The decentralized finance (DeFi) market saw a strong resurgence beginning in June 2020. According to the data from Defipulse.com, the total value locked across DeFi protocols rose from $1.90 billion in July to $13.5 billion within four months. The rapid growth of DeFi has caused user activity on the Ethereum blockchain network to soar.
The popularity of DeFi and the vast amounts of capital deployed across DeFi protocols could positively affect Ethereum in 2021 through four factors. The potential factors are the increasing percentage of ETH supply locked in DeFi and ETH 2.0, a considerable rise in user activity, the growing necessity for ETH 2.0 and scaling, and strengthening Ethereum blockchain fundamentals.
Why Did the DeFi Market Heat Up Starting June?
Governance tokens were at the center of the DeFi frenzy in 2020. DeFi protocols have native cryptocurrencies in the form of governance tokens that allow the coin holders and the community to decide on the development and the future of the project.
The launch of Compound (COMP) and Yearn.finance (YFI) marked the start of a new trend, causing an increasing number of DeFi protocols on the Ethereum blockchain network to release governance tokens. With it followed an unexpected craze around yield farming.
Unlike previous token sales, many major DeFi protocols decided to launch tokens in a more transparent way. In the case of YFI, as an example, users staked various cryptocurrencies to earn YFI at no cost, apart from the smart contract fees. Since users earned YFI solely by staking their cryptocurrencies — essentially locking in their cryptocurrency for rewards — and earned governance tokens in return, it led to high yields over a short period. That eventually turned into a marketwide trend called yield farming.
Factor #1: Ethereum Network Activity is Rising
According to the data from Etherscan, the popular Ethereum block explorer, the Ethereum network’s user activity is continuously rising. On September 17, the number of daily transactions on Ethereum achieved a record-high of 1.4 million transactions. The previous all-time high was established in January 2018, when the price of ETH surpassed $1,400 across major exchanges.
A major contributing factor to the rapid upsurge of user activity on Ethereum has been the active DeFi market. For users to send ETH or other tokens to and from DeFi protocols to stake or use DeFi services, they need to send it through the Ethereum blockchain network. As such, each token transfer registers as a transaction that is recorded on the public blockchain.
The increase in the total value locked of DeFi protocols means the number of DeFi users is also rising at a rapid rate. Consequently, the Ethereum blockchain network started to see higher user activity, causing daily transactions, transaction fees, and eventually hashrate to surge.
Factor #2: Calls For ETH 2.0 and Scaling Increases Due to High DeFi Activity
As the Ethereum blockchain network saw a significant spike in user activity, the network experienced a bottleneck scenario. On Ethereum, users pay transaction fees to miners in the form of “gas” to send transactions. During peak times, gas costs surged to the point where transactions, especially staking transactions, sometimes surpassed $100 per transaction.
Eventually, analysts called for scaling on Ethereum and emphasized the importance of ETH 2.0. While the substantial increase in user activity is a positive factor, the Ethereum blockchain needs to facilitate growth for the network to expand. In recent months, particularly when the yield farming trend hit its peak, Ethereum struggled to meet the outpouring user demand. Over time, as the anticipation for scaling and higher blockchain capacity grew, Ethereum co-creator Vitalik Buterin reaffirmed the roadmap of ETH 2.0.
ETH 2.0 is a critical step towards scaling Ethereum to a larger capacity. In essence, ETH 2.0 would shift Ethereum to a Proof of Stake (PoS) consensus algorithm from the current Proof of Work (PoW) algorithm. Currently, Ethereum uses PoW, like Bitcoin, which requires miners to use computing power to verify transactions. A PoS algorithm does not depend on miners, as users collectively verify transactions through staking.
|PoW||Solving computationally intensive mathematical equations||Proposing an invalid block would risk losing rewards and the resources depleted to mine the block||Mining rigs & energy costs|
|PoS||Staking wealth as collateral and vote on transactions and blocks||Proposing an invalid block would risk losing all or a portion of rewards and staked collateral||Amount of wealth being staked|
For Ethereum, when users stake their ETH, they will not be able to use the ETH until they remove it from staking. But during the period of staking, ETH holders would receive rewards for participating in the network to verify transactions and sustaining the PoS system.
Vitalik Buterin Clarifies ETH 2.0 Roadmap
Currently, Ethereum is processing between 14 to 15 transactions per second (TPS). To handle highly demanding applications like DeFi protocols, such a transaction capacity is insufficient. ETH 2.0 substantially increases the capacity up to 6,400x. The phases of scaling Ethereum through ETH 2.0 can be explained as a two-step process:
- Sharded rollups can achieve 1,000 to 4,000 TPS without ETH 2.0
- Sharding with ETH 2.0 can achieve 25,000 to 100,000 TPS
Initially, Buterin explained that the ETH 2.0 roadmap had three phases: PoS, sharding, then the sharded transaction processing. However, in a recent statement, Buterin noted that sharding can be front run by sharded rollups, which can happen without ETH 2.0. That way, Ethereum scaling can be achieved in two phases, rather than three.
Rollups would immediately provide 1,000 to 4,000 TPS, which would be around 100x of the current Ethereum blockchain capacity. Over time, ETH 2.0 would bring the TPS to over 25,000 TPS through sharding, further expanding the blockchain capacity.
Factor #3: More ETH are Locked in POS and DeFi, Less ETH in Circulation
For ETH 2.0 to work, users can adopt the role of a validator by staking their ETH to collectively verify transactions on the Ethereum blockchain. Under the new protocol, users would need to commit 32 ETH in the deposit contract to become a full validator. Consequently, the number of addresses holding at least 32 ETH has seen a sudden surge in July 2020.
The launch of the ETH 2.0 mainnet requires locking 524,288 ETH from at least 16,384 validators into a one-way deposit contract, which would lower the liquid supply of ETH immediately after launch, and potentially drive up the price in the short run.
Meanwhile, the rise of DeFi has resulted in a large portion of Ethereum’s supply being locked inside DeFi protocols. The amount has climbed back to a little short of 9 million ETH after a slight dip in early November. Uniswap alone has locked 3.2 million ETH in its liquidity pool. Between ETH 2.0 and other DeFi activities, the ETH’s liquidity, especially in the period immediately after launch, will be significantly reduced, potentially creating an upward momentum for ETH price.
An argument could be made that less ETH in circulation could cause less ETH to be used in ETH 2.0, hindering the scaling of Ethereum. However, industry executives, including Three Arrows Capital CEO, Su Zhu countered that the usage of ETH across DeFi actually makes ETH 2.0 more optimistic. Zhu argued that more ETH are being withdrawn from exchanges and are being used on-chain. That raises the overall user proficiency, which means fewer users would leave ETH on exchanges and more likely participate in ETH 2.0.
Zhu said that the fact that a significant amount of ETH are being withdrawn from exchanges and being used on-chain in DeFi “raises average user proficiency levels immensely, which is bullish for decentralization of staking.” He added that “the idea that everyone will stake on exchanges because [of] ease is stale.”
Factor #4: Ethereum Hashrate is at an all-time high
In October, the hashrate of the Ethereum blockchain network hit an all-time high at 250,000 terahash per second. Glassnode researchers attributed the steep climb to the DeFi hype. “Ethereum hash rate hits an ATH. Ethereum miners have pushed the hash rate to a new record high in the wake of the #DeFi hype and surging fees,” they explained.
Until Ethereum makes the switch to PoS, hashrate will remain an important metric to gauge the level of security of the blockchain network. Hence, at least in the near term, the record-high hashrate of Ethereum is a positive factor for sustainability and security.