Ethereum’s Value Capture Dilemma

In the past year, Ethereum’s price performance has been disappointing. Despite growth in the Ethereum ecosystem, ETH has struggled to appreciate compared to its competitors. The ETH/BTC ratio, a key indicator of ETH’s relative strength, has dropped over 32% in the past year.

This disappointing price performance has raised concerns, particularly given Ethereum’s core position in decentralized finance (DeFi) and smart contracts. The slowdown in price growth has sparked debate about ETH’s long-term value capture potential, especially in the face of increasing competition from other Layer 1 blockchains and the complexities introduced by Layer 2 scaling solutions.

Layer 2 Solutions Leading to Reduced ETH Demand

Ethereum’s Layer 2 solutions, such as rollups, emerged to alleviate congestion on the Ethereum mainnet. By handling transactions off-chain and then batching them back onto the main chain, these solutions offer faster and cheaper transactions, significantly enhancing the user experience. However, this shift poses potential challenges for Ethereum’s value capture.

As more transactions are processed on Layer 2 solutions, fees and economic activity that would benefit the Ethereum mainnet are increasingly redirected. This could lead to a reduction in ETH demand as users interact more with Layer 2 networks like Arbitrum and Optimism instead of the Ethereum base layer. Economic incentives driving ETH’s value may weaken, potentially impacting its price and utility as a primary asset in the ecosystem.

While Ethereum can serve as the data availability (DA) layer for these Layer 2 protocols, the fees and value captured by ETH are still significantly lower than if transactions occurred directly on Layer 1. Although the DA role is crucial, it cannot fully compensate for the reduction in direct transaction value on the Ethereum mainnet.

Significant Drop in Gas Fees

In July and August 2024, Ethereum saw a dramatic drop in gas fees, reaching levels not seen in over five years. This trend is largely attributed to the ongoing effects of the Dencun upgrade and increased activity on Layer 2 solutions.

By mid-August, Ethereum’s gas fees had dropped to as low as 0.6 gwei, with low-priority transactions costing only 1 gwei or less. This represents a decline of over 95% from the 83 gwei peak observed during network activity in March 2024.

The Dencun upgrade, implemented in March 2024, played a key role in reducing transaction costs on Layer 2 networks. A notable aspect of the Dencun upgrade is the introduction of proto-danksharding, which allows Ethereum to process Layer 2 transaction data more efficiently using a new type of temporary data called “blobs.” These blobs are cleared from the blockchain after a set period, significantly reducing the storage costs associated with Layer 2 transactions.

Increase in ETH Supply

The substantial decrease in gas fees has also impacted the amount of ETH burned, as determined by the EIP-1559 mechanism. EIP-1559 set a base fee for each transaction, which adjusts dynamically based on demand for block space.

This base fee is burned, permanently removing ETH from circulation. This mechanism introduces deflationary pressure on ETH if the burn rate exceeds the issuance from staking rewards. However, if demand for ETH to pay gas fees is insufficient, issuance from staking rewards could lead to an increase in ETH’s total supply.

Due to reduced ETH burn, Ethereum’s total supply has been increasing in recent months, rising from approximately 120 million ETH in March to about 120.3 million in August. If demand does not keep pace, this increase in supply could exert downward pressure on ETH’s price.

Interoperability and Complexity Issues with Layer 2

The push towards Layer 2 solutions has introduced interoperability issues and increased complexity for developers, making it more challenging for users to achieve a seamless experience compared to other Layer 1 networks like Solana.

Each Layer 2 solution—such as Arbitrum, Optimism, and zkSync—operates as a separate environment with its own set of rules and standards. This fragmentation means assets and data cannot move seamlessly between different Layer 2 networks, creating silos within the Ethereum ecosystem.

Developers must build or integrate complex cross-chain mechanisms to achieve interoperability between these layers, which can be time-consuming and error-prone.

Currently, there are 64 Layer 2 solutions, 18 Layer 3 solutions, and 81 upcoming Layer 2 and Layer 3 projects entering Ethereum. The isolation of different Layer 2 environments makes seamless interaction between decentralized applications (dApps) and users across these networks difficult.

Furthermore, the multiple Layer 2 solutions significantly increase the complexity of building and deploying dApps. Developers must decide which Layer 2 network to build on, weighing factors such as user base, transaction costs, and technical specifications. Additionally, maintaining dApps across multiple Layer 2 solutions increases development and maintenance workload due to varying tools, APIs, and performance characteristics.

These interoperability and complexity issues not only affect developers but also impact user experience. Users may find navigating between different Layer 2 networks confusing, each with its own wallet, transaction processes, and fees. This fragmented experience can hinder adoption and diminish the seamless experience Ethereum aims to provide.

Does ETH Have a Monetary Premium?

A monetary premium refers to the additional value an asset has beyond its intrinsic or utility value, often because it is seen as a store of value, medium of exchange, or unit of account. Ethereum has long been considered to have a monetary premium, contributing to its status as the second-largest cryptocurrency by market capitalization.

For Ethereum, its monetary premium arises from several factors:

1. Utility within the Ecosystem: Ethereum supports a vast number of decentralized applications (dApps), DeFi platforms, and non-fungible tokens (NFTs). The demand for ETH to pay gas fees and participate in on-chain activities adds value beyond its technical functionality.
2. Perception as a Store of Value: Due to its widespread use, large market capitalization, and belief in Ethereum’s long-term growth, some investors view ETH as a store of value similar to Bitcoin. This perception adds to ETH’s monetary premium.
3. Staking and Earning Potential: ETH holders can earn rewards through staking their tokens, further enhancing its value proposition and increasing its monetary premium.

However, unlike Bitcoin, which has a fixed supply cap of 21 million, Ethereum does not have a fixed supply limit. Critics argue that this lack of a cap undermines ETH’s ability to serve as a reliable store of value, as its supply could increase over time, diluting value.

According to EIP-1559, when demand for ETH is high, ETH becomes a deflationary asset because part of the gas fees is burned. But when demand drops, ETH turns into an inflationary asset, weakening its store of value proposition.

Additionally, Ethereum is often seen as focusing more on being a “world computer” rather than just a monetary asset. While this multifaceted role provides utility, it may undermine its perception as a simple, reliable store of value, in contrast to Bitcoin’s focus on being “digital gold.”

The core issue revolves around Ethereum’s value proposition. If Ethereum’s primary goal is to function as a world computer, it needs to shift transactions to Layer 2 solutions for faster processing and lower costs. However, this shift inevitably transfers some value to Layer 2 protocols, weakening ETH’s value accumulation as an asset. The challenge lies in balancing scalability needs with maintaining and enhancing ETH’s value.

To sustain its status as “Ultra Sound Money,” Ethereum must ensure that Layer 2 solutions offer low-cost transactions while preserving the value of its native asset. This delicate balance is crucial for ETH to maintain its monetary premium.