Why Ether Stands Out Among Digital Assets

Summary ETH’s staking yield already is influencing other smart contract ledgers, differentiating it from other digital assets except bitcoin. As of September 2024, the Ethereum network issues ~940,000 ETH in new supply every year. Since its transition to PoS on September 15, 2022, and the implementation of EIP 1559, the Ethereum Network has functioned as a net deflationary asset, reducing supply by an average of 0.106% per year. In our view, the emergence of restaking offers investors greater control over their risk and return profiles, enhancing the utility and efficiency of ETH as collateral within DeFi. Introduction As bitcoin cements its position as a reliable digital store of value and the only asset with a rules-based monetary policy, Ethereum - the network - and ether (ETH) - the asset - appear to be gaining momentum with similar potential. Indeed, ETH is emerging as an institutional-grade asset with yield-generating potential. As the only real yield-bearing digital asset when staked , 1 ETH appears to have unique and distinctive characteristics that position it as a “reference indicator” 2 within the digital asset space. ETH already plays a pivotal role in private and public financial markets, influences the monetary policy of adjacent digital networks and applications, and gauges the health of the broad-based digital assets ecosystem. With a market capitalization of ~$315 billion and millions of monthly active users, as shown below, the Ethereum network is settling meaningful economic value. Source: ARK Investment Management LLC, 2024. This ARK analysis is based on a range of underlying data sources, which may be shared upon request. Data as of August 15, 2024. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. ETH’s staking yield already is influencing other smart contract ledgers, differentiating it from other digital assets except bitcoin. Similarly, U.S. Treasury bills play a pivotal role in the traditional economy in several ways: setting benchmark rates, serving as a quality store of value during uncertain times, and influencing market expectations of future economic conditions. Our research suggests that, as an asset, ETH is beginning to develop attributes in the digital asset space similar to those of U.S. Treasury bills. ETH’s potential to generate yield - and its widespread use as collateral in digital asset transactions - are emerging as its two most distinctive and significant qualities. Investors can gain exposure to ETH’s yield by staking it to secure the Ethereum ledger. In other words, the yield is not technically native to ETH the asset. Liquid staking derivatives like Lido, Rocket Pool, or Frax provide ways to tokenize staked ETH and its yield. Liquid staking allows users to stake their ETH, while maintaining liquidity, by receiving a derivative token that represents their staked ETH. Another method called “solo staking” provides more direct control over the staked assets, and a higher reward rate, but locks up the ETH. Our goal in this paper is to identify and define ETH’s distinctive characteristics. What is special about ETH, and how does it stand out within a broader field of assets? We are aiming to answer the following questions: How is ETH able to generate yield? How can Miner Extractable Value (MEV) yield predict economic cycles? Does ETH have bond-like properties? Do Staking and Restaking enhance ETH as programmable collateral? If so, how? Will ETH’s Staking Yield become the Reference Yield of the Crypto Economy? If so, in what sense? Within a standard classification of traditional assets, what are ETH’s hybrid properties? 1. How Is ETH Able To Generate Yield? “Proof-of-Stake” (PoS) is a fairly new “consensus algorithm” that is more energy efficient than “Proof-of-Work” (PoW). Why? In PoS, the consensus algorithm selects “validators” - equivalent to “miners” in PoW - to create new blocks and validate transactions based on the number of coins they hold and are willing to "stake" as collateral. The higher the stake, the higher the probability of being selected to construct and validate the next block. As a result, instead of requiring massive amounts of computational mining power, the PoS system requires validators to have a significant investment in the network - a stake they could lose if they validate fraudulent transactions or break core protocol rules. Validator stakes deter fraudulent behavior, as does the cost of electricity that Bitcoin miners pay to participate in the network. Both ensure that each participant acts with economic rationality and integrity. When the Ethereum network upgraded to Ethereum 2.0, its protocol shifted from Proof-of-Work to Proof-of-Stake. The associated implementation of EIP-1559, Ethereum’s latest monetary policy update, introduced a novel fee market structure. Both changes altered the way ETH generates and distributes yield. ETH yield is based on the following three components: Issuance (≈2.8% APR) + Tips ( Let’s look in more detail at each component of the yield. Issuance As of September 2024, the Ethereum network issues ~940,000 ETH in new supply every year - equivalent to an annualized percentage yield (APY) of ~2.8% at today’s staking ratio. The staking ratio varies based on the amount of staked ETH over time. If more validators stake, the staking ratio increases, pushing down the yield on issuance, because it is distributed equally among participating validators based on their weighted stakes. Importantly, the Ethereum network guarantees a minimum annual emission rate of 1.5% which, in the unlikely event it hit, would require the staking of 100% of ETH and no transactions on the blockchain. All validators who secure the network, by achieving consensus and processing transactions, receive the issuance. Tips Introduced by the London upgrade and EIP-1559, "tips" are optional fees that users can include with their transactions on Ethereum. Tips are "priority fees" because they incentivize validators to prioritize transactions within a block. When users want to send transactions, they must pay the base fee and can choose to pay the tip. The base fee adjusts dynamically based on network congestion, increasing when the network is busier. The priority fee, or tip, is optional if users want to expedite their transactions. In practice, the priority fee is a cost, varying with the network's usage and congestion. MEV In addition to the issuance and the user tip, validators also collect "Miner Extractable Value" (MEV) rewards, or the additional profits earned by including, excluding, or reordering transactions in the blocks they produce. MEV is the equivalent of “Payment for Order Flow" (PFOF) in traditional markets - extra revenue that high-frequency market makers and traders pay validators to prioritize their transaction flow. As with priority tips, the yield is volatile, as it relies on the supply and demand for block space and exploits less-informed traders conducting transactions on the network. Importantly, MEV rewards are available only to validators running an MEV client, such as MEV Boost. Base Fee Importantly, the Base Fee - again, the standard cost to send a transaction - does not contribute to the yield. Instead, it is “burnt” and does not provide stakers with direct cash flow. As part of the EIP 1559 upgrade, the base fee mechanism makes fees more predictable and the Ethereumnetwork more user-friendly. Only the base fee and issuance can alter the total supply of ETH. ETH tokens that users pay for the base fee are removed permanently from the total supply. If the base fee is high enough (greater than 23 gwei 3 in today’s market) and the “burnt” amount surpasses the network issuance (940,000 annual ETH), the total supply of ETH outstanding declines over time, making the protocol deflationary. Conversely, if the network issuance is higher than the burnt base fee, then the network becomes inflationary. Two dynamics support the deflationary trend in ETH’s supply. First, Ethereum’s proof-of-stake (PoS) mechanism enables validators to reduce the operating expenses (Opex) and capital expenditures ((CAPEX)) associated with running network servers. In other words, the energy and data center costs associated with PoW and ASIC 4 machines do not exist in PoS. Second, as the premier smart contract platform, the Ethereum network operates at the base layer with a constraint of 14 transactions per second. Thanks to its rigorously tested code, Ethereum has attracted the highest number of active developers, the widest variety of applications, and thehighest values settled - all in its short nine-year history. Since its transition to PoS on September 15, 2022, and the implementation of EIP 1559, the Ethereum Network has functioned as a net deflationary asset, reducing supply by an average of 0.106% per year. Had Ethereum continued to function with PoW, without EIP 1559, the network’s supply would have inflated by 3.2% per year, as shown below. Source: Ultra Sound Money. Data accessed 08/15/2024. Inflation Comparison Of ETH (PoS) vs ETH (PoW) vs BTC (PoW) since the Merge. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. 2. How Can Miner Extractable Value (MEV) Yield Predict Economic Cycles? As noted above, Miner Extractable Value (MEV) yield is a component of ETH's staking yield. In this section, we delve deeper into MEV, with particular attention to how it is created and how it can predict economic activity and market cycles. Equivalent to Payment for Order Flow (PFOF) in traditional finance, MEV occurs when market makers and high-frequency trading firms pay validators an extra fee to bypass the standard Ethereum “Mempool’’ queuing, prioritizing their transaction bundles. 5 Similarly, in the traditional financial world, companies like Citadel Securities compensate platforms like Robinhood, TD Ameritrade, Charles Schwab, and Fidelity for directing customer order flow their way. In practice, MEV was born in 2017 during the ETH ICO 6 boom as a basic form of priority “bribe.” During the ICO era, participants and investors buying tokens in certain projects had to deposit ETH into a smart contract in exchange for the project's native token. As they became more popular, the token offerings became oversubscribed and operated on a first-come, first-served basis. To be among the first to deposit ETH into those smart contracts, participants “bribed” validators off-chain. Like PFOF, MEV often reflects retail trading activity, as market makers are willing to pay more for less-informed orders than for informed ones. Just as PFOF payments are a gauge of spending excesses and risk appetite in the retail equity space, MEV plays a similar role in forecasting recessions and economic cycles in the Ethereum ecosystem, as shown below. Source: ARK Investment Management LLC, 2024, based on data from Daytradingz.com and MEV-Explore v1 as of 06/09/24.7 For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. While the revenue generated from MEV on Ethereum and PFOF in the stock market is comparable, MEV as a percentage of the combined market cap of ETH and ERC-20 tokens is much higher than the equivalent in the US equity market. The $0.79 billion in revenue extracted pro rata annually since the merge represents 0.20% of ETH's $315 billion in market cap. The combined market cap of ETH and ERC-20 tokens is ~$500 billion, taking the percentage of revenue extracted down to 0.15%, still 27 times higher than 0.0056% that the $2.891 billion in PFOF revenue represents of the US stock market's $50 trillion market cap. In its early stage of development, Ethereum’s order routing mechanism is more expensive than that in traditional finance but, important to note, Ethereum supports a broader range of order types through smart contracts - such as flash loans, staking, swaps - and other interactions with decentralized applications. Additionally, in traditional finance, other fees and profit centers - broker fees, exchange fees, and profits from hedge funds - sit on top of PFOF revenue. Those costs are not as transparent, but are important to the overall cost structure of financial transactions in the traditional world. Based on historical PFOF patterns in traditional finance, an increase in PFOF revenue has been correlated with higher retail activity involving less-informed traders, while lower PFOF has indicated the opposite. Between 2021 and 2022, for example, Robinhood's PFOF revenue dropped 40% from $974 million to $587 million as interest rates increased 16-fold, signaling the onset of a bear market. Similarly with MEV, from July 2021 to October 2021 block space used by high-frequency trading firms and MEV bots dropped five-fold before the severe crypto bear market in 2022, as shown below. Source: ARK Investment Management LLC, 2024, based on data from Explore.flashbots.net as of 08/15/2024. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. Source: ARK Investment Management LLC, 2024, based on data from Explore.flashbots.net as of 08/15/2024. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. Our research suggests that the majority of MEV over the next year is likely to be extracted and redistributed on Layer 2s. Layer 2s are secondary protocols built on top of Ethereum. They improve scalability and efficiency by processing transactions off the main chain while leveraging its security, enabling faster transaction times, and lowering transaction fees significantly. During the next two years, we expect more than 90% of total transactions to occur on Layer 2s. Catering to more price-sensitive retail investors, Layer 2s should dominate ETH trading activity, benefiting disproportionately from MEV, even more so when sequencers - or validators for Layer 2s - decentralize further. Today, Arbitrum and Optimism, the dominant Layer 2 networks, operate with a single sequencer - which means that block space is not auctioned to the highest bidder. Instead, transactions are ordered on a first-come, first-served basis, with no reordering possible by block searchers or builders. As a result, some forms of MEV (Maximal Extractable Value) are not possible, indicating that MEV is significantly lower than it could be in a more advanced state with multiple decentralized sequencers and a more mature MEV infrastructure. The MEV Yield, a subset of the overall ETH yield, is becoming a reliable indicator of activity and economic cycles on the Ethereum blockchain. Dominated by retail trading with a higher proportion of less-informed flow compared to traditional finance, MEV is a gauge of activity and economic health that impacts ETH’s yield during cycles and provides a framework for valuing Layer 1 ledgers. 3. Does ETH Have Bond-Like Properties? Fixed income assets, particularly bonds, have existed for centuries and are among the most important financial enablers of economies. Bonds represent loans made by an investor to a borrower, typically a corporation or a government. Our research suggests that, while not equivalent, staked ETH (stETH) 8 has features like those of sovereign bonds, similarities worth exploring. Among the most important similarities and differences between staked ETH and sovereign bonds are the following: Bond Component Sovereign Bond Staked ETH Issuer Government of a Country Ethereum Network Principal Face value of the Bond Staked ETH amount I nterest/Coupon Periodic interest payments, usually semi-annual or annual Staking rewards paid programmatically Maturity Fixed term after which principal is paid Indefinite (ETH remains staked until unstaked) Liquidity Traded in Bonds Markets Traded on Centralized and Decentralized Exchanges Collateral Full Faith and Credit of the Issuing Government Value of ETH and the Security of the Network Note: For the maturity section, staked ETH can be unstaked at any time, after which the initial amount staked called “principal” can be recouped in addition to the yield earned over that period. Source: ARK Investment Management LLC, 2024. For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. As we discuss the comparison of staked ETH and a sovereign bond below, we emphasize that their differences are as meaningful as their similarities. In our view, their risk profiles represent the most significant difference between staked ETH and a sovereign bond. Credit Risk Sovereign Bond: When a government issues local currency-denominated debt, the possibility exists, albeit less likely for stable economies, that the government could default on its bonds. Staked ETH: The Ethereum network cannot default on staked ETH, since technically it is not debt. The yield from staking is derived programmatically from on-chain activity and network issuance, meaning that the yield can fluctuate based on network performance, activity levels, and staking ratio. Inflation Risk Sovereign Bond: Inflation in the local currency can erode the value of bond returns, diminishing purchasing power. Staked ETH: Inflation risk is present if the issuance rate of new ETH meaningfully exceeds the Base fee burnt, leading to an increase in supply that diminishes the net yield, which dilutes the value of interest payments. Interest Rate Risk Sovereign Bond: Changes in interest rates can affect the bond's price, with rising rates typically leading to falling bond prices. Staked ETH: While Ethereum itself does not issue multiple bonds - multiple staking yields at different terms - changes in the yield expectations for other Layer 1 smart contract platforms can influence the perceived value and attractiveness of staking ETH. Currency Depreciation Risk Sovereign Bond: Depreciation of the local currency relative to other currencies can reduce the value of interest payments and principal significantly when converted to other currencies. Staked ETH: ETH's value relative to other major cryptocurrencies and fiat currencies can fluctuate, impacting the real value of the staking yield and principal relative to other assets. Political And Legal Risk Sovereign Bond: Changes in government or regulatory regimes can impact bond repayments, potentially leading to changes in fiscal policy and/or debt restructuring. Staked ETH: This analogy is less direct. Staked ETH carries additional risks related to network security and governance. If validators misbehave or collude, staked ETH can be slashed as a penalty, leading to the potential loss of principal. Regulatory changes impacting the broader cryptocurrency market also can impact the value and security of staked ETH. Volatility Risk Sovereign Bond: Sovereign bonds generally are considered low-risk and low-volatility investments. In times of economic instability or political turmoil, however, the volatility of bonds can increase significantly. Staked ETH: Staked ETH is more volatile because it is nascent. Volatility can impact both the staking yield and the value of the principal. Modeling staked ETH as a sovereign bond requires understanding the differences in their respective risk profiles. While both can be influenced by inflation, interest rate changes, and currency depreciation, the nature of those risks and their implications can vary significantly. Additionally, ETH staking introduces unique risks related to network security, validator behavior, and smart contract bugs, which have no direct parallel in traditional sovereign bonds. Similar to calculating the present value of Sovereign bonds, one could attempt to model the present value of a so-called “Staked ETH bond.” The formula would add the present value of each reinvested coupon payment to the present value of the bond’s face value at maturity. Then, by modeling the coupon interest with the staked ETH yield and the discount rates with a risk-free rate similar to US T-Bills, one could derive the present price of the staked ETH Bond. That said, one of the most important differences between the sovereign bond and a “Staked ETH bond” stems from the fact that the staked ETH yield can vary from day to day. Therefore, modeling a “Staked ETH bond” would require the calculation of an average yield over the maturity period. Additionally, unlike traditional sovereign bonds, staked ETH can be unstaked or “called” at any time, the principal redeemed at will. Today, ETH does not have a yield curve, which means no relationship between the staking yield and the time to maturity of the staked asset. Based on our research, however, an ETH yield curve is likely to evolve in the coming years, increasing the analogy to sovereign bonds, with ETH staked at different maturities and terms. 4. Do Staking And Restaking Enhance ETH As Programmable Collateral? Liquid Staking Derivatives (LSDs) are protocols designed to simplify the staking process for users with little technical expertise. LSDs partner with trusted node operators to manage staking operations on behalf of users. Users who stake their ETH through Lido - a leading LSD provider - receive stETH in return. The stETH is a synthetic version of their staked ETH and functions much like a tokenized certificate of deposit. stETH token rebases automatically to reflect staking rewards (3.2% APY) and can be converted to ETH on centralized and decentralized exchanges. Then, the token, or certificate of deposit, can be used in lending, acquiring leverage, rehypothecation, and many other financial activities within the digital asset space, particularly Ethereum-based applications/protocols. stETH is the yield-bearing version of ETH. Because it is as programmable and liquid, stETH is beginning to replace ETH in many DeFi protocols and applications. Indeed, stETH has been replacing ETH as high-quality collateral within the Ethereum economy. Today, stETH supplied as collateral in DeFi totals ~2.7 million, or roughly 31% of the entire stETH supply, as shown below. 9 Note: The left Y axis in this third-party chart is measured in dollars (billions). Each of the Abbreviations shown at right in the chart above refers to a different asset, which can be used as collateral, as follows: cbeth (Coinbase Staked ETH), reth (Rocket Pool ETH), dai (MakerDao Stablecoin), usdt (Tether Stablecoin), usdc (Circle Stablecoin), weeth (Ether.fi ETH), wbtc (Wrapped Bitcoin), eth (ETH), steth (Lido Staked ETH). Source: Dune (“@lido/stETH collateral compare to other collateral”) as of 08/15/2024. (https://dune.com/lido/steth-collateral-compare-to-others) For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. More than 80,000 stETH exists in liquidity pools across Curve, Uniswap, Balancer, Aerodrome, and other leading DEXes (decentralized exchanges). 10 stETH, the yield bearing asset, is becoming the preferred collateral, thanks to the capital efficiency it offers users, liquidity providers, and market makers. Currently, the collateral of choice on Aave V3, Spark, and MakerDao, 1.3 million stETH, 598,000 stETH, and 420,000 stETH, respectively, are locked into those protocols and used as collateral to issue loans or crypto-backed stablecoins, as shown below. Our research suggests that stETH and other liquid staking derivatives of ETH are becoming the high-quality collateral of choice for financial activities within the Ethereum ecosystem. Note: The left Y axis in this third-party chart is measured in the amount of stETH, not the dollar amount of stETH. Source: Dune (“@lido/stETH collateral compare to other collateral”) as of 08/15/2024. ( https://dune.com/lido/steth-collateral-compare-to-others). For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. Note: Each of the legend labels shown at right in the chart is the name of a specific protocol. But what if users were to seek a higher yield on their staked ETH while providing more utility as collateral? That is exactly what Eigenlayer - a repledging/restaking protocol - can facilitate. To date, Eigenlayer has amassed $13 billion USD in ETH tokenized certificates of deposit, accounting for 50% of Lido TVL and for ~4% of ETH’s total supply, as shown below. 11 Liquid staking derivative tokens representing staked ETH on the Ethereum network can be re-staked on the Eigenlayer platform, enabling other protocols to enhance their network security for a designated duration, a process similar to leasing security services. Certain protocols with tokens too volatile for reliable network security may face liquidity shortages and/or need to augment their security, both of which can be addressed either by dual token staking or by renting their entire security with a more stable form of collateral like ETH. For their security services, restaking protocols like EigenLayer reward restakers, much like the Ethereum network pays validators. In our view, the emergence of restaking offers investors greater control over their risk and return profiles, enhancing the utility and efficiency of ETH as collateral within DeFi. Note: Each of the Abbreviations shown at the top of the chart above refer to the protocol to which the different ETH liquid staking tokens belong, as follows: Steth (Lido), rETH (Rocketpool), sfrxETH (Frax), cbETH (Coinbase), ankrETH (Ankr), LsETH (Liquid Collective), oETH (Origin Protocol), mETH (Mantle), SwETH (Swell),wBETH (Binance). Source: The Block as of 08/15/2024. Restaking (theblock.co) For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. EigenLayer’s success demonstrates that users and institutions have strong interest in leveraging their ETH holdings in more sophisticated ways. By introducing new use cases, EigenLayer allows participants to preserve their ETH holdings while generating additional yield. As they emerge from the EigenLayer launch - much as stETH emerged with Lido from native staking - liquid restaking tokens are likely to serve as collateral across various platforms. Whether in liquidity pools, lending/borrowing platforms, structured products, or crypto-backed stablecoins, various forms of yield-bearing ETH are likely to become the programmable collateral of choice for the leading applications and products in DeFi - whether deployed on Ethereum Layer 1 or any of the Layer 2s available today. 5. Is ETH’s Staking Yield Becoming The Endogenous Benchmark Of The Crypto Economy? Thus far in this paper, we have characterized Staked ETH as a sovereign bond-like asset in some respects, and we have described both ETH and its liquid staking derivatives as high-quality liquid collateral within DeFi that supports many of the widely used applications. In this section of the paper, we highlight another unique characteristic of ETH’s staking yield: its influence on investments within the crypto economy, which our research suggests is comparable to the role of Treasury bills and the Federal Funds Rate 12 in the traditional economy. Today, the staking yield impacts both public and private investments within the digital asset space, much like the role of high-quality liquid assets (HQLA) in traditional finance. First, the ETH yield seems to be exerting significant pressure on native yields in competing Layer-1 smart contracts, compelling other blockchains to offer higher rewards to validators for their security and long-term commitment, as shown below. Why would investors/validators hold and stake a riskier and more volatile asset if its return on investment is not likely to be higher? Importantly, unlike ETH, the yield on other assets tends to be dilutive to cash flows. In other words, if an investor holds and does not stake any other Layer-1 token, network inflation dilutes it. Source: ARK Investment Management LLC, 2024, based on data from The Staking Explorer as of 08/15/2024. (Staking Rewards: Secure & Reliable Crypto Staking) For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. The staking yield on ETH also raises the opportunity cost of holding and borrowing stablecoins. As its native yield has increased and become the benchmark, ETH’s higher activity, MEV fees, and overall demand have placed several DeFi protocols under pressure. MakerDAO. Aave, and Compound are three such protocols. MakerDAO is a protocol that governs the issuance and management of the DAI stablecoin. DAI is issued against collateralized debt positions (CDPs), as users lock up collateral like ETH or other whitelisted assets to mint DAI. One of the core features of the MakerDAO protocol is the DAI Savings Rate (DSR), which allows DAI holders to earn interest by locking their DAI into a special smart contract. Following significant selling pressure on DAI and a decrease in its circulating supply, the MakerDAO governance decided to increase the DSR rate from 5% to 15%. In money markets like Aave or Compound, where supply and demand dictate terms, the reward rate for supplying/lending stablecoins has increased significantly. The supply APY for fiat-backed stablecoins 13 can range from 5% to more than 15%, depending on market conditions. The rate reflects investor willingness to borrow stablecoins while supplying ETH, or stETH, as collateral, without having to sell. Alternatively, protocols like Ethena Labs - which offers a stablecoin collateralized by a cash-and-carry trade 14 between a spot stETH position and a short position on a perpetual future 15 - have attracted many stETH holders. Why? Ethena’s stablecoin offers a significantly higher yield than DeFi alternatives, not to mention ETH’s plain vanilla staking yield. The yield from ETH staking also impacts yield farming opportunities. Teams looking to bootstrap new products or features and attract ETH-denominated capital to their pools must align their incentives with the prevailing market conditions. Higher staking yields typically translate into higher user acquisition costs for many teams and protocols, as potential investors and liquidity providers are more likely to stake their ETH for more stable returns instead of the higher risk-return associated with new or less-established yield farming opportunities. Investors allocating capital to early-stage digital assets are asking the same question: on a risk- and liquidity-adjusted basis, will this project provide a better investment return than that from staking ETH? We can explore the question with a hypothetical example. To what degree would a closed-end fund with a typical seven-year investment time horizon - the average harvesting period for tech startups - need to outperform ETH in order to break even, after compounding? If the ETH yield is 4% after compounding over seven years, the closed-end fund would have to outperform ETH more than 31%, even without taking into account price appreciation. Put differently, early-stage investors in the digital asset space often contemplate this: On a risk- and liquidity-adjusted basis, could a project they’re evaluating offer stronger returns compared to simply holding and staking ETH over the investment period? For example, consider a typical fund with a 7-year horizon, commonly referred to as the harvesting period, during which investments are expected to mature and deliver liquidity. If the same capital instead were allocated to ETH and staked, with an average staking yield of 4%, the project would need to outperform ETH by at least 31% to compensate for the compounded yield effect alone. In bull markets with oversubscribed private rounds, less attractive valuations, and less favorable vesting terms, the competition from staked ETH would become even more intense. 6. What Are ETH’s Hybrid Properties? The spot Bitcoin ETFs have found success perhaps because of the appreciation potential and stability relative to other stores of value, particularly fiat currencies. Human decision making by monetary authorities - sometimes arbitrary and inconsistent - has played a significant role in the devaluation of fiat currencies over the long term. Antithetically , bitcoin is “rules-based,” its supply mathematically metered to top out at 21 million coins. 16 As such, bitcoin is emerging as a compelling alternative to fiat currencies, a digital asset class akin to digital gold. As a younger asset, ETH has undergone several monetary and technical upgrades over the years. In addition, its Turing completeness 17 and cash flow yield have made it challenging to describe, define, and frame within traditional asset class boundaries. Robert Greer’s paper, “What is an asset class anyways,” 18 categorizes three types of assets: Capital Assets: Assets such as equities, bonds, or real estate that are productive and accrue value to the holder in the form of cash flow. Consumable Assets: Assets like commodities that can be consumed or transformed into other assets or goods. Store Of Value: Assets that cannot be consumed or transformed into other assets or goods but that maintain value over long periods of time. Source: Greer 1997.19 For informational purposes only and should not be considered investment advice or a recommendation to buy, sell, or hold any particular security or cryptocurrency. In this paper, we have illustrated the parallels between the yield on ETH and that on debt-like instruments, particularly sovereign bonds. We have demonstrated that the ETH staking yield is a gauge for smart contract activity and economic cycles in the digital asset space, much like the Fed Funds Rate in traditional finance. Additionally, like any other Layer 1 asset, ETH is a consumable asset, used in the Ethereum network to pay for transactions to be included in the ledger. That process involves exchanging the asset to pay validators to store and compute data. We’ve also highlighted staked ETH’s ability to function as a high-quality liquid asset within DeFi, functioning like pristine collateral that powers the most popular applications and stablecoins like DAI and USDe. So, what is the best way to categorize and define ETH as an asset? While the Bankless 20 team has popularized ETH as a "triple point asset" that simultaneously embodies the characteristics of three different asset classes - according to Robert Greer’s classification - we believe bitcoin has and will continue to be a distinctly reliable store of value. That said, we also believe ETH is paving the way for a new hybrid asset. While it exhibits store-of-value properties in the smart contract economy, what distinguishes ETH from any other digital asset is that it is a programmable and cash flow-generative asset that can be used as high-quality collateral in financial applications. ETH and staked ETH are highly liquid and widely traded on many exchanges. Their liquidity ensures that they can be liquidated and converted to other assets easily and/or used in various DeFi protocols. While more volatile than government bonds or real estate, ETH is one of the most established, valuable, and widespread cryptocurrencies in the world. With spot ETH ETFs now live, ETH’s acceptance is likely to increase and its volatility decrease. Currently, ETH and its liquid staking derivatives are entrenched as collateral in various DeFi protocols, not only securing loans, but also participating in liquidity pools, generating yield, and issuing stablecoins. Although ETH may not fit neatly into a single asset category, its multifaceted attributes highlight it as a unique asset, highly attractive for those seeking exposure to the rapidly growing global smart contract economy. Important Information Digital assets, often referred to as cryptocurrencies, such as Bitcoin and Ether are relatively new investments, which have unique and substantial risks, and which may be more volatile than other types of investments. Digital assets operate without central authority or banks and are not backed by any government. Even indirectly, digital assets may experience very high volatility. Digital assets are not legal tender. Federal, state or foreign governments could restrict the use and exchange of digital assets. Digital asset exchanges could stop operating or permanently shut down due to fraud, technical glitches, hackers or malware. There is no assurance that Ether will maintain its value over the long term. ARK strongly encourages any investor considering an investment in Ether or any other digital asset to consult with a financial professional before investing. All statements made regarding Ether are strictly beliefs and points of view held by ARK and are not recommendations by ARK to buy, sell or hold Ether. Historical results are not indications of future results. 1 Importantly, ETH can generate yield only if and when the holder is willing to perform staking; moreover, not every holder is permitted to stake. This differs significantly from a bond that generates a yield in virtue of being held. If an investor were simply to hold ETH, no yield is generated; the appreciation/depreciation of their principal investment is related solely to price movement as determined by supply and demand. 2 A “reference indicator” is a benchmark metric used to evaluate other data points. ETH and its staking yield are becoming benchmarks (reference indicators) within the digital asset space that are used to judge other Layer 1s, risk profiles, and returns. 3 Gwei stands for "gigawei," a denomination of ether (ETH). 1 ether ( ETH ) = 1,000,000,000 (1 billion) gwei. Gas fees on the Ethereum network typically are specified in gwei. Gas fees are the costs required to perform transactions or execute smart contracts on the Ethereum blockchain. 4 An ASIC (Application-Specific Integrated Circuit) is a highly specialized microchip designed to perform a particular task with high efficiency and performance. 5 Please note that this extra fee differs from “tipping” as described earlier in the paper. 6 An Initial Coin Offering (ICO) is a fundraising mechanism within the digital asset space; new projects sell their underlying crypto tokens in exchange for fiat currency or established cryptocurrencies like Bitcoin ( BTC ) or Ether (ETH). 7 See Daytrading.com . 2024. “Payment for Order Flow Data, Analysis and Insights.” ( DAYTRADINGz.com ). See also MEV Explore v1.2024. “Pre-merge Data: December 14, 2019 - September 15, 2022.” MEV Explore 8 Whether through solo staking or via a liquid staking derivative, staked ETH refers to ether that has been deposited in the Ethereum network and that is earning yield. 9 cbETH, rETH and stETH are liquid staking derivatives issued by different protocols. WBTC is a wrapped token of bitcoin issued on the Ethereum blockchain. USDT and USDC are two stablecoins pegged to the US dollar issued by Circle and Tether. 10 DEX stands for decentralized exchange, protocols that allow users to swap tokens in a permissionless way via smart contracts. 11 The Block. 2024. “Restaking.” ( https://www.theblock.co/data/decentralized-finance/restaking) 12 The Federal Funds Rate is the interest rate at which depository institutions like banks lend reserve balances to other depository institutions overnight on an uncollateralized basis. 13 A Fiat backed stablecoin is a type of cryptocurrency that is pegged to a fiat currency, such as the US dollar. The peg is achieved by holding the reserves of the fiat currency equivalent to the total supply of the stablecoin, either as cash equivalents or short-dated securities. 14 A cash-and-carry trade is a classic arbitrage strategy used to profit from discrepancies between spot and futures prices. 15 A short position on a perpetual future involves selling a perpetual futures contract with the expectation that the price of the underlying asset will decrease. Perpetual futures contracts are a type of derivative that, unlike traditional futures contracts, do not have an expiration date. 16 Downing, F. et al. 2024. “The Bitcoin Monthly, February 2024.” ARK Investment Management, LLC. 17 Turing completeness is a concept in computer science and mathematics that describes a system capable of performing any computation that can be algorithmically defined, given enough time and resources. 18 Greer, R. J. 1997. What is an Asset Class, Anyway? The Journal of Portfolio Management , pp. 86-91. 19 Ibid. 20 Bankless is a media and educational platform focused on the digital asset space. The Ultimate Guide To Crypto Disclosure: ARK's statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. For a list of all purchases and sales made by ARK for client accounts during the past year that could be considered by the SEC as recommendations, click here . It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. For full disclosures, click here . Original Post Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.