Information sourced from messari, with slight modifications, by Tom Dunleavy, Kunal Goel
The main points
- Ether experienced a strong rebound from its second-quarter lows, but the ethereum network struggled to return to pre-May sell-off levels in terms of transaction volume, fee income, total value locked or user activity. Behind the scenes, Ethereum’s future looks brighter as it continues to dominate the smart contract network developer share.
- User activity on Layer 2 has indeed increased as Ethereum’s rollup-centric roadmap appears to be slowly materializing. The total value locked on both Optimism and Arbitrum has reached $1 billion.
- Just before the publication of this report, the successful transition to proof-of-stake ushered in a new era for Ethereum. With a 99% reduction in energy usage, a potentially deflationary base currency, and investable yields, Ethereum may finally find something that its proponents have long been calling for.
Introduction to Ethereum
The Ethereum blockchain network is a decentralized data storage and transaction verification platform. Its groundbreaking introduction of smart contracts and virtual machines on the network created a decentralized Turing-complete software solution. There are thousands of independent tokens and applications built on the Ethereum blockchain. The protocol has gained widespread acceptance after developing a deep decentralized finance ecosystem and has recently developed many interesting Web3 use cases. The protocol transitioned from Proof of Work to Proof of Stake on September 15, 2022. Today, Ethereum is the second-largest cryptocurrency by market capitalization in the world.
The crypto market rebounded in Q3 2022, partially recovering from the collapse triggered by Terra and Q2 macro. From a price perspective, Ether has performed well as users accumulate spot assets for the airdrops that the merger could bring. On September 15, Ethereum successfully performed a consensus change from Proof of Work (PoW) to Proof of Stake (PoS). This transition ushered in a new era for the largest smart contract platform. After the merger, the daily block reward dropped from about 13,500 ETH to 2,000 ETH, which greatly reduced the network’s security spending.
Ethereum’s active addresses and transactions remained largely stable, with relatively minor quarterly changes. While addresses and transaction volumes will likely increase with the widespread adoption of the cryptocurrency, Ethereum’s scaling will come from second-layer solutions rather than a more performant base layer.
The protocol’s revenue decline can be attributed to the crypto bear market, an increase in L2 transaction volume, and gas efficiency upgrades for the protocol’s contracts. As a result, total expenses fell sharply in the third quarter to the lowest level since 2020. If these fees continue to decline in the second half of the year, it will directly affect the combined pledge yield.
Ethereum transaction counts have remained largely range-bound since the implementation of EIP-1559 in August 2021. After EIP-1559, whenever a block fills above or below the target limit, the gas fee for the next block changes in the opposite direction. The new setting effectively reduces the variance in the number of transactions per block by letting transaction fees absorb the variance.
During the quarter, the average daily transaction volume was 1.2 million, an increase of 6% from the previous quarter. ETH transfers and DeFi transactions increased by 7% and 14%, respectively, with average daily transaction volumes reaching 415,000 and 82,000. On the other hand, NFT and cross-chain bridge transaction volumes have declined. NFT transactions fell 17% in the quarter to 181,000 per day, and cross-chain bridge transactions fell 41% to 9,000 per day.
Active addresses naturally follow a similar pattern to transactions. Daily active addresses for the quarter were 550,000, an increase of 5% from the previous quarter. The main reason for the increase is the surge in active addresses on July 27, 2022, when well-known Ethereum miner Chandler Guo announced plans for a PoW fork of Ethereum, as well as some wallet “maintenance activities” on Binance. Most importantly, these activities are likely not due to an influx of new users or new applications.
During this period, ethereum supply increased by 0.7%, representing an annualized growth rate of 4.2%. All inflation comes from PoW rewards, as transaction base fee consumption is slightly higher than inflation of beacon chain rewards.
ETH in smart contracts has been on an upward trend since 2020, and the asset is increasingly being used in DeFi and other applications. This makes the ETH held by centralized exchanges decrease year by year. However, the collapse of Terra appears to have eroded trust in smart contracts, and even the entire ecosystem. On the same day Terra crashed, on May 9, 2022, the proportion of ETH in smart contracts peaked at 30% and has been trending downward ever since. At the end of August, ETH on smart contracts was 27%, down 2% from the end of June.
Unsurprisingly, traders increased their bullish bets in the third quarter as the timing of the merger was confirmed. With the official target block difficulty set at mid-July, suggesting a merger date of mid-September, buy volumes across exchanges have steadily increased. At the end of August, it was more than double the level at the end of June.
The buy-to-sell ratio also rose. Buy strikes topped out at the $5,000 expiry Sept. 30 and $2,500 expiry Dec. 30. These bets should have been made at a time when ETH was hovering around $1,500 for the past few months. The strike price of these buying volumes suggests that many gamblers are targeting contracts expiring in September (that is, expecting ETH prices to more than triple in value), while more fundamental investors are looking at December ‘s contract.
Volatility also tends to fall as sentiment shifts and ether’s price slowly rises. Ether had a much smaller daily range throughout July and August. After a very challenging second quarter, absolute volatility declined across the cryptocurrency and stock markets. Ethereum’s correlation with Bitcoin remained around 90%, while its correlation with the S&P 500 fell slightly.
Layer 2 Analysis
Ethereum’s rollup-centric scaling plan has finally come to fruition. While Ethereum’s average transaction count is likely to remain range-bound, L2 transactions have grown significantly. The average transaction volume on Arbitrum almost tripled, from 39,000 in January 2022 to 115,000 in August 2022. During the same period, Optimism’s transaction volume also increased from 41,000 to 142,000, an increase of nearly 3.5 times.
The emerging underlying ecosystem is driving L2 activity. L2 applications have attracted real use and attention, namely Arbitrum’s GMX and Optimism’s Synthetix. These applications are also one of the biggest drivers of TVL on their respective platforms.
More catalysts for L2 growth and adoption will emerge this year:
- Arbitrum’s Nitro upgrade recently went live with higher throughput and lower fees. With the upgrade locked, Arbitrum Odyssey is expected to resume again, which will lead to the release of its token.
- Three different teams, Polygon, zkSync, and Scroll, announced a breakthrough in zkEVMs. zkSync’s zkEVM is expected to launch its mainnet in Q4.
- StarkNet has announced plans to decentralize and launch its own token.
These token issuances with airdrops are important events for the ecosystem. They drive usage of the platform and help create a community of users and investors. However, this could end up being an unsustainable approach to adoption. These ecosystems need to create organic user adoption to thrive in the long term.
Decentralized Exchange (DEX)
During the second quarter, the average daily trading volume of DEXs was $2.78 billion. In the third quarter, that number fell to $1.83 billion. Year-over-year sales also fell to about $800 million. Uniswap’s dominance rose from 60% at the end of the second quarter to 72% at the end of August. Uniswap’s market share has remained around 75% of DEX’s throughout the third quarter. Notably, Curve’s market share fell from 16% to 8%, even as it continued to offer higher incentives than its competitors.
The average loan size fell sharply in the third quarter. Average daily volume fell to $116 billion from $280 billion in the second quarter. Trading volumes slowed noticeably in July, but recovered slightly in August as demand for spot ETH increased from individuals looking to get ETH POW airdrops.
While the average daily trading volume of NFTs has dropped significantly, the drop in the number of average daily traders has been much smaller. This shows that the user stickiness base is around 40,000 per day. Trading volume in dollar terms was down 90% from January. Average monthly sales in the third quarter were less than $1 billion, compared with $4.6 billion in the second quarter. This decline is not only related to a slowdown in the NFT market, but also to the falling price of ETH, the base currency used by most NFTs. OpenSea continued to dominate market share in the third quarter.
Sudoswap launched in the third quarter. It provides a new perspective on the NFT market by creating a Uniswap-like liquidity pool for NFTs. While trading volume appears to have peaked in August, sudoswap will be worth watching if the sluggish trend in the NFT market reverses.
Stablecoins are liquidity in the decentralized financial ecosystem. Its turning point is quite closely correlated with the overall market capitalization of Ethereum. While stablecoin movements and overall trading volumes were largely unchanged from the second quarter, there are a number of events worth noting that could have an important impact on DeFi development:
- Circle, the group behind USDC, suspended 38 addresses after the U.S. Office of Foreign Assets Control (OFAC) sanctioned the Tornado Cash smart contract.
- Following this, MakerDAO’s DAI plans to reduce its exposure to centralized stablecoins, and its founder Rune Christensen has plans for its “Endgame.”
- Due to increasing technical, financial and regulatory risks, the Tribe DAO plans to unwind and all FEI will be redeemed.
- Circle has launched EUROC, a stablecoin denominated in euros.
- Aave has announced its USD stablecoin GHO.
Circle’s ban on Tornado Cash addresses was not well received. During the quarter, USDC market share dropped from 44% to 41%. The decline was mostly absorbed by BUSD, which increased its market share from 14% to 16%.
Merger and transition to proof of stake
After much fanfare, the merger took place successfully on September 15, 2022. Validator exits and block failures are limited, and users and applications are not affected. Miners created an ongoing proof-of-work fork called Ethereum Proof-of-Work (ETHW), which, at the time of writing, trades at about 1% of Ethereum’s market cap in the futures market. The chain is not supported by users and has limited support from infrastructure providers. The failed coordination of the teams that launched the protocol seemed to have doomed it from the start.
After the merger, the block reward was reduced by 90%. This greatly reduces the network’s inflation and reduces its annual security spending. If Ethereum were to use PoS from the beginning of the quarter, its net deflationary supply would consume 1600 ETH more than the cumulative validator reward.
The transition to PoS has also enabled Ethereum to significantly reduce its energy consumption by 99.95%. The merger will further ease ESG concerns over the use of Ethereum. This will open the door for more organizations to use ETH as an investable asset or to operate using the network itself. Earlier, prominent organizations like Mozilla, Discord, and Tesla have halted their blockchain adoption plans due to environmental concerns.
In the two-month period, inflows to the Beacon Chain slowed significantly, growing by only 4%, compared with a 17% increase in the second quarter. The main reason for this low growth is that the largest collateralized derivative, Lido’s stETH, is currently trading below spot ETH. As long as the depreciation persists, users will gain more profit from staking exposure by purchasing stETH on the secondary market than by investing directly in Ethereum. Among the large centralized staking providers, Coinbase and Binance both grew by 4%, although their staking derivatives, cbETH and BETH, also trade below ETH. Among liquid collateralized derivatives, Lido increased by 1% to 4.2 million ETH in pledge, and Rocket Pool increased by 11% to 218,000 ETH in pledge.
Ethereum and its L2 ecosystem account for 62% of the total TVL of crypto smart contracts. Ethereum contributed the largest share of TVL at $34 billion, while Arbitrum and Optimistic contributed only $1 billion each. Ethereum’s TVL has only grown 8% since the end of the second quarter, but Arbitrum and Optimistic have seen quarterly growth rates of 33% and 224%, respectively.
Looking at a longer time frame, Ethereum and its L2 share of TVL has continued to decline since the beginning of 2021. Q2 2022 was an exception, with the collapse of Terra leading to an 8% increase in the share of Ethereum and L2.
The key moat of the Ethereum ecosystem is its thriving developer landscape and the dominance of its virtual machines across the cryptocurrency. Its ecosystem has almost as many weekly active developers as the next four largest ecosystems combined. In the bear market, Ethereum development activity has held up better than other ecosystems, with its share increasing by 10% from last year.
While regulation has always been a potential issue for the cryptocurrency industry, the third quarter saw more action than ever. U.S. government agencies are due to respond in early September to Biden’s executive order, which outlines ways for agencies to “address the risks and exploit the potential benefits of digital assets and their underlying technologies.” But many institutions did not comply with that deadline, instead, the big news of the quarter was the U.S. Office of Foreign Assets Control (OFAC) sanctioning the smart contracts of privacy protocol Tornado Cash. This action makes it illegal for any U.S. citizen to interact with the agreement. This is the first time OFAC has sanctioned any entity other than an individual.
The decision sparked a wave of Tornado Cash address censorship from key infrastructure providers such as Infura and Alchemy. The event sparked a wider discussion in the Ethereum community about true decentralization. Users running their own nodes can still access Tornado Cash, but the vast majority of users rely on third-party infrastructure providers to access the blockchain. Simply put, if the most popular wallets do not allow users to interact with a certain smart contract, the protocol is basically inaccessible to most users. Lido, Coinbase, Kraken, and others all appear to be OFAC compliant, and they account for over 66% of the current validator set.
If the impact of the decision expands further, stablecoin operators like Circle (USDC) could be subject to government regulation like banking institutions, with a simple order from regulators requiring those operators to ban a subset of addresses. This scenario would essentially put DeFi under the direct jurisdiction of the government. USDC regulation is a particular concern for Maker, whose stablecoin DAI is backed by roughly 30% of USDC. Maker is considering alternatives to USDC, which includes ETH.
Sanctioning a smart contract has major implications for DeFi and the crypto space as a whole. The decision immediately sparked fears of government overreach. One of the key principles of democracy is the right to due process, how can smart contracts get a chance in court? How will it defend itself? Can any technology be banned by the government based on the precedent set by this decision? These are broad legal issues that will be decided by the highest echelons of U.S. courts in the coming months and years. Coinbase kicked off its next chapter, providing financial support to six users accused of interacting with sanctioned Tornado Cash addresses.
The next step in the roadmap
After completing the major steps on the Ethereum roadmap, developers can focus all their attention on scaling the network for global adoption. Developers are now looking forward to the Shanghai upgrade, which promises several improvements to the protocol. Most importantly, Shanghai will allow stakers to withdraw their funds.
Another proposal that may be included in the Shanghai upgrade is EIP-4844. The proposal would reduce the cost of L2 posting its transactions to Ethereum L1 by orders of magnitude, resulting in a cheaper Ethereum experience for all users. EIP-4444 may also be listed in Shangha. It will enable nodes to delete transaction history after one year. Not downloading these histories will greatly reduce the resource requirements of nodes, thus enabling more people to run nodes and further decentralizing the network.
From the end of 2023 to 2024, Ethereum is expected to expand further through danksharding, a transitional step before data sharding is achieved. With the increasing number of L2 solutions, EIP-4844 and danksharding, Ethereum may become fast and cheap enough for 99% of users in the next 12-18 months.
Despite being in a cryptocurrency bear market, Ethereum remains the most dynamic ecosystem in the crypto space, with the majority of developer, user and application activity. A successful transition to PoS should only help foster further focus on the protocol. With the launch of new L1 challengers Aptos, Sui, and Celestia in Q4, Ethereum will have to continue to build a moat and accelerate its roadmap to remain the leader in the smart contracts space.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/ethereum-q3-2022-report-mergers-usher-in-a-new-era/
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