With an increase of 80% in one year, is Ethereum really underperforming?

The future of Ethereum remains bright.

Written by Zach Pandl Grayscale

Compiled by: Chief Villager Carbon Chain Value of Ivory Mountain

Ethereum saw huge returns in 2023. But its performance is not as good as Bitcoin and some other smart contract public chain tokens. We believe this reflects the positives unique to Bitcoin this year and the slow recovery in activity on the Ethereum chain.

Although Ethereum has gained less than Bitcoin, it has outperformed traditional asset classes this year in both absolute and risk-adjusted terms. The development of Ethereum’s growing L2 ecosystem may attract new users and support Ethereum’s valuation in 2024.

Few would say an asset that’s up 82% is “underperforming,” but that’s exactly how Ethereum’s token, ETH, will perform in 2023. As the second-largest crypto asset, Ethereum has made strong returns this year (with relatively low price volatility), but its appreciation is still significantly lower than that of Bitcoin, which is on track to gain 162% this year. The ETH/BTC price ratio has been declining throughout the year, reaching its lowest level since mid-2021 (see Figure 1).

The ETH/BTC price ratio will trend downward in 2023

First, there were several Bitcoin-specific tailwinds during the year, including potential spot Bitcoin ETF progress and instability among U.S. regional banks, which highlighted Bitcoin’s role as an alternative digital currency system. These developments appear to have driven inflows into Bitcoin-focused cryptocurrency investment products throughout the year, which may be one of the reasons for higher Bitcoin price returns. For example, Grayscale Research estimates that net inflows into Bitcoin-focused cryptocurrency exchange-traded products (ETPs) - including futures products in the United States and spot products overseas - will be approximately $2 billion in 2023. In comparison, total net inflows into Ethereum ETPs during the same period were only $24 million (see Figure 2).

Bitcoin-specific positives appear to be driving greater ETP inflows

Secondly, most smart contract platform tokens have risen less than Bitcoin this year, while ETH’s trading volume is basically the same as Bitcoin. As shown in Figure 3, the FTSE Grayscale Smart Contract Platform Cryptocurrency Industry Index will increase by approximately 94% in 2023, only slightly higher than ETH. Ethereum outperformed its peers in the year to October, but other coins have been catching up recently (standout performers include AVAX and SOL). Looking at the full year, ETH is close to the mid-range among the 40 tokens in the smart contract platform cryptocurrency space.

ETH’s performance is consistent with the smart contract platform cryptocurrency space

Third, activity (certain categories) on the Ethereum mainnet chain has been slower to resume compared to other chains. For example, Solana’s NFT transaction volume has grown faster since the start of the quarter (approximately 15x) compared to Ethereum’s NFT transaction volume (approximately 2x). While Grayscale Research remains constructive on Ethereum’s NFT ecosystem, Solana and Bitcoin have recently taken market share in this area of on-chain activity.

Rising NFT activity on Bitcoin and Solana

From a broader perspective, while ETH has lagged Bitcoin and certain other cryptoassets this year, it has significantly outperformed traditional asset classes in both absolute and volatility-adjusted terms (see Figure 5). Therefore, we believe that while ETH price is “only” up 82% this year, its rebound should be seen as evidence that the cryptocurrency recovery is broader.

ETH’s risk-adjusted returns outperform traditional asset classes

While other blockchains are in the spotlight in 2023, Ethereum’s future remains bright. On top of that, Ethereum has historically benefited from the deepest network effects in the industry, with the most decentralized applications (DApps), the most developers, and the highest revenue. Ethereum is promoting a “modular” development approach, in which the Layer 2 ecosystem will be built on Layer 1 to expand the scale of activities. This is still a work in progress, but next year’s EIP-4844 will be a step forward by making it 10-100x cheaper for Layer 2 scaling solutions to confirm transactions on Ethereum. This will help reduce costs for Ethereum second layer users.

Ethereum has the potential to return to center stage in 2024 if it can attract new users to its growing Layer 2 ecosystem. Of the five grayscale cryptocurrency sectors, the smart contract platform segment may be the most competitive.

Low-cost “monolithic” public chains like Solana can provide a compelling experience for new users, especially if paired with well-designed wallets and other ecosystem applications. In contrast, Ethereum’s “modular” layout may be more difficult to navigate, because users need to actively connect assets between the main network and its L2.

However, the development of these networks is still in the early stages, and it remains to be seen which public chain design solutions will find the best product/market fit and bring the most value to their native tokens over time. Once end-users primarily interact with applications—with the blockchain infrastructure running in the background—Ethereum’s current user experience challenges should become less important than other Ethereum features such as trusted decentralization ization, may attract developers and ultimately support token valuation. For investors unsure of how competition among smart contract platforms will play out, diversifying into this cryptocurrency space may be worth a try.