There's Something About Ethereum
Today is all about Ethereum. Besides being on a tear recently (up 45% in the past month), there are big changes going on with the most successful "smart contracts" platform.
Combined, Ethereum and Bitcoin represent around 60% of the total market cap of crypto (almost surprising that it's not higher than that). Bitcoin is easiest to think of digital gold. You can pay people with it, but otherwise, there's not currently much functionality and it's intentionally designed that way. Less functionality means less surface area for attacks. And slower, simpler transactions lessens the computing and storage requirements, allowing for greater decentralization.
Ethereum, on the other hand, aims to be the "world's computer." Ethereum can be programmed in all sorts of ways to allow for decentralized stock exchanges, automated lending and borrowing, and expensive cartoons of monkeys. But as these applications have grown, transaction costs (know as "gas") have also increased. Spending $50 in fees isn't a big deal if you are moving millions of dollars, but it certainly prices out lower value transactions. To keep up, Ethereum has an aggressive road map, starting with the upcoming "Merge".
🟢 Shift to Proof of Stake
(Big Idea: How Blockchains Work)
Public blockchains generally work with one of two consensus mechanisms: proof of work or proof of stake. Bitcoin, for example, is adamantly proof of work. To verify transactions, specialized computers ("miners") basically burn energy looking for a random number to solve a puzzle. The "work" put in "proves" that you're not cheating. And to incentivize miners to secure the network, they get paid a reward for every puzzle they solve. For Bitcoin, this is 6.25 Bitcoin or currently about $150,000, every ~10 minutes. Those new Bitcoin entering the system create a 1.75% inflation rate currently, which is cut in half every four years.
Proof of stake works differently. Instead, of dedicated miners, holders "stake" their coins as collateral and each takes a randomized turn verifying the next block of transactions. Everyone else then checks their work to make sure it is legit. If a validator gets caught cheating, their stake is "slashed" and some of their collateral is taken as a penalty. Otherwise, the staker earns a portion of the transaction fees from that block as their reward.
There are pros and cons to each system, but the one huge pro of proof of stake is energy efficiency. The amount of energy used by Bitcoin is a controversial topic and it is likely a lot less impactful than is commonly perceived, but it is undeniably significant. Compared to gold, diamonds or even some estimates of the cost of the banking system, this may be tolerable, but for a new digital currency it remains a significant issue.
Ethereum has been working for years to switch from Proof of Work to Proof of Stake as part of a big release called the "Merge." This transition is estimated to cut Ethereum's energy usage by 99.95%! But implementing the change is a bit like trying to switch from a gas engine to all electric all while cruising down the highway at 80. For years, the transition has been perpetually nine months away, but a mid-September launch date is now looking increasingly possible. The last few months have seen a number of successful launches on Ethereum test networks, revealing a few remaining bugs and building confidence for a main chain launch. Prediction markets now list a 65% chance that the transition is done by October 1 which would be a huge milestone for Ethereum.
🟦 Why It May Be a Good Time to Buy
(Big Idea: Token Economics)
Besides massively reducing the energy usage, the shift to Proof of Stake will also dramatically change the economic model for Ethereum, changing it from an inflationary currency to a potentially deflationary one. Currently, miners earn a 2 ETH reward for each block discovered plus any transaction fees (an ETH block comes every 12-14 seconds vs. 10 minutes for Bitcoin). In a day, roughly 13,500 ETH (~$23M) are newly created for miner rewards. There have been some significant protocol changes in the past year to reduce new issuance, but ETH inflation is currently around 3%. But since most of the inflation comes from miner block rewards, those will go away after the Merge. Estimates vary, but Ethereum may become deflationary by roughly 2% per year.
In addition, the switch to Proof of Stake turns Ethereum into a yield bearing asset. While there are some technicalities to actually staking, once you do so, you begin to earn transaction fees in proportion to your ownership within the staking pools. Exact numbers will depend on a) the percentage of ETH that gets staked and b) the absolute level of fee generation, but many expect ETH to start paying staking rewards of 6-8%.
To make a comparison to equities, Ethereum will be buying back 2% of its shares every year and issuing a 6% dividend to everyone who asks for it. All while being the most popular blockchain network, generating $1.3 billion a year in revenue (i.e. transaction fees). You can see why some people get excited.
â—† More to Come
(Big Idea: Scalability)
While the "Merge" was the first big milestone on Ethereum's roadmap, the "Surge," the "Verge," the "Purge" and the "Splurge" are all yet to come. Each stage has its own goals, but together they aim to make Ethereum faster and more decentralized.
The Verge and the Purge are really about lessening data storage requirements. This should help increase decentralization since it will make it cheaper to validate transactions and help run the network. At roughly 400 GB, you can all of the Bitcoin blockchain five times over on a $50 external hard drive. The lower processing requirements also make it much easier to run a full node. With the size and speed of Ethereum, however, running an ETH node is much more expensive. A full archival node of ETH requires 11,000 GB of disk space. These changes should help around the edges for sure.
As Ethereum has become more popular and more expensive, there have been many thoughts about how to scale capacity. We've talked a little bit about "Layer 2" networks. These run transactions on a separate chain, but then bunch them up to settle back to the Ethereum main chain. The Surge is focused on expanding capacity and improving the speed of Ethereum through a technique known as "sharding." Sharding splits a database into pieces to help spread the load. Each shard becomes semi-indepedent and shares data without having to be involved in every transaction, thus speeding up performance and capacity.
While it sounds great in theory (kind of like splitting your soul into 7 horcruxes), this is a complicated engineering endeavor. Keeping shards in sync is not easy and smaller shards may introduce new security risks. Currently targeted for 2023, I suspect this will be more of a Tesla kind of launch date. Hopefully, it will be more Model 3 (i.e. a few years delayed) vs. FSD.
As always, thanks for reading. Send me questions and share with your crypto curious friends.