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MEMO W17 APR 2024

Usage over possession. This will drive the future. - xh3b4sd

Over the past couple of weeks some debates have started around the amount of ETH issuance that Ethereum uses to secure the network. Some researchers think that Ethereum is paying more than it should for securing the network. The argument here is related to the idea of a balanced household budget, and what it takes to achieve such a balance. The main concern some researchers are trying to address here is the amount of ETH staked relative to the total supply of ETH. Some arguments raised concerns that one day all of the ETH in existence could potentially be staked. The amount of ETH staked is one important metric to consider for a healthy and sustainable blockchain network, because staked ETH implies ETH tokens wrapped by another token to some extend. Examples of wrapping ETH could be liquid staking or restaking. And since wrapping ETH does always imply some form of risk then all of ETH staked might become a systemically critical issue given that the majority of ETH staked is wrapped in some third party ETH derivative contract. So for one we do not want to overpay for security. And then we want to make sure that the majority of ETH in existence is not wrapped in all kinds of smart contracts that implicitly carry all kinds of risk with them. I have one interesting data point to contribute here, based on my own anecdotal observations. So far I have not seen a significant proof of stake network that ever had more of their native tokens staked than roughly 80%. So far, we have never seen a relevant proof of stake network that had 100% of its tokens staked for a significant amount of time. The current ETH issuance curve predicts a real total staking yield of 1% per year at 80% of ETH staked, and that is including all MEV related yields. If we consider 1% of staking yield at 80% of all ETH staked, we could maybe look at the ETH issuance debate this way: "John Bull can stand many things, but he cannot stand two per cent.". That timeless wisdom was once brought forth by Walter Bagehot, expressing the observation of some form of financial eqiulibrium. Throughout the decades and centuries, all kinds of investors, on average, have one thing in common. They are unwilling to tollerate a yield below 2% for their hard earned money. Engineering and mechanism design back and forth, the socio economic perspective tells us that all of ETH will never be staked, simply because the current issuance curve does already cause too much pain for ETH stakers at 80% of all of ETH staked, because at that point everyone is only getting 1% yield anymore. And that is not good enough for anyone. Given only that line of thought we could argue that the concerns of having all of ETH staked one day are rather unreasonable. One interesting question to ask here now is how much additional yield one can get using protocols like Eigenlayer, considering the additionally taken risks involved. My expectation would be that people would be wanting to increase their yield from 1% to 3% or maybe even 5% using all kinds of layering techniques, once 80% of all ETH staked has become a reality. At that point, some will certainly go far out on the risk curve. But most wont, simply because it would imply too much of a bad trade from a risk adjusted point of view. My currently more realistic assumption would be that there won't ever be more than 60% to 80% of ETH staked, for a variety of reasons as described above. And then, generally speaking, instead of trying to artificially defining a magic number of some desired amount of ETH staked, and instead of prematurely defining a magic curve that will never be able to account for most of the future unknowns, it would be a more pragmatic and more antifragile approach to make unstaked ETH more attractive and competitive across the available crypto economic systems than trying to manually configure the amount of ETH issued in perpetuity. Let the market decide what is right and good.

In Ethereum land we saw some headlines about its Q1 profitability. With 1 billion USD revenue in Q1 2024, Ethereum has a profitability of around 35%, which is used to effectively do something akin to share buybacks. That equates to roughly 0.1% of quarterly share buybacks relative to Ethereum's market cap. That alone might not be dramatically relevant in the grand scheme of things. What is more important here is that Ethereum as a blockchain network is profitable at all. And among all economically relevant L1 blockchain networks, Ethereum is the most profitable of them all. For comparison, Ethereum had a positive cashflow of 370 million USD in Q1 2024. Bitcoin had a negative cashflow of almost 4.5 billion USD in that same time period, and Solana had a net negative cashflow of almost 800 million USD. A net positive cashflow implies a positive security budget, which makes for healthy long term economic security. A net negative cashflow implies a negative security budget, which makes for unhealthy long term economic security. The future outlook for Ethereum remains to expect the current positive security budget. And the future outlook for Bitcoin and Solana remains to expect the current negative security budget. Now what does this mean? I think nation states and blockchain networks can operate under negative security budgets for far longer than any individual can remain solvent betting against them. And while there might not be a simple bet to be had only based on either security budget, what will be more interesting to see in the long term is how blockchain networks may develop in order to address their individual security budget concerns.

There was an interesting thought I came across last week regarding higher interest rates and their impact for potential capital allocation. At the moment we do only expect one or two modest interest rate cuts in 2024. We are in the higher for longer environment. At the same time commercial real estate as an asset class does not promise any meaningful returns in the foreseeable future, compared to its performance in the past. I could not find accurate and conclusive data, but let's assume there is well over 1 trillion USD invested in US commercial real estate, which is mostly financed using debt. The funds that conclude, roll over or look for allocation may not be as likely anymore to choose commercial real estate as an asset class in the short to medium term. And that implies that this money has to go somewhere. Let's say that within the next 18 months about 300 billion USD are looking for a way to be allocated. That excess capital may has to go out on the risk curve as global liquidity will rise. And with that tech stocks and blockchain networks may catch a bit from what has once been a preference in commercial real estate, simply because higher rates make the gamble for certain asset classes not worthwhile anymore.

At last, I would like to invite anyone of my readers to reach out, if there are any questions or ideas for collaboration. I want to write about your startup, strategic execution and elegant mental models. My brand archetypes are sage, outlaw, magician and creator. If you would like me on your cap table as an angel investor, then feel free to send your pitch my way. If you would like my feedback or engage in an interesting conversation, then I am happy to chat or have a nice dinner over some sweet red wine. If you are a writer yourself, then I would love to talk about the art of writing and maybe get your feedback on my writings here. If you think we should work on something cool together, then please reach out and let's be friends.

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