Sector

Crypto

Background

Justin Drake is a researcher at the Ethereum Foundation. We cover what differentiates Ethereum from Bitcoin, the increasing number of projects being built on the Ethereum platform, and what a shift from proof of work to proof of stake means for Ethereum.

Cover

Date

May 19, 2021

Episode Number

9

Ethereum Business Breakdown

Background / Overview

Ethereum, launched in 2015, is a decentralized blockchain platform that extends the foundational concepts of Bitcoin by introducing programmability, enabling developers to build applications and issue assets on its network. Unlike Bitcoin, which primarily serves as a ledger for tracking ownership of its native cryptocurrency (BTC), Ethereum operates as a Turing-complete virtual computer, allowing for complex smart contracts and decentralized applications (dApps). Its native cryptocurrency, Ether (ETH), is the second most valuable cryptocurrency after Bitcoin, with a total supply of approximately 115 million ETH as of the podcast date. Ethereum’s ethos centers on innovation, aiming to provide a trustless coordination platform for internet users who don’t know or trust each other, replacing traditional intermediaries with code-based trust.

The platform was co-founded by Vitalik Buterin, who sought to address Bitcoin’s limitations, particularly its constrained scripting language, which restricted its programmability. Ethereum’s design achieves “escape velocity” by offering unrestricted programmability, making it a foundation for diverse use cases, from financial applications to non-financial services like the Ethereum Name Service (ENS). The Ethereum Foundation, where Justin Drake serves as a key researcher, supports the platform’s development, though the ecosystem operates decentrally with contributions from a global community.

Ownership / Fundraising / Recent Valuation

Ethereum is a decentralized protocol, not a traditional company, so it lacks conventional ownership structures or private equity sponsors. Its initial funding came through a 2014 crowdsale, where ETH was sold to early supporters, raising funds to develop the platform. As a public blockchain, Ethereum’s “valuation” is reflected in the market capitalization of ETH, which, at a price of approximately $3,500 per ETH (as mentioned in the transcript), equates to a market cap of roughly $402.5 billion for 115 million ETH. Transaction multiples or enterprise value metrics don’t apply directly, but the network’s economic activity—generating $20–30 million daily in transaction fees—underscores its value as a critical infrastructure for decentralized applications.

Key Products / Services / Value Proposition

Ethereum’s core product is its blockchain platform, which provides a decentralized, programmable environment for executing smart contracts and hosting dApps. Its value proposition lies in enabling trustless, intermediary-free interactions through code, offering immutability, censorship resistance, and universal access. Key services and applications built on Ethereum include:

1. Smart Contracts: Self-executing contracts with programmable logic, enabling trustless agreements.
2. Decentralized Finance (DeFi): Financial applications like Uniswap (token swapping), Maker, and Aave (lending), which leverage Ethereum’s programmability to create composable “money legos.”
3. Non-Financial Applications: ENS, a decentralized name registry mapping human-readable names to blockchain addresses, simplifying user interactions.
4. Token Issuance: Ethereum supports the creation of ERC-20 tokens, used for crowdfunding (ICOs) and representing assets or governance rights.

Ethereum’s value proposition is unique due to its programmability, which allows developers to build arbitrarily complex applications, and its decentralization, ensuring no single entity controls the network. This contrasts with Bitcoin’s focus on being a store of value.

Segments and Revenue Model

Ethereum’s primary “segments” can be categorized by use cases: DeFi, non-financial dApps (e.g., ENS), and token issuance. The revenue model centers on transaction fees (gas fees), paid in ETH, to access the network’s scarce block space. Gas fees compensate validators for processing transactions and securing the network. Key dynamics include:

• Gas Fees: Users pay for computational resources (measured in gas) to execute transactions or smart contracts. Simple transactions cost 21,000 gas (~$8 at 110 gwei and $3,500/ETH), while complex operations (e.g., DeFi trades) can cost 100,000 gas or more.
• Fee Structure: Post-EIP-1559 (implemented after the podcast), fees consist of a base fee (burned, reducing ETH supply) and a tip (paid to validators). Approximately 70% of fees are burned, with the remainder incentivizing validators.
• Demand-Driven Revenue: High demand for block space, especially from DeFi and NFTs, drives $20–30 million in daily fees, reflecting Ethereum’s role as a global financial infrastructure.

Splits and Mix

Revenue Mix

• DeFi: Dominates due to high transaction volumes in Uniswap, Aave, and Maker. Approximately 95% of Uniswap’s trading volume involves ETH pairs, indicating DeFi’s outsized contribution.
• NFTs: Significant contributor, with NFT trades denominated in ETH, driving gas fees.
• Non-Financial dApps: Smaller share (e.g., ENS registrations).
• Token Issuance: Contributes through gas fees for deploying ERC-20 tokens.

Geographic Mix

Ethereum’s decentralized nature makes geographic segmentation less relevant, but transaction demand is global, with notable activity in North America, Europe, and Asia.

Customer Mix

Users range from individual traders (NFT buyers, DeFi participants) to developers building dApps. Institutional interest is growing, with 1% of Bitcoin bridged to Ethereum as wrapped Bitcoin (WBTC).

Historical Mix Shifts

• 2017–2018: ICO boom drove token issuance fees.
• 2020–2021: DeFi and NFT surges increased transaction volumes, shifting revenue toward financial applications.
• Future Forecast: Post-merge (proof-of-stake transition), DeFi and NFT activity is expected to grow, with layer 2 solutions reducing per-transaction fees but increasing volume.

KPIs

• Transaction Fees: $20–30 million/day, indicating strong demand (acceleration in 2020–2021).
• Validators: 130,000 (proof-of-stake), expected to grow to 500,000–1,000,000, enhancing security.
• Staked ETH: ~4 million ETH (4% of supply), projected to reach 20–30 million post-merge, driven by 25% APR at 6 million ETH staked.
• Load-to-Power Ratio: Currently ~50 (vs. Bitcoin’s 100), expected to improve as staking increases, reducing vulnerability to attacks.

Headline Financials

Ethereum’s “financials” are unconventional, as it’s not a company but a protocol. Revenue equates to transaction fees, and “costs” relate to issuance and validator rewards. Free cash flow (FCF) is less applicable, but the protocol’s economic impact can be framed as follows:

Revenue Trajectory

• Historical: Fees surged with DeFi (2020) and NFTs (2021), reaching $20–30 million/day.
• Drivers: Demand for block space, driven by DeFi (Uniswap, Aave), NFTs, and token issuance. Programmability enables diverse applications, sustaining demand.
• Future: Layer 1 (sharding) and layer 2 (rollups) scalability improvements could increase transaction volume by 10,000x, potentially offsetting lower per-transaction fees.

Cost Trajectory / Operating Leverage

Ethereum’s “costs” are issuance (new ETH minted to reward validators) and validator operational expenses (minimal, as staking requires entry-level hardware). Key dynamics:

• Fixed Costs: Validator hardware and internet connections are low-cost, providing high operating leverage. Validators can run on entry-level laptops, with total costs estimated at ~1% of staked value (including slashing risks).
• Variable Costs: Issuance scales with validator count but is projected to drop 10x post-proof-of-stake transition due to higher efficiency (5 cents per $1 of security vs. $1 for proof-of-work).
• Profit Margins: Not directly applicable, but the protocol’s efficiency improves as fee burns outpace issuance, reducing ETH supply and enhancing scarcity.

Capital Intensity and Allocation

Ethereum requires minimal capital expenditure (capex) compared to traditional businesses:

• Maintenance Capex: Validator hardware and software upgrades, negligible at scale.
• Growth Capex: Protocol upgrades (e.g., sharding, EIP-1559) are community-driven, funded by grants or developer incentives, not centralized capex.
• Capital Allocation: The protocol doesn’t allocate capital like a firm. Instead, ETH is burned (reducing supply) or issued (rewarding validators). Community funds, like Uniswap’s $10 billion governance token pool, support ecosystem development.

Free Cash Flow (FCF)

FCF isn’t directly applicable, but the protocol’s economic surplus is reflected in fee burns, which reduce ETH supply, akin to a stock buyback. Post-EIP-1559, ~70% of fees are burned, potentially deflating ETH supply below 120 million, enhancing value for ETH holders.

Value Chain Position

Ethereum operates as a foundational infrastructure in the blockchain value chain, analogous to a cloud computing platform like AWS but decentralized. It provides:

• Primary Activities: Transaction processing, smart contract execution, and consensus (security).
• Supply Chain: Minimal, as Ethereum relies on validators’ hardware and open-source software. No physical inputs are required beyond electricity and internet connectivity.
• Position: Upstream, enabling downstream applications (DeFi, NFTs, dApps). Ethereum captures value through gas fees, akin to a toll for using its computational resources.
• Go-to-Market (GTM): Organic adoption by developers and users, driven by Ethereum’s programmability and network effects. No centralized marketing; community-driven education and developer grants fuel growth.

Ethereum’s competitive advantage lies in its programmability and decentralization, enabling it to capture value from diverse applications while maintaining trustless security.

Customers and Suppliers

• Customers: Developers building dApps, users transacting (DeFi, NFTs), and institutions bridging assets (e.g., WBTC). Demand is global, with DeFi and NFT users driving fee revenue.
• Suppliers: Validators provide computational resources, incentivized by issuance and tips. Hardware and electricity providers are indirect suppliers, but their role is minimal due to low requirements.

Pricing

• Contract Structure: Gas fees are market-driven, determined by block space demand. EIP-1559 introduces a base fee (burned) and tip (to validators), stabilizing fee volatility.
• Pricing Drivers: Demand for block space, transaction complexity, and ETH price. High-value applications (e.g., DeFi arbitrage) tolerate $8–$100 fees, but low-value use cases are priced out.
• Visibility: Fees are transparent, trackable via sites like gasnow.org. Long-term contracts don’t apply; pricing is per-transaction.

Bottoms-Up Drivers

Revenue Model & Drivers

Ethereum generates revenue through gas fees, paid in ETH, for:

• Simple Transactions: 21,000 gas (~$8), e.g., ETH transfers.
• Complex Transactions: 100,000+ gas, e.g., DeFi trades or NFT auctions.
• Key Drivers:
• Volume: High transaction volumes from DeFi (95% of Uniswap pairs), NFTs, and token issuance.
• Price: Gas prices (e.g., 110 gwei) reflect block space demand, amplified by ETH’s $3,500 price.
• Programmability: Enables diverse applications, sustaining demand.
• Network Effects: More dApps attract more users, increasing transactions.

Cost Structure & Drivers

• Variable Costs: Issuance (new ETH) to validators, scaling with validator count. Post-proof-of-stake, issuance drops 10x due to efficiency (5 cents per $1 of security).
• Fixed Costs: Validator hardware and internet, minimal (~1% of staked value). High operating leverage as costs don’t scale with transaction volume.
• EBITDA Margin: Not applicable, but fee burns (70% of $20–30M/day) reduce supply, enhancing ETH scarcity.

FCF Drivers

• Net Income: N/A; protocol doesn’t generate profit.
• Capex: Negligible; validator hardware is low-cost.
• Net Working Capital (NWC): Not applicable; no inventory or receivables.
• Cash Conversion: Fee burns act as a cash flow equivalent, reducing ETH supply.

Capital Deployment

• M&A: Not applicable; protocol doesn’t acquire assets.
• Organic Growth: Driven by developer activity and scalability upgrades (sharding, layer 2).
• Inorganic Growth: N/A; growth is ecosystem-driven.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Size: Ethereum’s market cap (~$402.5B) reflects its dominance in programmable blockchains. The DeFi market, largely Ethereum-based, has ~11 million ETH ($38.5B at $3,500) locked.
• Growth: Transaction fees grew to $20–30M/day by 2021, driven by DeFi and NFTs. Scalability upgrades could enable Visa-scale throughput (~10,000x current capacity).
• Industry Growth Stack: Blockchain adoption grows with internet penetration, financial digitization, and distrust in centralized systems.

Market Structure

• Competitors: Fragmented, with Ethereum leading programmable blockchains. Competitors include:
• High-Scalability, Low-Decentralization: Solana, Binance Smart Chain, EOS.
• Decentralized Innovators: Polkadot, Cardano, Dfinity.
• MES (Minimum Efficient Scale): Ethereum’s 130,000 validators (growing to 500,000–1,000,000) suggest a high MES, limiting competitors needing similar scale for security.
• Cycle: Early adoption phase, with growing penetration in DeFi and NFTs.

Competitive Positioning

Ethereum leads due to:

• Programmability: Enables diverse applications, unlike Bitcoin’s store-of-value focus.
• Network Effects: 95% of Uniswap volume in ETH pairs; NFT economy denominated in ETH.
• Decentralization: 130,000 validators ensure trustlessness, vs. centralized alternatives.

Market Share & Growth

• Share: Ethereum dominates DeFi (11M ETH locked) and NFTs (ETH-denominated). Over 1% of Bitcoin is bridged to Ethereum as WBTC.
• Growth vs. Market: Ethereum’s transaction volume outpaces Bitcoin’s, driven by programmability.

Hamilton’s 7 Powers Analysis

1. Economies of Scale: High validator count (130,000+) creates a large MES, deterring competitors needing similar scale. Layer 1/2 scalability will amplify this.
2. Network Effects: Strong, as more dApps attract users, increasing transaction volume and ETH demand. 95% of Uniswap volume in ETH pairs exemplifies this.
3. Branding: Ethereum’s reputation as the leading programmable blockchain drives developer and user trust, akin to a monetary premium.
4. Counter-Positioning: Proof-of-stake (20x more efficient than proof-of-work) and fee burns create a superior model, challenging Bitcoin’s security model.
5. Cornered Resource: Vitalik Buterin’s vision and the Ethereum Foundation’s research provide intellectual leadership, though the open-source community mitigates exclusivity.
6. Process Power: EIP-1559 and proof-of-stake upgrades demonstrate superior innovation, enhancing efficiency and deflationary dynamics.
7. Switching Costs: High for developers, as Ethereum’s ecosystem (tools, libraries, dApps) creates lock-in. Users face lower switching costs but prefer Ethereum’s liquidity.

Strategic Logic

• Capex Bets: Minimal; scalability upgrades (sharding, rollups) are community-driven, not capital-intensive.
• Vertical Integration: Ethereum is a platform, not vertically integrated, but enables downstream applications (DeFi, NFTs).
• Horizontal Expansion: Supports new use cases (e.g., NFTs, gaming) and geos via global adoption.
• M&A: N/A; ecosystem growth is organic, with community funds ($100B estimated) supporting developers.

Unique Dynamics and Critical Insights

Ethereum’s business model is unique due to its programmability, enabling a decentralized “world computer” that supports diverse applications, from DeFi to NFTs. Unlike Bitcoin’s focus on being digital gold, Ethereum’s value stems from its role as infrastructure for a programmable economy. Key dynamics include:

1. Triple-Point Asset: ETH serves as a currency (for fees), collateral (staking, DeFi), and store of value, with 11M ETH locked in DeFi and 4M staked. This versatility drives demand and scarcity.
2. Fee Burn Mechanism (EIP-1559): Burning ~70% of $20–30M/day in fees reduces ETH supply, creating deflationary pressure (projected to peak at 120M ETH). This “ultrasound money” contrasts with Bitcoin’s fixed 21M cap.
3. Proof-of-Stake Efficiency: 20x more efficient than proof-of-work, requiring 5 cents per $1 of security vs. $1 for Bitcoin. This lowers issuance (10x reduction) and enhances security (load-to-power ratio of 50 vs. Bitcoin’s 100).
4. Network Effects and Moat: Ethereum’s dominance in DeFi (11M ETH locked) and NFTs (ETH-denominated) creates a self-reinforcing cycle, attracting developers and users. Competitors like Solana sacrifice decentralization for scalability, weakening their long-term position.
5. Scalability Roadmap: Layer 1 (sharding) and layer 2 (rollups) promise 10,000x throughput, enabling Visa-scale processing and supporting low-value transactions, broadening Ethereum’s appeal.

Standout Interviewee Insights

• Ultrasound Money: Justin Drake’s concept of ETH as “ultrasound money” due to deflationary fee burns is a compelling narrative, enhancing ETH’s monetary premium.
• Economic Engine Analogy: Comparing Ethereum to a car with a battery (ETH), engine (consensus), and solar panel (economy) highlights its self-sustaining design, where fee burns recharge the battery, unlike Bitcoin’s volatile fee-driven security.
• Security Advantage: Proof-of-stake’s anti-fragility (destroying attacker collateral) vs. proof-of-work’s fragility (repeatable attacks) positions Ethereum as more secure long-term.
• Developer Leverage: $100B in community funds (e.g., Uniswap’s $10B) underscores Ethereum’s ability to attract talent, amplifying innovation.

Critical Analysis

While Ethereum’s programmability and network effects create a strong moat, challenges remain:

• High Fees: $8–$100 transaction costs exclude low-value use cases, necessitating scalability solutions.
• Competition: Solana and Binance Smart Chain offer higher throughput but compromise decentralization, appealing to specific applications.
• Complexity Risks: Programmability introduces vulnerabilities (e.g., smart contract bugs), requiring robust auditing.
• Regulatory Uncertainty: As a decentralized financial infrastructure, Ethereum faces potential regulatory scrutiny, though its censorship resistance mitigates this.

Conclusion

Ethereum’s business model is a paradigm shift, blending monetary, computational, and economic functions into a decentralized platform. Its revenue from gas fees ($20–30M/day) reflects robust demand, driven by programmability and network effects. The transition to proof-of-stake and fee burns positions ETH as “ultrasound money,” with a projected deflationary supply enhancing scarcity. Scalability upgrades promise to democratize access, while Ethereum’s moat—built on decentralization, developer leverage, and ecosystem lock-in—sets it apart. However, high fees and competition require vigilance. Ethereum’s ability to evolve, as evidenced by EIP-1559 and the merge, underscores its potential to redefine internet-native economies.