Given our high allocation to crypto and specifically Ethereum, we want to track any progress (or lack of progress) towards The Merge to Proof of Stake, and also Shards and Rollups. We’ve also recently placed Avalanche into the LTBH category and this analysis looks at why we plan to trim ETH slightly and re-allocate what we trim to Avalanche.

In 2019, we wrote that the catalysts for Bitcoin trading at higher price levels (and holding those levels) would be economic uncertainty, the Lightning Network for mobile payments and institutional adoption. These three things came to fruition and Bitcoin has held higher prices.

The upcoming catalyst for Ethereum to expand its network and host more apps is well-known, which is The Merge to proof-of-stake. We discussed in March of 2021 that proof-of-stake would be necessary to lower gas fees and to help realize Ethereum’s full potential as a network for decentralized apps (d’apps), which would ultimately function like an operating system. The issue is not what Ethereum needs to do to realize it’s vision rather the question is when will Ethereum do it? When will Ethereum complete The Merge?

The delays on The Merge are one reason we are diversified with a Layer 1 in LTBH. It’s likely you see us add more Layer 1s pending technical analysis, such as Solana. We discuss below the additional delays that Ethereum faces on PoS and the upcoming timing issue in June when Proof of Work is scheduled to “freeze” over a period of five months.

Quick note regarding crypto selling off, I had discussed how OpenSea received a 10X valuation right before crypto sold off. You can read the full forum post here:

“The Series C was led by Philippe Laffont of Coatue Management, who has successes on the public markets such as Anaplan, Snap, Spotify and Databricks not yet public [..] Certainly, OpenSea would likely go for a lower valuation today given the Luna bust and all altcoins being down in sympathy. However, rather than stress over a 4-month bad timing decision, private investors will simply hold until market conditions are favorable for their investments and then go for the exit. Private investors assume their timing will not be entirely perfect and instead they make their exits perfect.”

The reason we have been dollar cost averaging into the crypto selloff is that timing a bottom is futile. It’s much easier to time an exit. According to industry analysts, blockchain should scale rapidly between 2025-2030 from $176 billion to $3 trillion. I imagine we will see Coatue and others exit through IPOs around the later part of this time frame, and as early-stage investors in crypto, we will want to consider doing the same. This doesn’t mean we won’t trim, etc., rather it provides a nice timeline for an exit on middleware like Chainlink and also Layer 2s. I’ll touch more on those in an upcoming analysis.

Ethereum Network Delays on PoS

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. Vitalik Buterin’s vision is to create an open network for decentralized applications and smart contracts based on the Turing complete programming language Solidity.

Ethereum faces constraints in transactions per second (TPS) and how to overcome the high energy costs of mining that comes with decentralized security. The network simply can’t scale without the upcoming release of Ethereum 2.0.

In our premium analysis last year on Ethereum here, we discussed the difference between Proof of Work (PoW) and Proof of Stake (PoS). In addition to the Proof of Stake merge that Ethereum must complete, the network must also launch shards. In last year’s analysis, we said: “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.”

We went into great detail on ZK Rollups, as well. The quick summary on ZK Rollups is they allow 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 November, we wrote another update on crypto and Ethereum, stating that the expectation was for Proof of Stake to merge in late 2021 with Shards and Rollups expected by late 2022 or early 2023. The timeline for PoS is delayed yet again until Q3 2022, which puts Sharding and Rollups out another year potentially to Q3 2023.

Update on Proof-of-Stake (PoS) Merge

In August of 2021, Ethereum went through the London Hard Fork. This was a step towards PoS as Ethereum Improvement Proposal (EIP) 1559 changed the management of transaction fees on the network. Previously, the transaction fees would go to the miner directly. The London upgrade introduced a fixed-per-block transaction fee that is burned. This results in more predictable gas fees and also helps the blockchain network prepare to eliminate miners by Q3 of this year.

According to Statista, the average gas fee in August of 2021 was 136 Gwei. In January of 2022, the average gas fee was 122 Gwei. There have been some lower months for gas fees both pre-London upgrade and post-London upgrade, yet ultimately EIP 1559 will not resolve gas fees by any means and The Merge is still (badly) needed.

Gas fees reflect the fact that blocks reach their maximum capacity during peak transaction periods. However, this can actually work to increase the price of Ether in the event that transaction fees are prohibitively high to transfer ETH. The London Hard Fork also helps to create scarcity as ETH is burned with each transaction.

Ethereum’s Difficulty Bomb is Ticking…

The “Difficulty Bomb” refers to a deadline where Proof of Work (PoW) will become more difficult by impacting block times. The Bomb refers to the exponential difficulty that PoW will face, which will cause block times to implode similar to a bomb.

According to Tim Beiko, the block time will increase 487% from 12-14 seconds to 64 seconds about five months after the difficulty bomb is released. This is achieved by making it more difficult for miners to crack the cryptography, and the result is that it becomes too time-consuming to be profitable. This is referred to as the “Ice Age” when PoW will be effectively frozen and miners will be deterred from minting more blocks.

In addition to pushing miners to move away from PoW, the difficulty bomb also removes the ability to create centralized currency on the Ethereum network, prevents a blockchain fork that could occur if miners continue PoW, and also forces node upgrades.

There have been five delays on the Difficulty Bomb with the current deadline extended to June of 2022. For obvious reasons, it’s ideal if the Difficulty Bomb “goes off” after The Merge occurs otherwise the Ethereum network will be frozen without an adequate replacement for the consensus mechanism. As of early May, however, Ethereum developers have decided to ignore extending the Difficulty Bomb in favor of remaining focused on proof-of-stake.

I believe the (current) decision to ignore the Difficulty Bomb reflects the lack of patience that is growing across ETH investors and also Ethereum users (due to high gas fees) on the Proof-of-Stake Merge. This is the first time that the Ethereum Foundation has decided to forego delaying the ticking bomb as they must heavily weigh the pros/cons of delaying PoS again.

There’s a chance that the All Core Devs meeting on May 27th reverses this decision and chooses to focus on delaying the freezing of PoW. However, it seems that Vitalik Buterin, the co-founder of Ethereum, is prepping expectations that block time increases temporarily: “We have to evaluate the pain of doing an extra delay hard fork versus the pain of living with 21 or 25 second blocks for a while, which is something we have done and the world didn't end.”

Ethereum’s delays with the PoS Merge is one reason we added a second Layer 1 to the LTBH portfolio. To complicate matters, the Difficulty Bomb is now weeks away from detonating (sounds like we need Batman).

Although it’s hard to give up any allocation on Ethereum given its concentration in d’apps and developers, it’s also important to acknowledge that if other Layer 1s want to compete alongside Ethereum, June-September is their chance to lay some serious groundwork on building a developer and app ecosystem because Ethereum will be juggling two hot potatoes – The Merge to PoS and the Difficulty Bomb.

A Member shared the A16Z Crypto Report which helps to illustrate Ethereum’s dominance.

The decision that Ethereum must make between prioritizing Proof of Stake or the Difficulty Bomb is not lost on popular apps on the Ethereum Network as a slowdown in Proof of Work before The Merge would result in higher gas fees and more congestion. Investors should keep an eye out for popular apps diversifying their Layer 1 network due to high gas fees.

In our previous write-ups, we discussed how Time Magazine’s TIMEPieces resulted in exorbitant gas fees where 10 NFTs were priced at 1 ETH for $2500 or $2800 yet due to gas fees, one buyer paid as much as $70,000.

Yuga Labs is the creator of the Bored Apes Yacht Club and is a leading NFT creator. There are 10,000 apes with traits and unique characteristics, which you may recognize such as this:

Three weeks ago, Yuga Labs held a digital land sale that drove $285 million to the company yet resulted in $176 million in gas fees on the Ethereum Network. The average gas price was around 800 Gwei early Sunday and spiked to 6000 and 7000 Gwei during the sale, which equates to $3,000 or more per transaction in gas fees. In fact, there was one $25 NFT that carried a $3,300 transaction fee and complaints abounded on Twitter.

Yuga Labs issued an apology and publicly stated they are going to turn the lights off on Ethereum for a while.

In this high-profile decision, Yuga Labs is reportedly considering other Layer 1s.

Avalanche

The I/O Fund added a new LTBH position in Avalanche last month. We did a deep dive on Avalanche here.

What other Layer 1s will popular Ethereum apps choose to diversify with? We think Avalanche could be a top choice given it’s Ethereum Bridge, application-specific subnets and the launch of a consumer-facing app over the next few months/quarters. Avalanche also has a high Nakamoto Coefficient, which is a number that designates the number of nodes that would need to be corrupted to slow or prevent a chain from functioning properly.

Last quarter, Avalanche launched GameFi subnets with DeFi Kingdoms participating. The bridge protocol Synapse saw volumes surge from a previous high of $157 million to a record $330 million. This accounted for 82.5% of total bridging volume on Synapse.

Recently, the popular game Crabada migrated from Avalanche’s C-Chain to a subnet. This will help prove viability of subnets’ ability to scale and potentially attract more games as Ethereum goes through its growing pains over the next few months. Crabada draws in high daily volume of up to $1.5 million with transactions of up to 400,000 per day. The application has a total value locked of $50 million by the end of the quarter.

Avalanche launched with three chains. Per our YO/LO write-up: The X-Chain is for creating and exchanging assets including NFTs, the P-Chain validates and creates subnets, and the C-Chain is for executing Ethereum Virtual Machine (EVM) contracts. The C-Chain offers interoperability with Ethereum, which is why the Avalanche bridge is the most popular ETH Bridge currently. The P-Chain is what is used to create and manage subnets. The coordination of Avalanche validators occurs on the P-Chain and it can support thousands of subnets and millions of validators.

Subnets are important to reach scale. The customized chains allow blockchain verticals to have enhanced function by grouping together like-kind applications. Gaming d’apps are separate from Decentralized Finance apps (lending, borrowing, payments), which is key because these d’apps have different requirements.

As we stated in the AVAX write-up: “Ethereum is running into issues with 500,000 to 1 million daily active users. Meanwhile, a single mobile application sees hundreds of millions of users, such a Twitter or Spotify. What Layer 1 can handle this level of adoption? That is a platinum-level question for investors to answer. To be clear, it could be Ethereum in 2023 if the developers and users prefer to not migrate. However, if the ecosystem runs out of patience and seriously looks for an alternative, then Avalanche is a candidate.”

Avalanche came to market in 2020 yet in terms of total value locked, started to gain traction in August of 2021. The chart above by A16Z helps visualize how strong Avalanche has been out of the gate in terms of growth. I’ll repost it here for quick reference:

According to Messari’s Q1 report, Avalanche’s average daily transactions grew 82.8% sequentially and total revenue grew 72% from Q4 to Q1 2022. During this time, the market cap was flat at (5.4%) and price relative to revenue went from 160X to 91X (note: AVAX is two years old and very early stage).

In the first week of January, Avalanche had more active users than all of October 2021. The network averaged 70,000 daily active addresses, which grew to 92,000 in Q1. Average daily transactions rose from 473,000 last quarter to 865,000 in Q1 compared to Ethereum’s daily transactions of 1.17 million.

As stated above, some transaction fees on Ethereum were up to $3,000 during a popular NFT sale in the hundreds of millions. Avalanche surpassed $1 million in daily NFT volume for the first time with transaction fees of $0.67 per transaction. This helps illustrate the importance of Yuga Labs shopping for a new Layer 1 as one popular app can raise daily NFT volume substantially during auctions, helping to prove the ability scale for a competing Layer 1.

Perhaps most important for investors, there is an increasingly stronger correlation between revenue and market value for Avalanche. When daily revenue spiked in November, fully diluted value saw a similar spike. As Messari shows below, the spread between revenue and the fully diluted value had a tighter correlation, which helps prove fundamental value as the revenue has a closer relationship with network value.

Source: Messari.io

Why Terra Crashed

An analysis on crypto this month would be remiss to not include a note on the Terra crash. TerraUSD (UST) or “Terra” is an algorithmic stable coin that automatically tracks the price of other currencies, in this case the United States dollar. The idea is that transactions will be predictable and investors can hold their assets without the level of volatility seen across fully decentralized currencies.

Luna is the native token of the Terra Layer 1 blockchain that is used for governance and mining. Luna is staked to validators to record and verify transactions on the blockchain in exchange for rewards and fees.

As a stablecoin, Terra was designed to use supply and demand to balance its price. If demand for Terra goes up, then Terra’s price increases, and if demand for Terra is low, the price decreases. The two cryptos, UST and LUNA, have an arbitrage-type relationship as the Layer 1 is made up of two pools. Atomic swaps are made possible through a market module.

Arbitrageurs sell LUNA for UST when the price is below $1 and they buy LUNA when UST is worth more than $1. If UST is priced at $0.90, then traders would buy that coin and sell it for $1 of LUNA. The prices were propped up by the protocol burning both UST and LUNA as they were being minted and converted, which helps bump up the price of the burned tokens due to the restricted supply.

Expansion occurs when Terra is higher than the pegged dollar, and the protocol incentivizes users to burn Luna and mint Terra. The new supply creates a larger pool for Terra, and users mint more Terra from the burned Luna until it reaches its target price. Contraction occurs when Terra is priced too low and supply exceeds demand. The protocol incentivizes users to burn Terra and mint Luna, which causes scarcity and an increase in Terra’s price to be more aligned with the dollar.

The arbitrage relationship between Terra and Luna is important to understand in terms of the Terra crash that occurred. However, the primary use for UST was not for the arbitrage opportunity but rather to earn yield on the Anchor DeFi platform.

Anchor is a DeFi protocol with $16.16 billion total value locked at the end of April, which included 72% of all UST. There was an additional $3.2 billion in UST on DeFi Llama and $152 million on Avalanche.

The reason Anchor had three-quarters of total value locked for UST is that the DeFi platform required funds to be held in UST to earn an interest rate of 19.46%. That yield drew a lot of attention and helped prop up Terra’s success as a Layer 1 blockchain. Between November and the May 2022 crash, UST’s market cap grew from $2.73 billion to $17.8 billion.

Expansion occurred because Terra was in high demand due to the attractive yield from UST. In addition to the expansion, the yield attracted a ratio of 4:1 lenders to borrowers. This meant Anchor’s reserves were becoming increasingly vulnerable to a “run on the bank” in terms of risk that an outsized number of lenders would withdraw their principal and yield. Basically, theoretically, if too many lenders withdraw at once, Anchor would not have enough reserves.

As this incredibly prescient article points out, there were warning signs.

The first was in February when the founder of Terraform Labs, Do Kwon, added $450 million into reserves with Arca CIO Jeff Dorman stating that Anchor would require more capital infusions to maintain the current yield. In late March, a proposal was passed to change the yield. Proposal 20 stated that the rate would change by a maximum of 1.5 percentage points once per month and would be a variable rate.

Here is what the Decrypto.co article stated at end of April in regards to the February cash infusion from Terraform Lab’s Founder and the subsequent decision to allow for lower interest rates:

“Without a clear, long-term solution, though, the rate will continue to decrease. After a certain threshold, which the market will decide over time, investors will generate returns elsewhere. This could lead to withdrawals from Anchor and investors potentially abandoning UST for another stablecoin that can be used for more lucrative opportunities in some other DeFi protocol. If this rotation were to happen en masse, it could be catastrophic for the health of UST as well as LUNA.”If this rotation were to happen en masse, it could be catastrophic for the health of UST as well as LUNA.”

We are not concerned about Terra in regards to our crypto holdings because on a granular level, the risk was unique the arbitrage relationship between Terra and Luna, plus the high yield of 20% on Anchor that was ultimately unsustainable. We will write an update on Aave soon.

Conclusion:

We have a large position in Ethereum that will likely be trimmed over time as we want to be prudent about the issues the leading network must overcome. This doesn’t mean we will exit entirely rather it means that 8% is too high when some of this can be allocated to an up-and-coming Layer 1, such as Avalanche. What we trim from Ethereum should be seen as diversification to lower risk during the transition to PoS and in anticipation of whether the difficulty bomb timeline is extended or not. We believe what happened with Yuga Labs and also the Axie Infinity sidechain hack (which was Axie Infinity’s solution to high gas fees covered here that ultimately hurt the company) could create a window of time where Ethereum sees heightened competition.

Revisiting Ethereum and Avalanche