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Monthly Outlook: What’s Eating Ethereum?

We believe crypto currently appears to be trading predominantly within a technically driven market, led mostly by supply and demand factors rather than fundamentals

September 12, 2024

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Key takeaways

  • ETH has been a notable underperformer among the crypto majors, which many have attributed to a decline in Ethereum’s revenues following the Dencun Fork in mid-March
  • But while Ethereum’s network activity and supply inflation are important factors to consider, we also think the price action has been driven by the current market structure

Written by

  • David Duong, CFA - Global Head of Research

Summary

Crypto markets have been sluggish over the last few weeks, as the lack of price momentum has weighed on investor confidence. In what’s been a largely technical (supply-demand) driven move, the price action has been choppy since the deleveraging event in early August. On a risk-adjusted basis, crypto has been trailing US stocks, which have largely recovered their losses since that time. Institutional players remain fixated on bitcoin and little else, with bitcoin dominance at its highest level (57%) since April 2021.

Among the crypto majors (by market cap), ether (ETH) has been a notable underperformer relative to peers, recently falling 1.6 standard deviations below its three-month average. Many pundits have faulted Ethereum’s decline in activity (pushing revenues lower) or ETH’s unfavorable token inflation dynamics, which we think is only part of the story. Indeed, we’ve previously discussed the tradeoffs inherent in Ethereum’s layer-2 focused scaling roadmap and the effect that this has had on ETH value.

More than likely, fewer idiosyncratic narratives in this space as well as a limited supply of capital have increased the scrutiny around how Ethereum compares to other smart contract platforms. Our view is that crypto natives are also driving the market at the moment, and this cohort may be crowded into altcoins and other crypto positions that are getting more difficult to exit. This could be leaving wealth mostly stranded, instead of flowing to other parts of the crypto ecosystem. Regardless, for ETH to catch up, we think Ethereum needs a new catalyst to help reignite both developer and investor enthusiasm.

It’s the economy, stupid

Bearish seasonals in September are typically associated with fiscal year end for many mutual funds, which might be a trigger for this market cohort to trim risk for tax loss harvesting purposes. However, we believe the poor market behavior for this year in particular (observed across both traditional risk assets and crypto) is also being exacerbated by the uncertainty regarding how US election results could affect the broader economy. This may be keeping many investors sidelined, particularly when the macroeconomic environment is already quite murky.

Indeed, positioning in the crypto space is fairly light, as evidenced by stagnant open interest levels on perpetual futures – averaging around US$14.8B for BTC and $7.2B for ETH in the first 10 days of September. This is mostly unchanged since mid-August, albeit still higher than any month between 2022-2023. See Chart 1. Meanwhile, funding rates are stuck in (positive) low single-digit territory.

Screenshot 2024-09-11 at 9.39.44 PM

In our view, the Federal Reserve decision on September 17-18 matters less as a directional driver and more as a hurdle keeping capital from being deployed. Fed Governor Christopher Waller already hinted on September 6 (ahead of the blackout period) that the most likely outcome is a 25bps cut in September with the optionality to ease more in future meetings. This appears to be fully priced into Fed funds futures. 

But while the disinflationary trend appears to be more well-established now, the Fed is concentrated on labor data in the US, which is being watched closely for signs of potential recession. Fears over an economic slowdown might help explain why crypto has failed to strengthen even as the multilateral USD index (DXY) weakened sharply in July and August, alongside the concerns over bitcoin-specific supply overhangs. Consequently, we believe crypto still appears to be trading predominantly within a technically driven market, led mostly by supply and demand factors rather than fundamentals. However, it’s also worth noting that the shape of the US 2y10y yield curve (often used as a leading indicator for recession) has recently ended one of the longest periods of inversion on record.

Examining ETH’s underperformance

Meanwhile, among the higher market cap crypto names, ETH has been underperforming peers like BTC and SOL even following the advent of spot ETH ETFs in the US in late July. Why this has happened is the subject of intense speculation among institutional investors. The general view is that this performance has been a function of the decline in both Ethereum’s total transaction fees and transaction count, particularly following the Dencun upgrade in mid-March. The thinking is that the introduction of binary large object storage (or blobs) have led to unprecedented levels of transactional activity on Ethereum’s layer-2 scaling solutions (L2s) – to the detriment of Ethereum’s mainnet. Many believe this has not only been extractive to ETH value but that it has actively contributed to the reversal of ETH’s deflationary supply status.

Screenshot 2024-09-11 at 9.40.35 PM

In “ETH and the Rise of L2s” (published August 13), we argued that this is not the full story. We agree that ETH’s performance has become closely tied to its ultrasound money thesis, and as such, disrupting that may have put a substantive dent in the price. But the activity growth on L2s is a red herring. It’s true that only the base and blob fees are burned in accordance with EIP-1559 and that the latter (generated by L2s) has often been de minimis. However, our calculations indicate that even if 100% of the transaction fees spent on L2s (which are 80-90% lower post-Dencun) were burned, ETH would still be inflationary. In other words, ETH’s positive inflation rate is not the exclusive result of activity migrating from the mainnet to the L2s.

Moreover, although crypto markets are not as efficient as traditional markets, it seems odd that we could see as much as a five-month time lag between the moderation in Ethereum’s onchain activity and the subsequent effect on ETH price. Of course, one could argue that monthly fees on Ethereum layer-1 didn’t reach their four-year lows until as recently as August 2024. See Chart 3. Except that was also true in the three months prior (May, June and July), during which time ETH kept pace with (if not - at times - performed slightly better than) BTC or SOL on a risk-adjusted basis. In fact, from a risk-adjusted perspective, ETH only started to underperform its peers beginning in late July / early August. See Chart 2.

Screenshot 2024-09-11 at 9.41.03 PM

What’s more likely is that the reversal of the JPY carry trade in early August was the trigger for mass deleveraging in many asset classes, and ETH may have been the most vulnerable position across the many portfolios that required forced selling. Indeed, following the launch of spot ETH ETFs in the US on July 23, this group of funds generated a small net outflow of $57M in its first two weeks whereas US-based spot BTC ETFs had had a small net inflow of $69M over the equivalent period. This may have discouraged market players who were expecting ETH’s price chart to mirror the same pattern as BTC’s. Thus, we believe the current ETH weakness may simply reflect the extent to which many had already piled into a crowded trade, relative to ETH’s existing spot supply.

That’s why even though ETH’s inflation rate of around 0.7% YoY is still low relative to other layer-1 tokens, the flip from negative to positive supply growth still matters. (Of course, comparing inflation rates across layer-1 tokens isn’t necessarily straightforward, which we’ve covered in our “Interpreting Token Inflation” report, published August 28.) Yet, this trend towards a growing ETH supply is not exactly new information. ETH supply has been in reverse since just after the Dencun Fork, having increased by over Ξ240K in recent months. Although this is salient information, we think it raises a question about why markets weren’t already pricing this in until recently.

Screenshot 2024-09-11 at 9.41.29 PM

Perhaps that’s because inflationary block rewards are only one part of the supply equation. The amount of ETH staked has increased by Ξ2.65M over the same 5-6 month period, far outstripping the amount of new ETH supply by over 10x. However, the pace of staking has slowed from around 27% YoY in early August to around 12% as of September 10. This is also far below the 40-50% pace we saw before the Dencun Fork, in part because EIP-7514 reduced the max validator churn limit to 8 per epoch (down from a variable rate as high as 14 prior to the upgrade) – slowing down the pace of validator onboarding.

Conclusions

Overall, it’s hard to say whether ETH price is forming a bottom here. Total value locked (TVL) on Ethereum has fallen from $67B in June to $44B, back to where it was in mid-February this year. In our view, the token still needs a catalyst to help reverse its current market structure, but both traditional and crypto markets are in general very quiet at the moment. Demand for spot ETH ETFs could be supportive if that materializes, but institutional interest has so far been concentrated in bitcoin. Indeed, we think many traditional players remain distanced from a better understanding of Ethereum’s supply schedule and smart contract utility.

Outside of bitcoin, we also think this market is dominated mainly by crypto natives, who are increasingly less likely to buy ETH as a beta to the asset class’ performance. Indeed, ETH’s beta to the broader crypto market averaged only 0.60 in 1H24, even though it’s since increased to 0.85. This cohort of market players may also be crowded into altcoins and other positions that are getting more difficult to exit, particularly as memecoin activity gets fragmented across different chains and token unlock schedules appear to be tapering off. Moreover, Ethereum mainnet may be facing new challengers with the upcoming launch of upstart L1 and L2 projects in the months ahead, such as Berachain, Monad and MegaETH.

Ultimately, we think a narrative change is needed for ETH to overcome these hurdles in the short term. That could involve more experimentation on the mainnet to compete with alternative L1s or the onboarding of more real world assets onto the platform. What most institutional players want to see, however, is the launch of applications with broader public appeal that fully utilize Ethereum’s potential.

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