Ethereum’s Vicious Cycle
Once the epicenter of a booming cryptocurrency market, Ethereum has faced crippling price blows in recent months. The coin’s sudden and perpetual decline is being framed by some as an existential crisis, which has transformed a once virtuous cycle of appreciation into a vicious downturn. As it turns out, an evaluation of Ethereum’s value-utility matrix could yield some important insight on the future of the developer’s cryptocurrency.
The ICO melt-up of 2017 made Ethereum the de facto reserve currency of token offerings. Since May 2017, investors have been keen on acquiring and holding ether to participate in the hundreds of initial coin offerings being launched on the Ethereum network They were duly rewarded for their efforts as 80% or more of token offerings were launched on the ERC protocol. This helped catapult ether’s price above $1,400 earlier this year.
The influx of ICOs and investors’ appetite to participate in them boosted Ethereum’s reservation demand, which measures how long users hold a currency. Reservation demand is also the main catalyst for how a currency is priced.
Most metrics available on ICOs show a sizable and growing market but the pace of expansion has slowed significantly in recent months. According to ICOData.io, startups raised just $337 million via coin offerings last month, the lowest in over a year. Through the first 17 days of September, token sales have amounted to a meager $21 million. To get a sense of just how fast the market has fallen, consider that token offerings raised more than $1.6 billion in December alone and roughly $5.5 billion over a four-month stretch.
There’s also strong evidence that ICOs are cashing out their ETH holdings for fiat currency as companies begin funding their operations. As Hacked reported last week, ICOs recently sold 157,700 ETH over a seven-day period, the largest fire-scale since March.
While ether’s collapse cannot be divorced from the broader market downturn, it appears that the loss of reservation demand is partly to blame.
The decline in reservation demand raises deep concerns over ether’s long-term value proposition. That’s because some observers aren’t convinced that the network’s “gas” impetus can provide a steady avenue for growth. As Jeremy Rubin recently argued, Ethereum will eventually fall to zero through economic abstraction – a phrase that describes network fees paid in assets other than ether. Rubin also argues that this fix isn’t as easy as requiring smart contract payments through ether. Requiring every token transaction to also depend on ETH for fees creates third-party dependency and downward pressure on the price. If a user had to sell their token for ETH every time they wanted to transact in that token, then the selling would occur before the transaction needs it.
But solving the gas problem, as Vitalik Buterin is purporting to do, seems to run contrary to the idea that Ethereum should benefit from reservation demand. Software engineer Vijay Boyapati recently argued this point in a series of 12 tweets. Some highlights:
“The investment case for Ethereum is that it will become the most liquid token in a digital economy built atop of a Turing-complete decentralized computer that can execute smart contracts. But how do these contracts affect reservation demand?
“For the most part smart contracts have no [e]ffect whatsoever on reservation demand, just as transactional use on Bitcoin plays little-to-no role in reservation demand for it. The primary source of reservation demand is the removal of currency from the order book of exchanges.
“There is, however, one particular kind of smart contract that has increased reservation demand for ETH: contracts used for ICOs. These contracts lock up supply as ETH is held in reserve by companies raising capital to fund operations.”
Value and Price
Despite these concerns, a future where ether’s utility value correlates with its price isn’t difficult to imagine. According to Michael J. Casey of the MIT Media Labs Digital Currency Initiative, the top blockchains will always retain a level of reservation demand even as their utility improves. In the case of Ethereum, reservation demand will likely increase once it transitions to proof-of-stake consensus in the near future.
What many experts seem to agree on is that the ICO market must evolve from the current cash-grab model to something more beneficial for the blockchain space as a whole. After all, the latest cash-out of ether suggests that very few startups plan on utilizing the protocol’s smart contracts anytime soon.
The author recent argued that ICOs may be approaching a mass extinction event in the not-too-distant future. This view isn’t unique: at the height of ICO mania, Vitalik Buterin said the vast majority of token offerings will fail, ushering a new era of higher quality ICOs (“tokens 2.0”). Whether the ICO market is “dying” or “evolving” is a matter of semantics. A more accurate description is that it is being purged of scams and overt speculation as investors become more in tune with proper valuation metrics.
Disclaimer: The author owns bitcoin, Ethereum and other cryptocurrencies. He holds investment positions in the coins, but does not engage in short-term or day-trading.
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