“The Ethereum network could function just fine even if Ether was worth $10.”
The above statement is something we see discussed regularly throughout the cryptocurrency community.
It’s not based on fact, assumes that the only function of Ether is to pay network transaction fees (gas), and is misleading for a number of other reasons.
In this essay, we will explain why Ether has value for substantially more reasons than just being used to pay transaction fees on the Ethereum network and we’ll also showcase how Ether is being used as money for the new Ethereum digital economy.
Let’s start by exploring why Ether is valuable.
What gives Ether value?
Ether, the native currency of the Ethereum network, derives its value from a plethora of different factors. It is used within the Ethereum network to perform a range of functions, including:
- Used to pay Ethereum transaction fees (in the form of ‘gas’)
- Used as collateral for a wide range of open finance applications (MakerDAO, Compound)
- May be lent or borrowed (Dharma)
- Accepted as payment at certain retailers as well as service providers
- Used to as a medium of exchange to purchase Ethereum-based tokens (via ICOs and/or exchanges), crypto-collectibles, in-game items, and other non-fungible tokens (NFTs)
- Earned as a reward for completing bounties (Gitcoin, Bounties Network)
Further, in Ethereum 2.0 (Serenity), users will be able to become a validator and help secure the network by providing computational resources and locking up 32 Ether per validator.
Because of this, it is expected that Proof of Stake will lock a substantial amount of the circulating supply of Ether.
There are also discussions around introducing a ‘fee-burn’ model where a percentage of Ether used to pay transaction fees would be ‘burned’ and thus reduce the circulating supply of Ether.
In addition to utility value, Ether also has speculative value. This is value that is derived from speculative activities (such as trading/investing) which currently accounts for most of the value behind all crypto-assets.
As observed in 2017, crypto-assets can attract substantial speculative interest, with some assets increasing in value by 100x over just a few months. This speculative interest often brings fresh capital into the ecosystem that can be reinvested into various verticals, but it can be damaging to the short-term market sentiment of all crypto-assets.
Could tokens on Ethereum be used instead of Ether?
Theoretically, yes. Practically, no. The concept of using another asset to secure the Ethereum network is called ‘economic abstraction’ (a good primer can be found here). This would involve miners / validators accepting tokens other than Ether in exchange for adding valid transactions to new blocks.
It is unlikely that the Ethereum protocol will ever implement economic abstraction as it could potentially reduce the security of the blockchain by compromising the value of Ether.
How exactly does valuable Ether help to secure the network?
In Proof of Work systems, miners compete with each other to find a block and be rewarded for their work (in the form of the native crypto-asset of the protocol).
As the price of the asset increases, it naturally brings with it more miners, which then increases the network difficulty. As the network difficulty increases, it becomes increasingly difficult for miners to find a block which results in large scale mining operations (referred to as “mining farms”) being one of the only profitable ways to mine on a Proof of Work network. Miners can also join ‘mining pools’ in order to increase their chances of finding a block and thus increase their rewards.
It would currently cost an individual or group a large amount of money to successfully attack or take control of either the Bitcoin or Ethereum PoW blockchains.
When Ethereum transitions to Proof of stake under Ethereum 2.0, it’s expected that users will be able to stake 32 Ether per validator and receive rewards for their work in the form of additional Ether.
Under Proof of Stake, the cost of attacking Ethereum will be tied to the cost of Ether.
Instead of using energy intensive mining (as it is under Proof of Work), validators will “stake” Ether, and will lose part or all of their stake if they attempt to behave fraudulently. The more validators with staked Ether securing the network, the more Ether an attacker would need to purchase in order to carry out an attack. Such an attack would likely rapidly increase the price of Ether and thus make it prohibitively more expensive for the attacker.
What the Ethereum network secures:
The Ethereum network currently secures billions of dollars in value including: utility tokens, work tokens, crypto-collectibles (and other NFTs), Dai (through collateralization of CDPs), asset-backed securities, among many other things.
If we expect a decentralized financial system to grow and one day usurp the existing system, we must have guarantees that the Ethereum network is sufficiently able to secure billions of dollars of value and be incredibly resistant to change.
Ethereum 2.0 (Serenity) favors liveness over safety. What this means is that the protocol should be able to function even if the majority of validators go offline (such as a catastrophic event like WW3). This level of liveness can be achieved if Ether is sufficiently valuable (in order to incentivize people to continue running their validators).
What is money?
There are plenty of examples throughout history of various objects being used as money — seashells, gold, paper notes and more. Humans used these things as money because they had perceived value based upon their difficulty to counterfeit, their scarcity and the fact that they were accepted as money. In modern times, commodities such as gold are not used as money because it is not considered a medium of exchange, even though gold is still considered quite valuable.
Money is primarily a social contract. Fiat money, the current form of money used by most of the world, is backed by a given nation’s government. The government decrees that a particular currency is to be used as legal tender (the accepted money) for their nation and, most importantly, what the government accepts as payments for tax. Typically, the government controls the supply of the money and can create additional money at will.
Fiat money is a delicate construct — if managed incorrectly, it can have dire consequences for a nation (such as what has happened in Venezuela). Even though some governments are quite powerful and influential, a mere decree that something is money is not enough — the citizens must collectively believe that the money has actual value and that it will not be diluted by extreme inflation.
Is Ether money?
In order for something to function as money within an economy, it needs to act as a good medium of exchange (MoE), unit of account (UoA) as well as store of value (SoV). Ether is used as a medium of exchange within the Ethereum economy for a wide range of apps, with dApp providers accepting it in exchange for fungible / non-fungible tokens, and/or other services.
It is also used as a unit of account by various parties (including companies that have raised Ether via ICOs).
Finally, Ether has historically been used as a store of value, with investors and speculators purchasing Ether to hold for investment purposes, given its relative scarcity, predictable supply growth, and inherent utility.
An object (physical or virtual) must typically exhibit five distinct attributes in order to be considered money: portability, durability, divisibility, fungibility and established history (lindy effect). Ether is highly portable (because it’s virtual), durable (again, because it’s digital), divisible (up to eighteen decimal places), but has limited fungibility as ETH tokens are interchangeable with one another, but accounts/addresses can be blacklisted quite easily. Privacy protocols such as zk-SNARKs will eventually improve this property for Ethereum.
Ethereum has been in operation since 2015 and continues to build a strong established history. The Ethereum network (and Ether) have functioned as expected for 99.99% of its life. The other 0.01% includes surviving The DAO, multiple large hacks of smart contracts, multiple protocol-level exploits, the Shanghai DoS attacks, constant negative remarks from the wider cryptocuency community and multiple bear markets (including a recent 92% drop in price).
On top of all of this, Ether has additional properties such as being censorship-resistant, permission-less, pseudonymous and interoperable with other crypto-networks.
The supply scheme of crypto-assets is hotly debated among various parties (particularly those in the Bitcoin community) and there are currently two main approaches: a capped supply (like BTC) or a low, predictable and hard to change issuance rate (like what is planned for Ethereum 2.0).
In Ethereum 2.0 (with Sharding/Proof of Stake implemented), while a low inflation rate will always guarantee the validators are rewarded for securing the network, it suffers from the fact that it may dilute the value of Ether for those that are not validators.
However, this is offset by Ether being taken out of the circulating supply through staking, various open finance applications, fee burning, and people simply losing access to their Ether.
Supporting Data (as of 7/01/2019)
Ethers money-like properties can be tracked via many different metrics:
- The Ethereum network is processing an average of 600,000 transactions per day
- An average of 250,000 active addresses per day
- Gas usage is at capacity (which means Ethereum is being used for more than just simple sends)
- Thousands of companies have raised billions of dollars by issuing tokens via an ICO on Ethereum
- Ethereum has an average of $2 billion USD of exchange volume every 24 hours
- Over 1.7 million ether is currently being used to secure MakerDAO CDPs
- A further ~40,000 ether is locked in various finance apps.
The expected issuance rate of Ether:
As of time of writing, Ether’s annual issuance rate is around 8%. In January of 2019, the Constantinople upgrade will go live on the Ethereum network bringing with it a reduction in block rewards from three ETH per block to two ETH per block (and an additional drop in uncle block rewards). This will reduce the overall annual network issuance rate to around 4.6%.
In Ethereum 2.0 Phase 0, due to the beacon chain running in parallel to the Eth1.0 chain, there will be a slight bump in issuance rate (potentially from 4.5% to 5%). In Phase 2, the Eth1.0 chain will be deprecated and the network issuance rate will dramatically fall to the planned target of <1%.