Renowned investment firm Dragonfly Capital: How to interpret the investment value of Ethereum (ETH)

This article is authorized to be reprinted from ChainNews, with the translated title "Dragonfly Capital: Rethinking the Value Narrative and Investment Logic of Ethereum for a Rough Valuation," and the original link can be found here.

Dragonfly Capital believes that Ethereum and DeFi have the potential to disrupt traditional finance, and therefore should be given a corresponding valuation; a rough estimate places Ethereum's total potential valuation between 3.7 to 4.7 trillion US dollars.

Authors: Kevin Hu and Celia Wan, Partner and Junior Partner at Dragonfly Capital respectively

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Compiled by: Perry Wang

This article seeks to help readers understand the Ethereum network and its native asset ETH as an investment target with potential impact. However, this article does not attempt to provide precise valuations or price predictions. It is assumed that readers have a basic understanding of Bitcoin, Ethereum, and the broader cryptocurrency ecosystem. The views expressed in this article are not, and should not be considered as, investment advice.

Overview

Bitcoin was introduced in 2009 as the first trustless digital native currency. Due to its scarcity and unforgeable nature, Bitcoin has the potential to become a universal non-sovereign store of value. With traditional financial institutions beginning to adopt Bitcoin in the latter half of 2020, the narrative of Bitcoin as digital gold has solidified. Eleven years after its inception, institutional investors are finally starting to invest in Bitcoin, as this simple yet powerful narrative of value storage is making its way into mainstream finance.

On the other hand, understanding the Ethereum network and its native asset ETH is complex. Smart contracts, decentralized finance (DeFi), and Web 3.0 are still niche topics. ETH as an asset has a complex value narrative, challenging even full-time crypto professionals to articulate clearly.

According to the design of the Ethereum blockchain, ETH is the fuel Gas within the Ethereum network (often referred to as the "world computer"). But what is the use of this "world computer"? Is ETH a consumable, capital asset, or programmable collateral/currency? How does ETH accrue value?

There has yet to be a concrete singular value narrative for ETH.

The rest of this article will explore different emerging perspectives surrounding ETH and help investors understand what they might actually be betting on when investing in ETH.

Popular (but slightly outdated) Economic Analysis of ETH

The current version of Ethereum resembles a distributed operating system with a native token ETH used to pay for computational costs, and miners who provide computing resources are rewarded through block rewards and transaction fees. Historically, ETH block rewards have undergone adjustments based on explicit targets for specific expenditures. Notably, compared to Bitcoin, ETH has a more aggressive monetary policy.

In this current model, Ethereum users pay transaction costs with ETH, and ETH holders bear the cost of inflation. Assuming no speculative trading, ETH holders bet that the demand for ETH from Ethereum's application users will exceed the inflation rate brought by block rewards (which has fluctuated significantly throughout Ethereum's history).

A popular economic analysis of ETH is to view the Ethereum network as an economy and describe the total value of the network using GDP. Then, we can calculate the value of the Ethereum network based on the equation PQ = MV, where the price multiplied by the quantity (total output) must equal the money supply multiplied by the money circulation velocity. Thus, the total value of the Ethereum network equals the total circulating ETH multiplied by the ETH turnover rate.

A common speculation is that in the long run, the GDP of the Ethereum network may be considerable but not exceptionally large, as it is constrained by the cost of computation and the fact that Ethereum transaction fees must be very cheap to be accepted by the public. The turnover rate of ETH may also be very high because there is no reason to hold this frictionless payment method. Therefore, the valuation of ETH may be relatively low but still able to support a reasonable economic scale. In this framework, ETH cannot attain significant economic value as it is a completely substitutable commodity that does not need to be held.

The core of this theory is: 1) The sole function of 1 ETH is as a means of payment; 2) The open-source nature of public chains makes it impossible to retain IP value; 3) The cost of switching applications to another blockchain is close to zero. As a result, Ethereum will have weaker network effects, and ETH should be priced like a commodity, as users will not be willing to pay more than the cost of production.

Recent Theoretical Developments

While the logic behind the PQ = MV equation is reasonable, this theory has not been fully perfected thus far. To date, Ethereum remains at the forefront in terms of user adoption and developer adoption among various blockchains. Its network effect seems to be strengthening, and the market cap of ETH is five times larger than the currency of the first layer (L1) public chains ranked third in market capitalization.

Compared to two years ago, today's Ethereum is vastly different. In 2017 and 2018, the sole use case of the Ethereum blockchain was to conduct token issuance for projects through ICOs (where the vast majority of projects did not deliver anything meaningful). Today, Ethereum supports a thriving DeFi ecosystem, and other use cases such as non-fungible tokens (NFTs), gaming, metaverse, and Web 3.0 are gradually taking shape.

DeFi has become the first widely used application on the Ethereum network. Currently, DeFi has a total assets under management (AUM) of $600 billion (peaking at over $1.2 trillion in early May 2021), over $17 billion in outstanding loans, and an average daily transaction volume of over $5 billion. These DeFi applications together generate over $4.5 billion in annual revenue (fees paid to protocols in the past 30 days, which can be seen as an indicator of revenue), accumulating a significant amount of liquidity to generate network effects.

The DeFi ecosystem on Ethereum has now formed a positive feedback loop, where users bring liquidity-based network effects to DeFi and benefit from the liquidity market of DeFi. With more assets locked in DeFi, decentralized exchanges (DEXs) based on automated market makers (AMMs) and lending platforms see reduced slippage and borrowing costs, making them more attractive to users (although there is no network effect across liquidity pools, the aggregation network effect is sublinear relative to the total locked value).

Furthermore, the composability and interoperability of DeFi protocols create a lock-in effect for Ethereum, making it difficult for other L1 public chains and side chains to compete.

To compete with Ethereum, other chains need to nurture a complete DApp ecosystem and acquire liquidity from scratch—this is no easy task and usually requires significant token subsidies. Indeed, we have seen chains like Polygon and Binance Smart Chain (BSC) succeed by copying DeFi applications on Ethereum while offering additional incentives such as low gas fees and liquidity mining projects. However, bridging these different blockchains still disrupts the composability between DeFi protocols, forcing L1 public chains to develop independent ecosystems.

From an architectural perspective, the most significant change coming to Ethereum is Ethereum 2.0, Layer 2 (L2), and the EIP-1559 proposal improvement. We do not delve into technical details here, but Ethereum 2.0 will transition the Ethereum network from a proof-of-work (PoW) consensus model to a proof-of-stake (PoS) consensus model. Ethereum 2.0 will no longer use computational resources to verify the next block but instead rely on ETH holders (validators) to vote on the next block, establishing a security model based on game theory and economics. Ethereum 2.0 will also shard the network into 64 shards, enabling parallel operation and future scalability for Ethereum.

In the short term, L2, especially rollup methods based on fraud proofs and zero-knowledge proofs, may make the Ethereum network more scalable and significantly reduce cost by several orders of magnitude.

Today, Ethereum processes approximately 15-17 transactions per second (tps). We expect the upcoming Ethereum to increase Ethereum's throughput to over 2,000+ tps (using on-chain data) and 9,000+ tps (using off-chain data) on L2. L2 will also significantly reduce transaction costs. Currently, the typical cost of DeFi interactions ranges from $10 to over $100, meaning most applications and users are being priced out of the market. L2 could reduce the cost of DeFi transactions to below $1 (some estimates as low as 10-20 cents), increasing accessibility to DeFi and Ethereum by 100 times.

Finally, Ethereum may adopt a new monetary policy proposal called EIP-1559. EIP-1559 makes some changes to the Ethereum transaction fee algorithm. The most significant impact on our analysis is that this upgrade will result in most Ethereum transaction fees being burned rather than paid to miners.

If the PoS mechanism and EIP-1559 are implemented, the inflation rate of ETH may significantly decrease, and ETH may become a capital asset in addition to being a consumable commodity. This is expected to have a profound impact on the appreciation of ETH's value. More details will be discussed later.

How Do We View Ethereum Now?

As impressive as the story of Ethereum has been so far, the momentum of DeFi has created a fairly unstable existence among a limited user base, with users eager to take advantage of fleeting liquidity mining schemes and project IDOs. Nevertheless, the various developments in Ethereum have indeed made the PQ = MV model for evaluating ETH value outdated, requiring new approaches to conceptualize ETH to fully cover the rapid development of the Ethereum network.

The following three sections introduce different conceptualizations of ETH from both qualitative and quantitative perspectives. These conceptualizations will ultimately influence the final evaluation of ETH. It is important to note that these mechanisms and final evaluations should not be considered definitive conclusions on ETH. Nevertheless, they are honest attempts to understand ETH as an asset and Ethereum as a platform.

Ethereum as the Future Financial Layer

Ethereum enables smart contracts to execute automatically without the need for a trusted third party. Its various token standards allow for the representation of values other than ETH on the network. In summary, Ethereum allows value and ownership to be managed by code, which can serve as an alternative to existing transaction and settlement tracks in traditional finance. With technological advancements and reduced transaction costs, Ethereum and DeFi will make new use cases that were previously unimaginable a reality.

We believe that Ethereum and DeFi have the potential to disrupt traditional finance and should therefore be valued accordingly for the following reasons:

• Permissionless Innovation Driven by Software Speed: All DeFi protocols are open-source and composable. DeFi entrepreneurs can reimplement financial combinations and innovations at an incredible speed and cover a global audience with almost no fixed costs.
• Incentivized Consensus: Through correct token mechanism design, all stakeholders in the ecosystem, including protocols, users, liquidity providers (LPs), engineers/protocol maintainers, etc., can reach consensus on benefits correctly and can bootstrap without any upfront costs.
• Cost Reduction: DeFi eliminates costs associated with legal, labor, compliance, and fixed infrastructure. Financial transactions in the traditional world are based on legal frameworks and enforced by governments, with high and opaque retrieval costs in complex situations such as bankruptcy. These costs do not exist in DeFi since values are entirely controlled by code.
• Frictionless Capital and Near-Instant Settlement: Capital in DeFi enables sub-minute settlements in a frictionless and programmable manner—truly a digital-native experience. In contrast, in the traditional world, payment channels from different jurisdictions are not seamlessly interconnected (although companies like Stripe and Plaid have slightly improved the situation). In traditional finance, these processes are manually executed, and many systems are outdated systems with decades of history.
• Massive Customization and Synthetic Assets: Just as the internet allows companies to reach different niche users, DeFi enables users to access almost any asset in the world. Today, anyone can create a new trading pair through AMMs like Uniswap, as long as they have the trading assets in stock. Synthetic assets further advance this process. In theory, as long as there is a trusted data source, anyone can create synthetic assets by providing on-chain collateral. Synthetix, UMA, Mirror, and many other teams are exploring in this direction.
• Government Neutrality: The financial system built on Ethereum is open, and everyone can access it. While this may not sound appealing to users in financially mature markets like the United States, it offers unparalleled advantages to people living in countries with inefficient or corrupt local financial systems.

ETH as a Capital Asset

The value of ETH comes from two sources: first, its utility value as discussed in the arguments above. The second part of its value comes from its monetary premium, which stems from the preference for ETH as a "quasi-currency" asset in the Ethereum economy.

As a medium of exchange and unit of account, ETH is unlikely to succeed. If the Ethereum network becomes ubiquitous and fees stabilize, ETH could become a popular currency, at which point a super ETH bull market might be sustainable. Overall, the likelihood of this is very slim, even if Ethereum does become a dominant platform, stablecoins perform significantly better in the aforementioned two functions. Today, the total on-chain transaction volume of ERC-20 stablecoins has already exceeded that of ETH (daily $1 billion versus $800 million), despite ETH having a market cap four times higher. The difference in off-chain transaction volume between stablecoins and ETH is even larger.

However, as a non-sovereign value store, ETH may still have an opportunity to gain some market share by being used as collateral in DeFi.

In the long run, it is conceivable that ETH could even compete with Bitcoin on dimensions such as scarcity, durability, and unforgeability, for the following reasons:

Due to the EIP-1559 upgrade, ETH's monetary policy will become more stable, and inflation may decrease by half (from 4% to 2%, according to Columbia University computer science professor Tim Roughgarden). While this is different from a capped supply, assets with well-publicized low inflation rates may be the next best option.

The security model of Ethereum 2.0 will eventually undergo almost the same battle-tested test as Bitcoin (20 years after, Bitcoin's existence is only 20% longer than Ethereum's). Additionally, if ETH becomes sufficiently valuable, Ethereum 2.0 and PoS may enhance Ethereum's security guarantees (we acknowledge that this idea is self-reinforcing).

Similar to Bitcoin, ETH as the first collateral for DeFi has a very strong Lindy effect. History tells us that the adoption of new technologies/assets/products depends heavily on the path taken. Typically, having better distribution channels is more important than having better products/technology. If Ethereum and DeFi truly become the future financial layer, ETH is likely to remain one of the primary collateral options as it was the first scaled collateral and the DeFi ecosystem is built around it.

However, if Ethereum and DeFi continue to grow, ETH may capture 10% of Bitcoin's market share. If we assume Bitcoin's potential market value is around $4.7 to $14.6 trillion, then the potential monetary value of ETH may be $0.5 to $1.5 trillion.

Potential Valuation of ETH

Ethereum has a complex value narrative, making it challenging to map out various mechanisms for ETH's value appreciation. We believe that the potential value of ETH should encompass its roles as 1) a consumable commodity, 2) a capital asset, and 3) a monetary asset (specifically divided into payment and value storage functions).

Based on the thought process above, we arrive at the conclusion that in the distant future, the total potential valuation of ETH could range between $3.7 to $4.7 trillion:

• Given its rapid development, the valuation of ETH as a consumable commodity may be limited.
• The valuation of ETH as a capital asset with cash flow may reach trillions of dollars, specifically in the low single digits. $3.2 trillion is an estimate point derived from a conceivable successful case.
• The monetary value of ETH may range from $0.5 to $1.5 trillion. We assume that the value of ETH's payment function will not exist, and all monetary value of ETH comes from: it being a non-sovereign value store driven by DeFi.

Important Note: These figures are by no means precise estimates. Through this exercise, we help readers grasp the potential impact of the Ethereum network and the corresponding value of ETH. It aims to highlight the potential narrative of Ethereum and provide readers with a psychological model of ETH value growth. We have not adjusted probabilities or introduced discount rates to account for numerous risks (such as technical, competitive, regulatory). Experienced investors need to consider these risks to ultimately measure the risk/return of ETH as an investment.

Special thanks to Haseeb Qreshi, Ashwin Ramachandran, Tom Schmidt, and other members of the Dragonfly team for their feedback.

Disclosure: Dragonfly Capital is an investor in BTC, ETH, Matter Labs, and many DeFi assets discussed in this article.