Focus: An update for Ethereum
A number of upgrades are due for the Ethereum platform, notably the EIP-1559 update as part of the London hard fork expected in early August. Even though these are only steps towards Ethereum 2.0 including moving to a Point of Stake consensus mechanism, these should begin to address some of Ethereum’s current challenges in terms of transaction capacity, speed, cost and transparency. However, competition among crypto platforms is also intensifying.
Chart of the Week: ETH supply in smart contacts continues to climb
The share of ETH supply locked in smart contracts has surpassed 25%
(source: Glassnode)
In Focus: An update for Ethereum
Since May 2021, Ethereum's momentum has weakened somewhat across a number of dimensions, with a correction in Ether prices and some slowing in the speed of adoption and activity, alongside broader discussions about the outlook for crypto markets, additional regulation, and also competitors.
Meanwhile, a number of upgrades are due for the Ethereum platform to address some of the current challenges, with the next major set of upgrades due as early as 4 August. Even though the next set of upgrades is incremental, additional upgrades are due overtime that should lead to significant increases in transaction capacity, transparency and speed, and a reduction in transaction costs and environmental impact. However, competition among crypto platforms is also intensifying.
Is ETH’s momentum stalling?
After a breath-taking rally that took the price of Ether from $130 in January 2020 to a peak, $4140 in May 2021 around the time of new Chinese official interventions in crypto markets, prices have stabilized in a $1700-2300 range recently. At its peak, ETH market cap was $481bn, and its share of the total crypto market cap 22% vs $270bn and 19% currently.
Alongside the loss of price momentum, momentum in the adoption of the Ethereum platform has also slowed. For instance, growth in non-zero balances in Ethereum was growing at 3% per month in Jan-May on average and has since flatlined. And daily active addresses reached 800k in May 2021 but have mostly been around 500k more recently. Open interest in ETH futures also declined, from a peak of $11bn on May 12, to $5bn more recently.
Ethereum is the clear category leader in decentralized applications
Source: State of the Dapps (www.stateofthedapps.com)
That being said, Ethereum maintains significant positive momentum. For instance, it remains the clear category leader to host smart contracts and decentralized applications (DApps). Further, if we measured usage through fees, Ethereum is also the clear category leader. The only platforms/coins that come close are Binance Smart Chain and Bitcoin, while all others in the top 10 are decentralized applications. And for a brief instance in early July, Ethereum even overtook Bitcoin in number of daily active addresses.
Ethereum is due for an update
We have long been looking for a series of upgrades to reinforce Ethereum’s category leadership and performance.
The next update for the Ethereum platform, the London hard fork, so named in reference to one of the cities in which Ethereum developer conferences took place, is set to launch at block number 12,965,000, which is currently expected to occur on August 4.
The London hard fork is part of the continued development towards Ethereum 2.0 including moving from a proof-of-work mechanism towards a proof-of-stake mechanism. The London update specifically puts in place five new EIPs (Ethereum Improvement Proposals), which includes:
Despite its success and momentum over time, slowing transactions speeds, and volatile and high transaction prices have challenged Ethereum’s prospects. Currently, Ethereum has a certain set amount of blockspace and can process around 15 transactions per second, which has recently become a looming constraint.
Ethereum transaction fees are determined by the supply and demand for processing power, and the bottlenecks due to limited blockspace have caused Ethereum transaction fees to rise. In mid-May, in the midst of the crypto sell-off likely caused by Chinese regulatory actions, the mean fee per transaction reached highs above $60, even though they have since moderated significantly.
Ethereum transaction fees had soared but have recently retracted off the peak
Source: BitInfoCharts.com
Currently, the transactions conducted on the Ethereum network are paid in ether (ETH), and are often referred to as gas. Miners decide which transactions are included in a block via a simple auction mechanism. The more a user is willing to pay, the more likely the transaction will be included in the next block. EIP-1559 now proposes to utilize flexible blockspace of varying sizes which can expand on contract depending on the demand for blockspace.
The current determination for gas fees would be replaced by an algorithmically determined fee called a “base fee”. The base fee would be mandatory for all transactions but would fluctuate depending on how full the current block is, increasing as capacity is used up. This base fee would then be burned and not collected by miners as revenue. This feature was introduced in order to reduce the circulating supply of ether. The reduction in supply could over time contribute to Ether scarcity.
A ‘tip’ would also be introduced. Users can pay a tip in addition to the base fee, with miners able to collect tips to prioritize transactions, particularly during periods of increased network congestion. The inclusion of flexible blockspace and tips that allow users and miners to prioritize transactions could potentially mean a decrease in the average wait time for users to have their transactions processed.
An additional change in the 1559 update includes forcing all users to pay fees in ETH, where before they could be paid in Ethereum-based tokens instead. This issue, labeled economic abstraction, was enough of a concern and often a point of criticism that the Ethereum developers decided to address it.
The history and prospects of Ethereum upgrades
Ethereum has gone through a number of major upgrades over the years. Previous ‘hard fork’ updates include: Byzantium in October 2017 introduced several opcode and compiler updates, reduced the block reward, and was an earlier example of delaying the ice age difficulty bomb, Constantinople in January 2019 introduced updates to improve efficiency and performance, such as bitwise shifting, and Istanbul in December 2019 introduced security and privacy updates.
The current roadmap towards ETH 2.0 began to be implemented in December 2020 with the Phase 0 beacon chain, which acted as the foundation for the development of ETH 2.0 to be built alongside the already existing ETH 1.0 chain. The Berlin hard fork in April 2021 implemented updates to gas prices and allowed new transactions types. EIP-2565 reduced gas coasts for specific types of transactions, and EIP-2930 introduced a new transaction type that allows users to create templates for more complex transactions in the future.
The EIP-1559 update provided by the London hard fork will not be enough to solve Ethereum’s scalability issues. But it is just one step towards the implementation of Ethereum 2.0. One of the most important features as part of the update framework is the implementation of sharding. The intended use of sharding is to break down the Ethereum network into separate “shards” to process transactions in parallel and later aggregate them, further increasing the capacity of the network and transaction speeds.
The ongoing Phase 1 plans to break the Ethereum network into 64 shards. Phase 1.5 will attempt to merge the existing ETH 1.0 framework with that of ETH 2.0 that has been in the process of being built. The ETH 2.0 framework being built alongside the current ETH 1.0, is already PoS enabled. It is at Phase 1.5 when ETH 1.0 and ETH 2.0 are merged that PoS will finally be “live” on the Ethereum network, and it can claim the status of a PoS blockchain. Once that has been accomplished, Phase 2.0 will introduce Dapp and smart contract development into ETH 2.0.
These planned updates are actively being developed by the Ethereum foundation and community. It is difficult to estimate exactly when these updates will be put into place, due to coding, testing and decision uncertainties and lags. As of today, Phase 1 is estimated to be completed in 2021, while Phases 1.5 and 2 are estimated for some time in 2022. These planned updates have been occurring in parts through hard forks, and the next update to be implemented after London is likely going to be called the Shanghai hard fork, which is expected in the fall of 2021.
What is Ethereum up against?
For many investors, crypto conversations began with Bitcoin and in particular its potential role as a store of value and digital gold. Bitcoin and Ethereum are the two leading cryptocurrencies, and there are incumbency, brand and other advantages to being the most widely used cryptocurrency.
However, the Ethereum platform is very different from Bitcoin, due to being programmable, making it a much more appropriate candidate to host an extensive ecosystem of uses and applications in smart contracts, including decentralized applications and decentralized finance (DeFi).
In those categories, the Ethereum platform is therefore competing and will be competing with other programmable blockchains. Even though Ethereum is the clear category leader, competition is rising and there are a number of competing platforms that could potentially offer advantages in terms of transaction speed, efficiency, versatility, or in other significant areas, including specialized niches.
Among the main currently competing blockchain platforms are Cardano, Polkadot, Binance Smart Chain, and Solana which currently boast faster transactions speeds than Ethereum, and still claim to have the potential to increase. In 2020, Cardano launched a layer 2 scalability solution called Hydra, which claims to be able to process 1,000,000 transactions per second, as does Polkadot, thanks to parallel transaction processing systems.
Solana, a DeFi specific blockchain, claims to currently have a potential of 67,000 transactions per second (tps). These numbers dwarf Ethereum’s current throughput of about 15 tps. With the implementation of Ethereum 2.0 and layer 2 solutions, it claims Ethereum’s transaction speeds will increase to 100,000 tps.
Of course, those benefits need to be weighed against Ethereum’s current incumbency benefit, its track record and strength of ecosystem, among other aspects. Ethereum momentarily beat Bitcoin in number of daily active addresses, and it is very well ahead of the competing platform blockchains as well. For example, as of July 14, Ethereum stood at 570k daily active users vs eg Cardano at 56k.
But the possibility of these other platforms chipping away and maybe even one day challenging Ethereum’s dominance implied that a number of these coins in fact outperformed Ethereum’s in 2020 and this year, even though usually at somewhat higher volatility as well. However, even with the outperformance, the overall market cap of the other alternatives remains far behind Ethereum, at least for now.
Ethereum's competitors have been outperforming on a risk-adjusted basis (as of July 2021)
Source: CoinGecko