Grayscale: The battle for value on smart contract platforms

Text: Grayscale Research, Translation: Golden Finance xiaozou

Abstract

· In the field of smart contract platform encryption, value accumulation is a flywheel that links fees and network usage to token valuation and the security and decentralization characteristics of the network.

· Networks within the field of smart contract platform encryption take a variety of approaches to compete for fee income: some platforms seek fee income at relatively high transaction costs, while other projects try to obtain more transaction volume at relatively low transaction costs.

· Grayscale Research believes that fee income can be regarded as the main driver of token value accumulation in this market segment, but other fundamental factors are also important because they will affect fee income over time.

· While industry leader Ethereum has accumulated network fee income for several years (over $2 billion in 2023), other smart contract platforms such as Solana have also shown maturity (about $200 million in fee income so far in 2024).

There is a common misconception that crypto assets have no fundamental value and cannot be analyzed like traditional investments. Grayscale Research believes that this is not the case. For example, smart contract platforms like Ethereum and Solana generate fee income from economic activity on their own networks. Grayscale Research believes that one way investors value assets in the smart contract platform crypto space is by analyzing their fee income generation ability over time.

1, Smart Contract Platform Fundamentals

Smart contract platforms like Ethereum and Solana are networks that support developers to build decentralized applications, involving a variety of applications from games to finance to NFTs. The role of a smart contract chain is to process transactions for the applications it serves in a secure and censorship-resistant manner.

As such, the value of a smart contract platform is inherently tied to activity on its network. Key metrics of network activity include the number of transactions the network can process, the number of users it can support (usually measured by daily active addresses), the value of assets it can support — known as total value locked (TVL), and the network’s ability to monetize its block space, or network fee revenue — more on that later.

Each metric tells a story. For example, Ethereum’s lead in the TVL metric ($66 billion, more than 7 times larger than its next-largest competitor by TVL) reflects its liquidity advantage and value proposition for financial applications. Additionally, its lead in the total number of ecosystem applications creates a network effect that continually attracts new developers, applications, and users. Meanwhile, Solana’s daily transaction count — reflecting its throughput advantage and low costs — makes the chain more suitable for high-volume use cases like DEPIN, as well as retail-friendly use cases like NFTs and meme coins.

In addition to comparing these basic metrics between assets, investors can also think about this data in the context of market capitalization, or the market's current valuation of a particular asset. For example, as shown in the figure below, while Solana's TVL ($4.7 billion) is currently higher than Arbitrum's ($3.2 billion), Arbitrum's market cap to TVL ratio (1x) is much lower than Solana's (16x). These metrics can not only allow investors to understand the relative strengths and weaknesses of different assets, but also help them discover value.

Figure 1: Smart Contract Platform Fundamentals

(Bold indicates the largest fundamental indicator in its category)

2, the core role of fees

Although there are many different ways to measure network activity, theoretically and empirically, the most important fundamental variable for smart contract platform valuation is network fee revenue (see the figure below). This indicator can be thought of as the total fee paid by users for using the network. There are many different revenue models for smart contract platforms, but all ultimately generate fees in order to provide value to token holders.

Similar to centralized entities in traditional industries, decentralized networks also use different ways to compete for fee revenue. For example, some smart contract platforms seek fee revenue at relatively high transaction costs, while others try to get more transaction volume at relatively low transaction costs. Both approaches are valid methods. Let's assume there are two blockchains as follows: Chain 1: Small number of users and transactions, high cost per transaction 5 users, 10 transactions, $10 per transaction Network fee revenue = $100 Chain 2: Large number of users and transactions, low cost per transaction 100 users, 100 transactions, $1 per transaction Network fee revenue = $100 The example above shows that both chains generate the same amount of network fee revenue, even though Chain 2 has more users and total transactions. While metrics like users and transaction volume are also important, they need to be considered in conjunction with transaction costs as these will determine fee revenue.

The importance of fee revenue holds true both empirically and theoretically. For example, the chart below shows the relationship between fee revenue and market capitalization for each component of our smart contract platform crypto space. While the crypto market is still maturing, investors are already distinguishing between different projects based on fundamentals. Grayscale Research’s analysis shows that the relationship between fee revenue and market capitalization has been relatively stable over time, with fee revenue being more correlated with market capitalization than other metrics of smart contract platform fundamentals.

Figure 2: Network fee income is most closely correlated with market capitalization

Grayscale Research believes that part of the reason for the close relationship between fees and market capitalization is that network fee income is critical to token value accumulation. Value accumulation means that the protocol structures its token in a way that ties network activity to the long-term sustainable value of the token. The following three examples show different stages of value accumulation: Ethereum, Solana, and Near.

(1) Ethereum: The “Premium Chain” of Value Accumulation

The first and largest smart contract blockchain by market cap, Ethereum, began to face serious scaling issues starting in 2022. Increased usage led to network congestion, which made transactions expensive for users: its average daily network fees reached a high of $200 per transaction on May 1, 2022.

However, increased usage and high average transaction fees also translated into significant value accumulation, with Ethereum generating more than $2 billion in total network fee revenue in 2023. The Ethereum network’s network fee revenue consists of two parts: base fees and tips. Whenever a user pays a transaction fee, the base fee is burned, removing ETH supply from the network. At the same time, tips paid for prioritizing transactions are distributed as rewards to validators and stakers who help secure the network.

Thus, the massive Ethereum network earnings in 2023 resulted in the burning of approximately 2 million ETH (1.7% of the supply), accruing value for ETH holders and providing $390 million in rewards to validators and stakers, incentivizing the promotion of higher levels of network security.

Ethereum has reached a stage of maturity where it has demonstrated its ability to generate value accumulation. On the Ethereum mainnet, users pay a premium for premium products - in this case, block space backed by the smart contract platform with the greatest network security. This is particularly important for applications that involve large amounts of transaction value and prioritize network security, such as stablecoins or tokenized financial assets. Its ability to monetize users is quite mature, which is reflected in its $458 billion valuation (as of June 6, 2024), nearly six times that of other smart contract platforms.

Figure 3: Increased network usage (reflected in periods of greater supply consumption) tends to correspond with higher valuations

(2) Solana: A “high-performance chain” for value accumulation

While Ethereum has a fee-earnings model, Solana has taken a different approach and has recently been closing the gap with the market leader and making significant progress. Solana, the second-largest smart contract platform by market cap, has long been considered a faster, cheaper alternative to Ethereum, with impressive transaction processing speeds (335 transactions per second) and low costs ($0.04 per transaction fee on average). However, in previous years, Solana has not been able to convert these into fee revenue. In 2023, despite processing significantly more transactions, Solana only generated $13 million in network fee revenue, compared to Ethereum's $2 billion (154 times less).

In the past, the lack of a value accumulation mechanism was a relative disadvantage for Solana, however, this changed in 2024. So far this year, Solana has generated 6 times more fees than in all of 2023, narrowing the fee gap between Ethereum and Solana from 154 times in 2023 to 16 times (as shown in the figure below). This shows that the Solana model - low transaction costs and high throughput - also helps create economic value. Figure 4: Solana has begun to accumulate value through its fee calculations. It is worth noting that this large increase in fee income coincides with a large increase in market capitalization. The large increase in network fee income is mainly due to the large increase in average transaction fees (up 37 times compared to last year) rather than the overall increase in transactions (up only 33% compared to last year). Ironically, the increase in average fees for a blockchain that has traditionally been called the "cheap option" coincides with the decline in Ethereum L2 transaction fees due to the Dencun upgrade (see figure below). Since April 1, the average transaction fee for Solana users ($0.04) is still lower than Ethereum ($4.80), but higher than Arbitrum ($0.01).

Figure 5: ETH's Dencun upgrade makes Layer 2 cheaper; the increase in fees helps Solana achieve value accumulation

Since Solana's per-transaction fees are more expensive for its users than Ethereum L2 Arbitrum, it may jeopardize its position as a cheap, high-throughput chain. Nonetheless, Grayscale Research believes that overall this fee growth is healthy as it reflects both high levels of user activity and value accumulation for stakers and token holders.

(3) Near: Solid adoption for onboarding to crypto, but early in network monetization

The above two examples stand in stark contrast to the smart contract platform Near, which has recently gained significant adoption through non-speculative use cases but has yet to demonstrate its value accumulation capabilities. Near is the underlying platform for KaiKai and Hot Protocol, two of the largest decentralized applications (dApps) for all crypto users. Near leads all smart contract platforms with 1.4 million daily active users and competes with the fastest chains in the industry, such as Solana, in terms of throughput (see chart below).

Figure 6: Near leads all smart contract platforms in daily active users

Despite its lead in user numbers, Near is still far behind its competitors in terms of user monetization, with only $4.1 million in fee income so far this year. This indicates that it is currently in a relatively immature stage of development, which is also reflected in its valuation relative to its competitors (market cap of $7.9 billion, compared to $458 billion for Ethereum and $78 billion for Solana). While the Near network has demonstrated the ability to process transactions at high speeds, it currently does not provide cumulative value to token holders or stakers.

Although Near’s profitability has been relatively weak so far, its mass adoption is an important starting point. If the network can continue to expand network adoption or increase average transaction fees without reducing network activity (similar to Solana’s recent progress), it can achieve meaningful value accumulation.

Each of the three smart contract platforms—Ethereum, Solana, and Near—represents a different stage of maturity in the decentralized network’s creation of network fee revenue. Ethereum has many years of revenue and growth. Solana has a strong user base but is only just beginning to generate significant revenue. Finally, Near’s product has shown traction in part because of its low costs, but has not yet generated significant revenue.

3, Notes and nuances on fees and valuation

To be sure, there are many notes and nuances when it comes to fees and valuations in the crypto space of smart contract platforms. First, each protocol involves different forms of value accumulation and different rates of token distribution (inflation) and token burn (deflation). For tokens with higher inflation rates, the impact of fee value accumulation may be greatly diluted by the distribution of tokens. Each protocol has its own fee structure. On Ethereum, transaction fees promote token burns, benefiting all token holders, and priority fees are distributed to validators and stakers. On Solana, the distribution is different: 50% of transaction fees are burned, and the remaining 50% goes to stakers. Recently, a governance vote determined that all of Solana's priority fees will be paid directly to validators. These measures reflect Solana's greater validation hardware requirements. In addition, the high level of MEV activity on Solana provides additional rewards to validators and stakers, but constitutes an "indirect" cost to token holders. So, ordinary token holders will receive more value in Ethereum's fee structure, while Solana's validators and stakers will receive more value through Solana.

Similar to how the valuation of traditional assets may involve discounting future cash flows, the valuation of cryptoassets may also involve discounting future expected network fees. This variable captures the potential future growth in adoption, usage, or monetization of a particular network in a different way than the total fees currently generated. For example, one could reasonably argue that Ethereum’s $458 billion valuation reflects not only the fees it currently generates, but also its potential to leverage network effects and the potential for future growth in L2 adoption, usage, and fee income.

Finally, the valuation of certain cryptoassets may include a “monetary premium.” In other words, users may be willing to hold an asset because its functionality as a medium of money — as a medium of exchange and/or store of value — outweighs the network’s ability to generate fee income. For Ethereum in particular, the idea of ​​a monetary premium may be very important to its valuation considerations (especially if the token is widely used as collateral assets across the industry).

4, Conclusion

If value accumulation is correctly implemented into the protocol, increased network usage will not only incentivize users to hold tokens, removing them from circulation and hopefully facilitating their value growth, but also to become validators or token stakers, thereby helping to improve network security. In addition to network security, transaction fees will incentivize more validators to join, thereby promoting greater decentralization and censorship resistance. So, value accumulation is a flywheel that links fees and network usage to token valuation and the security and decentralized nature of the network.

But it is important to recognize that while fees can be used as an indicator of network maturity, there are many other factors in this flywheel that can affect the growth of a network and its valuation. For example, if a particular application is widely adopted, it may bring in more users and attract more developers to build in the same ecosystem. Therefore, network fees should be considered in the context of other fundamental indicators and the relative valuation (market cap) of a particular ecosystem.

Looking forward, it will be important to keep an eye on some of these growth narratives. Despite relatively high average transaction costs for users ($4.80), can Ethereum continue to sustain fee growth on mainnet through high-value transaction use cases such as tokenized financial assets? Can Ethereum increase its transaction fees as L2 activity increases? How will Solana balance profitability with maintaining its own transaction costs low enough to avoid losing users to other cheap, high-throughput chains? Will Near attempt profitability, or will it forgo meaningful fee gains in favor of user growth as it has done in the past?

These dynamics underscore the importance of monitoring fundamental metrics, including fees, transactions, active users, and TVL. Grayscale Research believes that as the crypto asset class continues to mature and gain more adoption, these fundamental metrics will continue to grow in importance. These metrics will provide deeper insights into the relative strengths and opportunities in the crypto space for smart contract platforms, ultimately helping guide informed investment decisions by promoting a more nuanced understanding of network value.