The world’s largest programmable blockchain, Ethereum, is undergoing a massive transformation next week. The network will transition from the energy-intensive Proof of Work consensus mechanism to the sustainable Proof of Stake (PoS) consensus mechanism.
Called the Merge, the upgrade is the first in the Ethereum roadmap that will make the network’s infrastructure future-proof. It will be a historic moment for the nascent crypto industry and will set up Ethereum for increased security, sustainability, and scalability.
Ahead of the Merge, we take a look at the factors that are setting Ethereum up for long-term growth and success. In our previous posts, we discussed how network activity on Ethereum pointed to its growing popularity and maturity, and how the Merge will enhance the network’s security. In the final part of this three-part series, we will look at how Ethereum compares with other Layer 1 (L1) networks in terms of its valuation.
This series is adapted from the recently released ‘Impact of the Merge on Institutions’ report written by MetaMask Institutional and the Consensys Cryptoeconomic Research team. You can find the full report here.
Blockchains, quite simply, sell blockspace. Each blockchain has a methodology for pricing the transactions that are included in blocks. These methodologies range from first- and second-price auctions to a target number of transactions per block. Think of transaction flows in a blockchain as gross merchandise value, which is the total value of merchandise sold on a platform over a given period of time.
Different blockchains are at different stages in their life cycle. PoS requires the blockchain token to accrue value in order to function optimally, and burning the tokens is a popular mechanism for value accrual. It is similar to earning profit off of share buybacks. As a framework to value public blockchains, we look at data from CoinShares on network fees, issuance cost, sustainability and value accrual for L1s to derive pseudo profit margins.
Network fees: Network fees is the amount that a network sells its blockspace for. It can be considered as supply-side revenue, or the total fees paid by users who want to have their transactions included in the network. As we can see in Figure 1, Ethereum has the highest network fees, at $4.8B, among six networks, including Binance Smart Chain, Avalanche and Solana.
Issuance costs: The production and protection of the blockspace do not come for free. The network must pay out rewards to key participants (miners and validators) of the network to maintain liveness, order, and security. This is called issuance cost. Among the six networks, Ethereum has the highest issuance costs at $10.3B (Figure 2).
Sustainability: All six blockchains that we are looking at operate at varying scales. They have different hardware requirements, number of users, transaction speeds, number of validators, etc. Therefore, the issuance rewards for each network differ based on the network’s specific needs. Depending on the burn rate (coins issued minus coins burned), a blockchain would need a ratio of at least one to be sustainable. Among the six blockchains we are looking at, only Ethereum has a ratio over 1 (Figure 3).
Value Accrual: In a network secured by PoS, it is essential that the stake has a significant value in order to ensure the right crypto-economic incentives are in play. Some blockchains, including Ethereum, fulfill this need for value accrual by burning a portion of the fees paid to validators. Burned coins are akin to revenue, and have a similar effect on coin value as share buybacks have for shareholders. As we can see in Figure 4, Ethereum currently burns $5.7B worth of tokens annually.
Net Issuance: The net issuance of a blockchain is the number of coins issued less the number of coins burned. If burned coins are greater than issued coins, then value is accrued to the remaining coins. Ethereum running PoS is expected to have a deflationary supply, as we can see in Figure 5.
Burned coins less issued coins can be seen as a form of profit for the chain. If burned
coins are greater than issued coins, then value is accrued to the remaining coins. Keeping all the above factors in mind, we can see that an Ethereum chain running PoS is estimated to have pseudo-profit margins of 81% (Figure 6).
Ethereum is the foundation for the future of the internet (Web3), and the future of finance (DeFi). Currently, more than half of the entire DeFi ecosystem exists on Ethereum. And despite market volatility and macroeconomic uncertainties, Ethereum continues to garner interest from institutional investors. You can read more about the Merge and its impact on institutions in the full report, available here.On September 12th, the key contributors to the report will talk about it on our “Breaking Down the Merge for Institutions” webinar. You can register for it here.
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