Determinants of Ethereum Price: Review on Supply and Demand
**published 2018/10/06, translated 2019/07/31
Beginning of early 2018, Ethereum (ETH) price continuously faced downward trend and now it has finally slowed down. We are going to review the supply and demand side of Ethereum and identify the main factors which could drive the trend for ETH price.
1. Inflation Models — approaches from the supply side
Theoretically, intrinsic value of an asset should be kept at a similar level over time unless there is a fundamental change to the asset. The purchasing power is the key for a currency, where preserving low inflation rate or limited inflation is required for keeping the purchasing power.
Milestone of Ethereum
When ETH was first issued in July 2015, the block time was 12 seconds and the block reward was 5 ETH. Ethereum announced to issue 15,626,576 ETH every year, and the annual inflation was forecasted as 21.20% for 2015, 17.41% for 2016, 14.75% for 2017. (APPENDIX 1)
After Byzantium hard fork era and Constantinople hard fork era
The Byzantium hard fork adjusted the block reward from 5 ETH to 3 ETH. It did not adversely affect the network when ETH price started increase. Currently Ethereum is rewarding 3 ETH per block, 2.625 ETH for uncle block reward with the annual inflation of 7.4%. (APPENDIX 2)
From Constantinople hard fork era to Casper Protocol
Ethereum development team decided to update Constantinople hard fork, which is applying Casper and Sharding, but the plan was delayed and created some issues. To mediate the issues, Ethereum team adjusted the compensation from 3 ETH to 2 ETH while extending difficulty bomb for about 12 months by implementing EIP 1234. (APPENDIX 3) After the Constantinople hard fork, the estimated ETH block time, based on 15 seconds, to be 5,760 blocks/day and 2 ETH/block which means they will make 4,818,701 ETH (about 4,800k) annually in total with about 5% of inflation (4,204,800 ETH + Uncle block reward of 613,901 ETH).
After Casper
Vitalik estimated that ETH annual yield will be 500k ETH presuming staking 10 millions with 5% interest after switches to POS. (APPENDIX 4) This means that block compensation decreased from 3 ETH to 0.22 ETH assuming the current block generation time of 15 seconds and expected inflation rate of 0.5%. In addition, given the fixed output, inflation over time will eventually converged at 0. Also, Danny Ryan, a key member of Ethereum, suggested EIP 1011 (APPENDIX 5) will create ETH compensation of 0.6 ETH (2 million ETH/year) with the 1.5% inflation after switch to POS. This calculation meets the Ethereum’s inflation estimate of 0–2%. (APPENDIX 6) Therefore, ETH block compensation will be fixed between 02.-0.7% after switch to POS. On the other hand, assuming Casper is launched first and then Sharding comes next, there will be some time differences to the compensation. (APPENDIX 7) Nevertheless, the final ETH inflation level would be in 0–2% range follow by Vitalik and their core developers.
Current Ethereum Price in Supply Side
After applying Casper, overall estimation of ETH inflation kept between 0–2%, which decreased the current mining compensation of 3 EHT/block to staking compensation between 0.2–0.7 ETH/block as well as supply side. In addition, it could decrease the liquidity due to many ETHs get caught up on staking.
Due to Casper (APPENDIX 8) delays, there will be some gap at least 12 months. Nevertheless, annually ETH yield will be about 4.8 million ETH even the block compensation decrease to 2 ETH after the Constantinople high fork.
In conclusion, considering the supply point of view, the increase of ETH due to the delayed Casper, the decrease in the expected Store Value effect on ETH, and the consequent decrease in investment demand could put down pressure on the price of the ETH.
Long-term outlook — Supply side of forecasts
Vitalic and his core crew showed some signs that the volume of Ethereum is expected to decline after Casper. Early this April, Vitalic expressed his concerns about Ethereum infinite supply model and suggested limiting the capacity: according to him “Cryptocurrencies with inflation could lose its value, which could lead to a loophole protecting the power of capital networks”. This shows that ERC-20 tokens could be more useful for Value Storage if ETH supply capacity isn’t regulated, and the higher market value on a token will put ETH network in a difficult situation. (APPENDIX 9) His comments, which was about there will be no incentive for subsequent participants if the volume of publication is restricted, are still very controversial in the ETH community. Going forward, the community should focus on estimating inflation and restriction after Casper.
Based on the discussion, Ethereum Foundation and core developers are unlikely to reduce the purchasing power and indefinitely secure liquidity by increasing the quantity of ETH. It will be challenging to see the decrease in value over time when the platform coin is used as medium for exchange. Unlike the legal currency, the effect of long-term retention will be reduced, which could make it unclear on platform existent due to the weakened network protection.
2. Cryptocurrency market induced inflation and imbalance due to ICO — demand-side approaches
Inflation is simple when it comes to the issue of ETH, but there is an ironic side to the ETH smart contract and the fluctuation of cryptocurrency supply and demand in ICO market.
At first, cryptocurrency was originally created due to the Fiat Currency’s frequent mistakes that decreased in value from the over-issued currencies. The existing Fiat Currency is a currency issued by the central bank without guaranteeing its value to specific assets. Especially countries have been regulating the quantity of currencies based on the Fractional Reserve Banking System; this system for banks to flexibly control the amount of assets that are exchanged around the world by taking out loans of 100 and deposit of 90 by tying/holding up 10 assets.
Satoshi Nakamoto, the founder of Bitcoin, has limited the amount of Bitcoin quantity in protest of the system. However, the technology of blockchain has not only played a role as a currency. The smart contact function, which made trustless third-party transactions useful, was implemented in blockchain giving a glimpse of the explosive industrial expansion.
At the center of this industry expansion there is the ICO. The ICO is a way to issue new tokens to the market and create a new blockchain ecosystem through the sale of those tokens. The success of several early ICOs has driven many investors’ attention which has led to more than 1,800 current currency transactions in the cryptocurrency market compared to 7 types in 2013.
However, some of the events were brought up on the market. Demand for Bitcoin and Ethereum, which are the main existing currencies to enter the ICO market, has exploded, and thanks to this Hype, new cryptocurrency has generated high yields without verification. Even more unusual event was that the market capitalization of the cryptocurrency market has increased exponentially through the indiscriminate increase of money. In addition, it has expanded the liquidity of the issued cryptocurrency compare with the existing Fiat Currency.
Satoshi Nakamoto’s wary has come real. The decline in the value of the currency due to the issuance of excessive money and expansion of liquidity started to occur. The cryptocurrency market is now appearing to be leading to a plunge in the value of money after the rapid bubble formation. In December 2017, the total market capitalization of the cryptocurrency market fell below the current USD 200 Billion due to successive plunges since it reached USD 800 Billion at its peak.
Ethereum brought up on hotspot in the declined crypto market. Ethereum has become the center of the DAPP (Decentralized Application) platform due to its relatively easy development environment with smart contact function. The number of DAPPs created on the Ethereum platform are more than 1,900, which is more than 99% of DAPP that currently exist. Therefore, ETH became the priority currency in ICO investment, and it is estimated to represent about total accumulation of 13 billion USD since 2016 in ICO market.
The charts below show clearly. It is difficult to find out which mechanism was applied, but the price of ETH and ICO projects fired up the positive feedback loop.
There is another issue followed by the positive feedback loop. Each successful ICO project must raise R&D costs. From ICO white paper, the implementation timeline is set for 3–4 years. Later when DAPP ecosystem are successfully created, that is a time to maintain and repair the ecosystem using reserve tokens. In calculation, more than 2.9 billion ICOs are required when 4 years of research and development costs are carried out. According to a recent Satis Group analysis, 81% of recently listed tokens have led to fraud, 6% faced failed fundraising, and rest of 5% of projects were eventually ended. Currently the ICO returns has decreased as well as ICO performances. This could affect the ETH supply and demand. Therefore, we see the ETH price is based on how big and successful ICO can go.
According to another research firm, DIAR, tracked 51 ETH ICO accounts and found that 63% of ICOs are currently collected their raises. Facing uncertainty of whether they were transferred to the hard wallets or already sold, there will be about 16% of continuous sales between April and August.
Long-Term Outlook — Predicting Demand side
Smart Contract let the market to be guaranteed on the reliability of transactions without the middleman, and individuals could expand without the market trust. We see that the blockchain revolution will make it easier to exchange individual’s values without any related businesses. By doing so, it will bring extremely high returns to individuals and other derived markets will form fast enormously.
Although, there is still a long way to go. As an example, Amazon, was founded in 1994 but the company began to make profits after enduring years of doubt about its business model after being ‘worshipped’ by the internet believer in IT bubbles in the 2000s. Blockchain world is not an exception. It could take longer than we anticipated to let the people see its economic value.
One thing that is for sure, if any blockchain protocol can simultaneously secure decentralization and scalability, ETH has shown one early example, making a big ripple in the fight for the next protocol.
3. Conclusion
As we have seen earlier, connection between the liquidity limitations from a long-term view on decrease of capacity and staking, and DAPP as a supporter of demand are certainly attracting investors.
However, from a short-term perspective, the most important determinant of the current ETH price is the demand from the ICO project’s role as a financing mediator. The price of ETH will be mainly affected by the sale of ICO projects, and the success will attract future investment.
Ultimately, for ETH to overcome the issue, securing a user-friendly DAPP is paramount, and the issue of scalability must be addressed. (That is why some people think the future cryptocurrency market is at Shasper (Casper + Sharding).
At last, we want to emphasize two things to keep in mind: have the scalability to be widely used in real life, yet do not undermine the value of decoupling.
Appendix: Value of currency
The currency intrinsic value is deeply related with the economy. The key to the method of currency valuations is the currency exchange equation: MV = PT.
MV = PT
M: Money supply.
V: Velocity of circulation
P: Average price of transactions
T: Total number of transactions
The formula is not easy to apply in cryptocurrency economy. Let us start from the top, “M”. It collectively refers to the money supply, which refers as a fixed supply (number of coin) in cryptocurrency world. It will have a certain output in mining, but the real money can adjust liquidity on the market through banks and other financial institutions. The role of regulating the liquidity of cryptocurrency will be played by as we call “whales” who hold large amounts of money. Currently, the value of M may differ from the amount of actual currency issued.
The issue above could be solved by adjusting the adequacy of the velocity of money. The “V”. However, there are limits to the fact that “whale” movements could instantly affect the value of money, which could not be estimated from the collected transaction data. Moreover, even in real economics in the form of Exchange, estimating the money distribution speed is the most difficult value.
In conclusion, the calculation can be explained as M = P * T / V. We could assume that the number of cryptocurrencies is fixed, however, the right interpretation is to value the entire cryptocurrency from M. To do so, we could calculate the value of each cryptocurrency based of the total amount of coins.
In the end, the most important part of determining the value of future cryptocurrency assets is P * T. The key to the value of a particular cryptocurrency is the size of the economy using that currency. The DAPP ecosystem is fragile, and we should keep that in mind that estimated accuracy will have exponential errors until we correct/fix the Scalability issue. Therefore, speaking about the value of the actual cryptocurrency could be a chary topic until the development of the ecosystem and the winner takes place. The purpose of this analysis, supply and demand for cryptocurrency, is to share applicable information for investors.
Disclaimer
- This article contains personal opinions and may not be consistent with Fair Square Lab team.
- While we have made every attempt to ensure that the information in this article is obtained from reliable sources, but it may include any misinterpretation or errors.
- Fair Square Lab nor the authors are not responsible for any errors for the results obtained from the use of this information. All information in this article is provided “as is” which no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.
[1]https://blog.ethereum.org/2014/04/10/the-issuance-model-in-ethereum/
[2]https://medium.com/@eric.conner/a-case-for-ethereum-block-reward-reduction-in-constantinople-eip-1234-25732431fc77
[3] https://www.coindesk.com/ethereum-developers-move-to-reduce-new-cryptocurrency-creation/
[4] https://www.trustnodes.com/2018/03/22/ethereum-slash-inflation-90-just-0-5-year-says-buterin
[5] https://github.com/ethereum/EIPs/blob/master/EIPS/eip-1011.md
[6] https://www.finder.com/ethereum-inflation-rate
[7] https://cointelegraph.com/news/ethereum-to-combine-casper-and-sharding-upgrades
[8]https://bitcoinmagazine.com/articles/devcon-4-will-set-stage-ethereums-next-milestone-constantinople/
[9]https://www.coindeskkorea.com/%EB%B9%84%ED%83%88%EB%A6%AD%EC%9D%98-%EC%A7%84%EC%A7%80%ED%95%9C-%EB%86%8D%EB%8B%B4-%EC%9D%B4%EB%8D%94%EB%A6%AC%EC%9B%80-%EB%B0%9C%ED%96%89%EB%9F%89-%EC%A0%9C%ED%95%9C/
[10] ICOdata, CryptoMarketCap.com 자료
[11] www.coinmarketcap.com
[12]stateofdapps.com
[13] coinmarketcap 월간 자료(매월 마지막주 집계)
[14] Satis자료 http://research.bloomberg.com/pub/res/d28giW28tf6G7T_Wr77aU0gDgFQ
[15] DIAR 자료 https://diar.co/ico-treasury-balances/
