To be perfectly honest, I was going to publish a post on a totally different topic today.
But… it was a long weekend here in the UK (the last one before Christmas), I had some spare time and ended up falling into yet another crypto rabbit hole, which ultimately culminated in today’s writeup.
At 5,000+ words, this is by far the longest post I have ever written.
One reason for it is that crypto is such a nascent area.
In crypto, however, many terms are still very loosely defined (or worse, defined incorrectly).
It’s important to lay a proper foundation before getting into higher-level analysis.
Another reason for the length is that unlike with property or equities, I am still educating myself on crypto.
In other words, I know that investing in real estate and shares is a good idea.
But with crypto, I am still going through that process – and the outcome is never pre-determined.
The third reason is that I am considering allocating a significant (low to mid-five figures) amount of money to Ether over the next few weeks.
I don’t know about other people, but I like to make such investment decisions on the back of proper data and analysis as opposed to just being a “believer”.
Hope makes for a bad strategy – and an even worse investing strategy!
With that in mind, what today’s post looks to accomplish is to build up a fundamental, grounds-up investment case for Ether.
You simply can’t accomplish a task like that in 500 words.
Thus, it will be a lengthy post, which took a significant chunk of my weekend to write up.
However, it really helped me flesh out my thoughts on Ethereum and Ether. After all, if you really want to learn something, you should try explaining it to other people.
So yes, it will take you more time than usual to read today’s write-up. Sorry about that.
But if I’ve done my job properly, this is what you will get out of it:
- A simple, non-technical explanation of Ethereum
- An understanding of how Ethereum creates value (a must for any investment analysis)
- The various stakeholders in Ethereum
- The interplay between Ether and Ethereum
- An overview of how Ether derives its value today
- The important changes to Ethereum that underpin the Ether investment case going forward
- The actual investment case for Ether
- The risks (and some mitigants) for both Ether and Ethereum
Before we begin, here’s a public service reminder:
Why You Should Pay Attention To Crypto
As a quick recap, I have long stayed away from crypto as an asset class.
Even today, I would hardly characterize myself as a crypto zealot. However, I am now firmly convinced that it is time to pay attention to crypto.
To be very clear, paying attention is not the same as going 100% crypto and shouting from the rooftops about how great it is.
Instead, it is at least having an opinion on both the technology and the asset class.
At this point in time, I am convinced that crypto and blockchain technology will drive an absolutely seismic shift in how we live and do business.
However, that’s the easy part.
The hard part is figuring out how to monetize the trend as an investor – and building enough conviction to put some real money behind it.
I mean, the internet has revolutionized the way we live and do business. But have you met anyone who made money “investing in the internet”?
Neither have I – but I did meet a LOT of people who were curious and open-minded about the internet in the early days.
They educated themselves, formed an opinion about where things were heading – and subsequently invested in very promising technology companies, realizing incredible monetary value over the past 20 years or so.
Lifting The Kimono
For full disclosure, since I published this post, I did put some of my money where my mouth is.
To be precise, I bought about £3k worth of BTC and ETH in late June / early July.
As of this writing, the value of my portfolio stands at about £5k.
It’s a nice percentage gain on the back of the most recent crypto rally, but frankly irrelevant in the context of our overall investment portfolio.
That being said, I’ve got a targeted allocation of about £100k, which means I will continue to be a net buyer for the foreseeable future.
And based on my research so far, Ether (ETH) will get a very big allocation from my “crypto pot”.
Why not Bitcoin, you may ask?
Well, based on where I sit (and more on this below), Bitcoin can be a great store of value.
From a practical perspective, it’s just as useless (or even more so) as gold.
However, people believe it has value – and it could well be Bitcoin becomes the new gold.
An industrial-first society designated a specific metal as a store of value. It’s only fitting that a digital-first society designates a collection of bits and bytes as a store of value.
Thus, most investment cases for Bitcoin center on it becoming the new gold – i.e. “If BTC reaches the market cap of gold, each BTC will be worth X”.
Ether is a totally different beast, because while it can be a store of value, it also has utility far beyond that.
With that long-winded introduction, let’s kick off.
The rest of this post will be structured along the following sections. Feel free to read in order, or scroll down to the one that interests you most.
#1: What Is Ethereum?
#2: How Does Ethereum Create Value?
#3: How Does Ethereum Capture Value?
#4: Who Actually Owns And Controls Ethereum?
#5: What Is Ether – And What Determines Its Value?
#6: The Big Changes To Ethereum
#7: What Happens To The Price Of Ether Going Forward?
#8: What Are The Risks For Ethereum And Ether?
Off we go.
#1: What is Ethereum?
It’s impossible to build a credible investment case for Ether (ETH) without first understanding Ethereum.
You should think of Ethereum as a decentralized platform that runs apps with smart contract functionality.
A smart contract is a self-executing contract where the terms of the agreement are written directly into lines of code.
For example, if I transfer you 2 ETH, you sell me 2 Amazon shares.
The execution of such a contract changes the ownership of ETH from me to you – and the ownership of those Amazon shares from you to me.
No question marks, ifs, or buts. No banks and lawyers involved.
Just me, you, and a smart contract.
The apps that execute these smart contracts run on a custom blockchain, which is essentially an online ledger that keeps a permanent, tamper-proof record of information, including information about ownership of property (got to keep track of that ETH and Amazon shares!)
This ledger is continually verified by a network of computer nodes similar to servers, which are not centrally controlled by anyone.
The parties that operate these nodes are called miners. It’s a heterogeneous, global group of independent operators.
(As a curious aside, the fact that the ledger is globally distributed protects Ethereum and other blockchains from potentially catastrophic events like EMP attacks, which is what usually keeps preppers at night)
This is pretty much all you need to know about Ethereum for the time being. We don’t want to get lost in complex technological definitions.
Instead, let me give you some real-life examples that will help you understand what Ethereum is all about.
#2: How Does Ethereum Create Value?
There are a couple of different ways to wrap your head around what Ethereum actually does – and the value that it generates.
Analogy #1: The Internet
One way is to think about Ethereum is as a globally distributed software and hardware platform that enables new ways of doing business.
For example, the internet enabled the creation of Amazon – a drastically new way of shopping and WhatsApp – a drastically new way of communicating.
In a similar vein, Ethereum enabled MakerDAO – a crypto-lending platform that connects borrowers and users while cutting out the middleman (i.e. the bank).
It’s important to note that as of today, the vast majority of Ethereum’s use cases are related to trading and lending crypto, as well as NFTs (non-fungible tokens).
However, the big promise of Ethereum is to expand beyond crypto into other use cases.
I mean, if you can use a decentralized app (aka a “dapp”) to trade crypto, why can’t you use it to trade regular currencies?
And if you can use a dapp to trade regular currencies, why can’t you use it to trade regular stocks without the middleman?
At this point, you don’t need to be a genius to see why banks are particularly worried about crypto and blockchain.
Just as communication was one of the first frontiers to be disrupted by the internet (think email vs snail mail), finance is becoming one of the first frontiers disrupted by blockchain and crypto.
Analogy #2: A Credit Card Network
Another way to think about Ethereum is to think of a global card network like Visa or Mastercard.
The reason Visa is so valuable in the first place is that pretty much any merchant in the world accepts Visa.
And the reason most people have Visa in their wallets is that they know that 99.99% of merchants in the world accept Visa.
I’d rather go on holiday without any cash than leave my Visa at home.
In other words, Visa benefits from network effects and is able to charge merchants a fee for accepting payments using a Visa card.
As I elaborate on below, network effects might be one of the most critical success factors for any blockchain technology.
Analogy #3: A Software Platform
In case you didn’t know this, this blog runs on a piece of software called WordPress.
Back in the day, if you wanted to start a blog, you had to pretty much design your site in HTML. That meant creating every page from scratch, code and everything.
But then, WordPress came along. All I had to do to create this post is to login into my interface, click on “Add new post” and just type a bunch of words in.
Importantly, there are a ton of third-party plugins on top of WordPress that help me do everything from optimizing images to improving my search engine rankings to moderating comments.
Just as importantly (we’ll come back to this later), there are blogs built on WordPress that generate millions of dollars in revenue (sadly this blog isn’t one of them!)
In a similar vein, the idea is that you can build a killer dapp on top of Ethereum and use it to make a lot of money by solving a specific pain point that’s actually unrelated to Ethereum.
In this scenario, Ethereum plays the role of WordPress, i.e. the underlying software infrastructure.
The dapp will then solve a specific problem – like connecting you and me to trade Amazon shares without going through a brokerage.
Of the three analogies above, I like the internet and WordPress ones best because of the versatility of the apps/businesses that can be built on top of those respective platforms. You could even liken Ethereum (and other blockchains) to an operating system of sorts, like Windows or iOS.
Credit card networks, on the other hand, have one primary use case – a verified transfer of value. In this respect, they are much more similar to Bitcoin (the blockchain, not the cryptocurrency) than Ethereum.
As of today, there are over 2,000 dapps built on top of Ethereum today – FAR above any other blockchain. It is also clear that more and more developers will look to build on Ethereum going forward.
Here’s the problem, though. It’s clear that Ethereum has the potential to create a ton of value.
But can it actually capture that value?
#3: How Does Ethereum Capture Value?
Let’s continue with our analogies above.
It’s damn clear that the Internet created trillions of value over the past 20 years – but it hasn’t really captured any.
WordPress is a slightly different beast.
First of all, it’s structured as a non-profit.
Also, unlike the Internet, it’s centralized – meaning there’s a developer body that takes care of the code.
That developer body (known as the WordPress Foundation) makes some money through sponsorship (aka advertising) and some other sources. It’s not a huge amount of money, but enough to cover the costs.
However, make no mistake – if you have a blog that generates millions of revenue per year and WordPress calls you up one day and says it will charge you $1,000 a year to use the software, you’ll take that offer in a heartbeat.
I mean, you can always transfer your blog to another platform – but do you really want to take that risk?
It’s kind of like switching from a Mac to a PC, or from an iPhone to an Android. Doable, but very inconvenient – and not something you want to do if your livelihood is riding on it.
In other words, massively successful software platforms tend to be very sticky – and always have a way of generating value for their owners.
And the idea is that Ethereum can grow into a massively successful software platform over time.
But who will make the decision on how to monetize it – and capture the value created?
#4: Who Actually Owns And Controls Ethereum?
The individuals or entities who own the Ethereum technology would naturally be incentivized to maximize its value, given they stand to realize a direct benefit from it.
In practical terms, you don’t even need to own Ethereum in order to monetize it.
As long as you control the source code, you can always find a way to make money from the technology – see the WordPress example above.
However, this is a topic on which there is a ton of misinformation out there – and very few accurate answers.
Some people will tell you Vitalik owns Ethereum.
Others will claim that owning Ether (the currency) makes you a partial owner of the technology.
And, of course, both are wrong.
I mean, I own some Ether – but Vitalik hasn’t called to ask for my opinion yet.
The bottom line is that no one can own Ethereum – just like no one can “own” the internet.
However, there are three distinct stakeholder groups that do exercise a degree of control over the technology:
- Ethereum Core Developers – who develop the software on a day to day basis
- The miners – who run the software nodes that validate the transactions on the blockchain
- The users – both ETH holders and developers who build applications on top of Ethereum
Crucially, all three groups have a very significant economic exposure to the value of Ethereum – and Ether.
The Core Developers (i.e. Vitalik & Co) own millions of ETH which they retained in the initial coin offering.
The miners generate revenues in ETH.
The users own ETH.
The developers don’t necessarily own any ETH. However, the ultimate value of their dapp is predicated on the value and success of Ethereum.
When it comes to implementing significant changes to the network, all three groups need to align on the way forward.
Of course, the idea here is that all groups are economically incentivized to ensure the Ethereum network is as successful as possible.
However, that doesn’t mean that they agree all the time. So what happens if there’s a disagreement?
In practice, a specific stakeholder (i.e. a miner) can disagree with the direction of the technology.
Then, when it’s time to upgrade the node software, they simply continue running on an old version.
However, if the majority of the other stakeholders decide to go ahead with the new technology, the miner in question would quickly find himself supporting a blockchain that no one uses.
In a way, it’s a process that is even more democratic than our political democracy – because you can choose to do whatever you want, provided you are willing to bear the economic consequences.
This is pretty much what you need to know about Ethereum governance (check this link for more information).
From an investment perspective, however, it’s very important to understand two things:
First, no one can own Ethereum.
Second, there are stakeholder groups that control Ethereum.
All of these groups have an economic exposure to the value of Ether and thus stand to benefit if Ether goes up in price.
We are now getting to the crux of the matter – what is Ether, how does it interplay with Ethereum, and why (or why not) should it go up in value?
#5: What Is Ether – And What Determines Its Value?
Ether is the native cryptocurrency of the Ethereum network.
Put differently, it’s a transactional token that facilitates the operations on the Ethereum network.
All the activity on the Ethereum network – whether sending Ether to another person, validating the ownership of those Amazon shares, or using one of the myriad of dapps – needs to be validated by miners.
To do that, miners need to deploy computing power – and that computing power isn’t free.
This is why, in order to incentivize miners to process a transaction, you pay them what is called a gas fee.
One good analogy here is to think of BTC as digital gold. It’s a store of value.
ETH, on the other hand, is digital oil. It helps power the Ethereum network.
Another good analogy is to think of the Ethereum network as a shared car.
If I (a user or a dapp developer) want to ride in that shared car, I need to pay for the fuel that it consumes.
That’s what gas fees are all about.
For example, if I want to send you 1 ETH, I may need to pay a gas fee of 0.05 ETH to cover the miners’ cost of validating and recording that transaction.
Thus, you will receive 1 ETH in your wallet while my wallet balance goes down by 1.05 ETH.
Sure, I just paid 0.05 ETH for this transaction.
But if the alternative is to shlep over to Western Union and pay 15% to send money back home, or to have HSBC charge me a 10% hidden FX spread, I’ll take it.
Thus, the basic utility of ETH is derived from the fact that it’s more efficient to process transactions on the Ethereum blockchain versus other, more traditional means.
And if ETH didn’t have “real world” value, miners wouldn’t accept it to pay those very real costs of computing and electricity.
However, that is just the beginning – because as with any asset (including “regular” oil), the value of Ether is very much determined by supply and demand.
In order to fully understand Ether supply and demand dynamics, you’ve got to understand the other way (in addition to gas fees) that miners are incentivized to validate transactions: new Ether issuance.
Currently, the miners on the Ethereum network validate a new bock every 15 seconds. The miner that validates a new block receives 2 newly issued ETH plus all the gas fees within that block.
Think about what happens when a new block is processed and added to the Ethereum blockchain:
First, all the users (including developers) need to buy some ETH to pay for gas fees.
The more transactions on the network, the more ETH they need to buy. As a result, demand for ETH goes up – GOOD for the price!
Second, 2 new ETH are minted. Supply goes up, BAD for the price!
Third, and most important: miners receive the 2 new ETH + all the gas fees – and sell 95% of it.
This third bit is what most people don’t realize.
In mining, the vast majority of the value accretes to hardware (GPU) makers and electricity providers, not the miners themselves.
In fact, profit margins on mining are about 5%.
As mentioned above, these mining costs are very real – and denominated in fiat currencies. Hence, miners sell the vast majority of ETH they receive to pay their bills.
Therefore, supply goes up – once again, BAD for the price.
You don’t have to be an economics genius to see that these supply/demand dynamics aren’t great.
Sure, as transaction volumes go up, so do the gas fees. You and I need to buy ETH to pay for them.
But if 95%+ of that ETH is sold again to cover mining costs, the rise in demand is pretty much offset by the increase in supply.
At the same time, there are 2 new ETH being minted every 15 seconds, equating to about 4m new ETH per year. No wonder people prefer BTC, which is capped at 21 million in total!
The quirk here is that what I’ve described above is the way the Ethereum network used to work before the two drastic changes to the Ethereum technology.
In a way, it makes Ether’s price performance to date that much more impressive – because the appreciation below has been achieved despite highly negative supply/demand dynamics:
But it is the upcoming changes that have the potential to shift the Ether investment case completely.
#6: The Big Changes To Ethereum
As mentioned above, the three groups of Ethereum stakeholders are incentivized to see the network grow and succeed – and for the value of Ether to go up.
Hence, they agreed (after much debate) to make two significant changes to the technology.
The first one is EIP-1559, which was implemented a few weeks ago.
The goal of EIP-1559 is to split the gas fee into a base fee and a tip.
The base fee then gets burned (i.e. eliminated) completely, while the tip goes to the miner. This ensures that demand for ETH always exceeds supply, at least as far as transaction fees go.
The second big change is called Eth2 (coming in early 2022).
The crux here is that instead of the hardware and mining-intensive Proof of Work (PoW) method, the miners will be able to validate new blocks using a Proof of Stake (PoS) method.
Eth2 will also make Ethereum much faster, enabling it to better compete with blockchains like Solana.
The speed aspect is obviously crucial to Ethereum’s long-term success, but it is the shift to Proof of Stake that will drive an economic inflection point here.
I will ignore the technical aspects here to avoid falling down another rabbit hole. You can google all you need to know about PoW and PoS approaches.
What’s super important, however, is to understand that with PoS, miners will no longer need to spend nearly as much money on computing hardware and electricity.
Instead, they secure/validate the blockchain by putting a significant portion of their ETH to work.
There are pros and cons to the approaches, but the overall idea is that miners who misbehave lose all of their ETH, incentivizing them to act in the best interests of the network.
With the Proof of Stake approach, the only significant cost miners incur is taxes.
As such, two things happen:
- Rewards for validating blocks can decline significantly. No more wasted computing power and electricity!
- Miners no longer need to sell 95% of the ETH they receive to cover their costs. Instead, they only sell what they need to cover taxes (if they actually pay any) and transfer a portion of their profits into dollars/euros/rubles
Both of the factors above serve to significantly reduce the supply of ETH going forward.
You no longer need to mint 2 new ETH every 15 seconds. And miners no longer sell nearly as much ETH as they used to.
So what does this mean for the value of ETH?
#7: What Happens To The Price Of Ether Going Forward?
Here’s a framework to think about the value of Ether in this new world post EIP-1559 and Eth2.
You start with the volume of activity (i.e. transactions) on Ethereum – driven by people sending each other crypto BUT also all the dapps that are being built on top of the blockchain.
In order for these transactions to happen, users and developers have to buy Ether – the digital oil that pays for the gas fee. This drives demand for Ether.
A significant chunk of that gas fee (the “base fee”) will actually be burned, reducing the supply of Ether.
Even if miners sell all of the ETH they receive in gas fees, burning the base fee ensures the supply is much lower than demand.
Sure, there will be new issuance of Ether every year, estimated by this model at about 2.1k / day or about 766k a year for PoS (as compared to about 4-5m ETH a year under PoW).
But as long as you believe the gas fees being burned will exceed 766k ETH a year, the overall supply of ETH will continue to decline.
Now, it’s hard to say when that point will arrive, as it’s highly predicated on the transaction volumes.
For all we know, ETH might already be a deflationary asset post EIP-1559.
It might become one post Eth2, when new issuance declines on the back of PoS.
But given the growth in supply is fixed, as long as Ethereum transaction volumes go up, ETH will become deflationary one day.
In other words:
Growth in demand + reduction in supply = price increase.
Here’s a nifty link that summarizes the supply/demand dynamics today – and what they could look like going forward (click on “simulate merge”):
I mean, what could possibly go wrong?
#8: What Are The Risks For Ethereum And Ether?
As ever, nothing is assured in life.
Based on where I sit, here are the biggest risks to Ethereum (and by corollary, Ether):
As I alluded to above, there are other blockchains like Solana that have significantly better technological characteristics (i.e. speed).
One of the things Eth2 is designed to improve is the speed of the Ethereum network, which should drive further adoption of the blockchain.
However, technological leadership is never guaranteed. There’s always the risk others will jump ahead while Ethereum becomes the Betamax of blockchains.
The implementation of EIP-1559 seems to have gone well.
However, it’s not a given that Eth2 or any subsequent changes to the code won’t result in a hiccup, resulting in meaningful (and possibly irreparable) damage to the blockchain.
Bad Actors (i.e. a Hack)
This is crypto… enough said.
I personally think that crypto and blockchain technology, like the internet way back when, is pretty much unstoppable at this point in time.
That being said, governments can and do interfere.
Significant regulatory intervention can pretty much kill off Ethereum or any other blockchain, annihilating the value of Ether in the process.
“Mainstream” Use Cases
As of today, the dapps being built on top of Ethereum (and other blockchains) are primarily oriented towards crypto use cases.
Only time will tell whether “traditional” activity like mortgages, fiat lending, equity trading, e-commerce will ever migrate onto the blockchain.
The consensus view suggests that it will happen eventually … but you never know.
The investment case above is built on the premise that today’s price is the right starting point. Therefore, as demand exceeds supply, price will go up.
But what if today’s price is wrong? This is crypto, after all. For all we know, ETH could be worth $3 and not $3,000.
Now, figuring out the right market value for Ether today is nearly impossible. There are simply too many variables at play.
However, I am pretty sure that if Ether price were to “reset” at a much lower level, it would take a very long time for the positive supply/demand dynamics outlined above to make up for it.
It’s unlikely given the incentives I’ve described above, but there’s a non-zero risk that another upgrade might make Ether inflationary again, and therefore put downward pressure on its price.
At the same time, the PoS method of validating transactions may turn out to be a total dog, delivering a mortal blow to the investment thesis above.
At the same time, there are a number of factors that play in Ethereum’s (and Ether’s) favour.
In investment banking terms, let me present you with some “mitigating factors”:
First Mover Advantage
Ethereum is the first blockchain of its kind (as BTC was only designed to facilitate payments).
In technology, being first past the pole doesn’t guarantee you will be a winner – but it does confer a significant competitive advantage.
So far, Ethereum hasn’t conceded its leadership position and remains the largest and most popular blockchain out there.
Strong network effects are arguably the most important ingredient in the success of any crypto/blockchain technology.
After all, as more developers build on Ethereum, the network ends up offering more use cases and users.
And the more users on the network, the more likely it is that developers will build on Ethereum. After all, you want your dapp to be in the middle of a thriving oasis, not a barren desert.
In other words, see the Mastercard / Visa analogy above.
While tech mishaps and hacker attacks are very real and credible threats, Ethereum has shown the ability to recover from such mishaps in the past.
Oligopolistic Nature Of The Industry
It is unlikely that the future will see one blockchain totally annihilating all others – and dominating the landscape entirely.
Chances are, there will be multiple big players – kind of like the Big Tech landscape today.
So while other blockchains could develop functionality that’s superior to Ethereum in specific aspects, it is more than likely that they will co-exist (and even be interoperable) as opposed to cannibalizing each other.
As I mentioned above, the key objective when writing this post was to lay out a case for why Ether may (or may not) be a good investment – and to keep it as digestible as possible.
With that in mind, I’ve gone light on the technological aspects of Ethereum, possibly oversimplifying certain aspects.
If you want to go down that rabbit hole, there are plenty of amazing resources out there (including the original whitepaper)
What isn’t nearly as well-covered, however, is the fundamental economic analysis of Ether.
In other words – why does it have value, and what could make that value go up or down in the future?
As always, this isn’t a recommendation in favor of (or against) buying Ether.
I’m obviously quite bullish here – and will back up the analysis above with cold, hard cash.
At the same time, I’ve got no ax to grind here. You won’t find any affiliate links or sponsored advertising in this post.
In addition, I will only be allocating a tiny portion of my portfolio to crypto.
I built my wealth through real estate and equities – and plan to keep the vast majority of my net worth in those two asset classes:
In other words, please please please do your own research, form your own opinion – and be very sensible in terms of total capital you are willing to risk.
As always, I’d love to see a constructive and logical debate in the comments section below.
In the meantime, thank you for reading – and happy investing!
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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