The State of Ethereum

• The potential launch of spot Ethereum ETFs will introduce more investors to the concept of smart contracts and decentralized applications—and therefore to the potential for public blockchains to transform digital commerce.
• Ethereum is the largest asset (by market capitalization) in our Smart Contract Platforms Crypto Sector, and the largest blockchain network in terms of users and applications.^[1] It is pursuing a modular design philosophy to scale, in which more activity over time will take place on related Layer 2 networks. To maintain its dominance in a competitive market segment, Ethereum will need to bring in additional users and grow fee revenue.
• Based on international precedent, the Grayscale Research team expects that the U.S. spot Ethereum ETFs will see roughly 25%-30% of the demand of the spot Bitcoin ETFs. Significant portions of Ethereum supply (e.g., staked ETH) will not likely be available for the ETFs.
• Given higher initial valuations, the scope for additional price increases may be more limited compared to the launch of Bitcoin ETFs in January 2024, but Grayscale Research remains optimistic about the outlook for both assets.

Last week, the Securities and Exchange Commission (SEC) approved Form 19b-4 filings from several issuers for spot Ethereum exchange-traded funds (ETFs), a sign of notable progress for these products to list on U.S. exchanges. Like the spot Bitcoin ETFs listed in January, these new products could open access to the crypto asset class to a wider range of investors. Although both assets are based on the same public blockchain technology, Ethereum is a separate network with distinct use cases (Exhibit 1). Whereas Bitcoin today serves primarily as a store of value and digital alternative to gold, Ethereum is a decentralized computing platform hosting a rich ecosystem of applications, often analogized to a decentralized app store. New investors interested in exploring this asset may want to consider Ethereum’s distinct fundamentals, its competitive positioning, and its potential role in the growth of blockchain-based digital commerce.

Exhibit 1: Ethereum is a smart contract platform blockchain

The Basics of Smart Contracts

Ethereum expanded on the initial vision for Bitcoin with the addition of smart contracts. Smart contracts are a type of pre-programmed and self-executing computer code. When a user engages a smart contract, it will perform a predefined operation without any additional input. The classic real world metaphor is a vending machine: a user inserts a coin and the vending machine delivers an item.^[2] With a smart contract, a user typically “inserts'' a digital token and the software performs some type of operation. These operations can include anything from exchanging tokens to making loans to verifying a user’s digital identity.

Smart contracts operate through the mechanics of the Ethereum blockchain. In addition to recording the ownership of assets, the block-by-block updating of the blockchain can also record any arbitrary changes in “state”—a computer science term meaning the state of data in a database. In this way, with the addition of smart contracts, a public blockchain can operate in effect as a computer (a software computer rather than a hardware computer). With these basic ingredients, Ethereum and other smart contract platform blockchains can host virtually any type of application—and serve as the neutral core infrastructure of an emerging digital economy.

Asset Returns and Fundamentals

The Ethereum network’s Ether token (ETH) is the largest component (by market capitalization) of our Smart Contract Platforms Crypto Sector.^[3] From the start of 2023 until very recently, ETH performed broadly in line with this market segment (Exhibit 2). However, it has underperformed Bitcoin, the largest crypto asset by market cap overall, as well as Solana, the second largest asset by market cap within the Smart Contract Platforms Crypto Sector. Like Bitcoin, Ether has outperformed certain traditional asset classes on both an absolute and risk-adjusted basis since the start of 2023.^[4] Over longer periods, both Bitcoin and Ethereum have delivered risk-adjusted returns comparable to traditional asset classes, albeit with significantly higher volatility (for details, see our report The Role of Crypto in a Portfolio).

Exhibit 2: ETH performed in line with its Crypto Sector until recently 

With Ethereum’s modular design, different types of blockchain infrastructure are intended to work together to deliver the end user experience. In particular, more activity is expected to take place over time on Ethereum’s Layer 2 networks—additional pieces of software providing blockchain functions and connected to the Layer 1 Ethereum mainnet—to allow the ecosystem to scale. The Layer 2s periodically settle and post records of their transactions to the Layer 1, benefiting from its network security and decentralization. This approach is in contrast to blockchains with a monolithic design philosophy, like Solana, in which all the key operations (execution, settlement, consensus, and data availability) occur within a single Layer 1 network.

In March 2024, Ethereum went through a major upgrade that is expected to facilitate its transition to a modular network architecture (for details, see our report Ethereum’s Coming of Age: “Dencun” and ETH 2.0). From the standpoint of blockchain activity, the upgrade was a success: the number of active addresses on Layer 2 networks has increased significantly, and now account for about two-thirds of total activity in the Ethereum ecosystem (Exhibit 3).

Exhibit 3: Significant growth in Ethereum Layer 2 activity 

At the same time, the shift in activity to Layer 2 networks has also affected Ether’s tokenomics, at least over the short term. Smart Contract Platform blockchains accrue value primarily through transaction fees, which are typically paid to validators or used to reduce token supply. In Ethereum’s case, base transaction fees are burned (destroyed and removed from circulation) while prioritization fees (“tips”) are paid to validators. When Ethereum’s transaction revenue is relatively high, the number of tokens burned often exceeds the rate of new issuance, and total ETH supply tends to decline. However, as network activity has transitioned to Layer 2s, fee revenue on the Ethereum mainnet has declined, and ETH supply has started increasing again (Exhibit 4). The Layer 2 networks also pay fees to post their data to the Layer 1 (so-called “blob fees”, as well as other transaction fees), but the amounts tend to be relatively low.

Exhibit 4: ETH supply recently increasing due to low mainnet fees

For the Ether token to increase in value over time, the Ethereum mainnet will very likely need to see an increase in fee revenue.^[5] This could occur either through i) modest growth in Layer 1 activity, paying higher transaction costs, or ii) significant growth in Layer 2 activity, paying lower transaction costs. Grayscale Research expects that it will be a combination of rising Layer 1 and Layer 2 activity and fee revenue.

It's our belief that growth in Layer 1 activity is most likely to come from low frequency and high value transactions, and anything that requires a high degree of decentralization (at least until Layer 2 networks are sufficiently decentralized). This may include many types of tokenization projects, where the transaction costs may be relatively low compared to the dollar value transacted. Currently, about 70% of tokenized U.S. Treasuries are on the Ethereum blockchain (Exhibit 5). Relatively high value non-fungible tokens (NFTs) are also likely to remain on the Ethereum mainnet, in our view, because they benefit from its high security and decentralization, and change hands relatively infrequently (we expect continued growth in Bitcoin NFTs for similar reasons).

Exhibit 5: Ethereum hosts majority of tokenized Treasuries

In contrast, relatively high frequency and/or low value transactions would more naturally take place on Ethereum’s various Layer 2 networks. A good example would be social media applications, where we have seen a variety of recent success stories hosted on Ethereum Layer 2s, including friend.tech (Base), Farcaster (OP Mainnet), and Fantasy Top (Blast). Both gaming and retail payments also likely require very low transaction costs and are more likely to migrate to Layer 2 networks, in our view. Importantly, however, these applications will need to attract a very large number of users in order to meaningfully increase fee revenue for the Ethereum mainnet, given low transaction costs.

Potential U.S. Spot Ethereum ETF Implications

Over the longer run, the Ether token’s market capitalization should reflect its fee revenue and possibly other fundamentals. But in the shorter run, the token’s market price can be influenced by shifts in supply and demand. While we have seen progress toward full regulatory approval of U.S. spot Ethereum ETFs, issuers still require their registration statements to be reviewed by the SEC’s Division of Corporation Finance and be declared effective. A full approval and the initiation of trading of these products could result in new demand, as the asset becomes available to a wider range of investors. Given simple supply-demand dynamics, Grayscale Research would expect an increase of access to Ether and the Ethereum protocol through the ETF wrapper, which would help drive demand and thereby increase the token’s price.

Outside the United States, where both Bitcoin and Ethereum exchange trade products (ETPs) are already available, assets in Ethereum ETPs amount to about 25%-30% of assets in Bitcoin ETPs (Exhibit 6). On this basis, Grayscale Research’s working assumption is that net inflows into U.S.-listed spot Ethereum ETFs will be 25%-30% of those observed for the spot Bitcoin ETFs to date, or about $3.5-$4.0bn over the first four months or so (25%-30% of the $13.7bn net inflows into spot Bitcoin ETFs since January).^[6] 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 ETFs. In the US market, ETH futures-based ETFs have only about 5% of the assets of BTC futures-based ETFs, although we do not think this is representative of the likely relative demand of spot ETH ETFs.^[7]

Exhibit 6: Outside the U.S., Ethereum ETP AUM totals 25%-30% of Bitcoin ETP AUM

In terms of ETH supply, Grayscale Research believes that around 17% can be categorized as idle or relatively illiquid. 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. Recently, issuers of spot Ethereum ETF applications, including Grayscale, have removed mention of staking from public filings, signaling that the SEC may allow these products to trade in the United States without staking. Therefore, this portion of supply will not likely be available for purchase by the ETFs.

In addition to these categories, the ETH used as gas for network transactions is $2.8bn on an annual basis. This represents an additional 0.6% of supply at current ETH prices.^[8] There are also a number of protocols that hold a substantial portion of ETH on their treasuries, including the Ethereum foundation ($1.2bn worth of ETH), Mantle (~$879mm in ETH), and Golem ($995mm in ETH). In total, ETH in protocol treasuries accounts for about 0.7% of supply.^[9] Finally, about 4m ETH, or 3% of the total supply, is already held in ETH ETPs.^[10]

Altogether, these groups account for nearly 50% of ETH supply, although the categories are partly overlapping (e.g., ETH in protocol treasuries may be staked) (Exhibit 7). For any potential new U.S.-listed spot Ethereum ETFs, we believe that net purchases of ETH are more likely to be drawn from the remaining circulating supply. To the extent that existing uses limit the available supply available to the new spot ETF products, any incremental increase in demand could have a larger impact on price.

Exhibit 7: Significant portion of ETH supply inaccessible to new spot ETFs 

From a valuation standpoint, Ethereum is arguably more richly valued than Bitcoin was at the time of the spot Bitcoin ETF launch in January. For example, one popular valuation indicator is the MVRV z-score. This indicator is based on the total market value of a token relative to its “realized value”: the market capitalization based on the price that tokens last moved on-chain (rather than their price as traded on an exchange). In January when the spot Bitcoin ETFs launched, its MVRV z-score was relatively low, indicating moderate valuations, and potentially more room for price gains. Since that time, crypto markets have appreciated, and the MVRV ratios for both Bitcoin and Ethereum have increased (Exhibit 8). This may suggest less room for price appreciation on the back of spot ETH ETF approval compared to U.S. spot Bitcoin ETF approval in January.

Exhibit 8: ETH more highly valued than BTC at time of spot Bitcoin ETF launch

Lastly, crypto native investors are likely to focus on the implications of spot Ethereum ETFs for competition within the Smart Contract Platforms Crypto Sector, and specifically on the SOL/ETH price ratio. Solana is the second largest asset in this market segment (by market cap), and Grayscale Research believes that it currently has the best chance to take market share from market leader Ethereum in the longer term. Solana has significantly outperformed Ethereum over the last year, and the SOL/ETH price ratio is now close to the peak of the last crypto bull market (Exhibit 9).^[11] Part of the reason may be the fact that the network’s community of users and developers continued growing the ecosystem despite some involvement (in terms of token ownership and development activity) from failed crypto exchange FTX. More importantly, Solana has also been able to drive increased transaction activity and fee revenue through a compelling user experience. Over the short term, our expectation would be that the SOL/ETH price ratio levels off, as inflows from the new spot Ethereum ETFs support ETH’s price. However, over the longer term, the SOL/ETH price ratio will likely be determined by the relative growth in fee revenue between the two chains.

Exhibit 9: SOL/ETH price ratio close to highs of last cycle

Looking Ahead

Although the launch of spot ETH ETFs in the U.S. market may have immediate effects on valuations, the importance of regulatory approval extends well beyond price. Ethereum offers an alternative framework for digital commerce based on decentralized networks. The modern online experience works reasonably well, but public blockchains may offer even more possibilities, including near-instant cross-border payments, true digital ownership, and interoperable applications. Although there are other smart contract platforms offering this utility today, the Ethereum ecosystem has the largest number of users, the most decentralized applications, and the deepest pools of capital.^[12] Grayscale Research expects that the new spot ETFs could introduce this transformative technology to a much broader range of investors and other observers—and help accelerate public blockchain adoption.

^[1] Source: Artemis, Dapp Radar. Data as of May 27, 2024.

^[2] This metaphor comes from computer scientist Nick Szabo’s 1997 memo “The Idea of Smart Contracts”.

^[3] Source: Artemis. Data as of May 27, 2024.

^[4] For example, from 12/31/2022 through 5/23/2024, Bitcoin and Ethereum price returns and returns divided by annualized volatility exceeded those for global equity markets (represented by the MSCI All Country World Index), global bond markets (represented by the Bloomberg-Barclays Global Aggregate Index), and commodity markets (represented by the S&P/GSCI). Source: Bloomberg, Grayscale Investments. Data as of May 23, 2024. Past performance is not indicative of future results.

^[5] While Grayscale Research believes that fee revenue is a primary driver of smart contract platform valuation, other factors may include maximum extractable value (MEV), possibly a “money premium” (a willingness to hold the asset for store of value and/or medium of exchange purposes), as well as other factors.

^[6] Source: Bloomberg, Grayscale Investments. Data as of May 24, 2024.

^[7] Source: Bloomberg, Grayscale Investments. Data as of May 28, 2024.

^[8] Source: Artemis, Grayscale Investments. Data as of May 24, 2024.

^[9] Source: DeFi Llama.

^[10] Source: Bloomberg, Grayscale Investments. Data as of May 24, 2024.

^[11] On a market cap basis, Solana has increased even more, due to its comparatively high supply growth.

^[12] Source: Artemis, Dapp Radar, Defi Llama. Data as of May 27, 2024.