Using Ethereum to Understand the Protocol Economy

A version of this article was first published on CoinDesk on March 21, 2024.

Most investors are familiar with the business model of the entrenched platform economy, in which a set of powerful tech companies rely on the network effects that they generate to obtain proprietary data, goods, or content from their users. These tech giants dictate terms that are favorable to their own businesses yet often limiting to users’ interests. One of the most exciting and perhaps underappreciated aspects of blockchain technology is that it has enabled a new business model – what we call the protocol economy. A blockchain, in its simplest form, is a secure digital ledger that, without the use or need of intermediaries, records new activity to its ledger in exchange for a fee, while adhering to its protocol (rules for how the process works). Why does this matter? Blockchains enable digital property rights. Digital scarcity and ownership can now, for the first time, be enforced through software and code rather than organizations and people.

However, not all blockchains function the same way. The Bitcoin network is an application-specific blockchain. It essentially does one thing – records wallet addresses and BTC amounts – but it does this very well. It’s secure, transparent, and permissionless. Ethereum, on the other hand, is a general purpose blockchain. Its programming language, along with the introduction of self-executing smart contracts, allows for more complex “if-then” activities. This innovation transforms blockchains from mere distributed ledgers into powerful, global virtual computers. These virtual machines enable developers to create comprehensive applications across various domains securely and autonomously, from marketplaces and financial tools to social networks and even other blockchains.

Ethereum's robust security layer and broader functionality paved the way for new digitally native economies to be built on top of its infrastructure layer. Tokens in such ecosystems are not just currencies but essential incentive mechanisms, encouraging coordination and integrity within the decentralized system. Holding Ethereum’s ether token ($ETH) signifies more than transactional utility; it represents an ownership stake in Ethereum's network, offering both participatory and economic benefits aligned with the ecosystem's growth. Moreover, the fundamentals of Ethereum’s network can be analyzed in a similar fashion to non-digital companies, which may help inform what $ETH is worth (similar to a stock, albeit with some different metrics and nuances).

The protocol economy of Ethereum currently has over 120 million token holders and this has grown at double digit annual rates over the past four years. Monthly active users grew 44% YoY last month and now stands at 7.1 million. If users on Ethereum Layer 2s (blockchains built on top of Ethereum to help scale the ecosystem) are included, that user base is over 12 million.¹ Total value locked, i.e. the amount of capital stored in Ethereum’s DeFi smart contracts, rose to ~$54B, but this figure still massively understates the total economic value that the chain secures, which is estimated at $0.64 trillion.² And, while Ethereum’s developer count is down YoY, most of that attrition is due to new, part-time developers while the ecosystem’s established developer base continues to rise.³

Ethereum’s financial state is likewise robust with YTD total fees and gross profits are both up roughly 100% YoY and Last Twelve Months (LTM) Total Fee Revenue currently stand at $3.1 billion. Furthermore, the network has an 85% gross margin and is profitable (23% net profit margin) even when accounting for the non-cash token incentives.

So how does one get exposure to this breakthrough technology asset and, just as importantly, the $0.64 trillion value built on top of the chain? Assuming a protocol’s tokenomic design has a value accrual mechanism that allows value of the network to flow to, and be captured by, the value of the token, then there’s a case to be made for holding the token. When any kind of economic activity happens anywhere in the Ethereum ecosystem, fees (revenues) are generated. A portion of those fees fund the network’s security costs (COGS) while the remainder support token value through strategic buy-and-burn mechanisms (akin to share repurchases). This approach highlights the advantages of protocol economies over traditional platform economies. Rather than buying stock in a company that built a platform that attracted a network, investors and users alike can now own a direct stake in their network’s success.