Ethereum: The Decentralized Programmable Money

In the fast-changing world of blockchain, Ethereum has become a game-changer. Launched in 2015 by Vitalik Buterin and his team, Ethereum started as a new idea and has now become a key part of the digital economy. While Bitcoin introduced decentralized currency, Ethereum has taken blockchain further by allowing programmability, which lets developers create decentralized applications (dApps) and smart contracts.

As of August 2024, the market cap is $333 billion, and the price is $2766 per Ether.

The Genesis of Ethereum: Beyond Digital Gold

When Bitcoin was created, it was meant to be like "digital gold"—a secure way to store and transfer value without middlemen. But Bitcoin's use is mostly limited to keeping track of transactions. Ethereum, however, was designed to do much more. Vitalik Buterin and his team saw that blockchain technology could power more than just value transfers. They imagined a platform where developers could build decentralized applications, eliminating the need for central authorities and allowing trustless interactions. This idea led to the creation of Ethereum, a decentralized world computer that can run applications and smart contracts—self-executing agreements with terms written directly into code.

Programmability: The Heart of Ethereum

Ethereum's programmability is its most unique feature. Unlike Bitcoin, which has limited scripting, Ethereum is fully programmable, allowing developers to build complex applications that work with the blockchain. This flexibility has led to a wide range of decentralized apps (dApps), including finance platforms, non-fungible tokens (NFTs), and decentralized autonomous organizations (DAOs).

The strength of Ethereum's programmability is in its ability to automate tasks. Smart contracts, for instance, can automatically execute transactions or enforce agreements when specific conditions are met, without needing intermediaries. This has major implications for industries like finance, supply chain management, and governance.

Tokenomics: How Ether Accrues Values

Ether's tokenomics works in three main ways, where usage adds value. When you make a transaction on Ethereum, you pay three types of fees: a base fee, a priority fee (tip), and MEV (Maximum Extractable Value).

• The base fee is a fixed cost in ether, which gets burned (destroyed) once your transaction is included in a block, reducing the total supply of ether.

• The priority fee is a tip given to the validator, the person or group responsible for processing transactions and maintaining the network.

• MEV is the extra profit validators can make by arranging transactions in a way that benefits them the most.

Validators are motivated to include transactions with higher priority fees because it directly increases their earnings.

The ways Ether's value increases can be seen as the network's "revenue" being used for different purposes. The “revenue” is a result of increased activity on the network, driven by DeFi applications, NFT transactions, and other smart contract executions. More activity on the platform leads to more ether being burned and higher earnings for validators.

The Transition to Proof of Stake: A New Era for Ethereum

One of the biggest changes in Ethereum's history is its shift from a Proof of Work (PoW) to a Proof of Stake (PoS) system, known as "The Merge", completed on September 15, 2022. This change has improved the network's efficiency, security, and sustainability.

In the PoW model, miners compete to solve complex math problems to validate transactions, which requires a lot of computational power and energy, raising environmental concerns. PoS, however, removes the need for energy-heavy mining by letting validators secure the network based on the amount of cryptocurrency they "stake" or lock up as collateral.

This move to PoS makes Ethereum much more energy-efficient, cutting its carbon footprint by about 99.95%. It also improve security by making it more expensive for bad actors to attack the network, as dishonest validators can lose their staked assets, encouraging them to keep the network secure.

Gas Fees and EIP-1559: Towards Deflationary Economics

One of Ethereum's challenges is the high cost of transactions, known as gas fees. Gas measures the computational effort needed to perform operations on the Ethereum network. As demand for Ethereum's block space has increased, so have gas fees, sometimes making transactions too expensive for users.

To tackle this problem, Ethereum introduced the Ethereum Improvement Proposal (EIP) 1559 in August 2021. EIP-1559 changed how gas fees work by introducing a base fee that is burned (destroyed) instead of being given to miners. This burning process has added a deflationary effect to Ethereum's economy, as some ETH is permanently removed from circulation with each transaction.

This deflationary model, combined with reduced new ETH issuance after The Merge, has led some to call Ethereum "ultrasound money." As the supply of ETH decreases over time, its scarcity could increase its value, making it an appealing store of value in addition to its role as a programmable asset.

The average daily fees on Ethereum have dropped after the Duncan upgrade in March 2024. The average gas price went down from 50-150 Gwei to just 3 Gwei, reducing daily transaction fees from around $10 million to about $0.85 million.

Demand vs Supply

As more applications use the Ethereum network, the demand for Ether increases, which can drive up its price and benefit Ether holders.  The number of active addresses (proxy for transaction demand) has remained steady around 500,000 from October 2023 to August 2024.

During this time, the active supply of Ether decreased from 74 million to 60 million, a 19% drop.

This reduction in supply, combined with steady demand, contributed to a 38% increase in Ether's price from $2,000 to $2,766. The active supply represents the Ether being actively used on the network, which is less than the total supply of about 120 million, as the total includes inactive and lost Ether.

Ethereum and the Rise of DeFi

Ethereum's impact is most noticeable in the rise of decentralized finance (DeFi). DeFi includes a range of financial services built on blockchain technology, offering alternatives to traditional banking, lending, and trading. These platforms operate without intermediaries, allowing users to borrow, lend, trade, and earn interest on their assets in a decentralized way.

The growth of DeFi has been extraordinary. Platforms like Uniswap, Aave, and MakerDAO have attracted billions of dollars, enabling users to participate in financial activities without relying on traditional institutions. Ethereum is the backbone of DeFi, providing the infrastructure and security that make these applications possible.

As DeFi grows, Ethereum is set to play an even bigger role in the global financial system. Its ability to support trustless, borderless, and programmable financial services could make financial inclusion the norm rather than the exception.

The Future of Ethereum: Scaling for Global Adoption

While Ethereum has many capabilities, one of its main challenges is scalability. As more users and transactions have joined the network, the demand for its limited block space has increased, causing congestion and high fees. To solve this, Ethereum is working on various scaling solutions, including sharding and layer 2 protocols.

Sharding involves splitting the Ethereum network into smaller parts, or "shards," each able to handle its own transactions and smart contracts. This should greatly increase Ethereum's ability to process more transactions per second and support large-scale applications.

Layer 2 solutions, like rollups, aim to move some of the transaction processing to secondary layers, reducing the load on the main Ethereum network. As these solutions develop, they will help make Ethereum more accessible to more people.

Valuation

The image below shows two charts that analyze Ethereum's valuation:

• NVT (Network Value to Transactions) Ratio: This compares Ethereum's market value to its transaction volume. Since the NVT ratio is slightly above the 1-year average of 83.2, it suggests the market value is high compared to transaction activity, indicating overvaluation. A rising NVT ratio points to speculative interest, where prices are increasing faster than transaction volume.

• MVRV (Market Value to Realized Value) Ratio: This measures Ethereum's market value against its realized value, or the total value based on the last time each coin was moved. An MVRV ratio of 1.32, above the 1-year average of 1.27, suggests that Ethereum might be overvalued. High MVRV ratios could signal a market peak, where investors may start taking profits.

Conclusion: Ethereum as the Foundation of a Decentralized Future

Ethereum has made massive progress since its launch in 2015. What started as a promising experiment in programmable blockchain technology has now become a powerful platform supporting a wide range of decentralized applications. Its shift to Proof of Stake, along with its deflationary model and role in DeFi, makes Ethereum a key player in the future of decentralized finance and beyond.

As Ethereum continues to grow, its ability to transform industries and drive new innovations is massive. Whether you're a developer, investor, or user, understanding Ethereum and its unique features is crucial for anyone interested in the future of the digital economy. Ethereum's journey is far from over, and its impact on the world is just beginning.

(Sources: Kraken, Ethereum Layer 2, Ethereum Developers, Cryptofees, Coinmetrics, glassnode metrics, Fidelity, Etherscan, Ethereum (ETH) Blockchain Explorer, TalkMarkets)