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ETH is going to $5K. The Ethereum “Aha!” Moment.

Ethereum Price: $271.80
Ethereum Price (BTC): 0.027697BTC
ETH Leveraged in DeFi: 2.80M (2.55% of circulating supply)
Market Cap: $29.82B
ETH Network Dominance*: 70.94%
7 Day Candle**: $249.14 / $286.99 / $243.51 / $271.80

Not financial advice. Please do your own research.

In recent months, it has been possible to deposit cash into Ethereum-based financial applications and earn upwards of 8.00% interest p.a.

The general response to this statement is not “where do I sign up?” but rather, “what’s the catch?”

It’s not hard to see why. Savers have not seen interest rates above 3-4% for the best part of two decades. During this time, investors have been inflated into submission, forcing anyone with a desire for real returns to move their money into equities. The idea that a cash savings account can earn anything even close to 8.00% is cause for concern in and of itself.

But rather than explaining how and why these interest rates exist (that’s been covered thoroughly here), this article is going to look more closely at the implications that these rates (and yes, they do exist) have on the price of ETH, hopefully leading to a moment of clarity (and perhaps even a spontaneous exclamation of “aha!”) for skeptics and advocates alike.

Ethereum’s Economic Bandwidth

The term “economic bandwidth” has been used to describe Ethereum’s capacity to support its network of decentralized financial applications. This isn’t capacity in the sense of transaction throughput or technological limitations, but one of financial capacity – how much financial value can the Ethereum network support today? This won’t make sense just yet, so it’s first key to understand how many of these decentralized finance (DeFi) applications operate today before we look at economic bandwidth.

Collateral, not credit

At this point in time, Ethereum does not support credit. Those looking to borrow dollars from the network cannot provide an ID to the system and for it to return a “yes” or “no” response. Instead, a more rudimentary process is required – the provision of collateral.

For a user to borrow dollars from the network, they must provide collateral in the form of ETH. This collateral is used to secure the loan and, if the value of the collateral (ETH) falls too far, it is sold to the market (at a penalty to the borrower) and the debt position is closed.

This entire process is done in a decentralized way. No individual or company can block the creation or repayment of debt with the only requirement being that the user posts enough collateral to secure the loan requested.

ETH collateral is not just used for securing loans. Synthetic assets, options and other financial derivatives are also created in the same way, with ETH working “under the hood” to secure this network’s burgeoning list of financial derivatives.

A one trillion dollar market

To understand how “economic bandwidth” works in practice, let’s consider this simplistic example:

Imagine the market capitalization of Ethereum was $1 million. For a user to take out a loan of dollars from the Ethereum blockchain they currently require a “collateralization ratio” of 150% meaning that with $150 of ETH, they can take out a loan of $100 USD (while retaining their ETH and its price exposure).

Now, consider a user that wishes to take out a loan of $800,000 USD. The system simply would not be capable of supporting the request as the entire network value of Ethereum was $1 million – significantly less than the $1.2 million required to generate the said loan.

We can now scale up this example to Ethereum’s market capitalization today of $30 billion. Under today’s conditions, the network would allow the borrowing of $20 billion USD if every single ETH was used to collateralize loans.

As it happens, not every single ETH is used to collateralize loans. The actual number sits at around 2 million (slightly under 2% of the total ETH circulating).

If we consider other financial applications (not just the issuance of loans), the number of ETH used as collateral increases to 2.8 million or roughly 2.5% of the total ETH circulating.

Now consider the future value proposition of decentralized finance. Is there long-term growth in the use of DeFi, or is the current 2 year growth indicative of a fad? Perhaps the system is flawed and the whole thing will crash to nothing?

If you’ve used decentralized finance then it’s probably clear that it’s not a fad. The Dai Savings Rate (8.00% at the time or writing) is very real and pays out on every block (~13 seconds) with the balance available for withdrawal at any time and without a fee. More advanced users may have even taken out a loan or traded synthetic assets, all without a third party custodian and available to anyone in the world.

Then there is the thought that it will all crash to nothing. Unfortunately, there are no guarantees in this space, however the way to approach this risk is to look at the current “bug bounty” of decentralized finance. The system is currently holding over $1 billion of value; if it was possible to exploit and steal these funds then it’s extremely likely that it would have happened already. Smaller exploits, such as the bZx attacks from last week will no doubt continue to some degree, however the risk of decentralized finance imploding is – in my opinion at least – very low.

So if decentralized finance isn’t a fad and it isn’t going to implode, what’s the direction?

Financial derivatives are a multi-trillion dollar market. For Ethereum, which is capable of hosting complex derivatives that can be built and transferred by anyone in the world, even a fraction of this market will require an enormous increase in the system’s economic bandwidth.

To roughly calculate what this means for the price of ETH we need to make a few assumptions. First, we can assume that the total supply of ETH will never exceed 120 million – this is a fair assumption given Ethereum’s expected supply inflation rate which has been considerably well researched.

The other assumption is that the proportion of ETH used in these systems increases to, a quite arbitrary, 10% (play with this figure freely). This would mean that 12 million ETH would need to provide the economic bandwidth to support a 1 trillion dollar derivative market.

As the system must be over-collateralized, the value of this 12 million ETH would need to be greater than the 1 trillion dollar market it created. This gives a price of over $80,000 per ETH. Quite a marked increase from today’s valuation.

The “Aha!” moment

Decentralized finance is one facet of Ethereum. Fundraising (ICOs/IPOs), digital assets, decentralized organizations, gambling, supply chain management and cloud computing are some of the other industries that stand to benefit from using the Ethereum framework. All of this will need to be secured by Ethereum’s “proof of stake” algorithm that begins its launch process later this year and will provide returns for those holding ETH.

While there is a lot that needs to happen for Ethereum finance to grow from $1 billion to $1 trillion, a scaled back version of this outlook is still difficult to reconcile to today’s valuation.

The “Hang on a minute…” moment

It wouldn’t be fair to write such a bullish piece on the price of ETH without considering the thoughts of someone reading this and raging with skepticism – although congratulations to the skeptics that got this far.

Other types of collateral

ETH is not the only form of collateral. In fact, one of the largest DeFi applications (MakerDAO), recently upgraded to a “multi-collateral” system. The reasoning goes that they can’t be solely reliant on the price of ETH – envisioning a cross-blockchain network in the future that allows for all manner of assets to be used to generate loans – creating a more secure system in the process.

MakerDAO’s multi-collateral system launched with the addition of Basic Attention Token (BAT), which (after 4 months) currently accounts for 1.36% of the loans created (the rest is accounted for by ETH).

As these applications integrate other collateral types, we can expect ETH’s dominance to drop, however ETH will undoubtedly remain the dominant force in this space. The reason for ETH’s dominance is that it is inherently the most trusted asset on Ethereum. ETH is Ethereum’s native asset and one that is baked directly into the protocol. Anything else on Ethereum will have at least 1 other potentially buggy or exploitable smart contract in between the protocol and the asset.

While many are excited for the introduction of Bitcoin on Ethereum, the same criticism will apply. Nothing can beat ETH’s monopoly on trust, making it the most desirable form of collateral on Ethereum.

What about credit systems?

At some point, it’s likely that identity and credit will begin forming a part of decentralized finance on Ethereum. While decentralized identity (DID) is a very exciting space to follow, it’s also not likely to appear any time soon. That said, when it does eventually appear in a meaningful way, won’t users borrow on credit rather than posting collateral?

The answer is yes, unsecured lending will be a pretty big deal if and when it becomes available.

However, secured loans will still have a significant place in the system. Going further, while credit and identity may change the dynamics of lending and borrowing, it will not replace the vast majority of DeFi applications that require ETH staking for other reasons.

Ethereum Killers

Ethereum killers have been swinging and missing since 2016. Some of the “best” Ethereum Killers are confined to simply text on a page (the famous “whitepaper” killer). Other Ethereum killers have faded into obscurity (remember when Cardano was a thing?) and Ethereum’s most successful killer (in the sense of a kitten pawing at a dog), TRON, is a literal copy and paste of code.

The Ethereum Killer argument is about the most elusive of all. While it’s true, Ethereum needs to continue its hard grind forward in order to “win” the space, it is not apparent where the actual competition is coming from.

The road to $5,000 (by the end of 2020)

This year is lining up to be explosive for Ethereum. Not only is the network due to start its highly anticipated upgrade to ETH 2.0, but decentralized finance applications are only now – having reached a $1 billion valuation – beginning to get interesting. Last week, Nexus Mutual paid out the first DeFi insurance claims and Opyn.co recently launched their options tokens (oTokens).

Mainstream media is lagging behind and the asymmetries of information between Ethereum market participants and those outside is reaching breaking point. Even individuals regarded as “in the know” are missing the point; famed venture capitalist, Fred Wilson, took to his blog to talk about the exciting promise of USDC’s “programmable dollars” – a stablecoin that earns 1.5% via a custodian and sees very little by way of programming. Whether this was as a means to avoid discussing low-regulation topics I’m not sure, but those not paying attention are due a blindsiding… That, or someone’s fiddling with my water supply.

– Nick, Owner EthereumPrice.org

* calculated as: (ETH Market Cap / Ethereum Network Market Cap)
** open / high / low / close