Below is an excerpt of DARMA’s Ethereum Investment Thesis, please request the complete document here and review all applicable disclosures.

Introduction

Digital Asset Risk Management Advisors (DARMA Capital) seeks to risk manage the best protocol layer digital assets of the Web 3 “stack”.

In our previous post, we spoke about the various layers of Web 3.0 including Mesh Networking, Computation, Messaging, File Storage, and Smart Contracts. Today, we’re going to dive into Ethereum, which is currently our best choice for the smart contract layer of the Web 3.0 Stack.

Why Ethereum for the Smart Contracts Protocol Layer?

Ethereum Developer Adoption Is Accelerating

Developer adoption for Ethereum is steadily increasing and this directly impacts demand for ETH. All major cloud providers, including Amazon, Google and Microsoft, offer Ethereum as a service.

The chart below is a graph charting the amount of downloads of Truffle, the most commonly used Ethereum Integrated Developer Environment (IDE). This is a great graph to show the increased amount of developers that are using Ethereum.

https://truffleframework.com/dashboard

In addition, Ethereum’s ‘unique address’ growth (chart below) shows adoption and usage of the Ethereum blockchain.

https://etherscan.io/chart/address

A blockchain address is a secure identifier, usually represented by a public/private key pair used to receive and send transactions on a blockchain network. Similar to a bank account number, a SWIFT code or a website URL, a blockchain address is anonymous and identifies a destination or recipient.

Increasing Blockchain Demand & Enterprise Adoption

The expanse of blockchain’s capabilities is encouraging people to rethink entire industries, processes and how value is created and distributed.

Organizations, industries, and governments worldwide are exploring the possibilities of the Ethereum blockchain.

The Enterprise Ethereum Alliance (EEA) represents the depth and breadth of interest and support for the Ethereum blockchain. With its goal of customizing Ethereum for large corporate use, the EEA is the largest open-source blockchain initiative in the world. The EEA has over 550 members, including globally recognized organizations like Microsoft, Mastercard, Shell, Deloitte and others. Significant industry collaborations such as the EEA will accelerate and enhance Ethereum’s road to widespread adoption.

WORKING GROUPS

Advertising/Media

Artificial Intelligence

Blockchain Airspace

Communications Protocols

Digital Identity

Energy

Financial Services

Healthcare

Insurance

Multiplatform Interoperability

Real estate

Security

Supply Chain

Telecommunications

Technical Evidence Supporting Ethereum: Scalability & Privacy Roadmap towards Ethereum 2.0, named “Serenity”

As shown, Ethereum has an extensive global network of developer support. The platform’s developer community is perpetually researching and educating each other in order to produce the next generation of decentralized applications and further the evolution of Web 3.0.

Developers contributing to Ethereum Research are continuously defining the pathway or ‘roadmap’ to advance and scale the Ethereum protocol.

On October 31st at Ethereum’s annual developer conference, Vitalik Buterin, Ethereum’s Chief Scientist, revealed Ethereum’s roadmap to “Serenity” which contains specific technical upgrades and solutions designed to improve the user friendliness, efficiency and security of the platform, while allowing Ethereum to scale. Simply put, Serenity includes the transition to proof of stake (Casper), Sharding, evolving the Ethereum Virtual Machine to Web Assembly, and further incorporation of zero knowledge proofs.

PRIVACY / CONFIDENTIALITY

Ethereum is incorporating best-in-class privacy functionality. Innovative solutions enable privacy-preserving computation in blockchain runtimes.

Zero-knowledge (‘zk’) proofs verify information while preserving privacy on the Ethereum blockchain. A zk proof allows statements to be made about confidential values without revealing anything other than those statements.

Privacy Protocols

zk-SNARKs and zk-STARKs fundamentally change how data is shared and protected.

zk-SNARKs (zero-knowledge succinct non-interactive argument of knowledge) and zk-STARKs (zero-knowledge succinct transparent argument of knowledge) are two cryptographic protocols, or zero-knowledge proof methods, designed to protect personal information from security breaches.

Building upon zk-SNARK technology, zk-STARK technology is newer and designed to provide faster computation and smaller proofs than zk-SNARKs.

Both proofs allow blockchain companies to build smarter, automated systems that can attest to certain facts without revealing the data behind those facts.

zk Range Proofs (ZKRPs) prove that a number lies within a certain range. ZKRPs are significantly more efficient than zero-knowledge proofs.

A ZKRP could verify that a person’s salary is sufficient to rent a house, or obtain a mortgage, without revealing the exact number. A ZKRP could prove that a payment amount is within a limit, but it does not show the exact amount or that a person is located within a country, without revealing the exact location.

These advances in privacy and security significantly improve the scalability of the Ethereum blockchain.

SCALABILITY ROADMAP

Ethereum’s roadmap is to dramatically increase transactional throughput per second. Ethereum also intends to support as many users as it can while remaining decentralized. To advance its scalability while preserving transaction accuracy and security, Ethereum uses a combination of technical methods: Sharding, Proof of Stake, State Channels, and Plasma.

Optimizing Transaction Verification with Sharding

Sharding is a scaling solution that uses shards, or micro-chains, to process separate types of transactions on the Ethereum blockchain.

Ethereum depends on a network of ‘nodes’, each of which stores the entire ethereum transaction history and the current ‘state’ of account balances, contracts and storage. Sharding removes the need for the entire network of nodes to process every individual transaction.

Sharding is a method of splitting and storing a single dataset into partitions called ‘shards’ that contain their own independent piece of state and transaction history. In sharding, certain nodes would process transactions only for certain shards.

In this way, each node effectively stores a subset of data and only verifies those transactions. By splitting the blockchain into smaller partitions, Sharding optimizes the process of verifying transactions and smart contracts.

Increasing Computational Efficiency using Proof of Stake (PoS)

Ethereum is moving from Proof of Work (PoW) to a Proof of Stake (PoS) consensus formation algorithm.

Under PoW, ‘miners’ compete to verify the integrity of a specific block by solving cryptographic puzzles. The first miner to solve those puzzles receives a monetary reward and announces the solution to the network. This method is based on competition and computational output.

Under PoS, ‘validators’ must first submit a deposit of Ether into a smart contract before they are allowed to propose and validate blocks. A set of validators take turns proposing and voting on a block, and the weight of each validators vote depends on the size of its deposit, or stake. A validator must stake at least 32 ETH to be compliant, but most will likely stake more to earn interest and validate multiple shards.

Additional advantages of the PoS system include security, reduced risk of centralization, and energy efficiency. In addition, PoS can significantly increase transaction speed.

Increasing Transactional Throughput with State Channels

Ethereum is considered a ‘stateful’ network, meaning within each block on the Ethereum blockchain there is information regarding its state, including all account balances, contract storage, contract code, etc. In a stateful network, transactions take up space on the blockchain.

State channels are pathways opened between users that want to communicate with each other in the form of transactions. These channels are ‘off-chain’ and private, known only to its participants. They allow for instant and anonymous transactions, and they have a limited lifespan which is predetermined based on time or amount of transactions carried out.

Once a channel closes, the transaction history within can be uploaded to the blockchain and its ‘state’ is thereby updated. In this way, the blockchain is spared from including the back and forward transactions in the channel that led to the final outcome. In legacy finance, this would be the equivalent of transactional batching.

Increasing Transactions throughput with Plasma

Ethereum Plasma is a another scaling solution that could enable Ethereum to dramatically increase transactions per second.

Plasma allows off-chain transactions while relying on the underlying Ethereum blockchain to maintain its security. Like state channels, Plasma takes operations away from the Ethereum ‘main chain’ and performs them ‘off chain’ to increase efficiency.

Additionally, Plasma allows for the creation of ‘child’ blockchains attached to the ‘main’ ethereum blockchain. These child-chains can, in turn, create additional child-chains.

As a result, more complex operations can be performed faster and more cost-effectively on the Plasma chain without being replicated across the entire Ethereum blockchain.

By eliminating unnecessary data in the main-chain, Plasma saves processing power and memory. This technology vastly improves ledger scalability leading to a higher data storage capacity of Ethereum-based applications.

SEC Regulatory Clarification — ETH Is Not A Security

Regulatory clarification is important as it provides a clear message to the investment community. Ethereum, like Bitcoin, is not a considered a security, according to remarks made by SEC director William Hinman. Since Hinman is technically in charge of interpreting securities law, his stance on ETH is particularly significant.

SEC Director Hinman said:

“…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.”

Regulatory clarity that ETH is not a security allows investors to view ETH as a utility and not just another cryptocurrency. More importantly, large investment funds are restricted from investing in certain assets even if there is significant upside. Regulatory clarity should have a positive impact on reducing ETH price volatility and attract liquidity as additional investors can participate. The impact has already been seen by announcements of derivative products from CME and the CBOE as well as custody offerings from Fidelity and Nomura.

Development of Blockchain Standards

Ethereum developers are creating standards in conjunction with the Enterprise Ethereum Alliance (EEA). The development of standards helps to facilitate Ethereum’s scalability.

Standards play an important role by:

facilitating developer and enterprise interaction

enabling developers to comply with objectives

speeding up the introduction of technology deployment

providing interoperability between new and existing Ethereum technologies

Standards also disseminate knowledge in industries where processes from different providers must interact with one another. Standardization represents cooperation among developers, industry officials, public authorities, researchers and other interested parties for the development of technical specifications based on consensus.

ERC-20 is the preeminent technical standard, or set of rules, used for implementing tokens on the Ethereum blockchain. This standard helps developers to accurately predict interaction between tokens. These rules include how the tokens are transferred between addresses and how data within each token is accessed. Most tokens released through Ethereum based ICOs are ERC-20 compliant.

ERC stands for Ethereum Request for Comment, a proposal request-approval system to accept changes introduced by the Ethereum developer community. ERCs include technical guidelines for the buildout of the Ethereum network. Before an ERC becomes a standard, it must be revised, commented and accepted by the community through an EIP (Ethereum Improvement Proposal). Subsequent ERC’s typically resolve outstanding issues or add new parameters not previously defined.

A token with ERC-20 compliance means it is fungible, or can be exchanged for other currencies. The issuer of the token retains complete control of their assets, however with ERC-20 standard it is possible to track who owns the token and how much at any given point of time.

ERC-721 defines standards for tokens that are unique and ‘non fungible’, or not interchangeable. While two ERC-20 based tokens can not be differentiated, ERC 721 proposes a concept by which token holders will be able to differentiate between the tokens they hold. Each ERC 721 token is totally different and each one can have a different value to different users.

ERC 725 is a proposed standard for managing identity on the Ethereum blockchain.

These ERCs provide developers with a basis for mutual understanding, resource knowledge and support to further the scalability, security, and privacy demands of the Ethereum blockchain.

6. Support From Network-Effect Caretakers

The Ethereum blockchain has a vast network of support from global organizations providing research, education, and funding to further blockchain adoption, development and scalability.

ConsenSys is a ‘caretaker’ organization with more than 750 employees worldwide focused on development of the Ethereum ecosystem, growth of the network, and global integration of the benefits of blockchain and tokenization.

The Enterprise Ethereum Alliance (EEA) supports development of best practices, open standards, and open-source reference architectures. With members including Fortune 500 companies, innovative start-ups and cutting-edge research facilities, the EEA aims to enhance the privacy, security, and scalability of the Ethereum blockchain.

J.P. Morgan’s ‘Quorum’ is the first Ethereum blockchain-based banking platform. Quorum aims to align financial regulator needs for access to financial information with private party needs for transaction privacy and identity confidentiality. Like other Ethereum ‘caretakers’, Quorum also supports the advancement of Ethereum’s scalability and enterprise adoption.

Summary

The future success of the Ethereum network depends on its scalability as demand grows. Like any emerging platform (think of the internet in 1995) Ethereum will encounter development hurdles as it struggles to scale early on, but Ethereum is well-positioned to expand.

Ethereum’s ‘real world’ use cases and network of global developer support allows the blockchain network to methodically develop solutions for each scalability challenge it encounters.

Ethereum is distinguished by having:

the largest developer adoption

global demand and support from major corporations and government entities

regulatory clarity supporting institutional investment

widely incorporated best practices and standards for functionality

a robust technology with a strong scalability roadmap

DARMA’s comprehensive technology research process indicates Ethereum holds the greatest potential investment opportunity for institutional investment in the smart contracts protocol layer of Web. 3.0.

For more information on why we chose Ethereum as our “Optimized Long”, please go to our website and request our Ethereum Investment Thesis here.

This post was an excerpt of DARMA’s Ethereum Investment Thesis, please request the complete document here and review all applicable disclosures. DARMA Capital is a member of NFA and is subject to NFA’s regulatory oversight and examinations. However, you should be aware that NFA does not have regulatory oversight authority over underlying or spot virtual currency products or transactions or virtual currency exchanges, custodians or markets.