DeFiUncovered: Hunting for Value

Source: Luke Posey, glassnodeTranslation: Katie Gu, Odaily

ETH has been steadily rising, and on-chain activities have also seen growth, largely driven by the launch of new NFT collections and market excitement.

In this article, we will explore:- The initial effects of EIP-1559- Exploring relative valuation models for governance tokens- Evaluating token valuations in the entire DeFi space using on-chain data

EIP-1559's Launch

EIP-1559 went live on August 5th, implementing crucial changes to the fee design on the Ethereum network. A portion of ETH network fees, called BASEFEE, is now burned instead of being given to miners.

This mechanism effectively offsets the new ETH issued as block rewards to the network. Currently, miners receive a mining reward of 2 ETH per block and an additional 0.0625 ETH for uncle blocks.

As on-chain activity increases, users will pay higher transaction fees, resulting in more ETH being burned. Therefore, this mechanism turns economic activity on the Ethereum blockchain into scarcity of ETH tokens. Since the launch of EIP-1559, the average burn per block is around 0.71 ETH/block. This means the effective issuance rate of ETH supply has slowed down by 36%.

In extreme cases of high demand for block space, ETH net issuance could indeed turn into net deflation, where more ETH is burned than issued. Some argue that the level of deflation required under the current proof-of-work issuance plan would require significantly higher network usage than what is currently shown. From August 5th to 10th, 80.0k ETH issued were burned through the fee burn mechanism, offsetting the previous supply of 284,000 ETH.

There have already been instances of deflationary blocks being mined. In high usage environments, especially after transitioning to a low issuance environment under proof-of-stake, deflation achieved through the burn mechanism could potentially surpass issuance structurally.

Another argument is that EIP-1559 reduces selling pressure as supply inflates at a slower pace, resulting in less dilution of existing tokens and an increased demand for ETH tokens. As the transition to proof-of-stake approaches and ETH holdings convert into validator counts, miners are also incentivized to hold a certain percentage of ETH.

An interesting side note is the net position change metric for exchanges. It shows that during most of July, with an ETH price around $2000, outflows have slowed relative to previous levels, but they are still increasing. It is yet to see if there will be a significant impact on trading flows after EIP-1559, but it will be worth keeping an eye on this metric.

Exploring Token Valuation Metrics

Over the past few weeks, token prices in the entire Ethereum ecosystem have seen bidding wars. In these market conditions, it is useful to take a step back and think about how to identify the asymmetric value of governance tokens. The purpose is to identify tokens that may be undervalued compared to core fundamental indicators and on-chain utilization.

TVL vs Valuation

Starting with the simplest analysis, we can compare the ratio of the total locked value (TVL) in a protocol to the token market capitalization. While TVL alone is not sufficient to measure the adoption, efficiency, and future value of a protocol, it can be a useful indicator to understand short to medium-term price behavior. Many people track TVL trends, so it has a reflexive impact on prices and attention. It also provides a sophisticated indicator of liquidity added to the protocol and market fit of products.

In the exploration of value, we can see, for example, in the case of Compound or Yearn, the TVL has recently outperformed the protocol's token price. On the other hand, Sushi is an opposite example where TVL growth remains relatively stable, reflecting its weak price performance.

Protocol Revenue vs Valuation

Protocol revenue can create a compelling narrative for token holders who are interested in existing or potential cash flows. These are accumulated revenues or fee generation from DeFi protocols. The higher the fee-to-market capitalization ratio, the greater the theoretical value token holders are getting from each dollar invested.

In theory, COMP presents another value proposition competing with AAVE as its 30-day revenue is equivalent but represents 50% of its market capitalization.

It is important to note how we juxtapose two lending protocols, Compound and AAVE, alongside two decentralized exchanges, Sushiswap and Bancor. When conducting these analyses, it is useful to compare projects by categories to reflect similar fee generation mechanisms and competition for the same set of users. Direct comparisons within each category often do not make sense and can be misleading.

Measuring Protocol Cash/Liquidity Efficiency

In the previous section, we compared TVL with the market capitalization, trying to find undervaluation or overvaluation relat