Why Ethereum is growing from the perspective of network valuation

Next week, ethereum, the world's largest programmable blockchain, will undergo a massive transformation. The Ethereum network will transition from an energy-intensive proof-of-work consensus mechanism to a sustainable proof-of-stake (PoS) consensus mechanism.

Dubbed The Merge, the upgrade is the first in ethereum's roadmap and will future-proof the network's infrastructure. This will be a historic moment for the nascent crypto industry and will set Ethereum up for increased security, sustainability, and scalability.

Before merging, let's take a look at the factors that will contribute to Ethereum's long-term growth and success. In previous articles, we discussed how network activity on Ethereum indicates its growing popularity and maturity, and how the merger will enhance the network's security . This article will analyze how Ethereum compares to other Layer 1 (L1) networks in terms of its valuation.

This article is adapted from the recent "Institutional Impact of the Merger" report published by the MetaMask Institutional and ConsenSys Cryptoeconomic Research teams. You can find the full report here.

network valuation

Blockchains, quite simply, sell block space. Every blockchain has a method for pricing the transactions contained in a block. These methods range from first-price auctions and first-price auctions to the number of targeted transactions per block. Think of the transaction flow in the blockchain as the total value of goods, that is, the total value of goods sold by a platform within a certain period of time.

Different blockchains are at different stages of their life cycle. PoS requires blockchain tokens to accumulate value to function optimally, and burning tokens is a popular mechanism for value accumulation. This is similar to making a profit through share buybacks. As a framework for valuing public blockchains, we study CoinShares data on network fees, issuance costs, sustainability, and L1 value accumulation to derive pseudo-margins.

Network Fees: Network fees are the amount for which the network sells its block space. It can be thought of as supply-side revenue, or the total fee paid by users who wish to have their transactions included in the network. As shown in Figure 1, among the six networks including Binance Smart Chain, Avalanche, and Solana, Ethereum has the highest network fee, reaching $4.8 billion.

Figure 1 - Annualized network fee estimates for 6 blockchains Source: CoinShares

Issuance costs: The production and protection of block space is not free. The network must pay rewards to the key participants of the network (miners and validators) to keep the network active, orderly and secure. This is the distribution cost. Of the six networks, Ethereum has the highest issuance cost at $10.3 billion (see Figure 2).

Figure 2 - Estimated annualized issuance rewards on various blockchains Source: CoinShares

Sustainability: The 6 blockchains we are working on are all operating at different scales. They have different hardware requirements, number of users, transaction speed, number of validators, etc. Therefore, the issuance rewards of each network will vary according to the specific needs of the network. Depending on the burn rate (tokens issued minus tokens burned), a blockchain needs a network fee to issuance ratio of at least 1 to be sustainable. Of the 6 blockchains we are looking at, only Ethereum has this ratio above 1 (see Figure 3).

Figure 3 - Network Fees to Circulation Ratio Source: CoinShares

Accumulation of value: In a network secured by PoS, in order to ensure that the correct cryptoeconomic incentives work, the stake must have significant value. Some blockchains, including Ethereum, satisfy this need for value accumulation by burning some of the fees paid to validators. Burned tokens equate to revenue, with an effect on token value similar to the effect of stock buybacks on shareholders. As shown in Figure 4, Ethereum currently burns $5.7 billion worth of tokens per year.

Figure 4 - Annualized Value of Tokens Burned Source: CoinShares

Net issuance: The net issuance of a blockchain is the number of tokens issued minus the number of tokens burned. If more tokens are burned than issued, the remaining tokens will increase in value. Ethereum running PoS is expected to have a deflationary supply, as shown in Figure 5.

Figure 5 - Estimated Annualized Supply Expansion Source: CoinShares

Burned tokens minus issued tokens can be considered a form of profitability for the chain. Keeping all the above factors in mind, we can see that the Ethereum chain running PoS has an estimated 81% pseudo-margin (see Figure 6).

Figure 6 - Estimated Pseudo-Profit Margin Source: CoinShares

epilogue

Ethereum is the foundation of the future Internet (Web3) and the future of finance (DeFi). Currently, more than half of the entire DeFi ecosystem resides on Ethereum. Despite market volatility and macroeconomic uncertainty, Ethereum continues to attract interest from institutional investors.