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Recently Tascha Labs has published an article titled “Why I am bearish on Ethereum” for no obvious reason but the rise of Ethereum’s own Layer 2 solutions. Her logic is that by using the currency valuation model for nation states, economic activity growth is the largest driver for currency price appreciation. And when transitioned into “Layered” design, Ethereum Layer 2s will take most end-user transactions as they bundle them up, process them in batches on Layer 1, thus will substantially reduce the number of transactions on L1. This is all true and her proposal of valuing blockchains like nation states instead of companies does make a lot of sense. Nevertheless, if you read the article carefully, it is not hard to spot a glitch in the calculation that causes the wrong result. Yes, the model is solid assuming ETH will be able to capture most of the Ethereum country’s economic activity. The problem is in the math.
Here is the model from Tascha’s article “How to Value Layer 1 Blockchains: The Right Way & the Wrong Way”.
And what this tells us is that the price of ETH vs. USD depends on three factors:
1. The ETH GDP (YETH) vs. US GDP(YUS), the higher the ETHGDP/USGDP, the higher the ETH price.
2. ETH money supply (METH) vs. US Money Supply (MUS) — the lower ETH Supply/ USD Supply, the higher the ETH price.
3. ETH money velocity (VETH) vs. US money velocity (VUS) — the lower ETH Velocity/USD Velocity, the higher the ETH price.
From this model, we see that ETH price is positively correlated with ETH GDP and negatively correlated with ETH money supply and velocity. The money supply factor has no controversy as we all know that ETH has much less money supply than USD and is potentially going deflationary upon its POS transition. According to this model, this money supply shock is very bullish for ETH price.
The trickiest part is how to calculate the ETH GDP. Tascha is using the number of transactions as the proxy of ETH GDP but this is the wrong metric and no one really uses the transaction count for measuring any country’s economic output. The GDP, which stands for Gross Domestic Product, is “the monetary value of final goods and services — that is, those that are bought by the final user — produced in a country in a given period of time”* (IMF Article “Gross Domestic Product: An Economy’s All, 2020).* The point here is GDP is a value metric, not a count. If you mistaken it for count, it will completely nullify your analysis. For example, if you spend $1 million to buy a house, while I spend $1 to buy a can of pop, we both contribute to the GDP by making one transaction. If you look at the count, then you and I are equal, however, when you look at the value being transacted, you are generating $1 million in GDP while I’m only contributing 1 dollar. Your contribution to the GDP is 1 million times of mine and I would have to buy 1 million cans of pop to equal your economic output. That being said, the transaction count measure is never a good metric for economic activity because it omits the monetary value. This is why population is not a good measure for economy neither. A country with a large population tends to have more transaction count, but that doesn’t necessarily translate into a higher GDP. For example, India has about 1.4 billion population, and the 2021 GDP estimated by IMF is $3,049,704 million USD vs. Germany has about 83.24 million people, and the 2021 GDP estimate is $4,319,286. The population of India is almost 17 times of that of Germany, while its GDP is only 71% of Germany’s. The same logic applies to blockchains. It is very misleading to use any count measure like population (number of active addresses) or number of transactions to project economic activity. The correct way to calculate the GDP is to sum up the monetary value of all transactions, which is how real-world GDP is calculated. And for blockchains, this is the “Total Value Settled on Chain” metric.
Well, then you may ask, there is a clear correlation between number of transactions and the ETH price shown in the chart, isn’t it? Here is the chart from Tascha’s article “Why I am bearish on Ethereum”:
Yes, up until now, the reason why the number of transactions has been a good measure is because there isn’t much Layer 2 (rollup) activity. If we assume the average transaction value on ETH layer 1 is stable, then the number of transactions will be perfectly correlated with the total value settled. Here is the formula:
Total Value Settled = Average Value per Transaction * # of Transactions
However, when Layer 2s gain traction, most transactions move from Layer 1 to Layer 2. What Layer 2(Rollups) are doing is aggregating a bunch of transactions into one big transaction to be posted on Layer 1, therefore, the # of transactions drop on Layer 1 while the value for each transaction increase proportionally resulting in no change in Total Value Settled. Using Tascha’s example: “Eth L1 does 1.3 million daily tnxs right now. ZK rollups can have 60k-80k tnxs in a batch before submitting to L1. If we move all end-user tnxs from eth L1 to rollups today & all L2 batches are full, that means # of tnxs on eth L1 could drop to 1/20 of current level.” This 1/20 drop in transaction count is made up by a 20 x of the average value of transactions. Simply put, the aggregation process does not change the total value of that batch. A simpler analogy of this is: say you are going to spend $20 to buy 20 cans of pop. You can buy 1 can each time and execute 20 transactions. You can also buy all 20 cans at one time in one transaction. Yes, the number of transactions dropped to 1/20, but the average spending increased 20-fold from $1 to $20, keeping the total value the same ($20).
Alright, now we know that the end-user transaction migration from Layer 1 to Layer 2 won’t change the total GDP of Ethereum so there is no bearish case, but where is the bullish sentiment come from? Again, thanks to the potential GDP growth. Currently, the high gas fee on Ethereum has priced out the average people and many developers. By significantly lowering gas fees on Layer 2s, anyone will be able to use Ethereum again and many new projects will deploy on Ethereum. More users and more developer activity = more GDP for the Ethereum nation. This low cost, high throughput environment will boost strong economic growth. And because anyone can create a rollup for Ethereum, and there are many types of technologies (Optimistic, ZK, etc.) the healthy internal competition of different Layer 2s will spur more innovation and result in better infrastructure for all DAPP builders and users, which creates a flywheel for the whole ecosystem.
All in all, I think Tascha has done a good job outlining the economic model for valuing blockchain nations and their native tokens. However, when applying any model, we need to make sure we are using the accurate measure. The wrong input will generate the wrong output leading to the wrong conclusion. Remember, GDP is a value measure, not a count of transactions. We don’t use the # of transactions or population size to measure a country’s economic activity in the real world. The Total Value Settled is the GDP of a blockchain country. Therefore, Layer 2s not only won’t reduce any value for Layer 1 but instead will supercharge the economy by attracting more user and developer activities.
Here comes the next question: what about the Layer 2 tokens? Will they steal the show from ETH the asset? My answer is: Unlikely. I will explore the characteristics and implications of the Layer 2 tokens in the next article. If you are interested in the series, please follow me on Medium or Twitter.
Recently Tascha Labs has published an article titled “Why I am bearish on Ethereum” for no obvious reason but the rise of Ethereum’s own Layer 2 solutions. Her logic is that by using the currency valuation model for nation states, economic activity growth is the largest driver for currency price appreciation. And when transitioned into “Layered” design, Ethereum Layer 2s will take most end-user transactions as they bundle them up, process them in batches on Layer 1, thus will substantially reduce the number of transactions on L1. This is all true and her proposal of valuing blockchains like nation states instead of companies does make a lot of sense. Nevertheless, if you read the article carefully, it is not hard to spot a glitch in the calculation that causes the wrong result. Yes, the model is solid assuming ETH will be able to capture most of the Ethereum country’s economic activity. The problem is in the math.
Here is the model from Tascha’s article “How to Value Layer 1 Blockchains: The Right Way & the Wrong Way”.
And what this tells us is that the price of ETH vs. USD depends on three factors:
1. The ETH GDP (YETH) vs. US GDP(YUS), the higher the ETHGDP/USGDP, the higher the ETH price.
2. ETH money supply (METH) vs. US Money Supply (MUS) — the lower ETH Supply/ USD Supply, the higher the ETH price.
3. ETH money velocity (VETH) vs. US money velocity (VUS) — the lower ETH Velocity/USD Velocity, the higher the ETH price.
From this model, we see that ETH price is positively correlated with ETH GDP and negatively correlated with ETH money supply and velocity. The money supply factor has no controversy as we all know that ETH has much less money supply than USD and is potentially going deflationary upon its POS transition. According to this model, this money supply shock is very bullish for ETH price.
The trickiest part is how to calculate the ETH GDP. Tascha is using the number of transactions as the proxy of ETH GDP but this is the wrong metric and no one really uses the transaction count for measuring any country’s economic output. The GDP, which stands for Gross Domestic Product, is “the monetary value of final goods and services — that is, those that are bought by the final user — produced in a country in a given period of time”* (IMF Article “Gross Domestic Product: An Economy’s All, 2020).* The point here is GDP is a value metric, not a count. If you mistaken it for count, it will completely nullify your analysis. For example, if you spend $1 million to buy a house, while I spend $1 to buy a can of pop, we both contribute to the GDP by making one transaction. If you look at the count, then you and I are equal, however, when you look at the value being transacted, you are generating $1 million in GDP while I’m only contributing 1 dollar. Your contribution to the GDP is 1 million times of mine and I would have to buy 1 million cans of pop to equal your economic output. That being said, the transaction count measure is never a good metric for economic activity because it omits the monetary value. This is why population is not a good measure for economy neither. A country with a large population tends to have more transaction count, but that doesn’t necessarily translate into a higher GDP. For example, India has about 1.4 billion population, and the 2021 GDP estimated by IMF is $3,049,704 million USD vs. Germany has about 83.24 million people, and the 2021 GDP estimate is $4,319,286. The population of India is almost 17 times of that of Germany, while its GDP is only 71% of Germany’s. The same logic applies to blockchains. It is very misleading to use any count measure like population (number of active addresses) or number of transactions to project economic activity. The correct way to calculate the GDP is to sum up the monetary value of all transactions, which is how real-world GDP is calculated. And for blockchains, this is the “Total Value Settled on Chain” metric.
Well, then you may ask, there is a clear correlation between number of transactions and the ETH price shown in the chart, isn’t it? Here is the chart from Tascha’s article “Why I am bearish on Ethereum”:
Yes, up until now, the reason why the number of transactions has been a good measure is because there isn’t much Layer 2 (rollup) activity. If we assume the average transaction value on ETH layer 1 is stable, then the number of transactions will be perfectly correlated with the total value settled. Here is the formula:
Total Value Settled = Average Value per Transaction * # of Transactions
However, when Layer 2s gain traction, most transactions move from Layer 1 to Layer 2. What Layer 2(Rollups) are doing is aggregating a bunch of transactions into one big transaction to be posted on Layer 1, therefore, the # of transactions drop on Layer 1 while the value for each transaction increase proportionally resulting in no change in Total Value Settled. Using Tascha’s example: “Eth L1 does 1.3 million daily tnxs right now. ZK rollups can have 60k-80k tnxs in a batch before submitting to L1. If we move all end-user tnxs from eth L1 to rollups today & all L2 batches are full, that means # of tnxs on eth L1 could drop to 1/20 of current level.” This 1/20 drop in transaction count is made up by a 20 x of the average value of transactions. Simply put, the aggregation process does not change the total value of that batch. A simpler analogy of this is: say you are going to spend $20 to buy 20 cans of pop. You can buy 1 can each time and execute 20 transactions. You can also buy all 20 cans at one time in one transaction. Yes, the number of transactions dropped to 1/20, but the average spending increased 20-fold from $1 to $20, keeping the total value the same ($20).
Alright, now we know that the end-user transaction migration from Layer 1 to Layer 2 won’t change the total GDP of Ethereum so there is no bearish case, but where is the bullish sentiment come from? Again, thanks to the potential GDP growth. Currently, the high gas fee on Ethereum has priced out the average people and many developers. By significantly lowering gas fees on Layer 2s, anyone will be able to use Ethereum again and many new projects will deploy on Ethereum. More users and more developer activity = more GDP for the Ethereum nation. This low cost, high throughput environment will boost strong economic growth. And because anyone can create a rollup for Ethereum, and there are many types of technologies (Optimistic, ZK, etc.) the healthy internal competition of different Layer 2s will spur more innovation and result in better infrastructure for all DAPP builders and users, which creates a flywheel for the whole ecosystem.
All in all, I think Tascha has done a good job outlining the economic model for valuing blockchain nations and their native tokens. However, when applying any model, we need to make sure we are using the accurate measure. The wrong input will generate the wrong output leading to the wrong conclusion. Remember, GDP is a value measure, not a count of transactions. We don’t use the # of transactions or population size to measure a country’s economic activity in the real world. The Total Value Settled is the GDP of a blockchain country. Therefore, Layer 2s not only won’t reduce any value for Layer 1 but instead will supercharge the economy by attracting more user and developer activities.
Here comes the next question: what about the Layer 2 tokens? Will they steal the show from ETH the asset? My answer is: Unlikely. I will explore the characteristics and implications of the Layer 2 tokens in the next article. If you are interested in the series, please follow me on Medium or Twitter.
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