Analyzing Ether: A Bitcoin Investor's Skeptical Take

P4man' is an active bitcoin miner and investor with an academic background in economy and IT. He has been a member of the online discussion forum Bitcoin Talk since September, 2011.

In this opinion piece, P4man looks at the cryptocurrency market to see if there is a credible alternative to bitcoin. Can ethereum cut the mustard?

I've been following (and holding) bitcoin since 2012. I admit that until recently, I've largely ignored altcoins because none of the early cryptocurrencies offered any substantial advantage over bitcoin. At best, they were clones with a few minor tweaks, at worst, heavily pre-mined "scamcoins" primarily designed as a money grab scheme for developers and a few promoters.

After seeing a few dozen of those, I had seen enough.

But today, due to the scaling issue, bitcoin is in a crisis, and altcoins have overtaken bitcoin in market cap. While many will consider me a lucky early bitcoin adopter, clearly, I'm late to the altcoin party. So, it was long overdue that I took another look at this market to see if perhaps today there is a credible alternative to bitcoin or some promising coins to help me diversify my crypto investment.

So, I dove in, started reading and talking to people, to see what the buzz was about.

Let me be clear, I don't claim to be an overnight expert in any of these coins now. I may have gotten some facts wrong, but I'm going to give you my impressions. Take them for what they are worth.

Repeating bitcoin's miracle growth

First, a general observation. Many people I talked to say they invest in altcoins and ICOs because they feel they missed the boat with bitcoin and presume newly launched coins offer them a similar opportunity. This is a fallacy.

When bitcoin was launched, no one knew for sure if cryptocurrency would even work at all. Few people believed it would ever gain traction and be understood and trusted by millions of people, let alone, become a multibillion-dollar phenomena. Even though I held bitcoin, you may count me among those early doubters. But that doubt was priced in.

That uncertainty over the core concept itself was the main reason that a pizza once cost 10,000 BTC.

Now that the protocol itself has worked flawlessly for eight years, and the blockchain market as a whole achieved the recognition, penetration and value that it has, most of that doubt has evaporated. It's still early, but cryptographic blockchain technology has proven itself, and most people now believe it has significant potential.

A new coin today may be unproven, but the concepts it is based on, are not.

That part of bitcoin's early and exponential value growth, which represents a shift from initial ridicule to increasing trust and understanding of blockchain technology, can never be repeated. You cannot turn back that clock and un-invent blockchain technology.

Moreover, bitcoin wasn't launched through an ICO like almost altcoins these days. Bitcoin started off with a valuation of approximately zero. It took 4–5 years of proving itself, building trust and adoption for it to grow by dozens of thousands of percent, and only then reach the market cap of a typical ICO launch today.

So, a new coin today, simply cannot have the growth potential that bitcoin had in its earliest days, and you can't even get in at the same bottom price. If that is why you are investing in ICOs, then don't.

Of course, that doesn't mean they can't substantially grow in value, so let's take a look at that.

Valuing cryptocurrencies

The overall crypto market has exploded this year, breaching $100bn recently.

Let me be the first to freely admit I have no idea if this is a low or high valuation for current blockchain implementations. Good arguments can be made to value existing cryptocurrencies anywhere from a tiny fraction of their current market cap, to trillions of dollars.

I'm not even going to attempt to make a fiat-denominated value estimation. Your guess is as good mine. However, I do feel it's reasonable to make value comparisons between blockchains.

To do that, first we need to understand what functions give a cryptographic token value.

Here are the functions I look at, in no particular order:

Value as a transactional currency: To make or receive payments. Let's call this its 'PayPal' function
Value as a secure store of wealth: The "electronic gold" function
Derived value: The value created indirectly by enabling certain functionality that can be external to the blockchain, like executing contracts or storing data.
Weighing ether

Speculative value, isn't value. It's just speculation on future value. With that in mind, let's take a look at the most popular altcoin currently: ethereum.

Despite a market cap that is almost on par with bitcoin, as a transactional currency, ethereum has not achieved much, if anything yet – I'm ignoring ICOs for now. I will consider that as part of its derived value.

Compared to the hundreds of thousands of online shops that accept bitcoin, ethereum is hardly used at all for online purchases, there is no merchant infrastructure, there are no payment providers like BitPay that I've found and I see little evidence it's used for remittance or other transactional purposes.

I’m also not convinced ethereum is well suited for this purpose. While bitcoin has an urgent scaling problem, making it currently less than ideal for (micro) transactions, the fix for this is relatively simple from a technological point of view – the problem is mostly political.

Despite hearing many claims to the contrary, ethereum with its vastly more complex blockchain, has a much bigger scaling problem than bitcoin, that is yet to be solved, even in theory. Concepts exist to address this problem ("sharding" etc), but those do not exist yet and may not even work.

So, in its current form, ethereum is not a viable alternative to bitcoin as a transactional currency, and it remains to be seen if it ever can be and will be.

As a store of wealth, ether faces even larger problems.

Due to its complexity and by allowing code to run inside the blockchain, it creates a lot of potential for bugs and opens up attack vectors. This has already caused at least five hard forks and one blockchain split.

Fundamental properties are still being worked on, not just from an implementation perspective but conceptually. For instance, it's currently unknown what the future inflation rate will be, or even how the network will be protected (whether via proof-of-work or proof-of-stake).

Everything seems to be in flux and under development. It's also difficult to trust a blockchain that has proven not to be immutable and rolls back transactions that are considered "unfair". All this just adds to the sense of uncertainty. For a store of wealth, nothing is more important than trust and predictability, and ethereum currently offers neither.

Even if these major issues get resolved and clarified eventually, I'm not convinced ethereum is even the right concept for a store of wealth. Intertwining store of value and such broad functionality in one complex, ever-changing blockchain, just doesn't make much sense to me.

That's no criticism of the project, as I don't believe ethereum was designed for this, nor do I see core developers make such claims.

King of functionality

On the contrary, it should be clear by now that ethereum's major appeal, and the only possible reasonable ground for its current valuation, should lie in its derived value. By focusing on smart contract functionality, ethereum does allow a wealth of functionality to run inside its blockchain, in a way that's currently very difficult or impossible to do with bitcoin or other blockchains.

ICOs are by far the most popular use case for this, and to its credit, ethereum has enabled hundreds of millions of dollars-worth of funding via this method. It's probably fair to say the ethereum's technology is what enabled most of the recent altcoin market explosion. This is indeed, quite an impressive achievement.

These ICOs drive demand for ether in two ways: First, most of the ICOs are priced in ether, so investors wanting to participate usually have to buy ether first. You could say ether does function as a transactional currency here, be it for a very specific application.

Secondly, processing of smart contracts and private tokens on its blockchain have to be paid for in "gas", which really is just ether. This creates some demand for ether, even when projects implemented on ethereum use a private token, and only allow funding of that token with fiat money, as is the case, for instance, with the often referenced RWE electric vehicle charge station project.

First, let's take a look at the gas. At the time of writing, the average daily use of gas was roughly 12bn and the average gas price was 0.000000022 ether. That means a total daily average of 260 ether (or around $100,000).

For comparison sake, bitcoin, which no sane person will claim derives its value primarily from transaction fees, averaged 400 BTC in daily transaction fees (or around $1m). If you think gas usage justifies ethereum's market cap, then bitcoin ought to be worth 10 times more, based on its arguably least-desirable metric alone.

That leaves us with the one remaining rational price driver that I can see for ethereum: financing ICOs. Clearly, this is a huge market. It's hard to fathom how large this market has become virtually overnight. The amount of capital being raised through ICOs is now roughly on par with Kickstarter!

But as basis for its current valuation, even that doesn't quite make sense, given that ethereum’s own current market cap is many times larger than all the ICOs it has ever helped finance.

Moreover, the companies that launched ether-denominated ICOs are not likely to hold onto most of their ether for a very long time – they raised the money to finance their own development (of potentially competing tokens, no less). They will need to spend substantial portions of their ICO money to pay for services, salaries, offices, promotion, etc, and virtually none of that can be paid for in ether. So, they will need to sell their ether again.

Danger ahead?

Then there is the legal aspect: ethereum is breaking new ground.

By providing a platform for private tokens and smart contracts, it's blurring the line between virtual currencies and securities. In a way, this is exciting and certainly innovative. But, it's hard to see how at least some private tokens issued on the ethereum blockchain, could be considered anything other than unregistered securities that violate regulation in virtually every country.

This gives me a déjà vu, as I argued the same many years ago when bitcoin stock exchanges like GLBSE where all the rage.

Those exchanges allowed the issuing and trading of unregistered, bitcoin-denominated securities (company stocks, mining and other bonds, loans), no different than some private tokens on ethereum today. IPOs of virtual companies were as much a hype back then as ICOs of virtual currencies today.

And one more parallel I find difficult to ignore: Virtually all assets that were traded on these exchanges, even the ones that weren't plain scams and Ponzi schemes, were hopelessly overvalued. They were bought because prices were expected to go up. Even when the prices exceeded any remotely rational valuation of the underlying assets, including mining bonds, simple arithmetic would prove beyond a doubt that they could never return a profit.

Those "stock exchanges" were eventually all closed by authorities, and some of the issuers of securities got in serious legal trouble. I don't know what, if anything will happen with ethereum-based ICOs, or how it might affect ethereum, but it is a concern one should not ignore.

Especially not when ICOs appear to be by far the primary driver of ether value.

Final thoughts

In short, ethereum is, without a doubt, a much more exciting blockchain than bitcoin. It's like comparing an operating system to a paper ledger. But that doesn't make it a better investment.

So, what is ether's value proposition today?

It's unused (and arguably not quite usable yet) as a general transaction currency; it's too uncertain to be trusted as a secure store of wealth; and it has a derived value that appears almost entirely dependent on legally dubious ICOs that can’t go on forever. Ether as a currency, I fear, is misunderstood by many, and compared to bitcoin at least, substantially more risky and overvalued.

Disclaimer: This article should not be taken as, and is not intended to provide, investment advice. Please conduct your own thorough research before investing in any cryptocurrency.