Why Is Ethereum Down and Will It Bounce Back?

Ethereum (CRYPTO: ETH), the second-largest cryptocurrency by market capitalization, has experienced a notable decline in its price over the last year. Investors might be concerned about the factors contributing to this downturn and whether Ethereum will recover.

With a deeper exploration, the reason behind Ethereum's recent price slump will become clear, and more analysis will show why there is still potential for a rebound.

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Measuring the impact of Layer-2 solutions on Ethereum's economics

Ethereum's struggles over the past year can likely be boiled down to one factor: the rise of Layer-2 (L2) solutions. While integral to the scalability and expansion of Ethereum's usage, Layer 2s have significantly impacted Ethereum's economic model, contributing to a shift from a deflationary to an inflationary state.

It is a nuanced topic, but by fully understanding it, we gain better context on Ethereum's position and where it might be headed. To start, we must go back to the London hard fork in August 2021, which introduced the blockchain network's EIP-1559 upgrade. This upgrade implemented a new fee structure where a portion of the transaction fees, called the base fee, is burned with every transaction, removing it permanently from circulation.

This burn mechanism was designed to make Ethereum's supply deflationary over time, counteracting the inflationary effects of new issuance. In theory, as Ethereum usage increases and more transactions occur, more Ether would be burned, eventually reducing the total supply and creating upward price pressure.

However, Ethereum's scaling strategy has relied heavily on the development of L2 solutions, like Arbitrum and Optimism. These L2s are designed to process transactions off the Ethereum blockchain, reducing congestion and lowering transaction costs. While this has succeeded in making the network more efficient and scalable, it has also had unintended consequences for Ethereum's burn mechanism.

By migrating transactions to L2s, users experience significantly lower gas fees, which means fewer base fees are burned on the Ethereum mainnet. Even though Ethereum's overall usage is at record levels due to the success of these L2s, the lower transaction fees on the mainnet have reduced the amount of Ether being burned. As a result, the amount of Ether removed from circulation has not been enough to counterbalance the new issuance from staking rewards.

This dynamic has caused Ethereum to enter an inflationary state. While the burn mechanism is still active, it's not burning enough Ether to offset the issuance, leading to the highest inflation rate in two years.

Add it all up and Ethereum is in a particularly unique predicament: Its technological scaling has succeeded, but with unexpected side effects. The very mechanism designed to control supply has been weakened. To return to a deflationary state, either Ethereum's base layer must become more congested, increasing fees and burned Ether, or new solutions must be devised to burn more Ether even as L2 usage grows.

A hopeful remedy looms

As problematic as the situation may be, there is hope. A recent proposal, EIP-7781, has emerged as a potential solution to Ethereum's growing challenge.

EIP-7781 proposes to reduce the time intervals between blocks from 12 seconds to 8 seconds. This change would increase Ethereum's throughput by 33%, allowing more transactions to be processed in less time.

This is particularly relevant for Ethereum's relationship with L2s. By making the base layer more efficient, Ethereum could reduce the overreliance on L2s for scaling, ensuring that its economic model remains sustainable. If more transactions occur directly on the Ethereum mainnet, because of faster block times and improved throughput, more Ether will be burned through the fee-burn mechanism. This could help reduce Ethereum's current inflationary state, where more Ether is being issued than burned, and potentially shift it back toward deflationary territory.

Though it is still just a proposal and not yet scheduled for implementation, EIP-7781 signals that the Ethereum community is actively seeking ways to improve the network's performance while also strengthening its economic model. This proposal, along with other planned upgrades, could address concerns about Ethereum being outpaced by L2s and becoming inflationary.

What this all means for Ethereum

EIP-7781 presents a promising step toward resolving the issues Ethereum faces with Layer 2s' cannibalizing base-layer activity. While it's still in the proposal stage, the potential benefits of this change signal that the Ethereum community is focused on addressing the inflationary pressures caused by L2 solutions. Should EIP-7781 be implemented, it could help restore balance between Ethereum's scaling needs and its long-term deflationary goals.

But even if EIP-7781 isn't implemented, there are still reasons for optimism that Ethereum will bounce back. Increased network activity, greater use of L2s feeding transactions back into the mainnet, growth in decentralized finance (DeFi), and interest from institutional finance all could serve as catalysts for Ethereum.

As one of the most widely used blockchains supporting innovative use cases, Ethereum's foundational strengths remain intact. Despite current challenges, these are likely temporary hurdles on its broader growth trajectory. Investors should recognize that Ethereum isn't going away and that this period of weak market performance will prove to be a speed bump in its long-term evolution.

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RJ Fulton has positions in Ethereum. The Motley Fool has positions in and recommends Ethereum. The Motley Fool has a disclosure policy.