What is Ethereum (Layer 1)?

(Tomasz Makowski)
(Tomasz Makowski)
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Today, our crypto coverage analyst, Jake H, walks us through Ethereum. How does it work? Why does it matter? And what does the blockchain’s future hold?

Make sure to catch his weekly crypto updates on the ROIC portal!


Key Takeaways

  • Ethereum is meant to be a foundation for all things blockchain related.
  • Ethereum currently sits as the number two crypto (market cap) and number one in developers.
  • Ethereum is planning on merging to proof-of-stake in mid-2022.
  • Ethereum’s strengths are in decentralization and security.

Background

In 2013 Vitalik Buterin, founder of Ethereum, published Ethereum’s white paper. At the time Bitcoin was well known for its store of value aspect, a digital asset with no centralized issuer or government in control. Ethereum was founded with the intent of taking advantage of all aspects of blockchain technology, with plans for non-fungible tokens, smart contracts, smart property, and decentralized autonomous organizations.

“The intent of Ethereum is to create an alternative protocol for building decentralized applications, providing a different set of tradeoffs that we believe will be very useful for a large class of decentralized applications, with particular emphasis on situations where rapid development time, security for small and rarely used applications, and the ability of different applications to very efficiently interact, are important.”

Ethereum Whitepaper

Ethereum provides the base layer for smart contracts and decentralized organizations to be built on. Today we see lots of money tied up in Layer 2’s, which are technologies and programs built on the Ethereum base layer. Arbitrum is the number one Layer 2 solution with $2.93B in total value locked. Arbitrum provides cheap transaction costs vs. Layer 1 Ethereum.


How It Works

Accounts

  • Each user is given an account containing the nonce (counter used to make sure each transaction is only processed once), ether balance, contract code, and storage.
  • Ether is the fuel of Ethereum and is what is used to pay transaction fees.
  • There are two types of accounts externally owned (controlled by private keys) and contract accounts (controlled by contract code).

Messages and Transactions

  • Transactions
    • Transactions are the signed data package that stores a message to be sent from an externally owned account.
    • Each transaction contains:
      • The recipient
      • Signature of the senders
      • Amount of ether being transferred
      • Optional data field
      • STARTGAS value (max number of computational steps)
      • GASPRICE value (feed the sender pays)
    • STARTGAS and GASPRICE are exclusive to the Ethereum blockchain to prevent accidental, infinite loops, and/or computational waste. The more computing power a transaction will take the higher the gas fee. This is why buying an NFT will cost way more in gas than sending ether to someone.
  • Messages
    • Contracts have the ability to message each other on the blockchain.
    • Each message contains:
      • The sender
      • The recipient
      • Amount of ether being transferred
      • Optional data field
      • STARTGAS value
    • Messages are like transactions but are produced by contracts and not external senders. Contracts have relationships to one another just like external accounts can.

Code and Mining

  • Ethereum and Bitcoin have similar blockchain structure, Ethereum however contains a copy of the transaction list and the most recent state.
  • Ethereum is currently using a Proof of Work (POW) model to run its blockchain, this is a system where miners race to solve mathematical puzzles (e. finding the next block) and earn a reward for doing so. This is the same system Bitcoin uses.
  • This similar structure is what results in the small amount of TPS for Ethereum vs. other blockchains.
    • Bitcoin (POW) can process 7 TPS
    • Ethereum (POW) can process 15-45 TPS
    • Solana can process (POS) 50,000 TPS with a max of 710,000 TPS
  • Ethereum is planning on merging to Ethereum 2.0 which changes the entire blockchain from Proof of Work to Proof of Stake (POS) which will improve the TPS to 100,000.
    • We will cover the merge in a different report, it’s expected to happen in June or July of 2022 but from reports that we are reading it’s likely to be pushed back by a couple more months.

Why It Matters

With Bitcoin arguably the main store of value cryptocurrency Ethereum will gain its value from its ability to be usable. This will come from DeFi and Dapps that are built and used on the blockchain resulting in inflows of capital to ether. Ethereum’s main reason for moving to POS is that the slowness of the network results in problems for users of DeFi and Dapps, increasing the TPS will theoretically allow the blockchain to be more scalable.

Some use case examples outlined in Ethereum’s white paper:

  • Savings wallets
  • Crop insurance
  • Decentralized data
  • Smart multisignature escrow
  • Cloud computing
  • Peer-to-peer gambling
  • Prediction markets
  • On-chain decentralized marketplaces

Ethereum is also at its core very similar to Bitcoin in that it’s a currency under no corporate or government control. Under the Proof of Work model, there are rewards paid to miners for validating the network resulting in an increasing supply forever, currently sitting at around 3%. In order to counteract this inflation, an influx in value to the blockchain is needed. Once Ethereum switches to Proof of Stake, inflation will be near zero and some arguments are made that Ethereum will turn deflationary around -1% due to the issuance drop and similar burn rate to what it is now.

In August 2021, EIP-1559 a network upgrade was implemented where part of each transaction fee is burned (sent to an inaccessible wallet), removing it from circulation. This part of the fee used to be paid entirely to miners. EIP-1559 was implemented to slow the issuance down and prepare the network for the merge.


Analysis

Ethereum is currently the world’s second-largest cryptocurrency with a market cap of around $350 billion and has returned (21.74%) YTD. We like to structure crypto analysis around the three “T’s”: Total Addressable Market (“TAM”), Technology, and Team.

As mentioned in our Solana deep dive, Web 3.0 has a theoretical TAM of multiple trillions of dollars. Ethereum’s technology allows for use cases on the blockchain that aren’t even thought of yet and the team is full of high-level developers. Ethereum is also home to the largest amount of developers working on DeFi/Dapps totaling around 3,920 in 2021.

Ethereum is currently strong in security and decentralization while lacking scalability due to speed. This refers to the blockchain trilemma that explains the tradeoffs among security, decentralization, and scalability. After the merge to 2.0 Ethereum will become more centralized and increase its scalability.

If we look at Web 3.0 like Web 2.0 there will probably be 2-3 major blockchains that lock up most of the value. Ethereum is number two currently and is planning to hold that spot by increasing its TPS with the merge, as of now we have bets that ETH will continue to hold in the top three as seen on the ROIC Big Board.


Risks

  • Network security/hacks
  • Unfavorable government policy
  • Macro-economic factors such as a recession, inflation, etc.
  • Correlation to the Nasdaq in the short-term
  • ETH 2.0 Merge
    • When ETH merges all of the value currently locked on ETH 2.0 will be unlocked and this may result in some short-term selling pressure as investors take this capital out that has been locked in for so long.

Ethereum (ETH) explained. More upside than Bitcoin? — January 6, 2021

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