By Steven McClurg and Leah Wald
“We are stuck with technology when what we really want is just stuff that works.” - Douglas Adams (author of the Hitchhiker’s Guide to the Galaxy)
Ethereum was cutting edge when the network went live on July 30, 2015. It reminds me of the Palm Pilot Treo. For those who don’t remember, or are too young to know, for the first time ever, you were able to plug in a device to your computer to download emails, go away to answer those emails, and when you came back to plug your Palm Pilot back into your computer, all those emails were sent. There were even some cool games and other productivity applications contained in tiny cartridges that you could purchase at Best Buy and Staples. I bought Tetris. Shortly after, Blackberry gained popularity due to better functionality, size, speed, and price. It also had Tetris. We all abandoned Palm.
Pay The Tollbooth
Ethereum users need to pay directly for the computational power they use in Ether, known on the network as “gas”. Given you need Ether to power Decentralized Applications (Dapps) and pay developers and miners, it’s important that transaction costs are cheap enough to attract users. And as with all successful scalable technologies, depreciate in cost to stave off competitive networks.
Ether should be viewed more like data fees on a cellular network, rather than a currency because Ether’s main usage today is still largely transaction-based, and is charged as the cost to move a unit of data across a network. As with cellular technology, as participants join, the network grows, which improves the value of the service, more data is moved, and cost decrease (this is known as the network effect). This means the cost per unit of data will drop significantly. The average data plan for cell phones was $100/monthly 2011, but in 2012, the average bill was $47/monthly, and now, in 2020, the average bill for an unlimited data plan is $30/ monthly. In 2016, on average a smartphone consumed 1.7 GBs of cellular data per month; that number is projected to reach 8.9 GBs in 2021 and some providers offer more than 1T (1024 GB) of mobile data usage, which falls under the unlimited data plans at $35/monthly. As we will explain in this piece, Ethereum’s core design disallows for scalability to succeed and instead created a negative network effect.
“DeFi, DeFi, DeFi!”, yells the excited masses. Be careful what you wish for. There is $11 billion in crypto assets locked in DeFi right now. And as DeFi’s popularity continues to grow, Ethereum has become more congested, fees are still skyrocketing. Its demand is its downfall.
DeFi is fueling Ethereum’s growth which is also exacerbating the transaction fees. Coin Metrics reported that Ethereum’s cumulative transaction fees in 2020 are now over $350 million and more than double the aggregated total of Bitcoin’s network fees.
With the many options made available for “yield farming”, or decentralized finance “DeFi” gambling, the Ethereum network has clogged up and transaction prices have skyrocketed. High fees have become the new norm.
We mentioned the risk of this and the high transaction fees in our earlier piece, Ether And Bitcoin Are Not The Same. On June 10th, a user paid $2.6 million in fees to move $130 in Ethereum (ETH). Later that day, another ETH transaction with a large fee came through from the same address, many people are calling foul play. This type of dangerous activity decimates trust from users. This was the foreshadowing moment of future high transfer fees that we are seeing now.
Token trading volume on Uniswap, the largest non-custodial or decentralized exchange (DEX) on Ethereum, has increased from around $1M every day in June 2020 to nearly $1B every day in the beginning of September 2020. Uniswap trading occurs on-chain which made Uniswap too expensive to trade on, which priced out a large number of small-value users of the network.
As of September 1st, using a DeFi protocol costs more than $50 as Ethereum fees skyrocket. Following Uniswap’s UNI token launch, Ethereum transaction fees spiked to almost $1 million an hour, a five year high, and exchanges began passing gas fees to users.
“Making a simple Ether to Dai (DAI) exchange on Uniswap requires $55 in gas fees. Curve estimates a price of $33, while a trade on Mooniswap will cost over $80. Supplying an asset to Compound similarly requires about $57, while on Aave it requires $44.
At these gas prices, using these protocols becomes either impossible or uneconomical. In order for the gas cost on a DEX to be equivalent to a traditional exchange fee of 0.2%, one must trade at least $27,500 worth of assets in a single transaction. A user depositing 5,000 DAI on Compound would need to wait over 40 days to break even on gas — even when factoring in the COMP rewards.” — Cointelegraph
Despite this, numerous DeFi protocols are breaking all volume records. However, the economies of scale do not match, instead, we are looking at the law of diminishing [marginal] returns and diseconomies of scale. In Economics, a “Diseconomy of Scale” happens when a company has grown so large that its costs per unit will start to increase.
Linear businesses and platform businesses respond differently to diseconomies of scale. In a platform business model, the main asset is its network, which allows the platform to scale quickly and efficiently, sometimes exponentially. At times, platform business models can be immune to diseconomies of scale given they can grab close to total market shares if monopolized, but there is a catch: reverse (or negative) network effects and congestion when platforms scale too quickly.
And sometimes, as was the case with the Palm, when platforms scale too quickly, the user experience becomes poor, its value decreases, competitors enter and the platform collapses. Ethereum has reached a threshold of scale and its size is no longer an advantage, but instead, it has become its greatest risk factor.
If you have a developer or business owner of a Dapp that delivers a time-sensitive service, then your business is at jeopardy. You cannot simply wait in line for the congested network, excited about the latest craze, to finally accept your transaction. If you were a prudent businessman and/or woman, you will need to find a new platform.
More notably, the high gas fees meant that the majority of cryptocurrency users would be completely priced out. Considering that the median and average amount of cryptocurrency held by Americans was $360 and $5,447 per investor having to pay upwards of $50 per transaction would be unreasonable. Furthermore, consider that the average size of cryptocurrency portfolios are likely even smaller in other less privileged countries.
However, more stable chains, such as NEM and Algorand, have already come to market as user-friendly blockchains and other competing base-layer protocols like Polkadot, Cosmos, and Blockstack.
At the most basic level, Ethereum’s core design is at odds with the platform’s ability to regulate its gas prices, especially as usage continues to grow. Ethereum cannot remain competitive; Ethereum has failed.
Yield farmers and miners are pushing for higher gas prices and are incentivized for Ether to be used as gas to pay for transactions and smart contracts. Miners have the upper hand as they will prioritize the transaction with the higher gas price. Users compete to be in line for a trade. However, it’s the whales and users who are transferring large amounts that will be at the head of that line, kicking out those investing small sums. High fees are prohibitive for many and to note, fees are not proportional to the amount of value transferred. “Ethereum’s median transfer value has increased to hundreds of dollars since the rise of DeFi, signaling that the network is shifting towards larger players,” the Coin Metric report points out. This exacerbates a system of higher fees and its negative network effects.
It is scalability issues that transformed Bitcoin’s perception from a means of exchange to a store of value, “digital gold”. It would be prudent that ethereum change course in a similarly disruptive way to survive however ethereum’s protocol does not have the capability to serve as a store of value and therefore must continue along the diseconomies of scale curve. The stark reality is that its greatest success factor, its extreme demand, is its downfall.
Didn’t we switch from traditional process transfer avenues such as Paypal and SWIFT, because of their high transaction costs? Why would we use Ethereum when it is even more expensive and carries additional risks?
Smaller investors, casual enthusiasts, and smaller Dapp users are having an increasingly difficult time using ethereum’s high-fee environment. They are priced out and there is hesitation due to its various service issues. This has led to other blockchains gaining ground on Ethereum as many users have looked elsewhere where they are not treated as “second class citizens” for not being able to afford gas (e.g. Tron) for yield farming plays, even if arguably these blockchains have its own idiosyncratic issues.
Reverse Network Effect
The reverse network effect of Ethereum is simple: the more users and protocols that the network attracts, the more transactions that are sent through the network. The more traffic there is on the network, the more congested it becomes; as it becomes more congested, fees go up, and transaction times slow down.
Layer 2 Scaling
Ethereum creator Vitalik Buterin has been vocal about the issues, citing Ethereum’s second-layer solutions will solve the scalability problems. Yesterday at Invest: Ethereum Economy, Vitalik Buterin reiterated his push for users to begin migrating over to layer-2 scaling solutions such as “rollups.”
But it’s important to not hold our breath for a layer-two solution to save the day. Not only has the launch been delayed for years but all users will need to learn how to use these layer-two solutions. As Vitalik explained in a tweet later that day, “[in my opinion] they’re not hard” to learn.” That relative statement here is a barrier to many.
The Ethereum 2.0 protocol upgrade, which will change the consensus mechanism to proof-of-stake (PoS), is very complex and has been long delayed (Ethereum has been looking to shift to PoS since 2014). When it does go live, an investor must pay close attention as market narratives will drive the price action. Given historical precedence, there will be numerous setbacks and disruptive issues, leading to periods of significant underperformance.
“Right now, DeFi spends $500K+ in trading fees per hour because ETH1.0 can’t scale….When DeFi moves to a scaled layer-1, then we can see if it’s mature enough for the mainstream.” — Stuart Popejoy, co-founder, and president of Kadena in Finance Magnates
Further in Popejoy’s interview with Finance Magnates, Popejoy reported that he does not believe that the upgrade to ETH 2.0 will improve the blockchain enough to make it viable for widespread adoption, adding that “the biggest 2020 development in DeFi is the demise of the narrative that ETH 2.0 is a viable future platform.”
Right now, Ethereum users are stuck with ETH 1.0 and its continued path of higher gas fees and poor performance.
“I’ve changed my mind after using a dozen of Defi platforms. So long as ETH 2.0 is not fully rolled out, there’s an obvious opportunity for a highly scalable blockchain to dethrone Ethereum. Paying $10 transaction fee and waiting 15 seconds for settlement is just bad UX.” — Messari’s head of product Qiao Wang
Yield Farming Projects are Securities
Four days ago, SEC commissioner Hester Pierce warned that DeFi tokens could be classified as securities. She noted, specifically referring to the Uniswap token (UNI) and SushiSwap (SUSHI), that each individual case must be investigated.
“This does not necessarily mean that you are outside the scope of securities law. So even if you don’t sell it, you are basically issuing the token. In the end, it might still fit into the securities classification. So people have to be careful, and again, this is one more reason why the SEC has to be out there to provide guidance, because people are trying to figure out how to issue the tokens so that users can use the tokens, and we are not really active in providing the guidance that people need to feel comfortable.” — SEC commissioner Hester Pierce at the LA Blockchain Summit
Given the similarities with traditional equities, there may be a significant reprisal against DeFi from the SEC. This may have a dampening effect. And although DeFi deflation may give users a small reprieve from soaring fees, the long-term prospects of Ethereum succeeding without DeFi protocols is slim to none.
Just like how recent crackdowns by the SEC and CFTC against centralized projects have had a chilling effect on ICOs, exchanges, it looks increasingly likely that the clearly non-anonymous teams of most large DeFi projects will come under heavy scrutiny in the coming years. Furthermore, many DeFi protocols are now closely intertwined in many high profile cases such as the Kucoin hack, where the hacker traded many altcoins for Ethereum.
Investments And Speculations
In The Intelligent Investor, Benjamin Graham wrote: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
The Bitcoin White Paper built in a progressive vision of a future — a daring solution to replace the world financial order. Bitcoin has continued to develop into this vision, slow and steady, which includes its ability to successfully serve as a store of value and safe haven against certain fast-depreciating currencies. It is possible to invest in Bitcoin because it holds these intrinsic properties. Therefore, an investor can have a reasonable expectation that the money allocated towards the purchase may appreciate over a longer time-horizon.
On the other hand, given Ether’s inability to adequately serve as a store of value, it remains a highly risky speculative instrument. Ether traders look to take profit from its subsequent price changes over a short time-horizon. They chase high returns, coupled with high risk. Visions of digital ingots dance before their eyes. Even worse, many are speculating on ETH through the publicly-traded grantor trust, ticker: ETHE. In Don’t Buy The Grayscale Ethereum Trust (ETHE:US) we discuss the massive share price premium versus the underlying assets in the trust, which has and will continue to collapse.
These visions of digital gold riches have been formed without evidence. They are simply pyrite making a fool of all participants.