Part 2: Digital oil — Is Ethereum the liquidity crisis cure


Read Part 1 here.

Stay liquid, stay alive

Let’s briefly revisit the idea of crisis protection, which is when decentralized systems should theoretically be their most valuable. In a full-blown, end-of-days type of crisis where governments collapse, and fiat currencies become worthless; what people will really want to hold is food, water, guns, and oil. In such a grim dystopia, shiny rocks and magic internet coins won’t get you very far.

In the financial world, we should be far less interested in the capped downside of Armageddon and more interested in the type of lower-level crisis which dries up the lines of credit, lending facilities and cash flows which allow businesses to pay their liabilities and keep the economy churning.

Historically low interest rates have pushed modern businesses to tie up most of their worth in illiquid, productive assets, rather than cash which provides virtually no return. These businesses bridge any short-term cash shortfalls using money market instruments which may or may not be secured against their illiquid assets or receivables. When an economic shock occurs, the cogs of the financial system become clogged by fear and uncertainty, creditors clutch their purses, and businesses default due to a lack of liquidity rather than an erosion in their long-run capacity to pay. This is how liquidity crunches can easily turn smaller economic shocks into full-blown financial crises.

This implies two important things:

  1. During times of crisis the ability to access deep liquidity is very important.
  2. Businesses generally prefer to hold productive assets.

Today we will discuss why Ethereum, particularly after “The Merge”, has the potential to assist businesses in meeting these needs to a greater extent than Bitcoin. If you are unfamiliar with Ethereum you can check out a brief explainer here.

Can Ethereum do everything Bitcoin can?

Ethereum’s ability to provide digital transaction infrastructure is slightly greater — enabling the processing of 30 transactions per second (tps) on average compared to Bitcoin’s 7tps. Ethereum is also planning a series of upgrades, starting with ‘The Merge’, to improve throughput to 100,000tps.

Both blockchains are obviously currently suffering from severe scalability issues which cause transaction fees to skyrocket during high traffic periods. Both are beneficiaries of ‘layer 2’ solutions, which batch or compress transactions — however, the throughput of the underlying blockchain always acts as a throttle to some extent.

One thing Bitcoin can boast about is its capped maximum supply of 21 million. Ethereum’s supply is a little more complicated.

There are two forces which influence ETH’s supply; inflationary pressures (the creation of new ETH) and deflationary pressures (the destruction of ETH). On the inflationary side, a fixed number of new ETH are created each year — but this number will be drastically reduced by “The Merge”.

A recent change to the Ethereum blockchain has made it so that a portion of every transaction fee paid is burned — decreasing the amount of ETH in existence forever. The amount of ETH burned each year is known as the burn rate. As the burn rate increases with transaction volume, it is possible for it to exceed the creation of new ETH during certain periods. When this occurs ETH becomes a deflationary asset because its total supply decreases. For the first 5 days of May that has been the case (see below) and as the number of new ETH created each year is going to decrease drastically soon, it is likely ETH being deflationary will become the norm.

Net issuance of ETH per month


Ethereum’s properties as a digital payment network and potential to become a deflationary asset imply the ‘digital gold’ thesis outlined for Bitcoin in Part 1 could also reasonably be applied to Ethereum. But that’s not all ETH can do.

How does Ethereum enable access to alternative liquidity channels?

Built onto the Ethereum blockchain is a set of decentralised applications which make up an entire financial system known as Decentralised Finance (DeFi). DeFi exists in parallel to our traditional financial (TradFi) system by cutting out third party intermediaries and instead using immutable code, executed on an unstoppable distributed computer, to execute financial contracts.

The DeFi ecosystem on Ethereum

Source: The Block, Note: Not exhaustive

I am not in the camp that believes DeFi is inherently better than TradFi. I think they are both unique, complementary systems, and the future would benefit from the coexistence of both.

In its brief history, DeFi has been riddled with ponzi-nomic experiments, hacks, and other unsustainable behaviors — but it is rapidly maturing and currently is a $140Bn market. With enough intellectual and financial capital investment, much of which appears to already have arrived, DeFi could be capable of evolving into a legitimately value-add financial system.

Venture capital investment into crypto/DeFi

Source: Galaxy Digital Research

This DeFi system could effectively relieve the blockages in capital markets during liquidity crunches; enable the securitisation and trade of novel real-world assets; and disrupt the clearing house and settlement services of traditional exchanges.

In a crisis, a traditional bank may be too slow or unable to deliver life-line financing to a business for a variety of reasons. They may have simply reached their risk tolerance limit with an individual business; have their own liquidity concerns; be in direct violation of covenants; or the borrower could have run out of the traditionally accepted basket of assets to use as security for their loan. During such times, DeFi applications which enable retail users and institutions to pool and provide capital to businesses could have an important role to play.

Provided there are effective systems to protect participants from issuing exclusively bad loans; DeFi lending markets may become more efficient than their traditional counterparts. DeFi lenders would have different risk profiles, low-to-no existing exposure to the borrower and could source and deliver capital efficiently from anywhere in the world using decentralised smart contract infrastructure. Repayments, defaults and liquidations could all be handled autonomously using smart contract agreements; making a variety of intermediaries and advisors obsolete. Additionally, DeFi could enable a wider range of assets to be used as loan collateral through the tokenisation of rights to receivables and other generally hard-to-trade assets.

But how does ETH fit into this?

ETH is the digital oil of the aforementioned DeFi system. As demand for the services and applications built on top of Ethereum increase — so too does demand for the ETH required to pay transaction fees. Ethereum can therefore be thought of as a commodity which unlocks access to deep liquidity during times of crisis — further strengthening its case to behave as an inversely correlated asset.

“The Merge” — Becoming an ESG-friendly, productive asset

Within the next few months Ethereum will attempt to transition away from its energy intensive and environmentally damaging Proof-of-Work consensus mechanism (the same mechanism used by Bitcoin) to a Proof-of-Stake consensus mechanism. Reliance on Proof-of-Work consensus mechanisms has been heavily critiqued due to the energy demanded by Proof-of-Work blockchains rivaling that of entire countries. This was why Elon Musk famously back peddled on his promise to accept payments for Tesla vehicles in Bitcoin — the ESG impact was too high.

A Proof-of-Stake consensus mechanism requires validators to put down a deposit of ETH to receive the right to earn fees by verifying and executing transactions. If they act dishonestly, their deposit is slashed; but if they act to secure the network, they earn a return on their staked deposit.

If this transition is successful a few things will occur:

  1. Ethereum’s energy usage and therefore carbon footprint will decrease by 99.95%. Commitments to investing in new technology and being more environmentally conscious are two of the most common signals corporations and institutions like to send to the market. Post-merge an investment into Ethereum would allow them to achieve the former without sacrificing the latter.
  2. ETH will become a productive asset, as people who stake their ETH are entitled to a share of transaction fees and mining rewards. Post-merge some parties estimate that liquid staking yields could reach >10% APY.
  3. Sell pressure will decrease as Proof-of-Stake incentivizes miners to stake any earned rewards; whereas Proof-of-Work encourages miners to sell earned rewards to cover electricity costs.
  4. Inflationary pressures will decrease as the ETH rewards issued to validators falls from 12,800 to 1280 per day.

Bringing it all together

Bitcoin’s fixed supply and innovative solution for creating censorship resistant digital payment infrastructure make it appear to be a candidate to disrupt gold.

Ethereum not only has a more technologically capable payment infrastructure solution than Bitcoin’s; but also has the potential to become a more favorable store of value as it becomes deflationary. Ethereum’s natural demand as a commodity which unlocks access to alternate liquidity channels (and other use-cases); greatly reduced carbon footprint (post-merge); and ability to be held as a productive asset give it a strong case to dethrone Bitcoin as the digital asset most deserving of commercial adoption.

It can’t all be sunshines and rainbows

ETH isn’t the only horse in this race. Terra, Solana, Near and Avalanche are all alternative blockchains with similar potential to Ethereum from a technological standpoint.

DeFi market share across alternative L1 blockchains

Source: DeFi Llama

I would even argue that NEAR and AVAX are technologically superior currently, and in many ways “The Merge” is an overdue upgrade which helps Ethereum play catch-up, rather than outrun its competitors. There are even teams attempting to build out a DeFi system on Bitcoin’s blockchain; but the lack of native smart contract support does act as a natural headwind.

In financial ecosystems, network effects do matter as liquidity begets liquidity. Ethereum’s moat may prove large enough to ward off competitors; but if its much needed upgrades don’t arrive soon then ETH’s scalability issues could end its reign over DeFi.

But threats far greater than competition exist for both Bitcoin and Ethereum in the short run…

Coming Soon

Part 3: Digital volatility — The harsh reality of the crypto casino

Disclaimer: All opinions represented are my own and are presented solely as an attempt to timestamp my own thinking or provide entertainment. Do not act on or interpret any of my content as financial advice.

Twitter: @isthatPatJaffe