Your Ethereum Questions Answered
Research Team
Q: What are the main differences between Bitcoin and Ethereum? How does Ethereum differ from other assets in the Smart Contract Platforms Crypto Sector?
A: Bitcoin’s primary use case today is as a store of value, while Ethereum’s primary use case is as a platform for decentralized applications.
Ethereum can be likened to a decentralized version of Apple’s App Store, as it provides the foundational platform for applications to be built upon. These decentralized applications (dApps) can range from financial applications to gaming to identity tools. In comparison to Bitcoin, Ethereum currently allows for greater transaction throughput, lower average block times, and around the same level of transaction fees for users (Exhibit 1).
Exhibit 1: Bitcoin and Ethereum Comparison
Exhibit 2: Fundamentals for top 10 Smart Contract Platforms by Market Cap
A: Since the transition to Proof of Stake (PoS) in 2022, the supply of ETH has been approximately unchanged. The issuance rate is determined by block rewards and transaction fees.
Exhibit 3: ETH supply has been about unchanged since September 2022
ETH issuance is influenced by block rewards and transaction fees. Block rewards are newly minted ETH distributed to validators, contributing to inflation. Transaction fees, or gas fees, include a base fee that is burned (deflationary) and a priority fee that is given as a reward to validators (neutral impact on inflation).
Q: What is “gas” on the Ethereum network? What is Ethereum network fee revenue and how does it accrue value to token holders?
A: Transaction fees on Ethereum are referred to as “gas,” which can be considered the network’s revenue. Revenue accrues to token holders through mechanisms that resemble equity dividends and buybacks.
Ethereum network fee revenue is generated by gas, or fees paid in ETH to perform transactions and use applications on the Ethereum network. Gas is necessary to help regulate network usage: without some type of transaction cost, the network could be overwhelmed by spam transactions.
Gas fees consist of two parts: base fees and tips. Similar to a stock buyback, base fees are "burned," removing ETH supply from circulation. In this way, rising transaction volumes can help benefit all token holders. Similar to an equity dividend, tips are distributed as rewards to validators. However, the difference in this case is that validators help secure the network by processing transactions and maintaining the blockchain (Exhibit 4).
Exhibit 4: Ethereum Supply Dynamics via Burn and Staking
Gas fees are crucial for the functioning of the Ethereum network as they provide an economic incentive for validators to participate in the network's security. By tying the network's usage directly to the value of ETH, network fee revenue plays a critical role in Ethereum's value accrual mechanism, benefiting token holders, validators, and the overall network ecosystem.
Q: What makes Ethereum attractive to developers building on the network? What are the largest applications on Ethereum?
A: Ethereum is attractive to developers because of network effects and network security. Most of the largest decentralized applications (dApps) today have financial use cases.
Exhibit 5: Ethereum leads competitors in TVL, a key indicator of liquidity
Decentralized applications on Ethereum range in use cases from financial/tokenization to gaming and NFTs. Two of the largest applications built on Ethereum based on metrics like users, fees, and TVL include Lido and Uniswap. Lido, a liquid staking solution, enables users to stake their ETH while retaining liquidity through the issuance of derivative tokens (stETH). Uniswap is a decentralized exchange, which enables peer-to-peer trading of various crypto assets without an intermediary. Both use Ethereum as a settlement layer, designed to execute secure and decentralized transactions.
Q: What does it mean that Ethereum is a modular blockchain design?
A: Ethereum’s modular design means that different types of blockchain infrastructure (multiple software “layers”) work together to deliver the end user experience.
Ethereum's modular design divides the network into specialized parts, such as execution (processing transactions), data availability (storing transaction data), and consensus (ensuring all transactions are valid). This approach allows for targeted innovations and updates without disrupting the entire network, enabling Ethereum to address its scalability challenges while still maintaining its network security.
This design contrasts with Solana’s monolithic approach, where each of these functions — execution, data availability, and consensus — are handled within a single layer, optimizing for speed, efficiency, and consistency.
Q: What are Ethereum Layer 2s, and how do they connect to the Ethereum mainnet?
A: Ethereum Layer 2s are scaling solutions built on top of Ethereum that execute transactions at lower cost.
Because Ethereum operates a modular design, it can separate transaction execution from transaction settlement. As a result, Ethereum Layer 2s process transactions, batch them together, and then send a compressed version back to the main network — the Ethereum mainnet or Layer 1— for settlement. Through this batching process, Layer 2s can offer users significantly greater throughput and lower costs in comparison to transactions executed on the main chain, while still relying on Ethereum’s network security.
Today, there are a wide variety of Layer 2 scaling solutions including Optimistic Rollups, such as Optimism and Arbitrum, and ZK Rollups, such as Starknet and ZkSync. From the standpoint of blockchain activity, Layer 2 networks have allowed the Ethereum ecosystem to expand significantly; Layer 2s now account for about two-thirds of total activity in the Ethereum ecosystem (Exhibit 6).
Exhibit 6: Significant growth in Ethereum Layer 2 activity
Q: How does Ethereum achieve consensus, and how do you measure network security?
A: Ethereum achieves consensus through a Proof of Stake algorithm. Network security can be measured in different ways, including the value of ETH staked and number of validators.
Exhibit 7: Network security measured by validators and staked value
Q: What is the ownership distribution of ETH holders?
A: As of mid-July 2024, ETH ownership can be categorized into distinct categories as follows: staked ETH (27%), ETH in smart contracts (11%), dormant ETH (6%), ETH held in ETPs (~3%), ETH in treasuries (0.7%), and ETH used as gas annually (0.7%). See exhibit 8 for more details.
Grayscale Research believes that around 17% of ETH supply can be categorized as idle or relatively illiquid (for more details, see our report The State of Ethereum). According to data analytics platform Allium, this includes about 6% of ETH supply that has not been moved for over five years, as well as about 11% of ETH supply that is “locked” in various smart contracts (e.g., bridges, wrapped ETH, and various other applications). Moreover, 27% of ETH supply is staked.
Altogether, these groups account for nearly 50% of ETH supply (Exhibit 8), although the categories are partly overlapping (e.g., ETH in protocol treasuries may be staked).
Exhibit 8: Staked ETH constitutes a large amount of the total ETH supply
Q: What could inflows into US Ethereum ETPs look like?
A: Grayscale Research estimates that inflows into US Ethereum ETPs could be equivalent to around 25%-30% of the assets in Bitcoin ETPs, or $3.5 billion to $4 billion over the first four months.
Outside the United States, where both Bitcoin and Ethereum exchange-traded products (ETPs) are already available, assets in Ethereum ETPs amount to about 25%-30% of assets in Bitcoin ETPs (Exhibit 9). On this basis, Grayscale Research’s working assumption is that net inflows into U.S.-listed spot Ethereum ETPs will be 25%-30% of those observed for the spot Bitcoin ETPs to date, or about $3.5 billion to $4 billion over the first four months or so (25%-30% of the $13.7bn net inflows into spot Bitcoin ETPs since January).
Exhibit 9: Outside the U.S., Ethereum ETP AUM totals 25%-30% of Bitcoin ETP AUM
Ethereum’s market capitalization is about one-third (33%) that of Bitcoin’s market capitalization, so our assumptions imply that Ethereum net inflows could be slightly smaller as a share of market cap. Although we believe this is a reasonable working assumption, the estimates are uncertain, and there are risks of both higher and lower net inflows into U.S.-listed spot Ethereum ETPs. In the U.S. market, ETH futures-based ETPs have only about 5% of the assets of BTC futures-based ETPs, although we do not think this is representative of the likely relative demand of spot ETH ETPs.
Q: What are the opportunities and challenges for the Ethereum network going forward?
A: Ethereum benefits from strong network effects and liquidity advantage. At the same time, it faces certain challenges, including Layer 2 centralization and increasing competition from other smart contract platforms.
Ethereum benefits from several fundamental positives. Most importantly, Ethereum’s network effects and liquidity advantage position it favorably towards retaining and attracting new developers, applications, and users. Ethereum also generates the most network fee revenue (over $2 billion in 2023) of its peer set, indicating its maturity, ability to monetize its user base, and its advantage towards attracting validators and stakers for network security. In total, Ethereum has the largest network security budget at 33mm ETH (currently worth around $112 billion).This is particularly important for use cases that require high levels of security such as stablecoins and tokenized financial assets.
Ethereum ETPs could increase the willingness of institutions to hold ETH as an asset and to adopt technology on the Ethereum blockchain. We have already seen strides in this direction, as the list of Wall Street firms building tokenized funds now includes Goldman Sachs and Blackrock, with Blackrock developing its BUIDL fund on Ethereum.[14] Beyond traditional finance, a spot Ethereum ETP approval could have implications on broader retail awareness of Ethereum, flows into ETH the asset, and adoption of the Ethereum network.
Ethereum faces increasing competition in the Smart Contract Platforms Crypto Sector. To maintain its dominance in a competitive market segment, Ethereum will need to leverage its strengths and bring in additional users as well as grow fee revenue.
[2] "ETH” refers to the native token on the Ethereum blockchain
[11] This reflects the dollar amount of Ethereum used as gas in transactions. This value is denominated in ETH in Exhibit 8
[12] Defi Llama, as of 7/18/2024
Important Information
Investments in digital assets are speculative investments that involve high degrees of risk, including a partial or total loss of invested funds. Investments in digital assets are not suitable for any investor that cannot afford loss of the entire investment. “ETH” refers to the native token on the Ethereum blockchain.
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