ETH has experienced a dramatic decline in value in 2018. The speculation that drove it’s value to new heights in 2017 is over. However, I believe ETH is still significantly overvalued and decoupled from the Ethereum network’s current technological state.

Ethereum’s market share has been mainly due to what is known as “first-mover advantage“. The first mover advantage allows a company to establish strong brand recognition and product/service loyalty before other entrants. However, being a first mover does not guarantee long-term success. Later entrants can reverse-engineer new products and make them better or cheaper. Later entrants can also identify areas of improvement and take advantage of it. With this in mind, it becomes possible to see there is a strong bearish case for ETH.

The Scalability Problem

The scalability problem lies in the fact Ethereum does not scale on the base-layer. This is why even halfway popular decentralized applications (dapps) can cripple the network (e.g. Cryptokitties or past popular ICOs). The scalability problem is a barrier to mainstream adoption. As it stands, Ethereum could not handle even one dapp going mainstream.

The Ethereum blockchain size has also exceeded 1 TB. The problem with this is larger blocks require more powerful machines to verify. The computational power needed exceeds the average user’s hardware and bandwidth. As a result, there are fewer and fewer full nodes that update the network. Fewer nodes mean more centralization. Thus, Ethereum’s growing blocksize is resulting in a more centralized network.

Scaling Solutions and Why They Won’t Work

Three main scaling solutions for the Ethereum Network have been proposed: Proof of Stake (PoS) verification, sharding and Layer2 solutions. Each of these has some severe limitations, which I describe below.

Proof of Stake (PoS) has no material basis

Unlike Bitcoin’s PoW, PoS verification does not need an external resource and is not anchored in material value. With PoW, this resource is electricity. The need for electricity ensures it is not economically viable to attack a PoW blockchain. Using energy to back a block also gives its immutability objectivity. Non-energy-based verification ultimately requires a subjective interpretation of immutability. In contrast, attaching energy to a block gives it a material existence in the physical world.

PoS is centralizing

Increasing blocksize means power is concentrated with those who can afford to have full nodes, which is to say, those with the most money. Currently, the entrance barrier to staking a node on the Ethereum Network is 32 ETH. This is different from PoW where miners compete through the use of energy.

Sharding

Sharding is a technique where a blockchain is split into multiple parts (“shards”) with different validating responsibilities. The idea is to lessen the workload on any individual node so there can be more of them. Yet, this solution only prolongs the problem. Sharding takes a single blockchain and turns it into multiple blockchains but does not eliminate growing block sizes and the increasing the cost of staking. In short, sharding does not fix the underlying problem.

Layer2 solutions

Layer2 solutions are the only viable scaling option in my view. New projects such as Raiden and the Loom Network are offering such solutions. Loom is especially promising as it enables sidechains on top of the Ethereum base-layer. However, Layer2 solutions have security issues. Moreover, if Ethereum adopts PoS it will have an insecure base-layer, and it not possible to build a secure second-layer on top of an insecure base.

Smart Contracts

Smart contracts lack the potential for mass adoption. Here is why.

They are hard to write (see the Parity and the DAO hacks for example) and they are not legally binding (i.e. not real contracts). Securing a smart contract is like proving a computer program doesn’t have bugs. It is challenging as every computer program in existence has bugs. Moreover, to write traditional contracts takes years of study and passing a bar exam. To have real-world utility, smart contracts need at least that level of competence. Yet, people who write them typically don’t understand the law and how secure a contract must be.

There is also the so-called oracle problem. Smart contracts rely on the accuracy of outside data. But where does this data come from? What guarantees these oracles or not wrong or even corrupt?

Other Issues with ETH

There are other issues with Ethereum. One is its issuance policy. There is no cap on ETH’s issuance. This means there is a constant flow of newly minted Ether, which makes Ethereum an inflationary asset. A second issue is the limited use cases for Ethereum. The number one of which is tokenization, used almost exclusively by ICOs. As the ICO trend declines, the price of ETH will decline. With this, Ethereum’s second use case (a capital raising platform) also dies. Tokenized securities and cryptocollectibles (ERC721) are potential future markets, but they will get nowhere as big as some expect (a topic for another article). Finally, BTC also increasingly cuts into these two use cases with Rootstock (smart contracts) and Drivechain (side chains)

Final Thoughts

Blockchains have advantages in particular areas, namely censorship-resistance and immutability. Implementing a blockchain makes sense in contexts where immutability and the prevention of centralized control are essential. The best use case of this is money. I can’t imagine a future where everyone holds an Ethereum wallet with hundreds of different tokens for hundreds of specific services. Ethereum is not leaderless (Vitalik Buterin and dev-team), not entirely immutable (e.g. DAO-hack and subsequent fork), not a good store of value because of an uncapped supply, and does not scale on the base-layer. This is why I am bearish on Ethereum.