ETH 2.0 - The Merge
September 19th will see the Ethereum network move from Proof of Work to Proof Of Stake - what does this mean for investors?
In brief
Simply put, this article explains the advantages and pitfalls of the upcoming and much anticipated Ethereum Merge event.
The merge is scheduled for September 19th 2022
It will affect the monetary policy of Eth and the supply and demand dynamics which will affect the price of Eth
It will become 99% more energy efficient
There is a risk it will be buggy
Tokens discussed: Ethereum and L2 scaling solutions (Polygon, Metis, Loopring)
What is the merge and what effect will it have?
The Ethereum merge date and transition to proof-of-stake (Etc 2.0) is expected to take place on September 19, 2022. It is the long anticipated switch from proof of work to proof of stake. This incentives holders of Eth to stake for rewards which dramatically changes market dynamics. Let’s look at a few of the forces that will be in play.
Remember: Price is a function of supply and demand. So as supply decreases or demand increases, so does price.
Supply side shock
Increased burn rate means Eth becomes deflationary, reducing supply.
Incentive of validators to hold earned Eth and not sell, decreasing supply, miners would sell off Eth to pay costs
Demand side shocks
High yield staking (4%+) encouraging people to buy
Hash rate falling when transitioning will increase Eth rewards for new validators, and redistribution of gas fee’s to stakers increasing rewards and therefore demand
Reduced energy consumption makes it the greener alternative to BTC
Speculative expectations of price increase increases demand
Deflationary asset - Reducing supply increases the price.
The merger is an excellent investment opportunity, because Ethereum becomes a more deflationary asset, with more people incentivised to hold and stake ETH as well as not sell upon receiving mining rewards. The increased burn rate also adds deflationary pressure. There is also demand side pressure thanks to a more appealing environmental impact.
“While current supply growth is 3.7% annually, after The Merge, it will be roughly about 0.4% per year. Amid all those changes, Ethereum's burn rate will be the same, which is estimated to be around 900,000 ether per year” https://watchtheburn.com/
According to some sources, like Bankless, Ethereum will not become deflationary under EIP-1559, but will have a net inflation rate of 1.26-2.66%. Remember that Bitcoin's inflation level is 1.17%. Other sources say that it will become deflationary and in fact has already had deflationary weeks.
https://thedefiant.io/ethereum-deflation-burn-rate/
The project Polygon Matic is also deflationary - Polygon followed in Ethereum’s footsteps by forking to introduce EIP-1559 on Jan. 18, meaning a base fee denominated in its native MATIC token will now be burned with every transaction executed by the network.
The newly launched burn mechanism will result in deflationary pressure as MATIC has a fixed supply. The Polygon team predicts 0.27% of the MATIC supply will be destroyed over the next 12 months based on current network activity. Seeing as the merge will not affect high gas fee’s… it’s safe to say there will be a high demand for L2 scaling solutions.
Other options include Looping and ZKSync.
In the next two years the amount of Ether that’s used for staking will likely increase from 8% to 80%, according to staking services provider Staked. That will reduce the Ether in circulation, potentially pushing up its value. This is a supply side shock.
Stakers will be able to use the Ether they receive as rewards for ordering transactions, but the staked Eth will be locked up until around 6 months after the merger when the anticipated upgrade takes effect. This means that they can't sell Eth on the market which reduced supply. Stakers are also more likely to hold their Ether for the long term than miners, who often need to sell some to cover electricity costs, says Kyle Samani, co-founder of Multicoin Capital.
Better Sustainability - increasing demand
After the Merge, the energy consumption of Ethereum’s network should drop more than 99%. To order transactions on the new proof-of-stake network, a validator can use a high-end laptop instead of a server farm. The entire proof-of-stake Ethereum is expected to consume around 2.62 megawatts—about as much as a small town with 2,100 American homes. By contrast, current proof-of-work setup gobbles up the energy of a midsize country. - Bloomberg
It is well known that a concern amongst investors is the carbon footprint of the POW cryptocurrencies. The merge alleviates those concerns and opens the door to green investment.
High Yield staking rewards
According to the Ethereum website, the APR for stakers is expected to increase post-merge. To understand by how much, it is important to recognise where this increase in APR is coming from. This does not come from an increase in protocol ETH issuance (ETH issuance after The Merge is decreasing by ~90%), but is instead a reallocation of transaction fees that will start going to validators instead of miners.
This makes ethereum a yield baring investment product… Current estimated yields of 4.08% on staked Eth is a good investment, set to increase come september. That is high incentive to hold, and its a sustainable yield unlike the kind you get at firms like Celsius. The investor essentially owns a stream of the transactions fee’s paid by users in the form of gas. Eth has a cash flow stream.
STETH
Staked Eth is the token you receive for staking your Eth at a firm like Lido.. what is fascinating about these tokens is that you can trade them or use them as collateral on the secondary market. So you are able to take out a loan on your staked Eth, and put that capital to work and leveraging your yield.
Pitfalls
The Merge itself will be tricky, with exchanges and definitions protocols not allowing trading in case of a system failure.
Miners may flee the network prior to the merge which could cause a dangerous drop in hash rate and leave the network open to hacks. To combat this the Eth developers have said they are able to bring the merge forward in an emergency scenario where they see the hash rate dropping.
Is it for real this time? “There’s a lot of skepticism because Ethereum has promised proof of stake for five years,” Beiko says. “It’s hard to convince people that this time it’s for real.” says Tim Beiko, a computer scientist who coordinates Ethereum developers.
In summary
The merge is a really exciting opportunity for Ethereum supporters. There are many advantages to the move. If successful, it will change the perception of Eth as well as the economics of the currency.
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