Fundamental Analysis of Ethereum Price Plunge

Exactly one year ago, the price of Ethereum hit an all-time high of $1,448.18 on 13 January 2018. However, in the mid-2018, the price of Ethereum started to slump and this caught many crypto investors by surprise. By January 2019, Ethereum lost 90% of its value over a year. Ethereum’s speed of decline was one of the highest among the coins which experience price plunge.

Will Ethereum lose its value completely? To answer that question, we’ll need to understand the factors that determine Ethereum’s price.

According to Vitalik Buterin’s initial white paper, Ethereum was not originally intended to be used as a currency or to have any more than a nominal value but Ethereum is “a blockchain with a built-in Turing-complete programming language, allowing anyone to write smart contracts and decentralized applications.” That capability has led to new use cases for Ethereum, such as its use as a platform for ICOs.

Ethereum’s value today is tied to its ability to fulfil the promise of being a foundation for decentralized development as well as being a cryptocurrency. The triggers that can cause a price drop spring from both of these functions.

Trigger 1: Tokenization Falter and ICOs Sell-Off Factor

A token is any digital asset built on top of a blockchain. Currently, there are over 1,000 actively traded tokens, the majority of which are built on Ethereum’s blockchain. Developers can use tokens as the basis for building a type of protocol called decentralized applications, or DApps, on the token’s blockchain.

A graphical, high-level representation of the Ethereum ecosystem. Source: Hackernoon

Two main reasons why the majority of ICOs is built on Ethereum blockchain:

a. Ethereum’s native protocol

Ethereum’s native protocol makes it easy to use smart contracts to build new tokens on top of its blockchain what one might call “nonintrinsic” tokens, meaning that (unlike the “intrinsic” ETH) they weren’t originally part of that blockchain — which makes it an ideal platform for initial coin offerings. ICOs typically gain funding by selling their nonintrinsic tokens in exchange for Ethereum. If an ICO project is successful, the tokens may become valuable as a way to purchase the product or service, at which point investors can either use them or sell them to others. If a project fails, the tokens will become worthless, and investors may receive little or no return on their pre-ICO Ethereum donation.

A graphical model of the distinction between intrinsic and non-intrinsic tokens on the Ethereum blockchain.

b. Ethereum network effect

Building an ICO on the Ethereum blockchain also allows developers to take advantage of Ethereum’s “network effect.” Ethereum is a popular investment, so fundraising ICOs can tap into the large pool of existing ether holders for fundraising purposes. As a result, ICOs can be an effective fundraising mechanism both for Ethereum-based tokens (for example, Gnosis and Augur) and for tokens built on entirely new blockchains (for example, EOS). The latter ICOs can use Ethereum for fundraising by selling their own tokens in exchange for ETH via smart contract.

When a large number of ICOs (or a few heavily hyped ones) are in the works, people will likely buy quantities of ETH so that they can invest in said ICOs — which may drive up the price of Ethereum courtesy of the law of supply and demand. For example, Block.one investors had contributed over 7 million ETH by June 2018. The total Ethereum supply today is just under 103 million, so that one ICO tied up almost 7% of the entire supply.

Note how ETH’s 2018 price peaked in May and has been trending down ever since. That timing matches Block.one’s ICO quite closely.

Source: BitInfoCharts.

There was a total of 875 ICOs in 2017, bringing in over $6.2 billion USD in funding (by contrast, in 2016, there were a mere 29 ICOs). That’s an enormous amount of Ethereum passing back and forth between investors and ICOs.

When interest in ICOs wanes, investors no longer need to buy up large quantities of Ethereum for that purpose. For that matter, when an ICO is complete, the new company is likely to sell off much (if not all) of its Ethereum holdings to get the fiat money it needs for operations. Again, Block.one (the creator of EOS) is a good example of this type of activity.

Source.

The sell-offs on both counts that occurred in 2018 likely contributed to the substantial Ethereum price drop reflected in the above price chart.

“ICO fever” is only one potential cause for interest in ICOs rising and falling (and the price of Ethereum with it). For example, the SEC considers most ICOs to be security offerings, and the agency has issued numerous subpoenas to ICO issuers and cryptocurrency funds in order to investigate their compliance with federal securities laws. This kind of increased regulatory scrutiny on crypto has the potential to temper ICO interest, both on the side of ICO issuers and on the side of ICO investors.

Although Ethereum can be used for a number of things, the bulk of the costs of running a startup are in fiat currency. Hence, these projects would have to get the bulk of their ICO pot converted into fiat currency. It is important to acknowledge that the amount raised by ICOs in their token sales do not necessarily mean new capital coming into the market but rather existing capital stored in major cryptocurrencies like Bitcoin and Ethereum moving to ICOs. This shows bad Asset / Liability management principles on their part and hence resulted in them getting caught off guard with the fall in the value. This has led to a sort of self-fulfilling prophecy as ICOs panic that other ICOs are selling and crashing the price.

Trigger 2: DApp usage plummets

Ethereum’s primary purpose is to serve as a native currency for the blockchain network to power computing via smart contracts, which developers can use to build DApps.

DApps have great potential, but they face substantial hurdles in these early days:

  • Usually, DApp users must first purchase the DApp’s own token before they can use the program. Right now, the relatively technical and unintuitive process of buying and using tokens consequently poses a significant barrier to entry. Remember, the majority of DApps are built on Ethereum, so users must convert Ethereum in order to get the DApp’s own tokens — they can’t just use fiat currency. Some DApps use Ethereum rather than creating their own tokens, but that still requires users to buy Ethereum to use the DApp.
  • A second major hurdle relates to Ethereum’s scalability. The Ethereum network is currently slow and inefficient, so as DApp usage increases, those users must spend more Ethereum simply to complete a transaction. The Ethereum network needs to be able to process more transactions per second before it can support high DApp usage. Developers are well aware of this limitation, and many are working on projects to improve Ethereum’s scalability, including Casper and Raiden Network.
  • Finally, transaction fees present a third hurdle for ICOs. Each transaction DApp users generate costs a certain amount of gas. Thus far in 2018, users have averaged 707,766 transactions per day. The average cost per transaction was 0.0976 ether or the price today (3 Januart 2019) is 14.6USD. However, during times when Ethereum’s price skyrockets, transaction fees can become prohibitively expensive. For example, in mid-January 2018, Ethereum hit a peak of $1448.18 USD. That means a transaction fee of 0.0976 ETH on that day would have cost users $141.34 USD. If users can’t predict how much a transaction will cost from one day to the next, they could be nervous about committing to heavy DApp usage.

Thus far, DApp usage has remained quite low. Of course, DApps are still very new: cryptocurrency itself has just barely begun to achieve mainstream acceptance, and most DApps have been around for only about a year. But, as the below chart shows, usage of all DApps put together peaks at fewer than 34,000 users per day and is usually far lower.

Source: Dappradar.com/charts

The DApp usage is prone to dramatic peaks and equally dramatic troughs. As hot new DApps are released or old ones catch the public’s eye, the sudden surge of interest can inspire new users to buy Ethereum for access to said DApps — and when interest drops again, so does the need to buy up Ethereum. This could easily result in major swings in Ethereum’s price.

What do Ethereum price drops mean?

We can’t ever really know with certainty what leads to a specific Ethereum price drop, but the above triggers can give us a good framework to think about those price drops based on what Ethereum is. Similarly, a framework for understanding Ethereum price drops isn’t especially useful unless one also has a framework more thinking about the fundamental value of Ethereum.

The future of Ethereum

ICO activity, DApp usage (or lack thereof), and market pressures may seem plausible as current triggers of Ethereum price drops, but other factors could also arise and yield similar effects in the future.

For example, Ethereum is no longer the only option for building DApps: EOS and other competitors have begun to grab some of the DApp market share. These competitors operate on their own blockchains, using different approaches to manage transactions in order to address scalability, processing time, and similar issues. If one of these alternative cryptocurrencies were to attract a large percentage of DApp developers, it could potentially draw investors away from Ethereum, leading to a price drop.

Apart from a certain portion of the ICO sell-off, there are people who are still holding a fair amount of ETH. The much-hyped Ethereum Improvement Proposal (EIP) where Casper Protocol will see Ethereum switch from PoW to a PoS system. So, while the impact of ICO selling could persist throughout this bear market, the “panic” would eventually cease. If developments continue and the updates are successfully rolled out, institutional and retail demand from Ethereum could pick up again.

So, when is the scheduled Casper Proof of Stake expected to arrive?

Vitalik and the team revealed that Ethereum 2.0 — namely the Casper upgrade and the addition of sharding — to begin rolling out in 2019. After that, Ethereum 3.0 would enable quantum secure systems i.e. systems that can withstand the power of quantum computers.

Ethereum’s shift from PoW to PoS is a very big deal indeed. Casper is a complex and important update for one of the world’s largest digital currencies and, if successful, it could be key to overcoming the scalability, energy inefficiency and centralization risks currently facing the network. However, the switch to PoS isn’t without its own obstacles and risks, so it’ll be fascinating to watch how it all unfolds.

Hence, in the short term, it is more likely that the ICO phenomenon could still impact on the price of Ethereum. However, in the medium to long-term, the focus will once again pivot to the technology.

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