The value of Ethereum has steadily increased out of fundamental value, out of growing interest, out of speculative opportunity out of – well you can imagine what you will as value drivers.
But what might be the true underlying value? Are we able to speculate based upon comparables that exist today?
At the end of the day, Ethereum is a processing network that is paid for securely facilitating transactions and maintaining a reliable transaction record. Sure it has the additional benefit of being a decentralized, trustless-based system but the need for such a system remains debatable for general transactions such as small value purchases and sales. Of course, the Ethereum network provides the ability to record many other things based upon whatever smart contract you want to layer over it so payments are but one form of transaction – but to me, this is purely a growth avenue.
It's all about the money......
When you start to dig into the payment systems, you find that they are a source of massive revenue for the incumbents. And then you start to realize why the FAANG group (not certain how to fit Meta in yet), Alipay, Paypal are actively interested in the space. The space has been hugely profitable.
So let’s look at the incumbent payment systems. We have previously explored this avenue in prior works and will reference our 2018 work with updates for 2021.
The major payment providers around the world are all recognizable names. UnionPay, VISA, and MasterCard.
UnionPay is privately held so data is a little less available but in 2018 they reported transaction volume of approximately 98 billion – slightly more that MasterCard at 90.2 billion Tx and less than VISA which reported 165 billion Tx.
From the September 26, 2021 VISA Inc 10-k we find the following:
Table 1: Card Processing Volume
Payments Volumes ($B)
Total Volumes ($B)
Total Transactions (B)
So the transactions processed by the two dominant providers VISA and MasterCard comprise over 90% of the total volume with an average transaction size of approximately 50-55 USD (slightly higher for the smaller card networks).
Following from the VISA 10-k we find the following revenue breakdown:
Table 2: VISA inc 2021 10-k Reported Revenues
Service Revenues ($B)
Data Processing Reveneus ($B)
International Transaction Revenues ($B)
Other Revenues ($B)
Client Incentives ($B)
Net Revenues ($B)
So all in VISA earned 24.1 B$ to process 205 billion transactions – approximately 8.5 cents/Tx. Incidentally, 205 billion transactions constitutes approximately 6,500 tps on average. Remember these numbers. We note that the revenue per transaction seems to be falling for VISA as in our prior report we noted they averaged almost 16.5 cents /Tx in their 2018 reporting. In other words, this is the beginning of the “price wars” of incumbents versus the up and comers…..
So as a floor we can see a revenue stream of 8.5 US cents/Tx. But is that all there is?
Well not quite.
The revenues earned by the card networks are only part of the story.
Again from the Global Payments Inc. 2020 10-k filing we find the following:
Figure 1: Non-Cash Transaction Flow of Proceeds (the Money Trail…)
So we can see that there is an average 2% fee earned by the network participants. This is further broken down in the following 2015 Heartland Payment Systems 10-k filing (Heartland was acquired by Global Payments that year).
Figure 2: Non-Cash Transaction Flow of Proceeds 2 (the Money Trail part 2…)
From these breakdowns we can see that the card networks on average approximately 6-10% of the revenue while banks (Card Issuers) and Acquirers earn the majority.
So if the Ethereum network can cut out the middlemen, they have the potential to earn up to 2 $/Tx for every transaction of 100$ of value. Sure that’s optimistic – see price wars commentary earlier.
Ok, so our homework is complete. We have the bookends 8.5 cents/Tx to 2 $/Tx. If the Ethereum network can’t get close to the low end, it will not compete. And if you are a bank or an acquirer, you should be very concerned about the price of your product/service.
Now let's look at where Ethereum is today and where it aspires to go
The Ethereum Network continues to juggle its move away from POW (Eth1.0) to POS (Eth 2.0). They still need the mining community to support the network but life would be so much simpler if they could just cut the old network loose. Not there yet but getting there. High transaction fees are the result and they will continue until POW is no longer required.
What then will the Network fees consist of? There is a cost to operating the computational equipment that will backstop the network, and depending upon the development path, perhaps a lot data storage capacity. But these costs will be minimal compared to the cost of POW miners redundantly chasing the same fees.
So what will be the primary cost? In a competitive POW network, the cost of the mining infrastructure ensures the network. The infrastructure and the ability to convince a utility that you will pay them for the copious amounts of electricity you will be buying is the collateral backstopping the system.
In the POS network, your stake is your collateral to be a good actor.
From Beaconcha.in, as of December 7, 2021, there are 266,680 validators on the network with 8,533,684 Ether staked.
With a December 7, 2021 price of 4,283 US$/Eth, that constitutes a staking network with a value of 36.55 B US$. So the network is sufficiently collateralized. How do we know this? Well the enterprise value of VISA and MasterCard combined is approximately 760 B USD$. This value reflects not only their income (current and potential) but also their reliability and trustworthiness (for which they are paid quite handsomely!).
On average, VISA and MasterCard processed approximately 10,500 tps in 2020.
Now stakers expect to earn income. Right now it has been driven primarily by capital appreciation and actual income has been a secondary feature – as everyone is getting paid in Eth – which must only be converted by miners to pay real world costs.
But once the network is mature, what will stakers expect?
Well staking should be a reasonably low risk investment but let’s use a premium to the US 30 year treasury yield (which is 1.802 % as of December 7, 2021) (CNBC). Current investment grade corporate 30 year yields are a little over 3% (3.04 % as of the same date)(FRED).
So let’s use 3.04% as our reference and add another 0.25 % to account for network operating costs (the computers/ the data storage etc) for a total yield rate of 3.29%.
With the current staked value of 36.55 B$ and an annual yield requirement of 3.29%, implies an annual fee of 1.2025 B$ to the stakers. At current network capacity (15 tps) the cost per transaction would be:
1.2025 B$ / 473,040,000 Tx/y = 2.54 $/Tx - not really too far off of current costs (if you only need the network to transact and no other middlemen are taking part of the fee).
So even if we view Ether as a means of cutting out all of the banking institutions and other middleware, if you recall the average Tx value was 55 $ for VISA and MasterCard. A 2% fee on that amount totals to 1.10 $/Tx. Of that $1.10, VISA/MasterCard earn approximately 8-12 cents. In July of 2020 JP Morgan announced that staking could be a $40 Billion industry. Capital invested – doesn’t seem to be realistic - even when tps increases by a lot. It’s just not necessary. I hope they didn’t imply that 40 b$ was the annual revenue stream. Seems to me that is a straight ahead swap of Eth network fees for current incumbents VISA, UnionPay, MasterCard et al. I hope we can do better than that!
Ok so what can we surmise from this:
About 2 – 2.5 X too much Eth are staked than necessary
Eth is 2 – 2.5 X overvalued
Eth investors expect at least 2 – 2.5X more growth in the business (voice or narrator – they expect a lot more than that!). A 40 B$ revenue business as surmised by JP Morgan would need about 40X more throughput (still only 600 tps!) to price to 2.50 $/Tx.
There is no one that expects that without scaling from 15 tps Eth will be a success (although one could already describe it as a success if it has started to reduce fees charged by incumbent transaction facilitators on top of creating a lot of wealth for early adopters).
So next we need to understand the development paths forward and how Eth will reach its appropriate valuation.
It's pretty complicated...
In an earlier publication, we discussed the Ethereum move towards a deflationary coin through EIP 1559. Why would Ethereum want to do this? Practically it reduces fees in the near term but in the longer term it enforces the concept that Eth is a store of value, not a currency (doesn’t mean it can’t be used as a general transaction currency, only that the rise of CBDCs make this unlikely). This is necessary if Eth is to be used to collateralize the blockchain.
Ok so the move away from POW to POS has begun. We have established that Eth will now be a deflationary asset so that it can reliably collateralize the main blockchain (the “Beacon Chain”). We still have a legacy POW chain operating for a period and the miners need to get paid. Fees are through the roof but that is a short-term pain issue for long-term gain.
And we still have a throughput capability of 15 tps. On a good day.
Sidechains. Layer 2. Roll-ups. No matter what chain you are talking about, the path to scalability is to increase the number of transactions through other processing and then memorialize them on the main chain.
Then why can’t we just have 700 sidechains and we are scaled up and done. Each chain will have the same capability and it will just memorialize its rolled up transactions on the Beacon Chain.
It’s not quite so simple. It never is….
Historically (and at the present) data processing capability of a block requires payment to the network providers in the form of gas – processing fees. A set amount of gas was established (currently 15 million gas per block on average (30 million to handle peaks). Each byte of computing required 16 gas and the simplest transaction required 21,000 gas. So currently @ 15 million gas per block and each byte of data processed @ 16 gas -each block can process about 937,500 bytes of data. 1 MB. Peaking at 1.875 MB.
With the change to POS the concept remains, that entities providing the computing nodes, even though there will be substantially less hardware requirements than for POW systems, will still need to be paid for their service. Just as stakers are getting paid to provide the appropriate network collateral, they must also be paid if they are providing computing power. Gas fees may not strictly be necessary if the stakers are also providing the computing infrastructure to run the nodes as the horsepower to compute, approve and facilitate a transaction is much less on a POS system . We elaborate a little further on this below.
So the debate has now begun. If there isn’t need to run a multi giga-, now bordering on tera -, hash rate do we need to control block size so tightly Yes and no. Larger block size means more substantive data volumes which leads to centralization. But a larger block size accommodates more roll-ups. So block size will be bigger – 1 MB per block certainly. From etherscan.io, randomly selecting November 30, 2021, the average block size was 70.186 kb. The average bytes per Tx was 347.3. The average block time was 13.63 seconds which translates to just under 15 tps. So the change to a 1 MB block is significant.
Now it may well be gas fees remain to more fairly allocate block computing as certain transactions are much more complex – think 500,000 gas fee vs 21,000 gas fee but since it with POS we are not really driving a massive fleet of computers to find a block solution that gas fees become a little less important.
Anyway, all of this takes us back to roll-ups, layer 2, side-chains…
Roll-ups can combine multiple transactions offchain that are then cryptographically memorialized on the Beacon chain. Because the Beacon Chain is not required computationally for each transaction off chain, throughput goes up as the rollup chains basically only provide data to be encoded on chain. Uniswap among quite a few others is already doing this.
For now, Ethereum has stayed away from any kind of debate of whether these side chains need to be de-centralized (voice of narrator – they are not…) as Ethereum has enough of its own problems to solve. This is not unique to Ethereum. But it does mean that side chain transactions are through (I hate to use this word because it starts to sound like Lightning Network speak) channels that roll up your transaction with others and submit the data summary to the Beacon Chain. It serves to reduce your transaction fees. And indeed Uniswap transactions need to be on the UniSwap sidechain
So roll-ups are the path forward. A transaction on the Beacon chain that might use 100 kB of block data space now might only need 10. With increased blocksize, bam you are up to 1,500-4,500 tps. Side chains are somewhat centralized but that will have to be lived with for now. Besides, it depends upon your definition of decentralization. Am I right?
To get further tps rates, sharding will be required. Sharding is and has been a topic that could take up pages and pages to further explain. As simply as it can be stated, a sharded Ethereum system will have multiple side chains (shards) that are interrelated to a certain extent prior to their transactions being memorialized on the Beacon Chain. Block proof is randomly assigned to validators to prevent single chain attacks on the system and verification of the proof provided for the randomly selected validator is carried out only to confirm the transaction signatures, not the full proof. Because of this, chain throughput should be raised substantively. 20X above the ability of simple side chain solutions -say 30-90 k tps. This far exceeds the combined average tps of VISA and MasterCard (10.5 kps). And more importantly than this, sharding is expected to provide the final piece to solving the Scalability Trilemma.
So this is the goal. There is a long road to travel. There is a high probability that the network might never reach the sharding stage and will stop with layer 2 sidechains. Effectively what we will arrive at is a number of essentially private Ethereum compatible blockchains that memorialize state every so often on the Beacon (Main) chain.
But with side chains, we are already nearing the realm of Tx throughput needed to compete with likes of existing payments networks. Sure the sidechains are not decentralized entities but that could come in time.
Ok so we have observed that we have 36.55 B$ of Eth staked on the network. If we no longer pay miners and if side chains bring our throughput up, the 2.54 $/Tx fee calculated earlier fall quite rapidly. If we can achieve transaction throughput of just 520 Tx/s (which with side chains we can quite easily), then we can match the current payment systems charges of 2% or $1.10 on an average 55 $ transaction. Of course, right now the sidechains are capturing value - approx. 1% or more of each transaction. What will be the distribution ultimate split of revenues between main and side chains? If the new regime mirrors the current system, the data network will receive only 10% of the revenue stream and the “store fronts” (the sidechains) will garner almost 90%. Anyway, at 50% split, throughput would need to go up to 1040 Tx/s to compete as the Eth network would need 55 ¢/Tx and the sidechain would garner the same.
And, and …. we still cannot quite handle the total throughput volume to match VISA/MasterCard Tx rate of 10,500 av Tx/s due to data limitations. Maybe multiple Beacon Chains? These would be separate networks which is challenging in its own ways with respect to interoperability. Sharding, when it comes, will bring the competitive throughput capability of a single chain. And it will provide a path for Ethereum to cut out or reduce the value proposition of the sidechains as the network will be able to collateralize the entire transaction pool directly (currently sidechains must also provide collateral to backstop their transactions to keep them honest).
So in summary, with sidechains a network processing approximately 1,000 tps can match current payments systems on costs with a 50/50 split of revenues between the main chain and the sidechains. Of course, incumbents will drop prices to try to maintain control (along with strong regulatory lobbying efforts) so perhaps we need to get 50 ¢/Tx. To achieve this the required network through would need to double to compete – say 2,000 tps. Still quite within the realm of doable with sidechains. Not fully decentralized, but maybe good enough. And maybe everyone in the payments world is happy. Transaction costs for retailers have dropped by 50%. But this does not address the need for lower Tx costs for Metaverse world activities where buying a new weapon to use in battle with your least favorite rival surely won’t command a 50 ¢/Tx fee. Maybe 10¢? 5¢??
Ok, now we are up 20,000 tps to support this. Sharding or alternative chain universes will be required. Well, there are lots of Ethereum competitors.
So now back to our original question – just what is Ethereum worth?
Based upon current valuations, the Ethereum network is more than adequately collateralized. If the price of Eth continues to rise, the network will become increasingly uncompetitive without one or two of three things happening,
a) The amount of Ether staked will need to be reduced;
b) The price of Ether must fall;
c) The throughput must go up (but other than lack of utility, it need not go up not by that much).
My bet is on a and c.
But only roughly 8% of all of the Ether staked what about the other 92%?
Well, the reality is that the other 92% has instantly become a store of value. It is worth a 3.25% yield annually so it can be held as a savings vehicle. The staked value of Ether on the network has established the price. If there are arbitrage opportunities to earn higher returns, people will not stake. So the price must equilibrate.
If the price of Ether keeps increasing due to speculation, well the network will have to adjust the amount staked to provide competitive pricing.
If the network never achieves throughput? Then Ether still remains a potential store of value as long as investors think it is a store of value. Without the underlying floor value of the staked Eth, it will be a much riskier proposition to hold Ether.
What are we to make of incumbents in the digital payment space? While some might see this as a big threat to incumbents such as VISA and MasterCard, the appropriate lens to view this from is to go back to how little of each transaction fees they actually command. VISA and MasterCard have been presented an amazing opportunity to capture some of the fees currently captured by the banks and acquirers. Maybe banks and acquirers become redundant?
If you haven’t figured it out yet, the changes coming to the world of global money and finance are a monumental change to the current world financial order. And we haven’t even begun to touch upon how NFTs will forever change how people store their assets, obtain mortgages and the list goes on. The change is reaching right up to the central banks – the printers of coin. At least to date…..