The Ethereum Economy is a House of Cards
In terms of the growth of various adoption metrics, such as active addresses and daily value transferred, the Ethereum (ETH) network has been killing it over the past year or so. Various applications in the area of decentralized finance (DeFi) have been the main drivers behind this growth, as those new to the crypto asset space have been mystified by the yields that are possible with the emergence of these new platforms.
But a lingering criticism around all of Ethereum’s recent success is that all of this could be nothing more than a house of cards. First of all, there are a myriad of concerns around Ethereum at the base layer in terms of issues around centralization. Examples of this specific critique include: much of the activity on Ethereum is actually routed through a centralized entity known as Infura, it is becoming increasingly difficult to run an Ethereum full node as activity increases on the network, and there is an upcoming move to a completely different consensus mechanism in the form of proof-of-stake (PoS).
On top of that, there are also risks at the application layer in terms of the reliance on centralized stablecoins, the use of developer backdoors in projects that are supposed to be decentralized and trustless, the Ponzinomics around many of the ERC-20 tokens issued on the platform, buggy smart contracts, questionable cryptoeconomics, DeFi governance tokens being centralized in the hands of a few entities, and the oracle problem, just to name a few.
To summarize, the criticism here is that the Ethereum community is effectively taking shortcuts to adoption that will eventually come back to haunt them when one or more of these Jenga pieces are removed and the Ethereum economy comes crashing down.
Let’s take a closer look at some of the more unsustainable aspects of the Ethereum economy and see if there are any fundamental building blocks that could provide utility to users over the long term after all of the froth is removed.
Centralized stablecoins, ponzi games, and “DeFi”
According to ETHGasStation, two of the top four uses of the computing resources on the Ethereum network over the past 30 days (at least at the time of this writing) have been for transferring the USDT and USDC stablecoins, which are pegged to the value of the US dollar. The growth in the transfer volume of these sorts of centralized stablecoins on Ethereum is often cited as an illustration of the network’s underlying value proposition, and many believe that the use of these stablecoins on the Ethereum network should lead to a higher ETH price. Indeed, the burning of ETH to pay for stablecoin transactions is a key tenet of the “ultrasound money” meme that has popped up in Ethereum circles recently.
However, there are at least two key, related risks associated with the heavy use of stablecoins on Ethereum. An obvious one is that government regulators or lawmakers may decide that they do not want people making pseudonymous transactions with US dollars over the internet.
This would lead to a crisis of identity for Ethereum as a whole, as much of the platform’s supposed benefits are built around the use of a variety of different assets and currencies rather than just ETH itself.
For now, regulators may not be too worried about the use of stablecoins on Ethereum due to the serious privacy issues found with the network and other networks compatible with the Ethereum Virtual Machine (EVM).
Companies like Chainalysis can likely help law enforcement identify the real-world users behind a pseudonymous Ethereum account with a stablecoin balance, so it’s not like these stablecoins are making it easy to get away with doing illegal things with US dollars on the internet.
There are also risks to be explored in a situation where regulators do not clampdown on the use of stablecoins on public blockchains. After all, if these centralized coins have the approval of the regulators, then what is the utility of issuing them on public blockchains? The need for a public blockchain gets a bit murky when you’re not looking for regulatory arbitrage, so more efficient competitors to Ethereum may be able to offer a cheaper service by adding even more centralization to the backend.
This has already started to play out a bit in the real world, as the USDT transaction volume on Tron (TRX) surpassed the stablecoin’s volume on Ethereum in early April (though Ethereum has since regained a lead over Tron in this regard). Additionally, much of the Ponzi-esque activity on Ethereum has started to migrate to Binance Smart Chain, where there are now more active addresses and transactions per day than what is found on Ethereum. There’s also the RSK sidechain for Bitcoin (BTC), which may be preferred by those who are interested in using bitcoin as their collateral and unit of account when operating in the DeFi world, as a separate token is not needed for gas payments.
As mentioned previously, USDT and USDC are two of the biggest gas guzzlers on the Ethereum network. But it’s also important to note how important they are to the Ethereum economy as a whole. If you look at any of the popular DeFi applications on Ethereum, these centralized stablecoins account for a large percentage of the activity in those apps.
This is not some hidden data point at all, and it’s viewable on the stats pages for the most popular DeFi apps including Uniswap, Sushiswap, Compound, and others. Obviously, another large chunk of the volume on DeFi exchanges is made up of outright Ponzi games, recent examples being ELON and SHIB, that cannot get listed on more centralized, regulatory-compliant exchanges.
To be clear, this heavy reliance upon centralized stablecoins and Ponzi games for adoption is found in all major DeFi apps on Ethereum. In fact, Curve Finance is effectively built entirely around this concept.
Outside of centralized stablecoins and explicit Ponzi games, there are some ERC-20 tokens that act more like traditional stocks by paying dividends to holders based on revenue generated by a specific DeFi application. But of course, these tokens are reliant upon centralized stablecoins and Ponzi games for generating much of their revenue. And what would the value of Uniswap, for example, be if there weren’t any useful tokens to trade against ETH?
An additional risk with these “DeFi stocks” is that a new developer could come in and fork out the need to pay additional fees to the DeFi project instead of just the base fees that are required to send transactions on the base Ethereum network (as happened with the 0x protocol). Alternatively, a developer could copy a DeFi project’s codebase and tweak it to create an improved, competing project without much effort (as occurred when Sushiswap forked Uniswap).
And why are people using these DeFi apps in the first place? It’s due to the attractiveness of the high yields that can be generated on their stablecoins, ETH, and other ERC-20 tokens.
Where do these yields come from? It’s almost always one of the three following sources:
- an overcollateralized loan,
- the aforementioned dividends for holders of DeFi stocks,
- or printing new tokens to giveaway as incentives for users to use a particular DeFi app.
The third of these three potential sources of DeFi yield is perhaps the least sustainable, as inflating the supply of a DeFi project’s token to acquire new users can only work over the short term.
In fact, this is exactly the problem (loss of savings through inflation) bitcoin is intended to solve in the first place! In many cases, these newly-created tokens are then staked themselves in an attempt to generate even more yield.
Is there any fundamental utility here?
A notable exception to the point regarding the heavy utilization of centralized stablecoins in DeFi apps is MakerDAO, which also just happens to be the largest DeFi app in terms of total value locked (TVL). That said, there are a variety of issues with this platform as well. For one, the overcollateralization requirements for creating DAI means the system doesn’t scale. This is why various ERC-20 tokens, including centralized stablecoins, have been added as alternative collateral options to ETH.
There are also centralization issues around the federation of oracles that power the price feeds used in the MakerDAO system and concerns regarding the concentration of the project’s MKR governance tokens in few hands. The federated security model is often brought up as a critique of Bitcoin sidechains like RSK and Liquid, but for some reason it’s rarely ever mentioned as a potential risk in Ethereum circles in relation to their DeFi apps.
The oracle problem is an issue that may be unsolvable in terms of getting the same sort of assurances you get when you’re holding bitcoin on the base Bitcoin blockchain, so it’s unclear if a truly decentralized stablecoin for consumers will ever be a possibility (or even desirable).
Additionally, a bitcoin-collateralized stablecoin already exists on the RSK sidechain in the form of Dollar on Chain (DOC) as part of the greater Money on Chain platform. Due to the counterparty risks that appear to be inherent to stablecoin systems, it’s unclear if there is much to gain from having stronger decentralization at the base layer than what is available with RSK, especially considering the tradeoffs in terms of efficiency and the lack of a need for a new token for gas payments.
Many of the most interesting Ethereum DeFi apps involve the creation of these sorts of derivative assets based on collateral held in ETH, some ERC-20 token, or a combination of the two. Synthetix (SNX) is another example of this, although it is not currently in the top ten based on gas usage or TVL. The basic idea is to create synthetic versions of real-world assets like gold or Apple stock through derivatives backed by the protocol’s underlying SNX token. However, this platform has an even bigger issue with overcollateralization, requiring 7.5x collateral to back its synthetic assets.
Obviously, this is a use case that involves the oracle problem as well. Additionally, the use of SNX instead of ETH as collateral for these assets points to the misaligned incentives for developers who are building on Ethereum. The incentive is to pump the value of their own coin rather than ETH. A similar phenomenon can be observed with Chainlink’s LINK token.
So, the most useful Ethereum apps appear to be those that involve taking out loans against some collateral, which may not even be denominated in ETH.
This sort of functionality is also already available on the Bitcoin sidechains Liquid (via Hodl Hodl Lend) and RSK (via Sovryn and Money on Chain). There are completely centralized exchanges that offer this financial service as well. It should also be noted that there is already much more liquidity in BTC than ETH, and if you take away all of the fluff of centralized stablecoins and Ponzi games, this liquidity advantage for BTC should expand greatly, meaning the case for using ETH as collateral over BTC in these sorts of DeFi systems weakens.
At the end of the day, all this uncertainty about the possible outlawing of stablecoins, unsustainable yield-farming initiatives powered by token printing, smart contract risk, oracle risk, utility of DeFi apps if stablecoins are not allowed, increased competition from EVM-compatible chains like Binance Smart Chain and RSK, and many other aspects of the Ethereum economy trickles down to the underlying ETH asset itself, which has the compounding impact of making ETH less useful as money and, therefore, less useful as collateral.
A pivot from characterizing ETH as gas to calling it money is probably the correct move for ETH proponents; however, this change may be coming too late in the game, as Bitcoin now also has a variety of avenues via the Lightning Network, Liquid, and RSK to do DeFi things without the need for the introduction of a new token.
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