b56b12b6-41b9-42e9-87d9-01624c5c7f3f_Ethereum+Network+Premium+Analysis.pdf
Ethereum Network: Premium Analysis
We began covering cryptocurrency and the blockchain after a month of launching our premium site because we felt it was an important component to any tech portfolio. The debate around crypto/blockchain is distracting investors from the opportunity that the blockchain will deliver.
Below is a full-length analysis on Ethereum as the Ethereum Network is going through extensive iteration that will propel the platform to become the backbone for crypto payments and decentralized apps. If you like my Nvidia thesis on the CUDA platform for AI development or if you understand the Apple thesis over the past ten years which centers around developers supporting the iOS ecosystem (rather than only the iPhone) – then you should like Ethereum.
The blockchain is coming … and debates over Bitcoin can’t stop the blockchain from maturing. If you don’t like Bitcoin, then that’s okay. But it shouldn’t deter you from considering blockchain investments. Ethereum is another choice and Chainlink is one I’ve been particularly keen on. In fact, Chainlink was my choice for the inaugural LTBH one-hour webinar because I think there could be notable upside and I don’t want my subscribers to overlook the technology because it trades as a crypto.
In my opinion, Ethereum also has notable upside and we want the I/O Fund to have some allocation here. As many of you know, we lean heavily on Knox for entering, exiting, or trimming crypto as it’s especially volatile. We will not necessarily enter right away — and also be prepared for Knox to require more than one entry if the crypto market turns. However, it’s well worth the effort as its early days for the blockchain.
You could see us trim Bitcoin and add to Ethereum in an attempt to participate in the blockchain trend while having proper allocation as Bitcoin had neared 10% of our portfolio and it’s now at 7% through trimming. Ethereum also helps diversify us for decentralized applications and other tokens. Or, we could add more to LINKUSD.
You can read our previous analysis on Bitcoin here and on Chainlink here.
The analysis below describes what Ethereum is setting out to achieve and why some of the best blockchain investments are not likely to come from a traditional stock (they’ll come from crypto). In other words, if you want to participate in the early blockchain trend, then you’ll have to get comfortable with crypto.
History of Ethereum
In October of 2008, the markets came to the realization that the Lehman Brother’s bankruptcy was likely not an isolated incident. While the world was scrambling to discern the severity and extent of financial crisis, the stock market hit a new low that resembled a genuine panic. At the same time, a mysterious person or group of people, under the pseudonym of Satoshi Nakamoto quietly published a white paper. This report described a new monetary system that would rely on a decentralized network of computers to verify all peer-to-peer value exchanges through a digital token called bitcoin.
Largely unnoticed at the time, while the centralized banking system was in a full melt down, Bitcoin was suggesting a new monetary system that could make the centralized banking system largely obsolete. It wasn’t until January of 2009 that Bitcoin was released with an initial market price of $0.08/bitcoin. Still, it took just over 10 years, and over 15,800,000% appreciation before Bitcoin’s stated thesis gained public acceptance from institutional buyers.
Next to Bitcoin’s dominance, the undisputed runner-up is Ethereum, which is the second most valuable coin in terms of market cap, as well as public mindshare. Without a full understanding of why this is, most people would assume that Ethereum must have been launched soon after Bitcoin. This is not the case.
The second cryptocurrency to launch in April of 2011 is known as Namecoin. Nearly identical to bitcoin, including the same number of coins in existence, it’s stated goal was to improve anonymity for miners. Roughly six months later, Litecoin was launched and was able to take on the moniker of being known as silver to bitcoin’s gold. It also was similar to bitcoin, but offered double the number of coins, and allowed for quick mining transactions.
Most altcoins track a similar path – using the same, if not closely identical mathematics in an attempt to provide slight variation of bitcoin and compete as the dominant cryptocurrency of choice. We saw hundreds of these alt coins hit the markets prior to Ethereum’s launch in 2015, including Ripple, Monero, and Dash. Unlike the previous altcoins, what Ethereum offers is a network and platform for developers to expand the use of blockchain rather than to compete with Bitcoin as a cryptocurrency.
Ethereum Network 2.0
The primary difference between Ethereum and Bitcoin is that Ethereum is not trying to compete as a currency. The focus of Ethereum is on its network, not the coin. Butkin’s vision is to create an open network for decentralized applications (dapps[1]) and smart contracts based on the Turing complete programming language Solidity.
The main issue that Ethereum has had to overcome is the constraints in transactions per second (TPS) and how to overcome the high energy costs of mining that comes with decentralized security. The network simply couldn’t scale without the recent release of Ethereum 2.0.
To understand this further, we need to break down Proof of Work (PoW) and Proof of Stake (PoS). The previous method for decentralization was run through PoW, which is an algorithm that requires a miner and large amounts of computational power to create blocks and to confirm transactions. Due to the high costs in terms of both speed and energy, the Ethereum Network struggled to scale. Last November, Ethereum 2.0 was released and introduced PoS. Instead of a large consumption of energy, PoS requires a financial commitment of 32 ETH to become a validator. The network required 524.224 ETH or 16.384 validators by December 1st in order to start the new phase of Ethereum 2.0. As of mid-December, more than 1.1 million ETH had been staked from 33,000 validators. The most recent number is 1.6 million ETH.
The Ethereum that is staked in the new protocol receives interest with early yields up to 20%. The more Ethereum that is staked, the lower the interest. Interestingly, Ethereum has not built the algorithm that will allow you to unstake them, so this is a long-term bet on Ethereum for anyone that is staking their coins.
Shards are another critical improvement for network bandwidth and the low transactions per second (TPS) as Ethereum 2.0 (ETH2) allows for improved data processing. Nodes in the previous network must download a transaction, calculate it, archive it and read every transaction in Ethereum’s history, which is terribly inefficient. Shards create a subset of the network where nodes are dispersed for more efficient processing. The Beacon Chain ensures the nodes are synchronized and the validators are reporting the blocks of transactions.
The original Ethereum network will run in parallel with ETH2.
Phase 0 of Eth2 went live on December 1st and there are a total of four phases. Phase 0 included the launch of Proof of Stake Beacon Chain.
The most recent road map released by Ethereum does not show the subsequent phases. The shaded green shows the current progress in the link provided. Missing deadlines is an issue with Ethereum so perhaps the removal of these phases is to make it easier on the team/network.
The term Rollups refers to ZK Rollups, which allows for hundreds of transfers to be rolled into a single transaction. This will replace Plasma, the current option where only a single transfer is made per transaction. In this case, the smart contract will verify all of the transfers in the Rollups. The goal is to reduce computing and storage resources by reducing the amount of data held in a transaction.
In the ZK-Rollup scheme, a transactor and relayer are needed. The transactors create a transfer and broadcast it to the network. In this case, a shortened 3 or 4 byte indexed version of the address helps to reduce resource needs. The relayers collect hundreds of transfers and roll them up, essentially, to generate a hash that compares a snapshot of the blockchain before the transfers and a snapshot of the blockchain after the transfers. In most cases, the transfers will be recorded by a change in the wallet values. The hash that represents the wallet values or the delta to the blockchain is called SNARK proof. The changes to the hash are reported to the blockchain.
Relayers are established by staking a required bond, or token amount, in the smart contract. The result will be fewer transaction fees that are processed faster than the previous Plasma framework. In the ZK-Rollup framework, blocks are computed in a parallel computing model that lends itself to decentralization. There will be less data than the previous framework which increases throughput and scalability.
Zero-knowledge proof techniques use mathematical equations for authentication without requiring passwords or sensitive information. The words “Zero-knowledge” means that the verifier can prove the first party can be trusted without revealing sensitive information. This is done through probabilistic assessments where the validity has a high probability.
Zero-knowledge is essential to cryptocurrencies because a crypto transaction can be verified without revealing information about where the payment came from, where it was sent or how much currency was exchanged. Bitcoin does not use zero-knowledge as all of this information is revealed and recorded.
The Ethereum network has more security risks than the Bitcoin protocol. The initial setup of ZK-Rollups assumes a trusted state and relies on a small group of developers to establish this initial trusted state and one of the developers could manipulate the code. The initial setup is not a decentralized.
Quantum computing could crack ZK-Rollups if the correct hash is guessed by the computer. This is more likely than guessing an encrypted protocol.
Ethereum is becoming the blockchain of choice through the Enterprise Ethereum Alliance, which is a list of over 200 companies, including AMD, Banco Santander SA, FedEx, Intel, JP Morgan, Microsoft, and VMWare. These companies have agreed to build smart contracts on the Ethereum blockchain, further increasing the value of Ethereum. We think the number of endorsements as Ethereum 2.0 is built out.
Decentralized Finance (DeFi)
DeFi, or decentralized finance, began in a telegram chat between Ethereum developers in August of 2018. The term refers to the open ecosystem of financial applications built on the Ethereum blockchain. Peer-to-peer (P2P) is used interchangeably as the network is verified by peer computing systems rather than one centralized source.
The basic tenants of DeFi applications are:
1) No Custodian. In other words, there is no bank or custodian in-between transactions. Each individual controls access to their own crypto, transactions and data around their activity.
2) The network is Global. There are no borders, exchange rates, currency differentials, or waiting for global transfers. Everyone on the network, regardless of country, will be able to transact instantly with anyone else in the world with ease.
3) The network is open source. This allows developers to view the code of any and all applications on the Ethereum blockchain and for the ecosystem to evolve.
4) Decentralized network. The Ethereum blockchain is run off of thousands of “nodes.” These nodes are constantly computing the transactions within the blockchain from around the world, making it nearly impossible to hack as well as regulate.
There is $24 billion locked into DeFi projects as of 2020.
Decentralized applications (dapps)
We discussed the difference between centralized and decentralized in the Chainlink webinar and why decentralized results in a more secure protocol or transaction. Ethereum’s network is often called a platform or the “world’s computer” because it allows for decentralized applications. Rather than having backend code on a centralized server, backend code is run on a decentralized network when built for the Ethereum platform. Developers use the Ethereum blockchain for data storage and smart contracts for the app logic.
We also discussed smart contracts on the Chainlink webinar. Ethereum is primarily set up for currency right now while Chainlink addresses off chain data for non-currency smart contracts. However, the principal is the same where there is a set of rules which self-execute like a vending machine. Dapps will rely on smart contracts.
Dapps deployed on the Ethereum network are controlled by logic written into the smart contract and cannot be altered by the developer. Smart contracts function like APIs (we also talked about this in the Chainlink webinar). This allows applications to build on one another similar to the way applications use APIs today; except blockchain applications will build on smart contracts.
The front-end application can be written in any language with calls made to the backend. The main qualities are that the applications are decentralized, can perform any action given the required resources (whereas Bitcoin is not Turing complete) and are executed in a virtual environment such as the Ethereum Virtual Machine. The virtual machine acts as a buffer to where if the application is faulty, it does not affect the blockchain network.
There are a few key benefits to dapps:
• Dapps are more secure and inherently protected from denial-of-service attacks.
• Censorship will be nearly impossible as a single entity will not be able to block users from utilizing the blockchain.
• Fraud and other malice will be prevented as the data has complete integrity from the decentralized and cryptographic qualities of the blockchain.
• Because smart contracts are self-executing, they remove the need for a centralized institution. Realworld identities can also be anonymous with dapps.
There are also some drawbacks to dapps:
• Most developers do not want to relinquish complete control over their creation*.
• If there is a bug that need to be fixed, that developer is unable to take back control of the dapp once it’s launched onto the Blockchain*.
• Dapps will need Ethereum 2.0 to achieve its final phase as applications will create too much network congestion at the 10-15 transactions per second.
• User experience needs to evolve in order for users to interact with the blockchain in a secure fashion.
• Some developers may utilize centralized servers for the frontend or to store business logic which could eliminate many of the decentralized security/anonymity benefits of the blockchain.
There are some applications that are decentralized but not built on the blockchain, like BitTorrent for peer-topeer file sharing. Tor is open-source software that enables anonymous communication and is also decentralized.
Some of the early DeFi applications allowed for seamless swapping of coins for Ethereum and lending of collateralized loans with built in interest payments to the borrowers. Contracts can also be created between crypto and non-crypto assets like gold, silver, stock, currencies, etcetera. People are allowed to deposit what are known as “synths”, or synthetic coins that allows for the contract to be written and then exchanged. This allows individuals to trade assets on Ethereum without the intermediary of exchanges and broker/dealers.
There are even applications known as yield farms that allow investors to deposit their crypto into liquidity pools, which are loaned out, which allows them to receive yields on their crypto.
Conclusion:
The Ethereum Network is becoming the backbone for decentralized finance and decentralized applications. Ethereum 2.0 needs another year minimum or about three years maximum to reduce energy use and increase throughput for transactions per second (TPS). Once this is achieved, Ethereum will be able to process payments faster than Visa, Mastercard or Paypal combined– going from 15 transactions per second to 100,000 transactions per second. For reference, most major credit card companies process about 2,000 TPS with 5,000 TPS as the upper limit.
Cardano and Polkdot are competitors yet Ethereum is receiving global acceptance among developers and major endorsements from companies who are likely to be the first to develop dapps and embrace defi, as well. If Ethereum 2.0 delivers what it promises to, I believe ETH will become the backbone for the blockchain and this will be hard to disrupt.