Why Does ETH Have Value?

In the previous lesson, I covered what ether is and how it’s used in Ethereum.

You learned that ether is used to pay for the computational resources and the transaction fees for any transaction executed on the Ethereum network.

The next question is:

Why does ether (ETH) have value?

Utility

As with most assets, value is often based on whether it is useful or not.

Let’s take silver as an example. Apart from its natural shine, the precious metal is considered valuable because of its usage as a semiconductor, electronic chip, or battery component.

People buy silver because it has an actual practical purpose, not just as pretty jewelry or fancy tableware.

In the olden days, silver was also used to make coins, so it served as a store of value and medium of exchange.

Similarly, ether has both practical utility and intrinsic value.

As covered in the previous lesson, the core function of ether (ETH) is to serve as gas for the Ethereum network. Every single operation that occurs in Ethereum, whether it’s a transaction or smart contract execution requires some amount of gas.

On top of that, ether can also be used to transfer funds and price digital assets on the Ethereum blockchain. It can be loaned and borrowed, and it is also accepted as payment by some merchants.

Lastly, its unique properties of being censorship-resistant, permissionless, and pseudonymous add to its appeal.

Network Effect

Whether ether’s value rises or falls can depend on how many people use Ethereum.

This is where dAapps come in, as these offer more ways to use the Ethereum blockchain beyond mere financial transactions.

The more innovative features dApps come up with, the greater the potential for mainstream adoption. As it is, Ethereum is already being used by crypto traders, gamers, digital art collectors, content creators, and more!

As the Ethereum user base grows, supply and demand dynamics also come into play when it comes to affecting ether’s value.

Tokenomics

As you’ve probably guessed, tokenomics is a mashup of the words “token” and “economics”.

It is a term for all the factors that go into the value of a token such as supply and demand, inflation/deflation rate,  distribution mechanics, market cap, etc.

Just imagine yourself as one of the sharks in Shark Tank, evaluating a project’s value based on revenue, profit margins, and growth potential.

Tokenomics looks into how tokens are created, how network participants are rewarded, and how tokens are removed from circulation.

So, how are the numbers looking for ether?

In its original version, ether shares similar tokenomics to bitcoin in that it relies on the Proof of Work (PoW) consensus mechanism.

Now, this came with some scalability issues that will be addressed in an update called EIP 1559, but we’ll get to this later on.

Ethereum 1.0 started off with a pre-mine genesis block of 72 million ETH, which was handed out to early contributors, investors, and the Ethereum Foundation in 2015.

Since then, miners are rewarded 2 ETH per block, amounting to a daily block reward of 13,500 ETH or roughly 4.9 million ETH each year. This translates to 4.5% annual network issuance, which means that the total supply increases at this rate per year.

Roughly 45 million ETH have already been mined, adding up to a total of more than 120 million ETH in circulation.

Pre-EIP 1559, transactions were auctioned, which meant that users could bid higher fees to have their transactions processed quickly. Miners would pick the higher bids to get bigger returns while users with lower bids would have no choice but to wait or increase their bids.

EIP 1559 split the fees into a fixed base fee and a small priority fee. This allows the transaction costs to be stabilized so that they won’t skyrocket during busy periods.

The base fee can be dynamic, but the total fee is capped at 12.5% of the previous block, keeping a lid on volatility while still allowing users to get prioritized by tipping miners.

In addition, EIP 1559 also burns the same base fee, effectively removing that amount of ETH from circulation. In short, EIP 1559 introduced a deflationary mechanism to the network.

Staking

In the early days of crypto, mining and trading were pretty much the only ways to make some serious moolah from this up-and-coming market.

While trading meant dealing with an insane amount of volatility and risk, mining had really high barriers to entry.

To start off, you’d need technical expertise, expensive hardware, and constant maintenance… only to potentially lose a chunk of your earnings to high electricity bills.

Thanks to the emergence of the Proof-of-Stake (PoS) consensus mechanism, the network is able to benefit from speed and efficiency while users enjoy lower fees and a new revenue stream.

Staking offers a more accessible way to earn passive income from blockchain maintenance.

It simply requires locking up tokens in a wallet or pool to support a network for a specified period of time, getting annual returns known as APR or annual percentage rate.

This is similar to earning interest from depositing money into a bank account, except that the potential rewards are much greater.

Staking also allows users to participate in blockchain governance, as some grant voting rights based on the amount of tokens staked and the lockup period.

Of course, this way of making returns comes with its own risks. For one, the lockup or “vesting” period means that the funds can’t be withdrawn or transferred for a certain time, which can range from a few days to a whole year.

Even if prices fluctuate significantly or if the project announces major setbacks, users won’t be able to pull their tokens out or risk losing more.

From the network side of things, staking also comes with big advantages mainly when it comes to scaling and securing the blockchain.

Staked tokens generally serve as a security deposit so that users can get incentives for validating transactions.

Each time a block needs to be verified, the network will assign the task to validators randomly. The likelihood of a validator being selected depends on how much they have staked and how long they’ve had the funds locked in.

If the validator or node successfully validates the assigned block, it earns the staking reward, similar to a miner getting incentivized in PoW blockchains. If the validator approves a fraudulent transaction, they could be penalized.

Staking helps secure the blockchain since staked tokens function as collateral against bad behavior.

Validators who follow the rules and verify blocks properly are compensated while those who don’t can get a portion of their tokens burned by the network in what is known as “slashing.”