Evaluating Ethereum: The World Post-Merge and what it means for Coinchange Yield

September 27, 2022
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The Merge is here! One of the biggest events in the history of Crypto has just been completed successfully. The long anticipated, years-in-the-making ETH Merge is finally here. Let’s look at some of the tweets from the crypto community.

Ethereum co-founder vitalik Buterin tweeted:

Tim Beiko from Ethereum Foundation tweeted: 

Yuga Labs, the company behind Bored Ape Yatch Club and Cryptopunks tweeted:

Even legendary boxer Mike Tyson is interested in the Merge:

There were several virtual parties and some met even in-person to celebrate the Merge. 

Wait, what was this Merge all about?

Ethereum blockchain was operating as a Proof-of-Work (PoW) blockchain and the merge is about its transition from PoW to Proof-of-Stake (PoS). PoW uses miners and the energy intensive mining whereas PoS uses validators and reduces the energy consumption by as much as 99.95%. And Merge is only a part of the full roadmap for Ethereum network. Ethereum co-founder Vitalik Buterin unveiled the next steps in the roadmap for the network at the annual Ethereum Community Conference (EthCC) in Paris on July 21 and has 5 key phases:

• The Merge (The merging of the execution layer  and the Beacon Chain.)

• The Surge (2023 - The introduction of Sharding on Ethereum.)

• The Verge (Introduces verkle trees, a "powerful upgrade to Merkle proofs that allow for much smaller proof sizes.")

• The Purge (Reduces the hard drive space needed for validators. This eliminates historical data and bad debt.)

• The Splurge (A series of miscellaneous *smaller* upgrades)

You can read more about the Ethereum merge phases here

So, how did the Merge go?

The Ethereum developers have been planning this since the network’s inception in 2014, and this was always a big question hanging over it. While many proof-of-stake systems exist now, converting an active proof-of-work system to a proof-of-stake system was very hard in the technical sense and was basically unprecedented. It was originally supposed to take less than a year in 2015, but ended up taking seven years. The Merge is only days old at this point and so far we have not had any bugs or downtime, which is a huge success. What most people don’t realize is the fact that nothing went wrong during the merge, is a huge engineering feat. This was akin to switching engines for a rocket at 50,000 ft mid flight and the rocket just continued the flight without any turbulence. The Layer 2 blockchains and Sidechains such as Arbitrum, Optimism, Polygon that rely on Ethereum for regular checkpoints, all continued to work without any downtime.  

It is fair to say that the ETH developers have achieved a huge milestone by coordinating this change at this scale and complexity and for users to not realize any difference in their ETH usage. This is not only a great accomplishment for Ethereum community but also for the entire crypto space. 

What are the benefits of this massive change?

Energy Consumption: The biggest benefit is the energy consumption by the Ethereum network being cut down by 99.95% and the energy intensive mining has stopped. 

Reduction is supply: The Merge will reduce supply issuance, and during periods of heavy volume, it could result in outright deflationary supply. The issuance rate depends on how many validators are active, while the burn rate depends on how heavy network usage volume is (which can be thought of kind of like share buybacks, where the more profits that are generated, the faster a company can buy back its shares and reduce its share count). So far since the Merge, the supply is increasing but at a much slower rate than before. Take a lookat the chart below: 

Source: ultrasound.money

The inflation rate if PoW was to exist would have been ~3.78% however since Merge it is at 0.19% which is even lower than BTC inflation rate of 1.72%

Rewards for validators increase: Prior to Merge, mining rewards were ~13,000 ETH/day and the Staking rewards were ~1,600 ETH/day. After the Merge, Stakers will likely experience an increase in the staking reward from ~4% to ~7% APR as transaction fees will be distributed to validators instead of miners. 

Institutional Adoption: For the longest time institutions preferred bitcoin as their only asset of choice when it comes to investing in digital assets. However more recently it is becoming clear that institutions are allocating their capital towards Ethereum. The yield from staking generates a real cash flow that is paid in ETH. If we can start valuing Ethereum through a cash-flow model, like the Discounted Cash Flow (DCF) model, and we have the growth in terms of cash flows through the staking, then that could be a very big deal in bringing in institutional investors. The staking yield (~4%-7%) could set a benchmark rate for yield in the Web3 industry. This will enable institutions to monitor risks as they do in TradFi markets with risk-adjusted strategies using US Treasury yield as the benchmark for comparison with other asset classes. Besides, the reduction in energy consumption could open ETH to a swathe of institutional investors who may have been hesitant to jump into it prior to the Merge due to its ESG implications on their portfolio. 

Technological benefit: Prior to the Merge, users would submit their transactions to the mempool, miners would fight to solve the PoW puzzle, and then miners collate all these transactions to build a block. In post-Merge Ethereum, this process is codified and defined into the protocol. This fundamentally allows ETH stakers to harness the value capture at every step, ensuring that the value is passed to them eventually. 

On-chain ETH Withdrawals Enabled: At the moment ETH staked by validators is not available for withdrawals. However with the Shanghai Hard Fork coming up over the next several months the core developers have already made a soft commit to enable withdrawals. 

That sounds great! But, what are the potential downsides of the Merge?

Reliance on Human Governance: In proof-of-work systems, energy is used by miners to update the global ledger state. In proof-of-stake systems, a subset of coin holders serve as validators to update the global ledger state. Some experts argue that the PoS validation can be quite efficient for things like crypto games, NFTs, and crypto asset trading, but do not offer the same hardness, decentralization, and trust-minimization as a proof-of-work system. They reduce their energy usage, but then rely more on human governance instead.

Transaction fee is still higher than other PoS chains: Prior to Merge, Ethereum’s uniqueness was that it was the main PoW smart contract platform, with all the other major ones being PoS. Now, it’s one of many proof-of-stake smart contract platforms. Although there are subtle differences even within the different PoS chains and Ethereum has much bigger branding, much higher liquidity, and much more developer activity than its competitors, the transaction fee still remains higher than competitors. This is however a temporary issue as the future upgrades including side-chains, roll-ups and sharding will solve the fee problem.

Centralization Risks: PoS is believed to concentrate power in the hands of the biggest  ETH stakers (Validator pools) some of which could be public corporations and this makes it more susceptible to centralization risks. Lyn Alden discusses this in detail in her article Proof-of-Stake and Stablecoins: A Blockchain Centralization Dilemma. In short, the coin holders determine the state of the ledger, and the state of the ledger is the record of who the coin holders are, which is a circular logic that tends to gradually centralize power over time. Let’s take a look at the current distribution of ETH among the validators:

Source: Messari

Coinbase, Lido, Kraken, and Binance control nearly 60% of all ETH staked at the moment. Lido in particular receives a lot of criticism due to its massive 30% share of the total pie. Although Lido's share is distributed between several independent validators, they are all indirectly under the control of Lido governance. 

Manual coordination to recover if the blockchain ever goes offline: Speak to any Solana validators and they will tell you that they manually meet in a Discord chat to figure out how to restart the network every time it goes offline. Same could happen with the Ethereum network although very unlikely due to the long existence of the network. 

I thought ETH was supposed to go up in price after Merge, what happened? 

Source: CoinmarketCap

Ethereum price was close to $1500 at the time of the Merge and since then it has been dropping to around $1200 as of this blog’s writing. One reason could be the very typical one in financial markets which is “Sell the News’ phenomenon. Some say that the Merge’s success was already priced in. It is important to note that we are still in a negative macro environment and prices of financial assets in general have been falling partly due to the Fed rate hikes. But what’s even more important to note is that had the Merge been unsuccessful, the price would have plunged catastrophically. And that didn’t happen. In the very long run, Ethereum’s price will in large part depend on its usage and its ability to retain the market share. 

How will the Merge affect Coinchange users and their Yield?

Coinchange team was up all night on Sept 15th, 2022 to witness the ETH Merge and to ensure everything goes smoothly. We have upgraded our Ethereum node software in support of this transition to PoS and we had no interruption in our service. As for our users, they do not have to do anything. They continue to earn yield on their ETH in the same way as before. As for the yield, our DeFi quantitative team is working hard to ship new strategies that will increase the yield across the assets we offer. Post merge, all the ETH rewards are being distributed to the validators which will result in an increase in the yield for Coinchange users as our strategies have exposure to Ethereum yield.

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