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Digital Nugget: Is Solana on track to flip Ethereum?

Solana has substantially outperformed ether since the beginning of 2023. As Ethereum’s transaction volumes and revenues declined, Solana’s growth trends continued to fuel its superior relative performance this year, and Solana is increasingly seen as a potential challenger to Ethereum’s dominance. However, after two years of substantial underperformance and  negative sentiment, ether is primed for a sharp reversal on a catalyst.

The Solana/Ether price is up over +300 percent year-on-year and +600 percent since the beginning of last year.

Performance of the Solana/ether pai

    Source: CoinMarketCap

The initial outperformance of Solana at the beginning of last year was primarily due to the protocol recovering from the price collapse following the failure of FTX. Solana and projects in its ecosystem had close ties to FTX, and the operational ties, financial losses and tarnished reputation led to a steep selloff in Solana. As this came on top of a history of outages and bugs, the market gave up on Solana, and the token lost two-thirds of its value relative to Bitcoin and Ether.

However, as the Solana developer community remained committed, the token recovered, and by last summer Solana was gathering strong momentum. Excitement grew around its potential for use cases that are only possible if blockchain transactions are extremely cheap and fast (branded as OPOS – “Only Possible On Solana”). An extended period of no outages further supported confidence, and the market narrative started to strongly favour Solana’s integrated scaling approach.

The relative performance occasionally reversed briefly due to either negative developments on Solana such as renewed outages, or positive developments on Ethereum such as the strong growth of the Ethereum-based Layer 2s and resulting optimism last year, or the Ethereum ETF approval more recently. However, such reversals in sentiment have proven fleeting, and the trend of Solana steadily appreciating versus Ether stayed intact. With important real-world collaborations, market share gains, Solana being seen as the favoured platform by DEPIN, one of the best performing application sectors recently in the crypto market, and the expected positive impact of the Firedancer validator client launch, the market has continued to favour Solana over Ether.

Solana is currently trading 150-200 percent above its pre-FTX collapse relative price to ether, and this brought Solana in line with ether in terms of market capitalisation based on their relative annualised revenues.

Solana’s drivers

With Solana trading 15 times above its post-FTX lows and increasingly described as the main rival to Ethereum, continued transaction and revenue growth and a continued increase in Solana’s market share are critical drivers of the token price going forward.

Although Solana rivals, and sometimes flips, Ethereum along certain metrics (stablecoin transaction volume, DEX traded volumes), the veracity of these metrics is sometimes questioned. The large volumes of bot trading on Solana, and the majority of failed bot transactions recorded as traded volume skew the statistics, while in terms of DeFi TVL and stablecoin AUM, Ethereum still dwarfs Solana. Progress on TVL metrics, therefore, is a particularly important driver going forward.

It is also important to note that in terms of transaction volumes, Solana competes with the entire Ethereum ecosystem, including Layer 2s, not just with Ethereum, and aggregate transaction volumes on Ethereum Layer 2s have been growing (even) faster year-to-date than on Solana.

The successful launch of Firedancer will be a further important driver. The expected benefits to decentralisation and network stability are arguably already discounted by the market. Any potential problems with the launch pose downside risk, while Firedancer catalysing another wave of growth in transactions, revenues and applications would be a positive driver.

While Solana’s prior history of frequent outages has been to some extent addressed, problems arose again earlier this year with the network going down in February and congestion causing a large number of failed transactions in April. Solana needs to make continued progress on bug fixes and network stability.

The success of the application sectors building on Solana is another important driver. As DEPIN projects favour the network, positive trends for this sector will benefit Solana. Conversely, the extremely high share of memecoin activity on Solana poses a risk – both due to its high concentration in terms of Solana’s volumes and revenues but also because the memecoin sector lacks fundamental value. Therefore, it is more vulnerable to collapse than economically viable sectors.

Meanwhile Solana has emerged as a prime contender in payments and tokenisation recently, with several traditional financial institutions referencing Solana’s strength in enabling fast and cheap transactions on chain at scale.

Ethereum’s drivers

Sentiment on Ethereum has been negative for the last two years, with Ether underperforming Bitcoin by almost 50 percent, and Solana by 100-150 percent.

Although transaction growth on Ethereum’s Layer 2 networks has been very strong since the March upgrade, which reduced data costs for Layer 2s by 90 percent, this has not led to growth on the Ethereum blockchain itself, which saw a decline of about 15 percent in transactions. This has depressed Ethereum’s revenues, and Ether turned inflationary again. Layer 2s, while growing the Ethereum ecosystem, came to be seen as cannibalising Ether’s economic value rather than enhancing it.

However, this has occurred in an environment of somewhat depressed on-chain activity across the market, and on future growth, Layer 2s – which transact off-chain but need to settle the final state on Ethereum – can become catalysts for Ethereum transaction growth as they enable activity and transaction types that previously were not economically viable.

The poor reception of the Ethereum spot ETFs further depressed sentiment on Ether. However, this was not unexpected due to the sudden surprise approval and resulting very short marketing period and Ethereum’s lesser name recognition relative to Bitcoin. Institutions will need time to assess Ethereum and go through due diligence and approval processes.

The lack of access to staking rewards also meant that selling from holders of the Grayscale Ethereum Trust (now converted into an ETF) was less likely to be swapped into other (much lower fee) ETFs – as was the case with Bitcoin – but rather into spot Ether. Although the Grayscale outflows create very negative optics, some of this money flows into spot Ether.

While institutional familiarity with Ethereum is currently relatively low, Ether makes more sense for traditional investors than Bitcoin: the concept of digital gold is less tangible, harder to value, and not all investors buy physical gold in the first place, while Ether derives most of its value from economic activity on the network and from the resulting revenues. Ethereum is more akin to an equity investment where growth, profits and cash flows are evaluated – this is more relatable for traditional investors than the digital gold concept.

Additionally, being by far the largest smart contract platform, Ether is a de facto “index” for the crypto industry – it benefits from the technology megatrend, the emergence of use cases and the growth of activity across the entire crypto ecosystem. In lack of easily accessible regulated investment products on crypto indices, Ether (and the Ethereum ETFs) are the best proxy for exposure to the crypto industry.

The risk of the SEC potentially regarding Ether a security has declined substantially recently after the Ethereum ETFs were filed for, and approved as commodity ETFs, and the SEC closed its investigation into Ethereum 2.0 (the proof-of-stake version of Ethereum launched with its 2022 upgrade, which was potentially seen as converting ether into a security in the eyes of the SEC). The SEC’s settlement with eToro, which it had accused of operating an unregistered securities exchange, included the permission to continue trading Bitcoin, Bitcoin Cash and Ether – de facto implying that Ether was not regarded a security by the SEC (although they have not made an explicit statement to that effect).

Ethereum restaking is an important emerging trend as this allows other younger, smaller, less battle-tested protocols to leverage Ethereum’s security, which is likely to grow demand for ether.

Meanwhile, Ethereum’s liquid supply has been declining. Ether staking continues to increase (+20 percent this year), removing Ether from the liquid supply, while exchange reserves (i.e. the readily available liquid tradable Ether) are near all-time lows. This creates the opportunity for demand shocks, for example, if Ethereum ETF inflows accelerate.

Opportunity for Solana to take over as the leading platform

Solana has made tremendous progress and surpassed other rival platforms on most metrics over the past year. However, the gap versusEthereum remains significant in many respects, and the vast majority of Solana’s growth has come from memecoins – a sector lacking economic merit or fundamental value. Growth trends across the industry, as use cases and activity pick up, will benefit the leading platform in the first place.

For the last year or so, the market narrative has strongly favoured Solana’s integrated approach to scaling. However, the integrated versus modular approaches both have advantages and disadvantages, and  the narrative can turn to favour Ethereum’s approach if certain catalysts alter the market’s perception.

Sentiment is currently very positive on Solana with growth in revenues and activity, market share gains, real-world partnerships, an upcoming upgrade that will further enhance Solana’s already very high scalability, and the rollout of a new smartphone and gaming console. Currently even traditional financial institutions appear to attach greater importance to Solana’s high scalability versus Ethereum’s superior security. If a trend emerges where large traditional financial institutions choose Solana over Ethereum for tokenisation and stablecoin issuance, this would be a strong tailwind for Solana, substantially increasing its chances of potentially challenging Ethereum.

Meanwhile the positive sentiment on Ethereum peaked in the run-up to the Merge, when everything appeared to be going right for Ethereum: a 99 percent decrease in energy use, a tokenomics upgrade making Ether potentially deflationary, the upcoming squeeze in liquid supply from the growth of staked Ether, Ethereum embarking on its scalability upgrades and the emergence of restaking, allowing other protocols to leverage Ethereum’s security. However, the Merge turned out to be the peak of positive sentiment on Ether, with the good news seemingly all priced in already and the token seriously underperforming since, especially on disappointments such as the impact of the Dencun upgrade or the poor reception of the ETFs.

Currently, everything seems to be going right for Solana, with a lot of the good news and positive expectations already priced in. Solana needs to surprise to the upside, not simply deliver on the expectations for the outperformance to continue.

Daily and monthly fluctuations in revenues notwithstanding, Solana’s market capitalisation is currently roughly in line with Ethereum’s, based on annualised revenues. This either means that the market expects the same growth rate over the long run, or that Solana’s expected faster growth is seen to be more at risk and, therefore, discounted.

For now, sentiment on Ethereum remains poor but this, and the prolonged underperformance, also create the potential for a sharp up move when the narrative and sentiment turn.

Ultimately, for Solana to successfully challenge Ethereum in the long run, it needs to shape future technological cycles and become the birthplace of groundbreaking decentralised applications that capture the market’s imagination and drive widespread adoption.

Read more about crypto assets from Sygnum here.

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