My Ethereum investment thesis
Why I'm accumulating ether NOW
Ethereum has a good chance of being the engine of the future multi-trillion dollar digital economy.
That's *not* why I'm betting on it right now.
My reasons for investing are less aspirational and more... practical.
- There will be a significantly lower supply of circulating ETH over the next 10 - 12 months.
- At the same time, I anticipate a surge in insitutional demand that, coupled with the reduced supply, will propel the price of ETH past its May 2021 high of $4,400.
Here's how the dots are connected.
Ether supply, demand, and price
Like any other asset, the price of ether depends on demand and supply. Everything else being equal, lower supply/higher demand results in a higher price.
So to set the context for my investment thesis, let's first take a look at the supply of ETH currently being held in crypto exchanges¹:
Very clearly, we see the amount of ether held at exchanges falling steadily over the past 10 months.
What this tells us is that there's a trend of increasingly fewer ETH holders looking to sell; They're moving their ETH out of the exchanges into their personally-held wallets.
This is a small, but not non-trivial factor that decreases the overall ETH supply available for sale.
Increasingly fewer ETH holders are looking to sell, and are moving their ETH out of exchanges.
Next, let's consider Ethereum Improvement Proposal 1559 (EIP 1559).
EIP 1559 is a set of upgrades² to the Ethereum blockchain coming into effect in July 2021.
Specifically, there's going to be a change to the way transaction fees are handled.
Prior to EIP 1559, all transaction fees are given to the blockchain validators.
This is a big deal.
After July 2021, every transaction on Ethereum will result in some ETH being permanently destroyed; It's an automatic mechanism that counteracts the creation of new ETH.
ETH supply growth will thus be considerably reduced, and in some situations even go negative.
Remember: the lower the supply, more likely prices goes up.
After July 2021, every Ethereum transaction destroys some ETH.
Yield Farming in DeFi
Yield farming⁵ is a relatively new development in the crypto industy where cryptocurrency is lent out for interest.
When an ETH holder - for example - lends out his ETH, it's a signal he's not looking to sell it any time soon. That ETH is essentially "locked up" for the duration that he intends to keep lending.
At the time of this writing, approximately 8.6 million ETH⁶ - and growing - is being "locked in DeFi" for this purpose.
Next, let's consider ETH staking⁷. This is something similar to yield farming, where ETH is "locked up" to generate more ETH (yield).
I'll talk more about ETH staking in the next section. For now, just note that approximately 5.6 million ETH⁸ is currently being staked, or "locked up".
With the total supply of ETH currently at 116.4 million⁹, this means that a minimum of 12% of all ETH is "locked up" with no intention of being sold.
The number ETH locked in DeFi is trending up, and the percentage of "locked up" supply is also expected to go up when the Proof of Stake mechanism kicks in. I'll talk more about this in the next section.
A minimum 12% of total ETH supply (and growing) is "locked up" with no intention of being sold.
Shift to Proof of Stake (PoS)
Ethereum is currently running on a Proof of Work (PoW) mechanism and will switch over to PoS in early 2022.
This change will have BIG impact on the circulating supply of ETH.
To explain how, let's first note the amount of new ETH being created each day:
Currently, there's approximately 13,000 ETH being produced each day¹⁰ under PoW.
Next, let's estimate the amount of ETH that will be produced each day under PoS.
Although PoS has not yet gone 'Live', there are already Ethereum enthusiasts who have staked their ether (for zero return) to facilitate the transition from PoW to PoS.
Here's what we know so far:
- Under the current PoW system, an average of 5,000 ETH is currently being charged in daily transaction fees¹². After EIP 1559 (at an average 45% fee burn), about 2,250 ETH would be burned daily.
- There are 5.6 million ETH currently being staked by Ethereum enthusiasts for an estimated yield of 6.6%¹¹, which would create about 1,000 new ETH per day. This is the amount of ETH that would be created today under PoS.
- Putting the two points together, when Ethereum switches over to PoS there would be a net decrease of new ETH supply to the tune of -1,250 ETH per day.
Take a moment to think about what this means.
Right now under PoW, approximately 13,000 ETH is created daily with the majority of it being sold by Ethereum validators to cover their heavy computing costs.
Come early 2022 when Ethereum switches over to PoS, the daily new supply will drop to near zero, and perhaps even go negative! The amount of new ETH created daily goes from 13,000 to approximately 0 or less.
To put it simply,
- Under Pow: The supply of ether increases 4% annually.
- Under PoS: The supply of ether stops increasing, and sometimes even decreases.
Let's assume that PoS has now kicked in, and no significant amount of new ETH will be produced.
The supply dynamics of ether would then be similar to that of bitcoin, which has a supply cap (of, if you recall, 21 million).
In this case, there will be approximately (116M/21M) 5.5x more ether than bitcoin.
Now look at the difference in price: bitcoin is currently priced at $35.4k and ether at $2.2k. Bitcoin is priced 16x more than ether, although there is only 5.5x more ether!
This is, of course, a simplistic comparison. After all, the two cryptocurrencies are not the same thing, and 5 ETH does not necessarily equate to 1 BTC.
However, this thought experiment gives us a sense of the extent at which ether is underpriced right now compared to when PoS kicks in.
On top of all this, don't forget:
- Unlike PoW that requires no ETH to be staked, PoS requires a percentage of ETH to be "locked up", reducing the supply available for sale.
- PoW validators are under pressure to sell their earned ETH to cover high operational costs, while PoS validators are under less pressure to sell because their operating cost is much lower.
The net effect of these forces is a signifciantly lower sell pressure as we move towards early 2022 and beyond.
When PoS goes into effect in early 2022, the sell pressure of ETH will be significantly diminished.
With a significant reduction of circulating supply, as long as demand does not drop too drastically, the price of ETH should move substantially higher.
So far, we have only considered the supply side of the equation. Now, I'd like to bring your attention to the demand side.
What I'll cover here is applicable to both bitcoin and ether since institutional demand relates to the crypto industry as a whole.
The blunt truth: In order for the price of BTC and ETH to break above their May 2021 highs, the crypto industry needs the support of institutional funds. The reality is that retail capital is much smaller (billions) than institutional capital (trillions).
So until the big guns come in, bitcoin is likely to stay below $60k and ether below $4k.
Until recently, most people saw crypto as a fringe market with no real utility... but this perception is changing and institutional interest has picked up noticeably over the past 6 months.
Some milestones we saw this year:
- Feb 2021: Tesla puts bitcoin on its balance sheet.
- Feb 2021: MicroStrategy invests $1 billion in bitcoin (for a total of $2 billion).
- Mar 2021: Ethereum is being considered as company treasury asset.
- Apr 2021: One of the largest crypto exchanges Coinbase becomes a publicly traded company.
- Apr 2021: Canada approves Ethereum ETFs, the first country to do so.
- Jun 2021: Goldman Sachs recognizes cryptocurrency as an asset class.
- Jun 2021: World Economic Forum publishes official review of DeFi.
- Jun 2021: El Salvador is the first country to make bitcoin legal tender, with Paraguay looking to follow suit.
- Jun 2021: MicroStrategy invests another $489 million in bitcoin.
To complete the point, here's a list of companies that have put bitcoin on their balance sheet.
Slowly but surely, countries, banks and corporations are warming up to the idea of investing in cryptocurrencies. The legitimacy of Bitcoin and Ethereum is no longer in question; It's not a matter of if, but when they go mainstream.
My guess is that institutional adoption will start picking up in 2022 after Ethereum's PoS mechanism goes 'Live'.
Ether becomes a yield-bearing asset
Stocks are commonly found in institutional portfolios because companies can be easily valued according to their earnings via the discounted cash flow (DCF) model¹³.
Cryptocurrencies, on the other hand, are difficult to value because they don't inherently produce any "revenue". This is a big reason why many financial institutions have hesitated to invest in cryptocurrency assets thus far.
Come early 2022 however, this dynamic is likely to change; When Ethereum switches over to PoS, investors can stake their ether and receive an estimated yield between 4.9% - 21.6%¹¹.
This is when ether becomes a revenue-generating asset like a bond or dividend stock, and this is when I believe institutions will start including ether in their portfolios, pushing demand up.
When ETH becomes a yield-bearing asset in early 2022, insitutional demand is likely to go up.
The Ethereum narrative
The public crypto spotlight is focused on Bitcoin, and there is virtually no mainstream media coverage on Ethereum.
Even among the few that have heard of Ethereum, it is merely seen as a "lesser Bitcoin".
This grave misunderstanding is another reason why I believe ether is largely underpriced; Bitcoin and Ethereum are two different animals, but the common perception is that they are similar.
Once the mass public realizes that Ethereum
- Can run smart contracts
- Powers the DeFi and NFT industries
- Is going to eat into the market share of multiple existing industries
- Has a bigger developer ecosystem than Bitcoin¹⁴
- Produces a yield
...public perception of Ethereum will change.
While the Bitcoin narrative is centered around it being a store of value, the Etheruem narrative will center around it being the engine of the next-generation economy AND a yield-bearing asset.
Once this becomes apparent to the public, demand for ether will skyrocket.
- Increasingly fewer ETH holders are looking to sell, as they move their ETH out of exchanges.
- After July 2021, every Ethereum transaction destroys some ETH.
- A minimum 12% of total ETH supply (and growing) is "locked up" with no intention of being sold.
- When PoS goes into effect in early 2022, the sell pressure of ETH will be significantly diminished.
- When ETH becomes a yield-bearing asset in early 2022, insitutional demand is likely to go up.
Bottom line: Circulating supply is going to be materially diminished, and demand is expected to materially rise. The result is a significantly higher price of ETH.
Unlike bitcoin (which is viewed as an alternative to gold or bonds), there is no other asset that can be closely compared with ETH. It’s a new asset class with distinctively unique characteristics.
It is therefore much more difficult to estimate its potential market cap and future price.
Regardless, I'll throw my hat in the ring and come up with an estimate.
In my view, ether is most similar to stocks and bonds, so I'll use those markets as a point of reference.
So the total market cap of these assets is $226.9 trillion.
As of today (Jun 2021), Ethereum has a market cap of $234.3 billion, at $2013 per ether.
If ether takes up just 5% of the market cap of stocks and bonds, it will have a market cap of $11.3 trillion at a price of (11.3tn/116.4m) $97,097 per ETH.
In the shorter term, if ether takes up just 0.5% of the market cap of stocks and bonds, its indicative price would be $9,746.
At current price of $2,000, that's a 5x return in the short term, and a 48x return in the long term.
Ryan Allis of Coinstack¹⁷ has - with more sophisticated valuation models - come up with similar estimates:
For the immediate term, Ryan has also used the DCF model to arrive at an ETH present value of $13,396¹⁸.
Elsewhere, Nikhil Shamapant published a 79-page writeup¹⁹ of why he thinks the price of ether is going to hit $150k within the next 2 years, before settling down to a more sustainable price of $30k - $50k.
Short term estimate (next 2-3 years)
Ryan Allis: $13k
Nikhil Shamapant: $150k
Long term estimate (by 2030)
Ryan Allis: $150k
Nikhil Shamapant: $30k - $50k
Nobody knows the future, of course; There are no guarantees.
But considering that even a conservative target of $10k means a 5x return from the current price of $2k, this is the clearest no-brainer investment I've ever seen.
The secret reason I'm investing early
There's one aspect of investing in Ethereum that has been largely overlooked.
It's something I don't see anyone talking about.
Once you understand this point, you'll see why I'm so aggressively bullish on Ethereum.
Ok, so here's the thing.
When Ethereum switches over to PoS and ether holders can stake their ether for a yield... notice that the yield is denominated in ETH, *not* dollars.
What's does this mean?
Let me quickly explain with an example.
Traditional stock investment: Buy $20,000 worth of stocks at $200 per stock. Average dividend is $12 per stock (6% at the current price).
- Number of stocks held = 100
- Total dividend per year ($12 x 100) = $1,200
- Total dividend per year after stock price rises 10 times = $1,200 (no change)
Ether investment: Buy $20,000 worth of ether at $2,000 per ether. Staking yield is 6% (for simplicity let's assume the yield doesn't change).
- Number of ether held = 10
- Total yield payout per year (10 ETH x 6%) = 0.6 ETH (worth 0.6 ETH x $2,000 = $1,200)
- Total yield payout per year after ether price rises 10 times = 0.6 ETH (worth 0.6 x $20,000 = $12,000)
For easy comparison:
Initial $ investment
Payout per unit (at 6%)
$12 per stock
0.06 per ETH
Total yield payout per year
Total yield payout per year
Bottom line: Since the staking yield on ether is denominated in ether, if the price of ether goes up, the dollar value of the yield goes up too.
In other words, if the dollar value of ether goes up 10x, the 6% yield goes up 10x as well, to 60%.
And if the dollar value of ether goes up 20x, the yield goes up 20x, to 120%! Then, every $1 invested pays you $1.20 per year.
Is it worth investing $1 for a decent chance receiving $0.60 - $1.20 or more per year, on top of a 10x - 20x capital gain?
There is no other investment that I know of with a better risk-reward than this.
This is why I'm betting BIG on Ethereum right now.
The key is to get in early when the price of ether is relatively low.
All this being said, Ethereum is not a sure-win bet and here are some of the risks that can threaten my investment thesis:
- The EIP 1559 fee burning mechanism fails to be implemented by end 2021
- The PoS (staking) mechanism fails to be implemented by mid 2022
- Transaction fees are too high to encourage mass adoption
- Scaling issues and low transaction speeds hinder mass adoption
- Ethereum's monetary policy²⁰ changes to a more inflationary stance
- Ethereum is banned in the U.S. or Europe
- The planned Ethereum ETFs in the U.S.²¹ are cancelled
- The price of bitcoin tanks and drags down the price of all cryptocurrencies, including Ethereum
- The U.S. stock market tanks and drags down all other risk assets - including Ethereum - with it
It's unlikely for these events to occur, but they cannot be ruled out entirely.
If they do occur, I'll reaccess my thesis and update everyone on my mailing list.
How much do I stand to lose if I'm wrong?
Firstly, my view is that Ethereum is here to stay and will not go to zero.
The question then is, how much lower can its price go from here (at $2k), after already having corrected -54% from its most recent high?
Let's say I'm prepared to see prices fall another -50% from here, down to $1k (below the previous 2018 peak of $1.4k).
If I start buying into the current dip and prices fall to $1k, I stand to lose up to 50% of my investment.
So here's the question: Given everything I know about Ethereum and its potential, is it worth risking a -50% investment drawdown for a decent chance of making a 500% return in the short run, and a 4,800% return in the long run?
My answer is a resounding 'YES'.
This is a no-brainer bet I'd be happy to take, any day, any time.
Since its inception in 2014, Ethereum has demonstrated remarkable resilience.
Over the years, it overcame numerous challenges such as the DAO hack²² and denial of service attacks²³ in 2016, and took just 6 years to reach a market cap of $500 billion²⁴ compared to 11 years for Bitcoin.
Importantly, it has multiples more developers in its ecosystem than any other blockchain¹⁴.
It's increasingly likely that Ethereum will be THE blockchain that powers the next-generation digital economy.
The question is, when is the best time to start investing?
In my view, the best time is now (mid 2021), because:
- EIP 1559 (Jul 2021) and PoS (early 2022) will materially reduce the circulating supply of ETH
- Institutional interest for crypto is picking up
- Prices have corrected >50% from its all-time high
The risk-reward profile of the opportunity has never been better.
I won't be betting the farm (that would be reckless) but I admit I'm allocating a sizable portion of my net worth. If Ethereum lives up to even half of what I think it's going to become, the price of ETH is likely to be multiple times what it is today.
Lastly, I'd like to add that I'm not an Ethereum fanatic.
I believe it has a bright future and I'm excited to see all the unexpected ways it will change the world, but my investment interest in it comes from a largely practical perspective.
If the premises of my thesis are no longer valid, I will reconsider my investment. If you'd like to be updated on this front, join my mailing list if you haven't already.
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