Recently, Ethereum, the most widely used blockchain for application development, launched version 2.0 of their software. Though the second most valuable digital asset behind Bitcoin, many remain unclear about Ethereum, how it works, and the significance of Ethereum 2.0.
Ethereum has emphasized the importance of the blockchain instead of just the financial applications (which are many) of BTC.
While we have not seen much of the hype materialize, ETH has continued to impress as a brand and a software platform and has proven it has staying power. The 2.0 version launch warrants a deep dive into the asset class and its role in the Digital Asset ecosystem.
To begin, Ethereum aims to be an open-source software platform for creating new digital assets and non-monetary software applications that run on a blockchain. A blockchain is an open-source database that no one corporation and no one government can control or hack.
There is no one behind the blockchains; they are internet denizens. These open-source databases have been first used to secure financial assets: this is the role of BTC and the financial role of ETH as stores of value currencies. Versions of it are currently used to move billions of dollars of value, both by retail and institutional participants, daily.
As the financial ecosystem becomes increasingly digitized, many suspect the new infrastructure for the economy will be built on Ethereum. Ethereum offered a tantalizing vision of the future: one where voting happens on a blockchain, where individuals can store identity and health data on a blockchain, but today we will focus on the financial applications.
It is important to differentiate between the software platform, Ethereum, and the digital asset that runs on it, ETH. ETH is a digital asset, like BTC, used to pay for running computations on the Ethereum blockchain.
As more people use the Ethereum platform for their own applications, the value of ETH tends to increase because the demand for platform usage increases, but processing speed remains fixed. ETH the asset is a speculative investment and currency, forget the tech, focus on the finance: it’s a financial store of value. Ethereum, the platform, the blockchain, is a software program, a technology.
Ethereum 2.0 is an effort to scale the processing speed of this technology drastically. Using a method called “data sharding.” Rather than a single blockchain for all computations, data will be split across 64 “shards,” thereby increasing computing speed by 64 times.
This is classic database scaling technology but applied to a distributed and shared open-source database. To do this, data must be logged to a master chain, called the “Beacon Chain,” to keep all the different data threads coordinated.
This is the core upgrade aimed at Ethereum 2.0, which will be implemented over the next two years in a series of predefined steps that will allow Ethereum 1.0 to run at the same time continuously. Each successive step towards the upgrade de-risks an ETH investment from a financial perspective and will offer news events likely to drive the price upward.
Another significant component of Ethereum 2.0 comes from a transition from a Proof of Work algorithm to a Proof of Stake algorithm. Without excessive technical explanation, the Ethereum blockchain will effectively ensure that the data on it is accurate with new incentives.
Before data was secured by having many computers worldwide, all processing changes to transactions with more computing power being rewarded more ETH.
Going forward, rewards will be granted to those that deposit ETH into a digital vault (a “smart contract”). This technical transition will reduce energy consumption associated with the blockchain and reduce the circulating supply of ETH in the market.
By incentivizing participants to lock-up their ETH in exchange for interest-earning, Proof of Stake has already taken over $500MM ETH off the market. This will increase over time.
Though the transition to ETH 2.0 has been successful thus far, it remains early in the process. Software bugs, competing blockchains, and regulatory considerations all present risks to the Ethereum platform’s success and the future price of ETH.
Fortunately, a significant derivatives market exists for Ethereum with hundreds of millions of dollars of trading volume daily on ETH futures and options. With savvy management, volatility and tail-risk can be hedged out of an ETH investment while still preserving much of the potential upside.
A significant derivatives market for Ethereum futures and options has emerged, with Deribit as the leading exchange at present. Volumes grew over 1800% in 2020, indicating that institutional cash flows and traders have truly started entering the market.
Simultaneously, the market is new enough and the asset volatile enough that, for experienced traders, the implied volatility and spreads on options offer significant upside. Additionally, for relatively cheap, investors can finance downside protection on positions while still preserving much of the upside.
The combination of a reduction in circulating supply, an improved software product, and new driven events along the way make it likely that Ethereum 2.0 will result in increased priced growth as well as volatility.
With a previous all-time high of over $1500 per ETH, some predict a price of greater than $3000 per ETH by the end of 2021. With increasing interest and utilization from institutional investors and technologists and a massive community of developers supporting the initiative, this incumbent blockchain will likely remain a dominant player for the foreseeable future.
This article is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This does not constitute a recommendation or take into account the particular investment objectives, financial situations, or needs of investors. There is not enough information contained in this document to make an investment decision.