• The Ethereum network is the leading smart contract blockchain in terms of market capitalization and total value locked[1], hosting a rich array of applications, many of which offer their own investable tokens. The Ethereum ecosystem is very diverse, however, and every token has unique fundamentals.
• In examining the wider ecosystem, one might look at tokens that demonstrate strong fundamental characteristics. These could include factors like robust user engagement, transparent value creation mechanisms, and controlled supply growth. Within the Ethereum ecosystem, some notable assets that exhibit such traits are the tokens associated with decentralized finance applications like AAVE, MKR, and UNI, as well as LDO, which is linked to staking applications.
• The Ethereum network’s design means that most activities on the platform are linked to its native token, Ether (ETH). As a result, ETH’s value tends to reflect the overall activity and growth of the Ethereum ecosystem. This relationship between network usage and token value is a notable aspect of Ethereum’s economic model
• ETH beta strategies, which aim to mimic ETH’s performance using alternative tokens, have underperformed compared to holding ETH directly as we show in this analysis (Exhibit 4). This is because most alternative tokens lag behind ETH, with only a few outpacing it. Another approach involves diversifying across multiple promising projects instead of focusing on a single alternative token.

As the second-largest cryptocurrency by market cap as of August 27.2024, Ethereum extends far beyond its native token, Ether (ETH), in influence. At its core, Ethereum is a blockchain-based platform that enables developers to build and deploy smart contracts and decentralized applications (dApps). This functionality has given rise to a rich ecosystem of projects spanning various sectors, including decentralized finance (DeFi), non-fungible tokens (NFTs), and gaming. Many of these projects issue their own tokens, broadening the crypto asset ecosystem.

However, it’s important for investors to be aware that the assets within the Ethereum ecosystem are far from uniform. Tokens can vary significantly in their use case, supply inflation, historical volatility, and mechanisms for value accrual. Some serve as governance tokens for decentralized autonomous organizations (DAOs), others as utility tokens within specific applications, and still others as representatives of real-world assets.

Exploring the ETH ecosystem

While the Ethereum ecosystem encompasses tens of thousands of tokens[2], in this report we focus on a select group of significant assets as specified in Grayscale Crypto Sectors — our framework for systematically categorizing digital assets and the related family of indexes. These assets represent various facets of the Ethereum ecosystem, from DeFi protocols to Layer 2 solutions and infrastructure projects (Exhibit 1) [3].

Exhibit 1: Ethereum ecosystem tokens with Grayscale Crypto Sectors

Given the complexity of the ecosystem, we can categorize the major components as follows based on the Grayscale Crypto Sectors data (for more background on terminology, please see The Grayscale Glossary):

Layer 2 (L2) solutions, such as Polygon (MATIC), Arbitrum (ARB), and Optimism (OP), aim to improve Ethereum’s scalability by processing transactions off the main chain, designed to increase speed and reduce fees while maintaining network security.

Financial Applications leverage smart contracts to provide financial services without traditional intermediaries. Notable examples include Uniswap (UNI), a leading decentralized exchange; Aave (AAVE), a major lending and borrowing platform; and MakerDAO (MKR), the protocol behind the DAI stablecoin.

Other Applications include a wide range of services supporting the broader ecosystem. For example, Ethereum Name Service (ENS) provides a distributed naming system. In the NFT space, marketplaces like Blur have gained traction among traders. Lastly, meme tokens such as Shiba Inu (SHIB), while not core to Ethereum’s functionality, have become a significant part of the ecosystem in terms of market capitalization and community engagement[4] .

The “High Beta” Argument

Crypto-native investors sometimes view ecosystem assets as a “high beta” way to invest in Ethereum’s development. This perspective is not without merit, as many ecosystem assets have indeed shown high short-term correlation to Ethereum returns year-to-date (YTD) (Exhibit 2). However, this view oversimplifies the complex nature of these assets. Each ecosystem token has unique features and should be evaluated individually.

Exhibit 2: Ethereum ecosystem tokens tend to correlate to ETH on a YTD basis

Performance of select assets this year highlights that short-term correlations can be a poor guide to assets’ medium-term performance. For example, ETH itself has appreciated 14% YTD. At the same time, ARB and MATIC — two relatively large Layer 2 solutions with high short-run correlations to ETH — have actually decreased 54% and 65%% (Exhibit 3). Although these protocols are deeply integrated and likely share many of the same users, the tokens’ fundamentals, and therefore price returns, can be quite different.

Exhibit 3: Some notable Ethereum ecosystem tokens have underperformed ETH on a YTD basis

Token Diversity

The Ethereum ecosystem is diverse, with assets varying significantly across several dimensions (Exhibit 4):

Exhibit 4: Ethereum ecosystem assets vary significantly based on use case and fundamentals

Volatility and risk-adjusted returns in the Ethereum ecosystem reveal that tokens typically exhibit higher volatility compared to ETH, reflecting ETH’s status as a larger, more established asset. Consequently, only a select few ecosystem tokens have managed to achieve higher Sharpe ratios[5] than ETH itself, underscoring the challenge of outperforming the ecosystem’s foundational asset on a risk-adjusted basis.

Ethereum ecosystem tokens exhibit diverse supply growth approaches, unlike ETH’s (mostly) deflationary model[6]. New projects often use high initial inflation to boost adoption and fund development, while established ones may have decreasing or fixed supply schedules. Some tokens implement adaptive mechanisms, adjusting supply based on usage or market conditions. These inflation strategies can significantly impact a token’s long-term value. High inflation can suppress prices if not matched by growing demand, while well-designed schedules can help support sustainable growth. Token supply growth patterns often reflect a project’s maturity and value generation processes.

Application-specific activity trends, measured through key metrics such as Total Value Locked (TVL), daily active users, transaction volumes, and fees generated, can indicate a project’s traction and economic viability. For instance, rising TVL in a DeFi protocol might suggest growing user trust and capital efficiency, while increasing transaction fees could indicate high demand for the service. However, these metrics should be interpreted contextually; a Layer 2 solution might prioritize low fees and high transaction volumes, whereas a lending platform might focus on TVL growth. Moreover, trends in these metrics can reveal competitive dynamics within specific niches of the Ethereum ecosystem. Strong on-chain metrics don’t always correlate directly with token price appreciation, as seen in cases where protocols with high TVL or fee generation might still experience underwhelming token performance due to factors like token distribution or market sentiment.

Performance Comparison

Exhibit 5: ETH performance leads averages and medians

ETH has outperformed its ecosystem tokens in 2024 so far, both in terms of average and median cumulative returns (Exhibit 5). ETH has also demonstrated better risk-adjusted performance, as indicated by higher Sharpe ratios. However, looking at longer-term historical data reveals a more nuanced picture. During certain bull market periods, some Ethereum ecosystem tokens have outperformed ETH on average. For instance, in the 2020-2021 bull run, meme tokens like SHIB significantly outpaced ETH[7], boosting the average returns of the ecosystem token basket.

Year to date, specific tokens such as ConstitutionDAO (which we also consider a memecoin) and ENS have been major contributors to the outperformance in the Other Applications category. In contrast, Layer 2 solutions and Financial Applications have underperformed ETH during this period. Grayscale Research believes the ecosystem tokens’ potential for outsized returns appears to be concentrated in a small number of high-performing assets.

Year to date, ETH tends to outperform its ecosystem tokens on both average and median bases. However, ETH can be outpaced by a few standout performers from the ecosystem (Exhibit 4). This analysis suggests that while ecosystem tokens can offer opportunities for significant gains, these opportunities are not evenly distributed. ETH has historically provided more consistent performance over longer timeframes.

Given the performance distribution of ecosystem tokens, a basket of ecosystem assets could provide exposure to potential outperformers while helping to mitigate the risk of selecting underperformers.

Asset Selection Approach

While a diversified basket of Ethereum ecosystem assets can be a viable investment strategy, a more targeted approach focusing on specific asset selection may yield better results — albeit while introducing more idiosyncratic risk. This method involves identifying assets with a combination of favorable fundamentals, and/or the potential for positive catalysts (for more details, see Grayscale Research Insights: Crypto Sectors in Q3 2024). Key considerations for asset selection include strong or improving fundamentals (such as usage metrics, market leadership, and innovative features), reasonable inflation rates, and price trends.

Some tokens show strong fundamentals but poor recent price performance, potentially offering attractive entry points. For instance, UNI (Uniswap) demonstrates high usage as a key DeFi primitive but has experienced ranging price action. Similarly, LDO (Lido) leads in liquid staking with a high TVL-to-market cap ratio, despite underwhelming price performance. Other tokens like MKR (Maker) and AAVE demonstrate strength across both metrics, with MKR capturing nearly 40% of Ethereum’s DeFi profits[8] and holding the largest portfolio of real-world assets, while AAVE has achieved record user engagement and a TVL exceeding $11 billion across 14 active markets. [9]

Exhibit 6: Some tokens exhibit strong protocol fundamentals but weak relative price action

It’s equally important to approach certain assets with caution. Potential considerations may include tokens with limited utility beyond governance, especially when their market capitalization significantly exceeds the value of the assets they govern. projects with decreasing user bases or consistently negative fee generation, may indicate declining relevance or unsustainable economic models. Large, regular token unlock events can also help create selling pressure and volatility. Finally, assets with large market capitalizations but comparatively small TVL or lacking clear catalysts for growth tend to be overvalued. To Grayscale Research, these characteristics often suggest misalignment between a token’s current valuation and its fundamental utility or growth prospects.

When evaluating Ethereum ecosystem tokens projects that have faded or failed, not just current successes can be an important piece of information — in other words, to control for survivorship bias. For instance, once-popular projects like Augur have seen significant declines in usage and relevance over time. Many tokens from the 2017-2018 initial coin offering boom have disappeared in relevance entirely. By considering only current major players, we risk overestimating overall success rates, underestimating risks, and misunderstanding the true factors behind project success or failure.

This strategic approach aims to identify assets with real utility, growing user bases, and effective tokenomics, potentially outperforming a simple basket strategy. However, it requires ongoing research and regular portfolio adjustments.

Conclusion

From our analysis of Ethereum’s ecosystem assets, several key points emerge. As the platform for a multitude of dApps, Ethereum’s native token, ETH, represents perhaps the simplest way to participate in the growth of the entire ecosystem. The Ethereum network is the foundational infrastructure for many dApps, but ETH also offers several specific advantages: low supply growth, particularly post-merge, which can be favorable for long-term value preservation; potential increased demand from exchange-traded products, as seen with recent approvals and launches; and strong network effects, as Ethereum’s dominance in smart contract platforms continues to attract developers and users (for more details, see our report on The State of Ethereum).

The Ethereum ecosystem is rich with innovative projects that may offer more potential upside, while also exposing investors to more potential risk. These include DeFi protocols revolutionizing financial services, Layer 2 solutions addressing scalability, and infrastructure projects supporting the broader ecosystem. A diversified approach, such as investing in a basket of assets like a selection of top DeFi tokens, can provide broad exposure to the ecosystem’s growth while seeking to mitigate some project-specific risks. Alternatively, a selective approach based on research and carefully selecting individual projects based on their fundamentals, utility, and growth prospects, potentially yielding higher returns, albeit with increased risk.

[1] Ethereum is the largest smart contract platform by market cap and total value locked as of 8/27/2024. Source: CoinGecko, DefiLlama

[2] https://coinmarketcap.com/view/ethereum-ecosystem/

[3] Note: Ethereum (ETH) itself has a market cap of about $319 billion, dwarfing the other assets in the ecosystem. Source: Artemis, Grayscale Investments. Data as of 8/27/2024

[4] Shiba ranks as the 13th largest token by market capitalization as of August 27. 2024. Source: Artemis, Grayscale Investments.

[5] The Sharpe ratio compares the return of an investment with its risk. The Sharpe ratio’s numerator is returns, and its denominator is the standard deviation of returns over the same period of time.

[6] https://consensys.io/blog/what-is-eip-1559-how-will-it-change-ethereum

[7] https://decrypt.co/89069/bigger-gains-than-bitcoin-or-ethereum-top-crypto-assets-2021

[8] https://www.syncracy.io/writing/makerdao-thesis

[9] https://defillama.com/protocol/aave#information

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