The Development Must Go On

October 2022 Commentary

Bad news is good news? This may appear so in October but was not really the case. More likely, bad news has been baked so much into investor expectations that the continuation of high inflation, Fed rate hikes, and ongoing geopolitical tensions are no longer a surprise to investors. That UK inflation rose to 10.1%, US inflation remained stubbornly high at 8.2%, and the US central bank pushed the Fed Funds rate upwards by another 75 bps for a target range of 3.75% to 4%, while still painful, were altogether no longer a shock factor. In a sigh of relief, investors were happy to bid up global equities by about 5% and US equities by 8%. Most of October also saw the digital assets market demonstrate stability with bitcoin remaining flat at $20,000 and ether stable at $1300 till rallying over $1500 at the end of the month.

Long term investors are often reminded of Ben Graham’s wisdom that “in the short run the market is a voting machine, but in the long run it is a weighing machine”, the point being that in the long run, the market will converge on the fundamentals. For digital assets, it is important to focus on the fundamentals that exhibit positive momentum despite the market volatility experienced over the last several months. With this in mind, we turn our attention to Ethereum Devcon 2022 that was held in mid-October in Bogota, Columbia.

DEVCON VI

DEVCON VI is the seventh (Devcon 0 was the first) Ethereum Developers’ Conference that is meant to attract “developers, researchers, thinkers, and makers”, according to the Ethereum Foundation. With over 6,000 attendees hailing from 113 countries (a third of whom arrived from Latin American countries), the global appeal of Ethereum was evident.

Figure 1. Devcon VI in Bogota, Columbia

For a conference of this size and geographic footprint, there was surprisingly very little traditional media coverage. Other than the Economist, neither Reuters, Associated Press, Bloomberg, the New York Times, Verge nor Techcrunch was present. Not even CoinDesk, which had covered previous DEVCON events, was present. Instead, the DEVCON VI action was picked up by the newer digital assets news outlets like Bankless, The Defiant, and Decrypt – and of course, by Firinne Capital’s own in-house Research Advisor, Victor Li.

Focusing on Foundational R&D

Arriving at Devcon straight after successfully completing the Merge (previously discussed here and here), the developers and speakers hardly spent any time talking about ETH being ultrasound money or as an asset. There was no hype, no patting themselves on their backs, no price pumping. Even discussions on consumer-facing applications like DeFi or NFTs were few and far between. Instead, the focus was on the foundational development that remains in front of them. A survey of the sessions and their respective areas of focus revealed the priorities of the Ethereum ecosystem.

Topics # of sessions

Zero-knowledge (zk) proof & privacy 33

Staking & validator experience 19

DAOs and governance 18

Scalability 10

Decentralized Finance (DeFi) 9

Account abstraction 8

Gaming 5

NFT 3

Table 1. Discussion Priorities

Allowing users to retain their privacy on their personal data was top of mind and is key for free expression in peer-to-peer transactions, ranging from simple communications to financial exchanges. Scalability is another key issue that needs to be addressed to allow the blockchain technology to scale up for the next million users (or the next billion, for that matter). Who wants to agonizingly wait several minutes or hours for transactions to clear, or pay high gas fees for a transaction that is only a few tens or hundreds of dollars?

Much of the discussion of the solution to both privacy and scalability centered around zero-knowledge (zk) proofs. ZK proofs prove the “validity of a statement without revealing the statement itself.” In short, they provide for “confidentiality, credibility, and compression”, according to a conference panelist. Multiple teams, including Polygon, Scroll, Aztec, and zkSync, are working on zkEVM (zero-knowledge Ethereum Virtual Machine) or similar privacy protocols. (The “VM” is the software that executes smart contracts and updates the global state of the blockchain after a new block is added. The “E” in EVM pertains to specific characteristics of the VM used by Ethereum and compatible VMs.) Scalability improvement expectations impressively indicate an improvement of two orders of magnitude from Ethereum’s current pace of below 14 TPS (transactions per second) to about 2,000 TPS.

Although the technology is practically in place, the developers are confronted with the challenge that consumers are not exactly clamoring for privacy and adoption has been slow. More obvious applications of this research will need to be delivered. Developers are actively working on these, including applications for finance, identity, decentralized social media, and contracts that require cooperation between two parties who may not necessarily trust each other (e.g., nuclear disarmament deals).

With the successful transition to Proof of Stake (“the Merge”) and over 14 million ETH being staked, it was not a surprise that improving staking and validator experience was a hot topic. The presentations on staking, given by Lido Finance and Rocket Pool, the two largest liquid staking platforms, were packed.

Decentralized Autonomous Organizations (DAOs) and related governance issues were similarly hot topics. Discussions circled around quadratic voting and funding, and proof of humanity, both of which are designed to favor democracy over plutocracy. To achieve these goals, the attendees tried to address the thorny issues of reducing Sybil attacks (same individual assuming multiple identities) and collusion, verifying identity, providing retroactivity (i.e., rewarding after impact is evident), and increasing community engagement in highly technical DAO decision making.

While garnering less attention, account abstraction is a topic of growing importance. In the new trustless and permissionless world of decentralized finance, self-custodying assets in one’s own account matters, but is hard for current users and will continue to be hard for new users to adopt due to hacks and lost keys. The purpose of account abstraction is to decouple the account owner from the account by using smart contract wallets to initiate transactions and pay fees. Being a smart contract, the account can be programmed to be fit for purpose. For example, the account security for spending small amounts may be relatively low, compared to security, say, for large spending amounts which may require multiple signatures. It’s like using a smart lock on a door so that the persons who are allowed entry do not need to be issued nor carry around a physical key which may be easily misplaced, lost, or stolen.

Albert Ni, one of the conference moderators, characterized crypto as an “intellectual gravity well” during one of the discussions. Overall, the Ethereum Foundation had invited about 50 academics to speak about their research at this conference. Indeed, the intellectual depth of the discussion was truly impressive, and one could have easily mistaken the event as an academic research conference given some of the highly technical details and multitude of math equations being presented.

Figure 2. Theo Diamandis, a MIT PhD student and researcher at Bain Capital Crypto, discusses a mechanism for pricing non-fungible resources in fee markets.

Indicators of Quality

That the excitement about Ethereum continues unabated despite contractions in both the crypto and macro markets, is encouraging. Indeed, continued interest amongst developers is a robust indicator of the health and probable longevity of a project and is one of several signals we use at Firinne to assess an asset in terms of its attractiveness as a portfolio holding.

Figure 3. Indicators of developer activities. Source: https://www.gokustats.xyz/

Although not immune to stresses imposed by bearish markets, developer activity as measured by weekly active developers has proven more robust than market cap over the past year. Drawing an analogy to traditional assets like equities, metrics like developer activity, daily active users, value transferred on chain etc. can be thought of a representing “fundamentals” or quality metrics of a project. Interesting to note is that the order of assets when sorted by weekly dev activity is quite different from the ranking as suggested by market cap alone, possibly implying that some projects are over/under valued on a relative basis. To quote Steve Ballmer “developer, developers, developers....” are everything.

Figure 4. Ethereum gas usage. Source: https://ultrasound.money/#burn

The month of October also saw a major uptick in onchain gas usage. Since a portion of the ether used in a transaction is permanently removed from circulation or “burned”, periods of high activity potentially may result in a net negative new supply issuance. Such was the case in October, with heavy gas burning from Uniswap and NFT platform OpenSea, resulting in a strong increase in ether burnt. Such was the demand for blockspace that almost all the new ether issuance since The Merge in September was permanently removed from circulation during the month of October. When coupled with the new supply reduction following the migration from Proof of Work to Proof of Stake, ether the asset very nearly became deflationary this month. Using onchain activity numbers from earlier in the year, gas usage during a bull market should turn ether into a so-called “ultra-sound” asset.

The current period of range-bound price action in the digital assets market is being described as a crypto-winter. What is evident is that the true adherents remain unfazed and development activity for Ethereum is in the spring of its cycle. All told with continued interest from developers, a sound tokenomics model and a successful recent migration to Proof of Stake, the future is looking positive for Ethereum.