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Grayscale: Ethereum ETF has limited room for growth after approval, Solana may seize market share

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24-05-31 09:00

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Original title: The State of Ethereum

Original source: Grayscale Research

Original translation: Felix, PANews

· The potential launch of a spot Ethereum ETF will expose more investors to the concepts of smart contracts and decentralized applications, thereby making them understand the potential of public blockchains to change digital commerce.

· Ethereum is the largest blockchain network in terms of users and applications, and is expanding with a modular design concept, with more activities to be conducted on the Layer2 network in the future. To maintain its dominance in a highly competitive market segment, Ethereum needs to attract more users and increase fee income.

· Based on international precedents, the demand for spot Ethereum ETFs in the United States is expected to be about 25%-30% of the demand for spot Bitcoin ETFs. A large portion of Ethereum supply (such as staked ETH) is unlikely to be used for ETFs.

· Given the high initial valuation, further price gains may be limited compared to a Bitcoin ETF launching in January 2024, but Grayscale Research remains optimistic about the prospects for both assets.

Last week, the U.S. Securities and Exchange Commission (SEC) approved several issuers’ Form 19b-4 filings for spot Ethereum ETFs, making significant progress toward listing these products on U.S. exchanges. Similar to the spot Bitcoin ETFs that were listed in January, these new products will allow a wider range of investors to gain exposure to crypto assets. While both assets are based on the same public blockchain technology, Ethereum is an independent network with different use cases (Table 1), while Bitcoin is primarily used as a store of value and digital alternative to gold. Ethereum is a decentralized computing platform with a rich application ecosystem that is often likened to a decentralized app store. New investors interested in exploring this asset may want to consider Ethereum’s unique fundamentals, competitive positioning, and potential role in the growth of blockchain-based digital commerce.

Exhibit 1: Ethereum is a smart contract platform blockchain

Smart Contract Basics

Ethereum expanded on the original vision of Bitcoin by adding smart contracts. A smart contract is a pre-programmed, self-executing computer code. When a user uses a smart contract, predefined actions are performed without any additional input. It's like a vending machine: the user inserts a coin and the vending machine dispenses an item. When using a smart contract, the user "inserts" a digital token and the software can perform some type of action, such as trading tokens, issuing loans, and verifying the user's digital identity.

Smart contracts operate through the mechanisms of the Ethereum blockchain. In addition to recording ownership of assets, block-by-block updates to the blockchain can also record any changes in "state" (note: a computer science term meaning the state of data in a database). In this way, coupled with smart contracts, public blockchains can actually operate like computers (software computers rather than hardware computers). With this, Ethereum and other smart contract platform blockchains can host almost any type of application and serve as core infrastructure for the emerging digital economy.

Asset Returns and Fundamentals

Since the beginning of 2023, ETH has performed roughly in line with the overall smart contract platform token segment (Table 2). However, ETH has underperformed BTC and Solana. Since the beginning of 2023, ETH, like BTC, has outperformed certain traditional asset classes on a risk-adjusted basis. Over the long term, both BTC and ETH have achieved risk-adjusted returns comparable to traditional asset classes, despite significantly higher volatility.

Figure 2: ETH has been performing in line with the cryptocurrency sector

Through Ethereum’s modular design, different types of blockchain infrastructure work together to provide a good experience for end users. In particular, the ecosystem has expanded as Ethereum’s Layer2 network activity has increased. Layer2 regularly settles and publishes its transaction records to Layer1, benefiting from its network security and decentralization. This approach is in stark contrast to single-layer design blockchains such as Solana, where all key operations (execution, settlement, consensus, and data availability) occur in Layer1.

In March 2024, Ethereum underwent a major upgrade that is expected to facilitate its transition to a modular network architecture. From a blockchain activity perspective, the upgrade was successful: the number of active addresses on the Layer2 network increased significantly, accounting for about two-thirds of the total activity in the Ethereum ecosystem (Figure 3).

Figure 3: Ethereum Layer2 Activity Grows Significantly

At the same time, the shift to Layer2 networks has also affected ETH’s token economics, at least in the short term. Smart contract platform blockchains accumulate value primarily through transaction fees, which are typically paid to validators or used to shrink the token supply. In the Ethereum network, base transaction fees are destroyed (removed from circulation), while priority fees (“tips”) are paid to validators. When Ethereum’s transaction revenue was relatively high, the number of tokens destroyed exceeded the rate of new issuance, and the total ETH supply fell (deflation). However, as network activity transitioned to Layer2, fee revenue on the Ethereum mainnet fell, and ETH supply began to increase again (Figure 4). Although Layer2 networks also pay fees to publish their data to Layer1 (so-called “blob fees,” as well as other transaction fees), the amounts tend to be relatively low.

Figure 4: ETH supply has increased recently due to low mainnet fees

In order for ETH to increase in value over time, the Ethereum mainnet will likely need to increase fee revenue. This could happen in two ways:

A modest increase in Layer 1 activity that pays higher transaction fees

A significant increase in Layer 2 activity that pays lower transaction fees

Grayscale Research expects that it is more likely to be a combination of the two.

Grayscale believes that growth in Layer 1 activity is most likely to come from low-frequency and high-value transactions, as well as any transactions that require a high degree of decentralization (at least until the Layer 2 network is sufficiently decentralized). This could include many types of tokenized projects that may have relatively low transaction costs compared to the dollar value of the transactions. Currently, about 70% of tokenized U.S. Treasuries are on the Ethereum blockchain (Table 5). In Grayscale's view, relatively high-value NFTs are also likely to remain on the Ethereum mainnet, as they benefit from its high security and decentralization and change hands less frequently (for similar reasons, Bitcoin NFTs are expected to continue to grow).

Figure 5: Ethereum hosts most tokenized treasuries

In contrast, relatively high-frequency and/or low-value transactions will occur more on Ethereum's various Layer2 networks. For example, social media applications, recent success stories on Ethereum Layer2, include friend.tech (Base), Farcaster (OP Mainnet), and Fantasy Top (Blast). In Grayscale's view, both games and retail payments may require very low transaction costs and are more likely to migrate to Layer2 networks. However, it is important to note that given the low transaction costs, these applications need to attract a large number of users to significantly increase fee income on the Ethereum mainnet.

Potential Impact of US Spot Ethereum ETFs

In the long run, ETH's market capitalization should reflect its fee income, as well as other fundamentals. But in the short term, ETH's market price may be affected by changes in supply and demand. While progress has been made in the approval of US spot Ethereum ETFs, ETF issuers will need to wait for the S-1 registration statement to become effective before they can begin trading. Full approval and launch of trading in these products could bring new demand as the assets will be available to a wider range of investors. Given the supply and demand dynamics, Grayscale Research expects that access to Ethereum and the Ethereum protocol will increase through ETF wrappers, which will help drive increased demand and, in turn, the price of the token.

Outside the United States, both Bitcoin and Ethereum exchange-traded products (ETPs) are listed, with assets in Ethereum ETPs accounting for about 25%-30% of Bitcoin ETP assets (Table 6). On this basis, Grayscale Research's forecast is that net inflows into U.S.-listed spot Ethereum ETFs will reach 25%-30% of net inflows into spot Bitcoin ETFs to date; or about $3.5 billion to $4 billion in inflows in the first four months or so (accounting for 25%-30% of the $13.7 billion net inflows into spot Bitcoin ETFs since January). Ethereum's market capitalization is about one-third of Bitcoin's market capitalization (33%), so Grayscale's assumption means that Ethereum net inflows may be slightly smaller as a share of market capitalization. But this is only an assumption, and there is uncertainty about higher and lower net inflows into U.S.-listed spot Ethereum ETFs. It is worth mentioning that in the U.S. market, ETH futures ETFs only account for about 5% of BTC futures ETF assets, although this does not represent the possible demand for spot ETH ETFs.

Figure 6: Outside the United States, Ethereum ETP AUM accounts for 25%-30% of Bitcoin ETP AUM

In terms of ETH supply, Grayscale Research believes that about 17% of ETH can be classified as idle or relatively illiquid. According to data from data analysis platform Allium, about 6% of ETH supply has not moved for more than five years, and about 11% of ETH supply is "locked" in various smart contracts (e.g., bridges, wrapped ETH, and various other applications). In addition, 27% of ETH supply is staked. Recently, issuers of spot Ethereum ETFs, including Grayscale, have removed references to stakes from public documents, indicating that the U.S. SEC may allow ETFs to trade without stakes. Therefore, this portion of the supply is unlikely to be available for ETF purchase.

Outside of these categories, $2.8 billion worth of ETH is used for network transactions each year. At current ETH prices, this represents an additional 0.6% of supply. There are also a few protocols that hold large amounts of ETH in their treasuries, including the Ethereum Foundation ($1.2 billion worth of ETH), Mantle (~$879 million ETH), and Golem ($995 million ETH). Overall, ETH in protocol treasuries accounts for about 0.7% of supply. Finally, about 4 million ETH, or 3% of the total supply, is held in ETH ETPs.

Collectively, these categories account for about 50% of ETH supply, although there is some overlap (for example, ETH in protocol libraries may be staked) (Figure 7). Grayscale believes that net purchases of ETH are more likely to come from the remaining circulating supply. Because existing uses limit the available supply for new spot ETF products, any increase in demand is likely to have a large impact on price.

Figure 7: A significant portion of ETH supply cannot enter the new spot ETF

From a valuation perspective, Ethereum is arguably more valuable than Bitcoin was when the spot Bitcoin ETF launched in January. For example, one popular valuation metric is the MVRV z-score. This metric is based on the ratio of a token’s total market value to its “realized value”: the market value based on the price at which the token last moved on-chain (rather than the price it trades on an exchange). When the spot Bitcoin ETF launched in January, its MVRV z-score was relatively low, indicating moderate valuations and potentially more room for price appreciation. Since then, crypto markets have appreciated, with both Bitcoin and Ethereum’s MVRV ratios increasing (Exhibit 8). This may indicate that there is less room for price appreciation following the approval of the spot ETH ETF compared to January’s approval of the US spot Bitcoin ETF.

Figure 8: ETH’s Valuation Metrics Higher Than BTC When the Spot Bitcoin ETF Launched

Finally, native crypto investors may be concerned about the impact of a spot Ethereum ETF on smart contract platform tokens, specifically the SOL/ETH price ratio. Solana is the second-largest asset in the segment by market cap. Grayscale Research believes that Solana is currently best positioned to take market share from Ethereum in the long run. Solana has significantly outperformed Ethereum over the past year, with the SOL/ETH price ratio now close to the peak of the last crypto bull run (Figure 9). This may be partly due to the fact that, despite Solana being affected by the FTX incident (in terms of token ownership and development activity), the Solana network's user and developer community continues to grow the ecosystem. More importantly, Solana has also driven increased trading activity and fee income through a "silky" user experience. In the short term, Grayscale expects the SOL/ETH price ratio to stabilize as inflows from the Ethereum ETF will support the price of ETH. However, in the long run, the SOL/ETH price ratio is likely to be determined by the fee income of the two chains.

Figure 9: SOL/ETH price ratio near last cycle high

Looking Ahead

While the launch of a spot ETH ETF in the U.S. market could have an immediate impact on ETH valuations, regulatory approvals have implications far beyond price. Ethereum offers an alternative framework for digital commerce based on decentralized networks. While traditional online experiences are quite good, public blockchains may offer more possibilities, including near-instant cross-border payments, true digital ownership, and interoperable applications. While other smart contract platforms can also provide this utility, the Ethereum ecosystem has the most users, the most decentralized applications, and the deepest pool of capital. Grayscale Research expects that the new spot ETF could popularize this transformative technology to a wider audience of investors and other observers and help accelerate the adoption of public blockchains.