Since the start of the new year, the cryptocurrency market has lost a jaw-dropping 25% (as of Jan. 27) in 27 days. The Federal Reserve's intention to start raising interest rates in March is encouraging investors to adopt a risk-off approach. This negatively impacts high-growth stocks, but it also adversely affects digital assets.
What is Ethereum?
As the top programmable blockchain, Ethereum's network allows developers to build smart contracts on top of it. These are computer programs that self-execute if and when certain conditions are met. Ethereum's founders set out to create a decentralized, global computing platform functionality that opens up the potential for real-world use cases, as I'll discuss later. This structure is completely different than Bitcoin (CRYPTO: BTC), which is meant to be a peer-to-peer electronic cash system.
One of the biggest knocks on Ethereum and Bitcoin relates to their proof-of-work consensus mechanisms. This validation method requires massive amounts of computing power to solve mathematical puzzles in order to verify transactions. It's extremely energy-intensive and slow.
But Ethereum is gearing up for a major makeover to solve these problems.
A more environmentally friendly and faster consensus system is on the way. Previously dubbed ETH2, but now simply called the consensus layer, the plan is for Ethereum to transition to a proof-of-stake mechanism, where owners of Ether (ETH), the native token, can stake their holdings in order to earn the right to validate new blocks. Proponents view it as a necessary update to make Ethereum more scalable and sustainable.
Another critical part of the upgrade is the planned introduction of shard chains, set to be completed in 2023. Sharding will improve Ethereum's capacity significantly by adding 64 new side chains to the entire network.
Ethereum can only process something like 15 transactions per second (TPS) today, not even remotely enough to handle surging demand. For comparison's sake, Visa and Mastercard can process tens of thousands of TPS. Because of this limited scalability, whenever network congestion is high, the cost to process transactions, known as gas fees, can skyrocket. The average gas fee right now is $145. If Ethereum ever wants to achieve widespread adoption, this obviously won't cut it.
That's why the implementation of the consensus layer, and a switch to proof-of-stake, will be closely watched this year. It could be a major catalyst for Ethereum's price.
Proving that real-world use cases exist
Scaling Ethereum is extremely vital to its long-term viability, particularly at a time when decentralized applications (dApps), including decentralized finance (DeFi) protocols and non-fungible tokens (NFTs), are gaining in popularity. There are nearly 3,000 dApps, from gaming and social media to security and identity functions, running on Ethereum today.
Some interesting projects built on top of Ethereum are DeFi services like Aave and Compound. These apps let users deposit their cryptocurrency balances and borrow against them, often at more favorable interest rates than what traditional banks can offer. And when it comes to NFTs, OpenSea is by far the largest platform, having just raised $300 million in funding and now valued at $13.3 billion.
Ethereum's programmability can pave the way for a wide range of use cases that can upend numerous industries. And because dApps built on Ethereum's blockchain require ETH to run, the growth of these innovative projects supports demand, and a rising value, for Ethereum over time.
Being able to stomach the volatility
While Ethereum definitely shows promise to bring real utility from the cryptocurrency world to the mainstream, its price will continue to be volatile. Investors should brace for this inevitability. Price drawdowns in excess of 50% can and will happen, so you have to ask yourself if this is right for you.
Although Ethereum has plunged 49% since Nov. 10, it's still up an incredible 23,000% over the past five years. The recent dip can be a perfect entry point for long-term investors.