rewarded with 5 ETH for every block. In October 2017, the Platform voted to reduce these rewards to 3 ETH per block, and this was subsequently lowered again to 2 ETH in February 2019. [12]

In July 2021, a platform update was processed (“EIP-1559”) to burn a portion of the transaction fees, which will lead to a portion of transaction fees being removed from total supply. [13]

As it stands, Ether’s annualized monetary base increase is between 2.0% — 2.5% and this is projected to fall in connection with the ETH 2.0 upgrade, where the amount of ETH issued for validating transactions will decline to an annualized monetary base growth rate of less than 1.0%. Eventually, we project ETH’s monetary base will decrease due to the impact of EIP-1559.

It is worth explicitly stating that both ETH Issuance and transaction fees are denominated in ETH, so aside from the reductions in block rewards mentioned above, the primary driver for variance in ETH Issuance revenue is the price of ETH in USD.

After all, 1 ETH always equals 1 ETH.

Ethereum Network Revenue: Transaction Fees

In what is arguably the most telling chart related to Network utilization — and a testament to the proliferation of meaningful applications running on Ethereum in the past year — Network Transaction Fees have exploded to an all-time high in the past year.

Ethereum’s relatively costly transaction fees are a major criticism that we will discuss in more detail below, but the next section will first explore the Platform’s various application categories.

Ethereum Applications Overview

Application developers have deployed over 5,000 tokens in connection with Ethereum projects. [14]

The Platform has seen solutions across three general categories: Tokenization, Decentralized Marketplaces, and Application Infrastructure.

Tokenization

Tokenization is the financialization of everything.

Tokenization, the process of creating an auditable, digital representation of anything, enables liquidity, accessibility and traceability for existing markets, new asset classes and evolved customer experiences.

A token is an Ethereum project’s virtual jackknife — it can apply to assets, governance or the right to a service or reward, and in some cases, all three.

Decentralized Marketplaces

Naturally, current and prospective token holders will want to transact and take advantage of Ethereum’s constant availability. As a result, there has been an emergence of various decentralized venues to buy, sell and provide liquidity.

Application Infrastructure

The below category is essentially an extension of the Ethereum Platform. As accessing the Platform can be intimidating and unintuitive for non-technical individuals, Application Infrastructure aims to make the development, customer experience and operations associated with token issuance and decentralized marketplaces more efficient. We anticipate significant innovation will take place in this category to boost ecosystem adoption.

Competitive Overview

Centralized Alternatives

Before we address other L1 competitors, it’s important for us to clearly state that not all applications should or need to run on Blockchain.

There are four primary reasons to consider a decentralized application architecture.

1. There is no central counterparty that everyone trusts. This is by far the most important consideration. If a particular problem has a “trusted” centralized provider — like the government or central bank — there is arguably no reason to decentralize the solution. By that definition, domestic-focused central bank digital currencies (“CBDCs”) have no benefits in using Blockchain.

2. There are adoption limitations. If a particular problem requires cross-border adoption to generate value (e.g. remittances).

3. There is a need for real-time settlement. If a particular problem such as limited liquidity requires the exchange of information (delivery) alongside a real-time transfer of value (payment).

4. There is a need to introduce a new incentive mechanism. This can range from asset ownership to community-based governance or a new business model.

   
   

If a use case doesn't meet the above criteria, it's likely better suited for a centralized technology stack.

Ethereum's L1 Market Dominance

It's worth explicitly stating that Ethereum's software is open-sourced. Anyone can fork it.

But similar to the world's largest social media conglomerates, Ethereum's network effect isn't easily copied given how much value is locked and distributed within the Platform.

In our view, Ethereum is the leading L1 platform in the space and we measure this across four areas: 1) Projects, 2) Value Locked, 3) Active Development and 4) Regulatory Awareness.

Ethereum Has The Most Projects

In arguably the truest sign of its dominance as decentralized economic infrastructure, Ethereum fuels by far the highest number of projects. [14]

While not all projects built on blockchains have tokens, and some projects have tokens on multiple blockchains, the number of token projects on a blockchain is a suitable proxy for the ecosystem's strength.

Also indicative of Ethereum's dominance, Polygon, xDAI, and Harmony, third, fourth and sixth largest ecosystems, respectively, are scaling solutions built at least partially on top of Ethereum.

This is critical for application developers because it implies that Ethereum has the most diverse, battle tested reference examples for smart contracts and potential for cross-application partnerships.

Ethereum Has The Most Liquidity

While decentralized finance (which predominantly falls under the decentralized marketplace category mentioned above) is certainly not the only measure of liquidity, Ethereum has a 75% market share, more than 7x larger than the second leading L1 in the $167 billion industry. [15]

Application developers and customers looking to benefit from this liquidity must engage with the Ethereum Platform.

Ethereum Has The Most Developers

Entrepreneur Jeff Booth has explained how the platforms with the strongest network effects attract a disproportionate amount of top talent because few people want to work for the second-best platform. [16]

As a result, it’s unsurprising to see that Ethereum has approximately 6x more active monthly developers than any other L1. [17]

This flood of intellectual property creates a powerful innovation feedback loop — continuous product development begets more transactions and value generated, which subsequently funds the next wave of innovation to further extend Ethereum’s market dominance.

In addition to the pace of developer growth being greater than the vast majority of ecosystems, these figures exclude the number of active developers building Ethereum-based applications, which we estimate to be multiples higher than other L1s.

Ethereum Has Regulatory Mindshare

In 2018, the United State’s Security and Exchange Commission’s Director of Corporate Finance William Hinman declared Ethereum was not a security. [18]

Current U.S. Security and Exchange Chair Gary Gensler also suggested that ETH wasn’t a security during a Senate Banking Committee hearing in September 2021. [19]

Furthermore, Ethereum has realized institutional adoption at many of the world’s largest, and most heavily regulated businesses including the likes of Amazon, Visa, Mastercard, J.P. Morgan. [20]

Unofficial Fifth Reason: Ethereum Is Less Risky than Other L1s

Aside from its market dominance in number of projects, liquidity, active development and regulatory mindshare, Ethereum also has three critical tailwinds that attract innovation.

1. Ethereum works. There’s no requirement to “wait for certain features to be delivered.” You can deploy applications on it now in a production environment.
2. Ethereum’s future is more certain. Applications on Ethereum have diverse teams and obtain funding from a myriad of global capital sources. Unlike other L1s, there is little reliance on any one individual or entity to fuel ongoing innovation.
3. Ethereum is resilient. Ethereum has overcome some significant challenges, namely hard forks, high profile hacks, challenging network upgrades and regulatory scrutiny. Many other L1s have yet to meet these challenges.

Ethereum’s Flaws

Ethereum has two main flaws: 1) cost and 2) scalability, and how the Platform is addressing them is critical for ETH reaching our price target.

A simple transaction like sending ETH from one wallet to another can cost as much as $10, and using decentralized exchanges like Sushiswap on Ethereum runs between $20 and $100, depending on network activity — this pricing is not acceptable for mainstream adoption.

In terms of scalability, Ethereum can currently only handle approximately 15 transactions per second, materially less than other L1 competitors. [21]

Fortunately, Ethereum is in the process of addressing these issues in ETH 2.0 by migrating its decentralized transaction validation model from proof-of-work to proof-of-stake where security occurs based on tokens locken in the platform versus using energy resources.

We estimate this enhancement will reduce costs by 90% and increase transaction throughput by 100x based on comparable L1 performance.

In the interim, a myriad of Ethereum-based scaling solutions (e.g. Polygon) have emerged and are being utilized by Ethereum’s largest projects to reduce costs and make way for higher throughput use cases.

So rather than moving to other L1s, Ethereum’s biggest projects are migrating some of their workflows to Ethereum scaling solutions to reduce the amount of computing power required from the Platform (and hence reducing network congestion) while still using it as the golden source of data.

L1 Competitors

Of the hundreds of L1 platforms in existence, we have provided a snapshot of Ethereum relative to select other Platforms with relatively high market capitalizations.

The only current serious competitor to Ethereum is Binance Smart Chain (“BSC”), though its limited platform innovation and security centralization make it unlikely that it will gain market share versus Ethereum in the future.

As vehicles for speculation, platforms like Solana and Cardano compete with Ethereum, however, the general lack of proven applications, production infrastructure, and established innovations make them unlikely competitors to Ethereum as L1s. Our research also indicates that the vast majority of applications funded on both of these platforms stem from a singular source connected to the respective L1.

Emerging competitors such as Polkadot and Cosmos have strong pipelines of diversely funded solutions given they offer attractive features for decentralized application development. However, the former is not yet live and the latter requires material project-level integrations to achieve material scale from a liquidity perspective.

In all cases, the above projects offer lower transaction costs and increase network scalability, which ETH 2.0 aims to address.

Provided ETH 2.0 is not delayed, there is no current Ethereum competitor that can materially challenge Ethereum’s market dominance over the projection period.

We’ve added specific commentary on each project relative to Ethereum in the Appendix, which is more technical than other aspects of this piece in order to offer more meaningful analysis.

But What About Bitcoin?

It’s time that we address the orange elephant in the room.

Whereas bitcoin, an L1 by our own definition, is a finished product, Ethereum is a functional platform evolving to meet the requirements of a thriving economy.

They are also targeting different audiences: investors and consumers.

To be clear, Ethereum has — and requires — more ongoing development than bitcoin.

If you are interested in a long-term, digital store of value with deflationary characteristics that are nearly impossible to change, there is no better option than bitcoin.

But that’s ALL bitcoin is.

If you are interested in the platform fueling the next generation of global growth, whis is also an emerging long-term digital store of value with deflationary characteristics, there is no better option than Ethereum.

At the end of the day, investors choose bitcoin as a portfolio hedge against fiat debasement whereas consumers require Ethereum to participate in the digital economy.

Ethereum Economic Model

Given the multifaceted nature of Ethereum, we considered three different valuation methods to arrive at ETH’s August 2026 price target of $32,468: 1) Dividend Discount Method 2) Payment Network Comparables and 3) Network Participants.

Dividend Discount Method

Introduction

Cashflow generation is arguably the truest measure of value, however, traditional cashflow valuation models are challenging to apply in negative real interest rate environments such as the time of writing. [22]

The Dividend Discount Method is generally also used for platforms generating fiat-denominated cashflows, and given Ethereum produces ETH-based cashflows, we convert them to USD on an annual basis.

Projection Model

Valuation Range — The Dividend Discount Method valuation range yields an ETH price of $20,993 — $33,711. The difference is driven by varying the USD debasement rate from 0% to 10%.

Assumptions and Comments

Global: Revenue and costs are denominated in ETH, with an annual conversion to a USD-denominated price based on anticipated debasement of the US Dollar.

USD Debasement: At the time of writing the expansion of US Money supply is 15% year-over-year. [23]

In the interest of conservatism, we assume a more modest 5% annual debasement relative to ETH, implying that by August 2026 the price of 1 ETH is $4,391 based on the August 31, 2021 price of $3,440. Given the current size of the US’s current debt relative to gross-domestic-product and the political preference for debt repayment through dollar debasement versus austerity, it’s hard for us to see a scenario without continued balance sheet expansion in the United States over the projection period.

ETH 2.0 Upgrade: We project the proof-of-stake upgrade to occur on February 28, 2022. This will not only reduce ETH issuance, but also average gas fees relative to today.

ETH Issuance Revenues: We project ETH issuance to grow based on 40% of outstanding supply being staked based on relevant proof-of-stake comparables.

ETH Supply: Alongside the projected token supply reduction from EIP-1559, ETH Issuance informs projected ETH supply. We consulted multiple sources to build the ETH supply projection, which is referenced across all three valuation methodologies. [24]

Ethereum Transactions: Since 2016, transactions have increased at a CAGR of 117%. Despite transactions only increasing at a 21% CAGR since 2018, on the basis that we model average reduced transaction fees, we model a modest increase of the current annual growth activity to be more inline with volumes seen on BSC by the end of the projection period. [25]

ETH Transaction Costs: We project approximately a 90% decrease in average transaction cost following ETH 2.0, which grows slightly over the projection period as throughput increases. Due to EIP-1559, we model Transaction Revenues based on the difference between projected average transaction fees and median transaction fees (the former of which is historically approximately 130% higher than the latter). [26]

Cost Structure: The transition to proof-of-stake will dramatically reduce costs associated with providing network security. Given the first 6 months of 2022 will still be proof-of-work in this model, we assume a 40% profitability margin based on the average margin in line with public mining businesses. While running a proof-of-stake consensus mechanism is extremely light weight (essentially just paying for a virtual machine, which is mutualized across anyone who delegates plus the ETH transaction fee), we conservatively assume a 90% profit margin (it is likely higher) after the first 6 months of 2022. [27]

Discount Rate: Since we are operating in the Ethereum ecosystem, the discount rate is 3.1% based on current stable coin deposit rates. [28]

Growth Rate: 3.05% growth in perpetuity is low for Ethereum, however, since the Dividend Discount Model gained popularity in times where the risk free rate was higher than growth (which is not the case today), assigning any rate higher than this would break the model. Assuming a higher risk free rate, we believe a minimum of a 5% long-term growth rate would be more appropriate as the likes of Visa and Mastercard are growing at approximately 7% annually and each have a far longer operational history.

Payment Network Comparables

Introduction

Ethereum’s Platform has similarities to cloud-computing, data warehousing, software development platforms and e-commerce enablers, however, our analysis indicates that the more relevant measure of an L1 platform’s footprint is the dollar amount settled on its Network.

Therefore, we seek to value Ethereum on a comparable basis not only to itself but also relative to Visa and Mastercard, which conveniently have comparable market capitalizations to Ethereum.

Projection Model

Valuation Range: The Payment Network Comparables valuation range yields an ETH price of $21,591 — $44,894. We calculated the average of the implied Ethereum prices based on trailing and future market capitalization to Platform Volume based on 1) historical Visa and Mastercard ratios and 2) historical Ethereum ratios relative to itself. To compose the range, we weighted 1) the implied ETH pricing from historical Visa/Mastercard ratios at 100% for the lower end and 2) the implied ETH pricing relative to its historical ratios at 100% for the higher end.

Assumptions and Comments

Total Network Transactions: From 2018 to 2021, total Network transactions have grown at a 45.4% CAGR. Given we estimate transaction costs to fall by approximately 90%, we assume a ~40% uptick from this rate for a 64.0% CAGR over the project period. For the avoidance of doubt, these Network transactions are the same made in the Dividend Discount Model.

Transaction Size: The average transaction size on Ethereum grew at an 18.8% CAGR from 2018 to 2021. Given the expected transaction cost reductions in ETH 2.0, we kept the average transaction size flat versus increasing the amount over the projection period, as presumably net new transactions taking advantage of lower fees will presumably offset existing players’ transaction size growth.

Valuation Multiples: We chose market capitalization relative to volume settled on both a trailing and forward basis taking the 5-year historical averages of Ethereum, Visa and Mastercard since transaction volumes are a key performance indicator for payment networks, and equity investors are buying future growth. [29]

Network Participants

Introduction

Popularized by Raoul Pal as a valuation methodology for crypto assets, Metcalfe’s Law states that the value of a network is directly proportional to the squared number of its participants. [30]

To complement the Dividend Discount Method and Payment Network Comparables, we incorporated this analysis by looking at growth of wallets with Non-Zero ETH Balances (“NZB”) alongside the implied value each one brings to the Network.

Projection Model

Valuation Range: The Network Participation Model range yields an ETH price of $16,727 — $56,892. The difference is driven by reducing the NZB Balance by 100% and increasing it by 50%.

Assumptions and Comments

NZB Balances: These have grown at a 47.95% CAGR from 2018 to 2021. We assume a more modest growth trend as the Network matures, with a 31.64% CAGR over the projection period, which represents YE August 31, 2021 year-on-year growth. While you could argue that we should decrease the year-on-year trend pursuant to the most recent year trend, we held it flat given the reduction in gas fees from ETH 2.0 should result in an uptick in the rate of NZB increases.

Market Cap / NZB: The second key driver in this projection model. While this ratio has grown at a 62% CAGR from 2018 to 2021, we assigned a more modest growth rate over the projection period of 17.79%, which is the CAGR from 2016 to 2021 for conservatism.

ETH Supply: As alluded to above, ETH supply is calculated based on anticipated ETH Issuance in ETH 2.0 and ETH removed from supply following EIP-1559.

The X-Factor: Flows

In today’s market landscape it would be incomplete to not consider the impact on investment flows into ETH and their potential price impact.

While this type of analysis is not our core expertise (like it is for our friend Lily Francus), we see three positive tailwinds that will drive positive price action independent of Ethereum’s market leading position as the top decentralized economic infrastructure.

1. Institutional Investment: In addition to its position as the second largest crypto asset with a $400bn+ market capitalization, Ether is de-risked from a regulatory perspective as there is a low likelihood of it being retroactively deemed a security based on public comments from the SEC and regulatory officials. Ethereum ETF applications have also been filed by global asset managers such as VanEck. [31]
2. Sustainable Yield Opportunities: With Ethereum’s upgrade to a proof-of-stake consensus mechanism, anyone willing to contribute to the network’s security can earn mid-single digit yields from ETH inflation and transaction fees without the potential risk of impermanent loss or credit defaults. In a world with rock bottom interest rates, taking tech infrastructure risk for mid single-digits feels like an extremely attractive trade.
3. ETH’s Monetary Policy — Between the recent EIP-1559 upgrade and the proof-of-stake upgrade in the coming months, Ether is set to experience a supply shock deemed the “Triple Halving,” which sees a drastic reduction in the sale pressure of Ether, and result in an explosive price increase. [32]

Conclusion

All else being equal, the market leader tends to accrue the majority of the market value, and in the case of L1s, the dominant player is undoubtedly Ethereum.

As ETH 2.0 represents a major milestone to address Platform limitations regarding costs and scalability, successfully delivering on this upgrade will diminish many emerging competitors overnight.

Given the incredibly attractive risk-adjusted returns profile of this asset, ETH represents our benchmark when assessing long-term positions in our liquid token strategy.

Projects not built on Ethereum or benefitting from its tremendous scale in some way are generally not investable for us at the present time.

A major tailwind to ETH 2.0 is the introduction of Network-wide yield opportunities for contributing to Platform Security, which will undoubtedly drive interest from income-hungry institutional and retail investors alike.

Ultimately, Ethereum is becoming this generation’s leading economic infrastructure and we plan to contribute to and benefit from its compounding innovations.

Appendix

Competitive Overview Continued

Evaluation Framework

To monitor the competitive landscape, we pay tremendous attention to token projects’ L1 platform choice and follow the flowchart below for challenging our Ethereum-centric view.

After all, application developers are the L1s customers, not the other way around.

Binance Smart Chain (BSC)

As evidenced by the number of token projects running on its platform, the only legitimate competitor to Ethereum is the Binance-assisted Binance Smart Chain (“BSC”).

In addition to using a proof-of-stake consensus mechanism to lower costs and improve scalability relative to Ethereum (the purpose of ETH 2.0), the centralized exchange Binance is an extremely well-funded, established organization in the token space, and openly invests in BSC applications.

While Binance certainly doesn’t fund every project in the BSC ecosystem, and Binance Smart Chain applications have introduced innovations such as gamification across its applications, our main objection to BSC as a future threat to Ethereum is its dependence on a single entity.

This is specifically related to BSC’s security centralization as Binance controls the majority of the nodes that validate transactions.

In other words, Binance being compromised has the potential to destroy the entire network.

Aside from application developers seeking assistance from Binance (which is objectively material), it’s unclear to us why any projects would choose BSC over Ethereum following Ethereum’s upgrade to proof-of-stake, especially since BSC’s platform innovation relative to Ethereum outside of the consensus mechanism is minimal.

Polygon

Polygon is an overlooked platform in the token space.

Many cast it aside as just another Ethereum scaling solution, and from xDAI to Arbitrum to Immutable, there are a myriad of technical solutions aiming to reduce Ethereum transaction costs and improve transaction throughput by bringing the computation element of transaction processing off of Ethereum while leaving the authoritative data record on Ethereum.

But Polygon isn’t only a scaling solution for Ethereum — it is a robust ecosystem for native application development in its own right with the potential to develop a niche as the default low cost platform for cross-chain solutions.

Given Polygon’s initial success as Ethereum’s currently most adopted scaling solution, it’s challenging to bet against its future growth, especially since its projects haven’t been fueled by funding from a centralized entity.

While a potential red flag to note is that Binance represents approximately 28% of the mining pool, we view Polygon’s future more as a standalone L1 (and thus a clear Ethereum competitor) as other scaling solutions capture market share from Polygon to assist Ethereum in maintaining its market dominance. [33]

Solana

In the case of Solana, which has objectively garnered terrific market awareness, we have not identified any challenges to our Ethereum-centric thesis.

Based on our investigations, the majority of projects built on Solana are directly or indirectly funded by FTX and / or Alameda Research (an FTX affiliate), and this is not a sustainable method for developing its ecosystem.

Aside from its proof-of-history consensus mechanism (which operates like an ordering service to increase scalability for high-frequency applications), we don’t see Solana introducing any novel innovations to build a meaningful application network.

As the network is only in beta, it is also not yet a battle tested platform, which could result in outages or security vulnerabilities being exploited. [34]

The more established Solana projects also tend to be dependent on meaningful aspects of the solution being managed by a centralized database manager, which furthers the risk of security breaches.

Avalanche

Similar to Solana, Avalanche has introduced its own version of the proof-of-stake consensus to increase transaction throughput and reduce costs relative to Ethereum.

But provided ETH 2.0 delivers its proof-of-stake upgrade in the next several months, this alone is not enough to challenge Ethereum’s platform dominance, even with the Avalanche Foundation recently launching a $180 million funding program to incentivize application developers to move from Ethereum to Avalanche. [35]

What makes Avalanche intriguing is that it contemplates the idea of a permissioned application, where the application developer may seek additional controls on the solution (e.g. onboarding).

Where Avalanche’s technical architecture falls short, though, is with regards to application-level interoperability, as there are no guarantees that all Avalanche-based solutions will subscribe to the same level of security, which fuels the notion of siloed liquidity.

Cosmos

We would first like to acknowledge that we highly respect the Cosmos’ ecosystem — there are a number of functional, value-generating projects that are based on Cosmos’ technology (including BSC).

But Cosmos took decentralization to the extreme with its platform, potentially to its detriment.

Cosmos’ platform has two main components: 1) a software kit to develop your own Cosmos L1 (“Hub”) and 2) an optional ability to connect to any Hub built with Cosmos’ software kit on an Hub by Hub basis.

Cosmos’ founding team also created its own L1 — the Main Cosmos Hub- to take the burden off of projects interested in using Cosmos’ software kit without needing to create their own Hub, which initially saw limited uptake (for the avoidance of doubt, the stats in the above chart refer to the the Main Cosmos Hub only, NOT an aggregate for every project using Cosmos technology).

So while there are dozens of projects running on Cosmos’ software, due to the fact that application developers using Cosmos generally decided not to deploy on the Main Cosmos Hubs and application interoperability is optional, there are large silos of liquidity.

To address this challenge, there are an increasing number of projects looking to connect to the Main Cosmos Hub in an attempt to increase capital efficiency.

Of course, similar to Avalanche, there is no guarantee that each Hub will maintain the same level of security, however, given the number of projects using Cosmos technology, it’s possible that a sufficient amount of liquidity could be connected to eventually challenge Ethereum’s liquidity dominance.

Terra

Our research indicates that virtually all applications running on Terra are built by Terra Labs.

While its innovation of creating a mechanism to algorithmically introduce an ecosystem-wide stablecoin has rightfully drawn platform interest, it is challenging to see how a niche-platform with one main application developer could pose material competition to Ethereum moving forward.

It’s worth noting that one of Terra’s largest applications is simultaneously being run on Ethereum.

Polkadot

Polkadot’s main network for running applications hasn’t launched yet, so this view is arguably more speculative than the above, but it is rooted in evidence of traction.

There are currently more than 100 projects developing with Polkadot’s application development framework (substrate); plus, Polkadot’s sister network Kusama, which operates as a pilot environment for Polkadot, is onboarding the first would-be applications for Polkadot’s network. [36]

Polkadot’s innovation is twofold: 1) substrate incorporates tools to more easily deploy and operate permissioned and permissionless applications and 2) enabling application-level interoperability with shared security across solutions.

It has also pioneered a new crowd-funding model, where community members have the right to choose which solutions ought to gain access to the shared network security in exchange for solution-specific rewards.

Due to Polkadot’s technical design and application pipeline, we view it as the most likely L1 to enable compelling enough solutions to organically drive network participants to its network from Ethereum, however, there is still a major delivery risk.

Cardano

Cardano’s primary (and arguably, only) strength is its marketing engine, led by its founder.

Based on its lack of current applications, solution pipeline, and innovation beyond an opaque, constantly delayed academic-based code review system, labeling Cardano as a competitor to Ethereum is disrespectful to the Ethereum ecosystem.

Cardano does compete, however, with Ethereum as a vehicle for speculation, which is outside the scope of this evaluation.

Other Niche Platforms

All else equal, applications focused on long-term viability ought to deploy on the L1 with the most liquidity and network participants.

Of course, if a project is able to source enough liquidity, customers and developers for its use case on a standalone basis, then it might not matter that it’s operating on a virtual island.

In this type of scenario, it is very likely that there is a trusted, centralized organization with a disproportionate amount of influence, which calls into question the architectural decision of using a blockchain platform in the first place, and whether a multi-tenant, cloud-based solution would be more appropriate.

An example of a niche Platform that may perform well is the Asia-based L1, Kalyton, which has strong government and regulatory partnerships within the region.

It may also be the case that an industry focused L1 with strong backing from existing players could achieve moderate success, however, our experience indicates that this type of model suffers from conflicts of interests and slow product development.

Risks and Mitigants

Regulatory

Risk Level: High

Description: Regulation within the token market is unclear. Key regulatory issues that are likely to arise related to ETH and ETH related projects include 1) whether ETH and ETH related projects are securities 2) AML/Financial Crime and 3) Consumer protections.

Mitigant: 1) This is more of a risk for projects running on Ethereum versus ETH itself. In 2018, the United State’s Security and Exchange Commission’s Director of Corporate Finance William Hinman declared Ethereum was not a security, though it may be revisited following Ethereum’s upcoming 2.0 upgrade. As it relates to the token projects on top of ETH, at this point, we hope to receive clarity more than anything else to understand which, if any, projects will be classified as securities. It’s also important to note that there is strong demand for both ETH and ETH-enabled tokens outside of the United States. 2) For trading venues listing ETH and ETH-enabled tokens, there are several relatively easy technical implementations to address this requirement such as geoblocking participants from sanctioned countries. 3) For trading venues listing ETH and ETH-enabled tokens, implementing consent forms / lightweight Know-Your-Customer processes would help alleviate this risk and are relatively easy technical implementations.

Technical / Platform Upgrades

Risk Level: High

Description: Ethereum may experience a technical glitch or hack in connection with its upcoming upgrade to a proof of stake consensus mechanism.

Mitigant: Changing the consensus mechanism of an L1 is about as high a risk of an upgrade as it gets as compromising the integrity of Ethereum’s ledger would destroy Etherum’s fundamental value proposition. Fortunately, the Ethereum community has been preparing for this upgrade for nearly one year on a parallel network and has a track record of implementing successful upgrades. While it’s unlikely that there will be another upgrade this significant over the next five years, material upgrades are a recurring upgrade event in a Platform like Ethereum.

Competitive Risk

Risk Level: Medium

Description: Ethereum is an open source platform. Anyone can fork it for their own purposes. New platforms can also innovate based on lessons learned / shortcomings from Ethereum’s first several years in production.

Mitigant: Ethereum’s market dominance is well articulated in this memo. Specifically its liquidity, number of projects, developers, battle-tested platform and regulatory mindshare. However, given the pace of innovation in this space, it would be unwise to not study emerging competitors closely to continuously challenge our ETH investment thesis.

Network Attack

Risk Level: Medium

Description: A malicious actor could seek to take control of 51% of the Network and/or destroy it.

Mitigant: If some actor with extremely deep pockets wanted to do this, they could. It would be very expensive to do so — likely trillions since acquiring this large of a stake in ETH would push the price up materially (an on chain analysts would take notice), so it would be unlikely that such an actor would profit from spending this much money on destroying the Platform (unless there was some broker willing to underwrite a massive short without realizing that they were selling to the entity accumulating 51% of the network, which seems unlikely). Therefore, the motivation would likely be non-economic (e.g. national security) and only a handful of governments would have the ability to raise this type of funding. While this sounds like an absurd scenario, certain governments have a long track record of funding questionable initiatives under the guise of national security. What is more likely, is actors attempting to expose security vulnerabilities of projects running on top of Ethereum, which while not directly related to Ethereum, could temporarily impact the Platform’s public perception.

Key Individuals Leaving

Risk Level: Low

Description: Vitalik Buterin, Ethereum’s Founder, or another high impact ecosystem player, leaves the project.

Mitigant: Vitalik, as an individual, has very little impact on day-to-day Platform functionality, but is viewed as a leader within the ecosystem. A number of ecosystem players take his vision as gospel. If Vitalik left, it would likely cause short term price pressure on ETH, however, given the decentralized nature of the Platform and the breadth of its adoption, it would be unreasonable to suggest that Vitalik, or another high-profile individual, no longer being involved in the project would disrupt its long-term potential.

Network Participation Falling

Risk Level: Low

Description: Ethereum Platform developers, Miners/Validators and Application Developers could lose interest in contributing to the Network.

Mitigant: This tends to occur in L1s where application customers subside. In Ethereum’s history, it’s never had a negative year of wallet growth. Ultimately, technologists want to build and harden solutions that people want to use. And that utilization will continue to drive a robust ecosystem. As a result, Ethereum wallets, and specifically, non-zero ETH balance wallets, are a key metric we actively monitor.

Innovation Risk

Risk Level: Low

Description: while decentralized architectures can drive value for many use cases, they are less favorable to centralized architectures in instances with a trusted centralized provider. We may have already reached the ceiling of value-generating decentralized applications.

Mitigant: Adoption for distributed ledger technology is analogous to the Internet in the 1990s. The most exciting aspect of this space is that today’s trends (e.g. NFTs) were essentially nonexistent eighteen months ago. Imagine what applications we will be using eighteen months from now. We will continue to monitor the pace of innovation.

Token Market Volatility

Risk Level: Low

Description: The token market is volatile and very susceptible to investor sentiment. There is limited market depth and leverage can trigger liquidations which move the market, which could impact ETH’s short term price.

Mitigant: Volatility is a reality of this asset class and has compensated long-term holders with strong risk-adjusted returns. We plan to mitigate this risk by taking a long-term position and locking in profits when appropriate.

Sources

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This article was first published at: https://medium.com/addresscapital/32k-eth-the-best-risk-adjusted-path-to-10x-crypto-returns-8727c8eb973d