Is Ethereum still a good investment?

$ETH supply shock incoming

May 04, 2024

GM! This is Milk Road PRO, lighting up your email inbox each Saturday with a report that helps you invest successfully in crypto. 💰

Today, we’re talking about one of the greatest supply shocks in any asset, happening right in front of our eyes.

Blockchain networks offer an opportunity that the investing world has almost never seen before – let alone one that is accessible to anyone in the world.

Just look at what happened with the Bitcoin supply and demand after the launch of the U.S. ETFs…

(...oh and that supply number was just cut in half after the Bitcoin Halving 🔥)

That’s Bitcoin. But get this. The numbers for $ETH are even better – if you understand this, you understand something that 99% of investors don’t. 👀

Supply shocks are nothing new. They occur in many assets, like commodities, real estate, and more.

However, supply shocks in assets are usually temporary. This means the price of the asset reacts like an elastic band; it shoots up and then settles back to an equilibrium once the supply issues are resolved. ⚖️

In recent years, we can remember this happening with lumber or even toilet paper during the lockdown.

For lumber, demand stayed steady while supply dropped significantly, causing lumber prices to skyrocket.

For toilet paper, demand increased unexpectedly and supply fell as factories shut down. However, once manufacturers adjusted their production to meet demand, prices returned to normal.

With blockchain networks, this dynamic works very differently.

No one can simply create more supply of network tokens. If demand keeps increasing while the supply remains fixed, it leads to a supply shock with very limited elasticity. 

Simply put, it’s not going back to its original price! 📈

But this is where Ethereum differentiates from every other asset on planet earth. 

In Ethereum's unique case, thanks to the burning mechanism introduced by EIP 1559, the supply of $ETH is continually decreasing. If demand rises, the supply diminishes even more.

Moreover, increased activity on the Ethereum network results in higher transaction fees, which in turn drives up the demand for $ETH because the yield from staking $ETH increases.

This creates a never-ending flywheel of increasing demand and decreasing supply. ⚖️

What this means for the price of $ETH is anyone’s guess, as we’ve never seen a financial instrument quite like this.

But we can assume one thing; the price appreciation of $ETH when this flywheel goes into full effect has the potential to be shocking. 🤯

In today’s report, we’re going to dive deeper into the supply and demand dynamics of $ETH.

The goal here is to get a deeper understanding of what’s happening with the current $ETH supply and where the demand is coming from.

We’re looking at various factors like:

• $ETH Tokenomics 📊

• $ETH Burn 🔥

• $ETH in Smart Contracts 📜

• $ETH (Re)staking 🔁

• $ETH ETF 👁️

• And much more! 🚀

Why is this important? Because we could be reaching an inflection point for Ethereum’s supply and demand, setting us up for one of the greatest investment opportunities in human history.

Let’s get into it 👇

$ETH SUPPLY 🔥

Let’s start with the high level numbers of $ETH tokenomics with a focus on the supply.

If you want a detailed refresher on how Ethereum tokenomics work, I recommend you check out our previous PRO report called “Is This Web3's Greatest Tokenomic Design?”

Ethereum has no cap on its supply – it’s always issuing and burning $ETH at the same time. 

The current supply of $ETH is 119,663,333, down from its highest ever supply of 120,530,930 back in October 2022.

You can see the lifetime supply of $ETH below…

Source: Glassnode

We’ve marked 2 specific points on this chart.

1/ EIP 1559, which was the beginning of Ethereum burning a certain % of the gas fees it generates.

2/ The Merge, which moved Ethereum from Proof-of-Work to Proof-of-Stake and significantly reduced the amount of $ETH being issued.

Together, these two upgrades have made the supply of $ETH deflationary. 📉

But it wasn’t just these upgrades that led us here. There have been multiple changes to Ethereum's monetary policy over its 9 years of existence…

Source: Glassnode

As you can see above, since late 2022 (after the Merge), Ethereum is still issuing new $ETH, albeit at a much lower rate than ever before.

Once you add the burn into the equation, you get a deflationary $ETH supply. Below we can see the monthly history of the $ETH burn. 

During bull markets, Ethereum's activity spikes, leading to a higher $ETH burn rate, whereas it drops during bear markets with less onchain activity.

Source: Glassnode

Overall, since the merge, we are decreasing the supply of ETH by .22%/year.

Source: UltraSoundMoney

You might be thinking… That’s not that much. How does this create a supply shock?

For this, we need to go deeper.

Firstly, we need to understand who is holding the existing supply, an analysis that’s commonly done to understand the dynamics of Bitcoin’s supply, which we did in our “Will $BTC Outperform Altcoins This Cycle?” report.

Secondly, we need to look at the $ETH that is locked up in smart contracts, something that’s unique with Ethereum versus something like Bitcoin. 

When it comes to supply, it's not necessarily about the number of units that exist. What matters is the number of units that are actually available and on the market to be sold. 

This is where things get really interesting for Ethereum, so let’s get into it. 👇

ETH HOLDERS ✊

To start, we can look at the Ethereum HODL waves chart, which gives us a breakdown of the length of time that $ETH has been held in wallets. 

As Ethereum ages, a larger percentage of the total supply remains unmoved for several years. Here’s what it looks like right now

• 50% of $ETH supply has not moved in 2+ years

• 20% of $ETH supply has not moved in 5+ years

• 7% of $ETH supply has not moved in 7+ years

Source: Glassnode

Note: These tokens are not locked up, so they can be sold at any time. 

However, it’s likely that these tokens are either lost or in the wallets of long-term, die-hard Ethereum believers that have no plan of selling in the near future (if ever).

Of course, most people have a number they are willing to sell at. You can see during each bull cycle how a higher % of $ETH moves (red/orange). 

But, even during each bull cycle, the amount of long-term holders rarely moves backwards. Instead, it pauses or continues to grow.

The other area that can give us some insight into who’s holding $ETH is looking at the balance of $ETH on exchanges. The more $ETH on an exchange generally means that more retail (short-term) holders are holding $ETH.

When someone holds $ETH off an exchange, it tends to be a more crypto-native holder and also more likely to be locked up in a smart contract. 

As you can see below, the amount of $ETH on exchanges has been on a steep decline since late 2020.

Source: Glassnode

$ETH IN SMART CONTRACTS 📜

The dynamics of $ETH holders continues to head in a supportive direction in terms of $ETH price, but it's the dynamics around $ETH in smart contracts that’s reaching an inflection point.

Currently, over 37% of the total ETH supply is locked in smart contracts, whether staked, used in DeFi protocols, or held in bridges. 

This number took off back in 2020, when DeFi first started to become popular and has had a resurgence in 2023 fueled by increased staking and the expansion of L2s.

Source: Glassnode

$ETH in smart contracts is important for the supply dynamics because this is active $ETH.

It’s $ETH that is being used to take out loans, generate yield, secure a network or various other use cases. It's $ETH that is less likely to be sold as it serves another purpose outside of just speculation.

This metric is also one we can use to track when demand is slowing down and people are beginning to remove their $ETH from smart contracts to sell.

Let’s dive into the $ETH in smart contracts a bit further.

First, below is the number of $ETH being used in DeFi (excluding staking), which is about 3% of the total supply.

Source: Dune

FYI, the above chart is pulling data only from the top DeFi protocols on Ethereum, so it’s likely that it’s a few % higher than this.

Secondly, we have the number of $ETH locked in bridges like L2s or to other L1s, also around 3%.

Source: Dune

Lastly, we have the number of $ETH being staked. This $ETH is very sticky and unlikely to be sold anytime soon, adding to the supply crisis of Ethereum

Currently, over 32 million $ETH are staked...

Source: Beaconchain

This sucks up about 26% of the entire $ETH supply…

Sources: Beaconchain, Glassnode

But this number has the potential to go closer to 50% in the next few years. Here’s why…

Firstly, Ethereum has one of the lowest staking rates among blockchains, primarily because it has only had Proof of Stake (PoS) for only about 1.5 years. 

As shown below, most other chains have over 50% of their total supply staked.

Source: StakingRewards

Secondly, restaking. Before we explain why restaking matters, we’ll first explain the limitations to staking.

The way the Ethereum protocol is set up is that the more $ETH that is being staked to validate the Ethereum network, the lower the % of $ETH that is earned. 

In the beginning, when there was no $ETH staked, $ETH holders were highly incentivized to stake their $ETH as they could earn more than 20% APY.

As more and more people began staking, that % has gone down to sub 4% today. 

At some point, we will reach an equilibrium, where the APY is so low that for many it doesn’t make economical sense to stake their $ETH – so there’s a theoretical limit to the total amount of $ETH that would be staked.

Source: Glassnode

However, with restaking, $ETH stakers now have the ability to restake their $ETH and earn additional yield on their staked $ETH. 

The more revenue that restaking protocols can generate, the more that restakers can earn.

Restaking on Ethereum is relatively new, and while the exact APY for stakers isn't yet known, 4.99 million ETH have already been restaked.

This surge occurred just weeks after EigenLayer, the leading restaking protocol, launched on the mainnet and lifted their deposit cap.

Source: DefiLlama

We believe that as restaking gains adoption and liquid staking and restaking tokens develop additional use cases across the Ethereum ecosystem, the percentage of $ETH supply staked will continue to increase significantly.

We can see the supply dynamics playing out live, with the total supply decreasing and the amount of $ETH locked up in staking increasing.

Sources: Beaconchain, Glassnode

These lines won't actually converge, but we can project when 50% of the total $ETH supply might be staked – based on the current rate of staking, we could reach this milestone by mid-2026.

Sources: Beaconchain, Glassnode

To summarize the supply side of $ETH:

• 33% of $ETH is either lost or held in wallets of long-term holders who didn't sell during the last bull market.

• 37% of $ETH is currently held in smart contracts, and this could potentially rise to well above 50% by mid-2026.

There is some overlap between the two categories mentioned, but our best estimate, after reviewing the data, suggests that currently about 50-60% of the total supply of $ETH is "sticky" and unlikely to be sold in the short to medium term.

This percentage is expected to increase, as we explained above.

While the total supply of $ETH is decreasing by 0.2% per year, the basic laws of economics suggest that even with no change in demand, the price of $ETH would have to significantly increase.

However, we cannot underestimate what is about to happen in terms of the demand side of $ETH.

$ETH DEMAND 🚀

$ETH has a variety of demand functions that exist today – by "demand," we refer to the reasons people have for buying $ETH. Here are the main 3 reasons.

1/ Speculation – this is likely the bulk of the demand driver for $ETH today. 

This isn’t a number we can quantify onchain, but of course, if we are heading into a full on bull market, there will be plenty of demand to speculate on $ETH. 

As mentioned in the “Where Are We In The Cycle?” PRO report, it's still early days, and most retail investors haven't entered the market yet. When they do, they’ll likely drive billions of dollars of demand into $ETH.

2/ Staking – The ability to earn yield on an investable asset. 

As mentioned above, we already see that more than 26% of the entire supply is being used for this. 

For $ETH to increase from 25% to 50% of the total supply staked, as mentioned earlier, an additional 30 million $ETH would need to be staked.

To be clear, that doesn’t mean 30 million $ETH needs to be bought, as current holders of $ETH could simply start to stake their $ETH without buying new $ETH, but a large % of that 30 million $ETH would be new demand.

3/ Gas – Users need $ETH to pay for every transaction they execute onchain. 

In 2021, 3.4 million $ETH was spent on gas fees. Over the last two years, which have been characterized by a bear market, the average spent was about 1.5 million $ETH annually.

In 2024 we are already on pace for 1.4 million $ETH, while at the same time Ethereum’s L2 ecosystem is providing cheap and scalable blockspace to the masses.

Source: Dune

With this in mind, it’s important to realize that it's not just humans buying $ETH for gas, it’s also other blockchains. 

L2s need $ETH to pay for all transactions they execute onchain too – regardless of what gas token users use on that specific L2. 

Currently, L2s account for more than 10% of all $ETH spent on transactions across the entire Ethereum ecosystem.

Source: Dune

Of course, gas fees don’t only drive demand for the purchasing of $ETH, it also reduces the supply of $ETH as a % of each transaction fee is burned.

But there is one more massive driver of demand coming to Ethereum in 2024 and that is… 

4/ Ethereum Spot ETF in the U.S. 

We don’t yet know when this is happening, but at this point it’s pretty much a sure thing. 

It might happen as soon as May 23rd, or it could be later this year. Regardless, a significant influx of capital is expected to flow into Ethereum over the next year.

Let’s try to quantify this…

Since Bitcoin ETFs launched on January 11th, they have received a net inflow of $19.6 billion. 

Source: Dune

Now of course, Ethereum likely won’t receive the same amount of inflows as Bitcoin. So let’s make some assumptions.

If we look at the % of assets that the Grayscale Ethereum Trust accumulated ($9.45B) vs. Grayscale Bitcoin Trust accumulated ($28.58B) before the ETFs were approved, we can see that $ETH accumulated about 33% of $BTC.

Source: Ycharts

If we then take that percent and apply it to the Bitcoin inflows, we can project that in Ethereum's first 3 months of the ETF approval we could expect close to $8 billion of inflows or about 2.2% of the entire $ETH supply.

Not to mention the typical demand from those front-running the ETF approval, just like we saw with Bitcoin for a few months leading up to the approval, which took Bitcoin from $25k to $47k. 

For perspective, the market cap of Bitcoin went from $510B to $920B in just a matter of months.

$ETH has yet to have its front running moment for the ETF, which is where the opportunity lies.

THE OPPORTUNITY OF $ETH 💰

To wrap things up, at some point this year, we believe $ETH will have a parabolic price move centered around the $ETH ETF approval. 

We’re not sure if it's in May (unlikely) or later this year (very likely), but it’s coming.

The demand that will come from front-running the ETF and then also from the flows once it’s live will move $ETH faster and farther than $BTC with its ETF. The reasons why are simple:

1/ $ETH has a smaller market cap than $BTC.

2/ $ETH’s supply is shrinking and a large % of its supply is unavailable to be sold as it’s locked up in smart contracts.

In our opinion, the longer that the ETF takes to be approved, the larger the move $ETH will have as it will give more time for more $ETH to be locked in smart contracts.

The ETF not only sets the stage for a short-term parabolic price movement in $ETH but also supports the fundamentals for longer-term price appreciation.

The ETF will legitimize Ethereum, just like it has Bitcoin, allowing more institutions not just to invest, but also to build on top of Ethereum, similar to how BlackRock has launched BUIDL – a tokenized treasury fund.

This further activates the flywheel of increased demand and decreased supply where:

1/ More Builders: Leads to increased reasons to lock up $ETH in smart contracts.

2/ Increased Activity: Results in higher transaction fees and more $ETH being burned.

Ethereum’s tokenomics are a work of art and were designed to act like rocketfuel to push the $ETH price higher – it just needs the activity onchain to set it off. 

We believe the coming $ETH ETF in the U.S. will be the inflection point for this. Friends, hold on to that $ETH. Its moment is coming. 👏

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