Ethereums Dilemma: Can a Narrative Revolution Reignite Developer and Investor Enthusiasm?

Ethereums Dilemma: Can a Narrative Revolution Reignite Developer and Investor Enthusiasm?The cryptocurrency market is currently in a state of doldrums, with price action driven primarily by supply and demand factors rather than fundamentals. Ethereum (ETH) has significantly underperformed other major cryptocurrencies, with many analysts attributing the underperformance to declining Ethereum revenues post-the Cancun upgrade and the token's inflationary dynamics

Ethereums Dilemma: Can a Narrative Revolution Reignite Developer and Investor Enthusiasm?

The cryptocurrency market is currently in a state of doldrums, with price action driven primarily by supply and demand factors rather than fundamentals. Ethereum (ETH) has significantly underperformed other major cryptocurrencies, with many analysts attributing the underperformance to declining Ethereum revenues post-the Cancun upgrade and the token's inflationary dynamics. However, we believe this is only part of the story, with the underlying market structure and institutional investor disinterest playing a more significant role.

The Deeper Reasons for Ethereum's Underperformance

While Ethereum's network activity and supply inflation are important considerations, we believe that price action is driven by the current market structure. The cryptocurrency market overall has been sluggish in recent weeks, with investor sentiment remaining subdued. Since the deleveraging event in early August, price action has been volatile, driven primarily by supply and demand dynamics.

Compared to the US stock market, the cryptocurrency market has significantly lagged, especially since early August, where the US stock market has largely recovered. Institutional investors remain fixated on Bitcoin, whose market dominance has reached its highest level since April 2021 (57%). Among major cryptocurrencies, Ethereum (ETH) has significantly underperformed its peers, recently trading 1.6 standard deviations below its three-month average.

Many experts believe that the decline in Ethereum activity (leading to lower revenue) or the unfavorable token inflationary dynamics of ETH are responsible for this underperformance. We believe this is only part of the story. In our report, "The Rise of ETH and L2s," published on August 13th, we discussed the inherent trade-offs in Ethereum's Layer-2-focused scaling roadmap and its impact on ETH value.

More likely, Ethereum's lack of a distinct narrative and limited capital supply has led to more comparisons of Ethereum with other smart contract platforms. The current market sentiment is dominated by crypto natives, who are likely moving into altcoins and other more illiquid crypto spaces, resulting in much of the wealth staying there rather than flowing elsewhere.

For ETH to catch up, we believe it needs a new catalyst to help reignite developer and investor enthusiasm.

Market Sentiment and Macro Environment

Seasonal bearishness in September is typically associated with the end of the fiscal year for mutual funds, which can lead to market segments cutting risk to achieve tax-loss harvesting. However, this year's poor market performance, both in traditional risk assets and cryptocurrencies, is further exacerbated by the uncertainty surrounding the US election outcome and its implications for the overall economy. This may keep many investors on the sidelines, especially as the macro environment is already quite murky.

The positioning in the crypto space is quite light, with perpetual futures open interest stagnating, confirming this. During the first ten days of September, the average BTC open interest was around $14.8 billion, and ETH was around $7.2 billion. This has been relatively unchanged since mid-August but remains above any month during 2022-2023. Funding rates remain in low (<1) positive territory.

The Federal Reserve's rate decision, to be announced on September 17-18, will act as a deterrent to capital deployment rather than a directional driver. Fed Governor Christopher Waller hinted as early as September 6 that the most likely outcome is a 25-basis-point rate cut in September, with further easing at future meetings. However, while disinflationary trends appear more solidified, the Fed is focusing on US labor data, which is being closely watched for signs of potential recession.

Concerns about a slowing economy might help explain why crypto has failed to rally despite the substantial weakness in the Dollar Index (DXY) during July and August, and concerns about a specific Bitcoin supply overhang. Hence, we believe that the crypto market appears to be still largely driven by technical market participants, and primarily by supply and demand factors rather than fundamentals.

The Disconnect Between Ethereum Activity and Price Action

Among high-cap cryptocurrencies, ETH has consistently underperformed BTC and SOL, even after the US launch of Ethereum spot ETFs in late July. Institutional investors have been intensely speculating why this has been the case. The common belief is that this performance has been a result of declining total transaction fees and transaction counts on Ethereum, especially since the Ethereum Cancun upgrade in mid-March. The introduction of the blob has been seen as a result of unprecedented activity on Ethereum's Layer-2 scaling solutions (L2s) - to the detriment of Ethereum's mainnet. Many believe that this has not only impacted ETH's value but has also actively driven the reversal of ETH's deflationary supply situation.

We believe that this is not the case. We agree that ETH's performance is highly correlated to its Ultrasound Money theory and therefore undermining this could have a material impact on the price. But growing activity on L2s is a red herring. Indeed, only base fees and blob fees are burned according to the EIP-1559, and the latter (generated by L2s) is generally negligible. However, our calculations suggest that even if 100% of the L2 transaction fees (which have been reduced by 80-90% since the Cancun upgrade) were being burned, ETH would still be inflationary. In other words, the positive inflation rate of ETH is not the sole outcome of the activity moving from the mainnet to L2s.

Moreover, while the crypto market is not as efficient as the traditional markets, it is curious to see a five-month lag between the slowdown of activity on the Ethereum chain and the subsequent impact on the price of ETH. Sure, one could argue that it was not until August 2024 that Ethereum's Layer-1 monthly fees reached a four-year low. But this was also the case in the three months before that (May, June, and July), during which time ETH tracked, and sometimes even slightly outperformed, BTC or SOL on a risk-adjusted basis. In fact, it was not until late July/early August that ETH started underperforming other currencies on a risk-adjusted basis.

More likely, the reversal of the yen carry trade in early August triggered a massive deleveraging across many asset classes, with ETH potentially being the most vulnerable position in many portfolios that required forced selling. Indeed, following the launch of the spot ETHETF in the US on July 23rd, this group of funds saw modest outflows of $57 million in the first two weeks, while the US spot BTCETF saw modest inflows of $69 million over the same period. This may have frustrated market participants who were expecting ETH charts to mimic the pattern of BTC.

Therefore, we believe that the current weakness of ETH may simply reflect the extent to which many people have gone into crowded trades relative to the existing spot supply of ETH. This is why the shift in supply from negative to positive growth is still important, even if it remains below other Layer-1 tokens with an ETH inflation rate around 0.7% year-on-year.

However, this trend of growing ETH supply is nothing new. ETH supply has been reversing ever since the Cancun upgrade, with over 240K ETH added in recent months. While this is a prominent message, we believe it begs the question of why the market has only recently priced it in. Perhaps because block rewards inflation is only part of the supply equation. Over the same 5-6 month period, the amount of ETH staked increased by 2.65 million ETH, more than ten times the new ETH supply. However, as of September 10th, the staking rate has slowed to around 12% from around 27% year-on-year in early August. This is also far below the 40-50% rates we saw pre-Cancun upgrade, partially due to EIP-7514 that lowered the maximum validator churn to 8 per epoch (down from a variable rate of up to 14 pre-upgrade) - slowing down the rate at which validators join.

Looking Ahead

In conclusion, it is hard to say whether ETH is forming a bottom. The Total Value Locked (TVL) on Ethereum has declined from $67 billion in June to $44 billion, retracing back to levels seen in mid-February this year. We believe that the token still requires a catalyst to help reverse its current market structure, but overall, both traditional and crypto markets are extremely quiet.

If this happens, demand for the spot ETHETF could provide support, but institutional interest has thus far been concentrated on Bitcoin. Indeed, we believe that many traditional participants still have a poor understanding of Ethereum's supply schedule and smart contract utility.

Beyond Bitcoin, we believe that the market is mainly dominated by crypto natives, who are increasingly less likely to buy ETH as a beta play on the asset class. Indeed, ETH has had an average beta of only 0.60 to the broader crypto market in 1H24, although it has since increased to ...