Ethereum | Fundamental Analysis

Ethereum, the second-largest cryptocurrency by market cap, has experienced a significant price decline over the past year. This downturn has raised concerns among investors about the factors driving it and the potential for a recovery.

Upon closer analysis, the primary cause of Ethereum's recent struggles becomes evident: the rise of Layer-2 (L2) solutions. While these L2 networks have been crucial for scaling Ethereum and improving its efficiency, they have also affected its economic model, pushing Ethereum from a deflationary state toward an inflationary one.

The key to understanding Ethereum’s current situation lies in the August 2021 London hard fork, which introduced the EIP-1559 upgrade. This upgrade implemented a new fee structure where a portion of transaction fees, known as the base fee, is burned with every transaction, permanently reducing the supply of Ether. The burn mechanism was designed to make Ethereum deflationary, with the idea that higher usage would increase the amount of Ether burned, reducing supply and potentially boosting its price.

However, Ethereum’s reliance on L2 solutions, like Arbitrum and Optimism, has altered this dynamic. L2s process transactions off-chain, reducing congestion and lowering fees on the main Ethereum network. While this has improved scalability, it has also led to fewer base fees being burned on the Ethereum mainnet. As a result, despite Ethereum's overall high usage, the amount of Ether being burned has decreased, and the new issuance from staking rewards has outweighed the Ether removed from circulation.

This shift has pushed Ethereum into an inflationary state, with the highest inflation rate seen in two years. The success of Ethereum's technological scaling has inadvertently weakened its deflationary mechanism.

One proposed solution to this challenge is EIP-7781, which suggests reducing block intervals from 12 seconds to 8 seconds. This would increase Ethereum's throughput by 33%, allowing more transactions to occur on the mainnet and increasing the amount of Ether burned. If implemented, this could help reverse Ethereum's inflationary trend and restore its deflationary model.

While EIP-7781 is still a proposal, it highlights the Ethereum community’s active efforts to address the economic pressures caused by L2 solutions. Even if this proposal isn't implemented, Ethereum remains a dominant blockchain with strong fundamentals. The continued growth of decentralized finance (DeFi), institutional interest, and increased network activity could all serve as catalysts for Ethereum’s recovery.

Despite current challenges, Ethereum's long-term outlook remains promising. Its ongoing development, innovative use cases, and strong community support suggest that this price decline may be a temporary setback on the path to future growth.