Just three years ago, Ethereum’s (CCC:ETH-USD) first NFT craze hit the market. Collectible online cats – known as CryptoKitties – were adorable and personalizable. But unfortunately for early investors, the digital equivalent of beanie babies performed precisely like their real-world counterparts. It wasn’t long after the most expensive kitty sold for $170,000 that prices collapsed. The infinitely multiplying number of cats, paired with limited consumer appeal, meant collectors could eventually scoop up hundreds of kittens for only several dollars.
But Ethereum’s story doesn’t end there. Just three years later, the cryptocurrency is back.
On Thursday, Christie’s record-shattering $69.4 million NFT sale sent the art world ablaze. Never before had anyone paid so much for digital art. But regular investors should also notice one other thing: the buyer paid entirely in ETH.
“We are accepting [a buyer’s premium of] Ethereum for this purchase,” said Noah Davis, the organizer of the auction. “I feel like that’s actually the biggest deal of this whole thing, secretly.”
It’s an open secret that all NFTs are traded on the Ethereum network. All transactions are done using Ether, the cryptocurrency of the Ethereum Network, and all pieces of art have a unique Ethereum token that anyone can verify. With a real-world use that exceeds even Bitcoin (CCC:BTC-USD), Ethereum could soon eclipse the world’s “digital gold” as the cryptocurrency of choice in this brave new economy.
Ethereum Prices: Emerging from the Shadows of Bitcoin
When Ethereum went live in 2015, crypto enthusiasts (like yours truly) became immediate fans. The collaboration between programmers Vitalik Buterin and Gavin Wood was a clear departure from Bitcoin’s concept of “digital gold.” Whereas Bitcoin operates much like coins at an arcade, Ethereum’s “smart contract” abilities make it more like Apple or Google Pay. In other words, Ethereum’s system is built to track and transact unique tokens.
Most of these tokens look much like this:
It’s an ERC20 code that (in this case) represents ownership of “Liberty Mural,” an artist’s online recreation of his famous Paris fresco. If you want to track the token – again, using Liberty Mural as an example – you can type the address online and see all 84 transactions as of this writing. And if you ever want to buy that GIF (and have $25,000++ to spare), confirming “Liberty’s” ownership is as easy as checking the latest seller’s wallet address. ERC20 doubles as a convenient digital certificate that NFT buyers today usually take for granted.
Ethereum’s start, however, looked a lot shakier. Back then, few people used these tokens for anything besides seemingly trivial pursuits like CryptoKitties. And when I first sold my tens-of-thousand dollars equivalent of Ethereum close to the $1,200 market peak in 2018, most people were invested in ETH for one simple reason: to make lots of money.
Even now, many people still don’t realize that Ethereum powers the entire NFT market. Many “What are NFTs” articles use Bitcoin as an illustration because the world’s largest currency is far better-known to average investors. Its $1 trillion market capitalization eclipses Ethereum’s $200 billion by a 5x margin.
But that’s starting to change. As more people start bidding on NFTs – from low-cost digital art to collectible NBA highlight reels – many of these same bidders will convert their dollars into Ether for the very first time to complete transactions. These people might never have had a reason to own Ether in the first place. But as NFTs grow in adoption, many investors will find themselves owning Ether for the first time.
There’s also the supply-side of the picture. Since all significant digital art auctions are done in Ethereum today, the currency has a world-beating first-mover advantage. Switching to a different ledger quickly becomes untenable as time passes.
Consider VINs, the 17-digit code that every motor vehicle worldwide gets assigned at production. (Internationally, they’re known as World Manufacturer Identifiers). Because these codes are ubiquitous, state governments and title companies use VINs to track vehicle ownership and run accident reports. Corporations have built entire industries to title-check used vehicles. No corporation, however, will find creating a VIN alternative particularly easy, since it will involve convincing everyone else to also sign on.
Meanwhile, Ethereum’s ERC20 tokens have quickly become the gold standard for tracking digital artwork ownership. The Ethereum blockchain links all $350 million of the NBA’s Top Shot NFT sales; thanks to an early deal with Dapper Labs, every single highlight reel has an Ethereum contract address.
Newer smart-contract cryptocurrencies like Cardano (CCC:ADA-USD) could try challenging Ethereum’s position. But overtaking Ethereum as the single authority on digital art ownership could also mean re-titling every existing piece of digital art that’s already been sold. From Taco Bell’s initial $1.60 set of taco GIFs to Beeple’s $69.4 million auction, a new system will need enough data from existing owners to have much real-world value.
Environmental Concerns and Proof of Stake
Ethereum is far from perfect. As one of the first major token-based cryptocurrencies, Ether shares many of Bitcoin’s flaws: slow speed, high fees and a ludicrously big appetite for electricity. At current rates, Ethereum miners use almost as much energy as the Republic of Ireland.
That’s because Bitcoin and Ethereum share a reliance on an energy-intensive “proof-of-work” (PoW) system – complex cryptographic problems that miners solve for rewards. At small scales, these PoW systems work exceedingly well. Low crypto prices will limit mining investment, keeping costs in check.
But Ethereum’s PoW reward system scales linearly with ETH price – the higher Ethereum goes, the more people spend on chips and mining power. And because its function adjusts its difficulty to maintain block speeds, the additional mining power gets wasted on more complicated problems. Some have even pointed out that transacting high-priced art can cost the equivalent power as 3.5 weeks of a household’s use. Meanwhile, Ether users see no net benefit.
For years, Ethereum has toyed with moving to the less energy-intensive “proof-of-stake” system (PoS). Under that system, the network randomly selects miners to add new blocks instead of having them prove their worth through calculations. That would theoretically reduce energy usage by 99% or more. PoS systems, however, need a complex layer of checks and balances. Without that, bad actors could potentially hijack the system and re-write the blockchain in their favor.
But change is coming. Ethereum’s co-founder and CTOs recently launched proof-of-stake blockchains Cardano and Polkadot (CCC:DOT1-USD), proving that the PoS system can work at scale in the real world. On Dec. 1, 2020, the Ethereum Foundation followed suit with its Ethereum 2.0 Beacon chain launch – a working version of a proof-of-stake blockchain. The foundation still has a long way to go – the system needs to get tested for security. And merging the two Ethereum blockchains could take months of planning.
But with some luck, the merge could happen as soon as 2022.
The $1 Trillion Opportunity
Ethereum NFTs aren’t stopping at digital artwork. Today, investors can buy digital trading cards, in-game items, and even domain names through NFT trading platforms. I’ve written before that the current market is worth upward of $1 trillion, and the opportunity will only grow as more players hop on board.
Even now, it’s easy to see a future where all collectible art (both real-world and digital) gets an Ethereum ERC20 token. The art world has long struggled with determining authenticity and ownership; NFTs offer a clever way to solve both problems.
Auctioneers are already waking up to this new reality. Christie’s might have been the first to accept Ethereum on such a large scale, but others will quickly follow suit as they realize Ethereum’s power in reducing transaction risk. Because Ethereum already performs the dual function of escrow and validator, auction houses have less need to risk their own capital to finance these sales. And while Ether’s current $10 transaction fee might seem high to pay for a $20 lunch, it’s a low price to gas the art world’s multi-million dollar transactions.
What’s Ethereum Worth?
Investors will need to act quickly. Ethereum is only up 20% from its 2018 peak compared to Bitcoin’s 150% gain, and it’s only a matter of time before regular investors realize that NFTs are essentially Ethereum transactions disguised as digital auctions.
For the wily investor, that makes Ether far more than just digital gold. It’s the grease that will turn the wheels of commerce for years to come. Buy in now before the world realizes that.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.