The Value of Ether

CoinShares is primarily interested in ether, Ethereum’s native token, as a long-term investment. This article explores the fundamental factors which have the potential to meaningfully and sustainably impact future returns.

Foundations are important

Executing and maintaining a record of transactions on Ethereum requires computing resources such as storage and memory, which come at a cost. The main purpose of ether, the protocol’s native token, is to pay for them. 

The network introduced a unit known as GAS to estimate the cost of these resources. Each transaction incurs a GAS fee, which rises with the level of resources consumed. The supply of these units is intentionally limited to both lower barriers to entry for network operators and encourage network decentralisation.  

However, the scarcity of GAS units means Ethereum can only settle so many transactions at a given time. It can handle around 60 simple transfers of Ether per second, but far fewer of more complex kinds of transactions, like sales of non-fungible tokens (NFT) or trades on a decentralised exchange, like Uniswap.

The GAS price sets an exchange rate for GAS units in ether. Market forces largely influence this rate, helping to balance demand for transactions with the limited supply of GAS. When demand increases, the GAS price rises, maintaining the equilibrium for GAS units. 

Over the longer term, GAS is steadily consumed and the price responds to changes in demand. Sudden peaks in transaction volume can lead to GAS prices rising rapidly in the space of a few minutes, and sustaining levels of high demand can lead to periods of more expensive transactions, as demonstrated by this graph.

The values of GAS and ether are deliberately detached because GAS represents the cost of real-world resources, whereas market forces dictate ether’s value. The GAS price depends on how much users are willing to spend.

It’s reasonable to assume that if Ethereum increases its utility, the Ether price will rise because users will be prepared to pay more for each transaction. Likewise, if the value of transacting falls, the price should also adjust as competitive forces take hold  with rival networks.

Adoption’s Impact on Ether Supply

In late 2021, Ethereum Improvement Proposal (EIP) 1559 halted the indefinite use and reuse of tokens. Instead, transaction fees are ‘burned’ or removed from circulation. Meanwhile, the supply of ether grows due to the staking rewards paid to validators as part of Ethereum’s ‘proof of stake’ consensus mechanism.   

These factors determine the supply of ether at any given time. As transaction fees increase, supply falls, but as the amount of ether staked rises, so does the issuance of new tokens.

Ether’s inflation rate is most sensitive to changes in GAS price. The greater the demand for transactions, the faster the burn rate of the fees paid by users and the greater downward pressure on the inflation rate. In the event of a sustained period of high transaction volume, ether supply could meaningfully decrease each year.  

While Ethereum’s tokenomics are complex, CoinShares’ bases its outlook for the protocol on a simple thesis: demand for transactions will increase in parallel with its utility. Users choose an Ethereum decentralised app (dapp) instead of one built on a rival blockchain because they believe it provides better value for their money- it’s faster, cheaper or more private.  

A surge in US dollar demand to use Ethereum boosts the GAS price; the value of ether; or a combination of both. To put this in context, imagine the network attracts $10 billion in transaction fees in five years’ time. Here’s an explanation of the two extremes from the spectrum of scenarios featured in the table below:  

• If the GAS price rises and ether remains unchanged, users likely spend tokens on transaction fees and then leave the ecosystem without topping up their balances. In this case, the circulation drops significantly as tokens are burned, suggesting users don’t plan to hold ether again or market participants expect its price to fall because demand won’t offset the decreasing supply.

• If the GAS price falls and ether rises, users spend less on transaction fees while the market drives up the native token. The circulation increases due to the drop in burned ether, suggesting the market believes demand will outpace the rising supply.

The Past and Future of Block Space Demand

Demand has grown for block space, the finite space within a block that transactions consume. There are several catalysts for this growth:

• The cyclicality of the crypto markets reflects bitcoin halvings, which take place every four years, when new narratives intrigue industry outsiders and attract speculation  

• As Ethereum has matured, user demand has risen due to its success in differentiating itself from rivals.  

• Ether transfers have been overtaken by a wide range of dapps, which have launched as the protocol’s utility has expanded.

To meet this increased demand and reduce fees, layer-twos (L2s) have been introduced. L2s compete with faster or cheaper rival networks, keeping users within the broader Ethereum ecosystem. Some believe they’ll be one of the primary drivers of transaction fees in the coming years, but the CoinShares team isn’t convinced. 

After EIP 4844 went live in March 2024, each block on the Ethereum chain must allocate space to L2 transactions, called ‘blob space’. Blobs charge fees based on the amount of data stored rather than GAS fees, which consume more expensive resources. As a result, fees on L2s are much cheaper, and they should fall further as Ethereum plans to increase the supply of blobs by twenty or thirty times.  

While L2s allow Ethereum to compete with other protocols, they won’t contribute to the volume of transactions processed on the base chain, so CoinShares doesn’t believe they’ll drive the value of ether.

From an investor’s point of view, it’s more important to identify which services will likely be prepared to pay for Ethereum L1 block space over the long term. Those valuable enough to sustain demand for transactions charging the highest fees, which either boost market appetite for ether or reduce its circulation, will help make the fundamental investment case for the native token take form.