Bitcoin gets all the glory, but ethereum, the No. 2 cryptocurrency for many years now, is being viewed as superior because of its blockchain platform.
Many people, including crypto investors and traders, have a fundamental misunderstanding of bitcoin
BTCUSD,
and ethereum
ETHUSD,
The two cryptocurrencies and their related blockchains are different yet complementary, explains Juan Villaverde of Weiss Ratings, an independent investment-ratings firm based in Florida, in this question-and-answer column.
Villaverde is an econometrician and mathematician who has been tracking and studying cryptocurrencies since 2012. He leads the team of analysts and computer programmers who created the Weiss Cryptocurrency Ratings.
Let’s start off simple.
MarketWatch: What is ethereum?
Villaverde: Ethereum is the world’s first — and today one of many — “smart contract platforms.” Unlike bitcoin, it was designed not to be a payment system, but a “decentralized world computer.” The idea was to take the concept of decentralization and apply it not just to money and payments, but also to financial contracts and any form of social interaction that requires trust between two or more parties that do not know or trust each other. By defining those social interactions in code, the ethereum network acts as the mediator — automatically enforcing the rules of said interaction — between the different parties. The idea behind this concept is that “code is law,” and any interaction that takes place between several parties should be executed exactly according to the way it was defined in code, with no room for special interests or subjective interpretations.
MarketWatch: Ethereum is different from bitcoin. How so?
Villaverde: It’s different because the scope is broader. Bitcoin is a payment network built to handle payments from A to B in a secure and trustless fashion. What ethereum does is attempt to retain the trustlessness and decentralization aspects of bitcoin, but to apply them to a broader sets of use cases and not just payments.
Ethereum is not alone in being built as a decentralized world computer. There are many smaller smart contract platforms built for the same use case, but none is as popular or widely known.
MarketWatch: A growing number of competitors have been vying for the elusive title of “ethereum killer,” but so far, none has succeeded. Clearly, ethereum has a key advantage over other platforms. What is it?
Villaverde: Network effect. As a smart contract platform, aka “decentralized world computer,” ethereum houses the most users, the most applications, and the most developers of any similar network. Ethereum even rivals or exceeds bitcoin itself in several metrics commonly used to assess the size of a distributed network, such as number of active developers or the amount of dollar value that moves through the network.
MarketWatch: Surely, ethereum isn’t perfect. Recently, we’ve been reading about prohibitively high transaction fees, as well as slow transaction times. Many of the budding smart contract platforms boast about having none of those issues. There are other issues as well, even when compared to bitcoin. Could you tell us more?
Villaverde: Compared to bitcoin, there are some key disadvantages. Chief among them is the higher complexity required for ethereum to fulfill its intended use case. As a distributed network that can handle just about anything you can code, it’s extremely difficult for ethereum to compete with bitcoin in terms of overall security. The higher complexity increases the potential attack vectors that could render the network partially, or fully, dysfunctional.
Another issue is that ethereum needs to be able to handle significantly more transaction volumes compared to bitcoin, yet relying on a proof-of-work blockchain — which bitcoin pioneered — is less than ideal for this ambitious use case. This has led to the emergence of ethereum rivals that claim to be faster and cheaper than ethereum. It also resulted in a collection of proposed updates commonly referred to as “ethereum 2.0,” which will be rolled out over the next 24 months and are intended to fix some of its issues.
Other issues stem from the fact that ethereum’s native asset, “ether,” is used by speculators to participate in the growth of the network, as well as pay for transaction fees within the same network. Demand for ether surges as speculators seek to have a stake in the growing ethereum ecosystem, which has the unintended side effect of crowding out real demand for the network, as higher ether prices directly result in higher transaction costs for using the technology. We saw this play out recently where the surge in prices resulted in a mass exodus of users from ethereum to cheaper alternatives. Ironically, if ethereum cannot grow the number of users due to technical limitations, the fundamental reason to own ether is somewhat eroded. Nothing of the sort is true in the case of bitcoin.
Bottom line: The increased complexity that ethereum needs to fulfill its purpose increases its risk as an investment.
MarketWatch: During the recent bitcoin plunge, some readers expressed the notion of ethereum being “better” than bitcoin and other cryptos.
Villaverde: Different doesn’t mean better or worse. A key analogy is gold and oil. Gold has basically one use: a safe store of value. This is far and away its most common source of demand. By contrast, oil is the main source of energy that powers our civilization. It is used in all manner of things, therefore its potential applications are incredibly diverse.
The same is true of bitcoin and ethereum. Bitcoin doesn’t need to do much beyond what it’s currently doing to fulfill its use case. All it needs is a robust security to guarantee user funds will not be hacked at the consensus level.
On the other hand, ethereum is “gas” for the digital economy. As such, its network not only needs to be secure, but also cheap, fast and easy to use.
A good example of the difference between bitcoin and ethereum is that higher prices are generally good for bitcoin, as this allows it to become a more viable investment option for more users. Meanwhile, higher ether prices fundamentally cripple ethereum’s ability to serve as gas for the digital economy. Contrary to popular opinion, higher ether prices aren’t “good” for ethereum — all else being equal. Yet they are everything you could hope for in bitcoin.
The truth is that bitcoin and ethereum complement rather than compete with one another. Bitcoin is the collateral layer for the crypto economy: A robust, hack-proof store of value. Ethereum is the gas that powers the same crypto economy: It powers all manner of decentralized applications.
Both are highly valuable and necessary to expand crypto’s influence in the world.
MarketWatch: So, staying safe, secure, fast and easy to use while remaining decentralized are the biggest challenges ahead for the ethereum network. What about other altcoins, or better yet, the industry in general?
Villaverde: The biggest challenge for the crypto industry today is the same as it’s always been: How does the industry upgrade its infrastructure to accommodate the next million, 100 million or one billion users without compromising on its key principles of decentralization and trustlessness?
Decentralization is expensive to produce and difficult to maintain. What users get in return is self-custody of their assets, as well as the freedom to do anything they want with them, free from censorship or repression by any centralized counterparty.
Yet, it is difficult to scale this technology for mass adoption. The industry is still trying to figure out how to scale without compromising on crypto’s key founding principles. We’ve seen many projects try and cut corners, increasing transaction speeds and reducing costs at the expense of decentralization. These projects predictably go nowhere as centralization is what the traditional financial system already excels at.
Those who figure out how to enable more mass adoption without compromising on decentralization stand to benefit handsomely from the changes this technology is ushering in.
MarketWatch: Earlier on in this discussion, you mentioned certain upgrades that ethereum team plans to implement to address the network’s shortcomings. One of these is Layer 2, also known as L2. Can you shed some light on what L2 is and how it helps ethereum solve its growing pains?
Villaverde: The road to mass adoption and mass scaling of distributed systems will take on many facets. Right now, the industry has begun to realize that Layer 1 — or the base blockchain — should evolve to a settlement layer for Layer 2 solutions.
Rather than using the ethereum blockchain directly, end users will be interacting with a variety of different technologies — sidechains, Optimistic and ZK-Rollups, etc. — and these technologies will periodically settle their activities on the main ethereum blockchain.
What this looks like in practice varies with each Layer 2 technology, but what they all have in common is that these applications aggregate large numbers of transactions and write a summary of them on the main blockchain, thus relying on it for security.
Roads are a good analogy here. If everyone uses the base layer, that is akin to every person driving their own car on the road. If the road becomes popular, this can lead to traffic jams. A good solution to this problem is to introduce buses that allow multiple people to share the same vehicle, thus helping clear out the traffic jam and allowing more people to use the road, as riding a bus significantly cuts down the cost per capita of using it.
While there are some differences, as long as roads are in good condition, whether you use a car or a bus should not make that much difference to you as an end user.
In crypto terms, the road is the base layer – or Layer 1 – and the bus is the Layer 2 solution that allows more people to use the base layer at a lower cost.
When I say that Layer 1 will be used almost exclusively as settlement mechanisms for Layer 2, I’m effectively saying that in due time, individual cars will be phased out altogether and only buses will be using the road.
MarketWatch: Finally, what does the future hold for ethereum? Will it rule the crypto world, or is it time to step back and let other, potentially more worthwhile projects take over?
Villaverde: This is potentially the trillion-dollar question. Right now, ethereum has the first-mover advantage and a significant head start over its competition. That said, upgrading ethereum to accommodate a billion users is no easy task. Going back to the road example, upgrading it while cars are still using it is quite a challenge. Competitors don’t have to grapple with these issues, and they are free to learn from ethereum’s mistakes, build on its successes, and hit the road running with significantly superior technology and without all the baggage that comes with ethereum.
That said, so far, the market clearly believes that ethereum’s large network effects will in time trump all else, and no competitor will ever come close to it in terms of adoption.
Ethereum has a credible and comprehensive roadmap to upgrade its technology in order to enable mass adoption. Whether it gets there before a competitor bites off a large chunk of its market share is something we can only speculate on.
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Back to you, dear reader. What’s your take on ethereum? Is it already a part of your portfolio? Are you eyeing other cryptocurrencies? Let me know in the comment section below.