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. In this blog, we will cover,
It is evident that the ETH network is growing much faster than the Bitcoin network and is more scalable. As per Metcalfe's law, the bigger the network gets, the more exponentially the valuation of that network becomes. Take the example of Apple, if you look at their annual revenues, the more iPhones they sell, the valuation goes up exponentially until it gets to the point where the network is so powerful and has such a large moat around it that even if someone invents a far better iPhone, they are not going to be able to penetrate the Apple network because it's too powerful. It seems like Ethereum has reached those thresholds, to be believed and taken seriously by the institutions. Institutions used to believe that Ethereum can get regulated out of existence but it looks like that ship has sailed.
As the Ethereum community inches ever closer to the Merge, the Ethereum blockchain is expected to switch from a Proof-of-Work (POW) to a Proof-of-Stake (POS) consensus mechanism. And to secure the POS chain, validators need to stake (aka lock) ETH on the Ethereum blockchain. In return, they are rewarded with more ETH from the fees collected from users of the blockchain. This is how the yield is generated and currently, it is ~4%. After the merge, stakers will likely experience an increase in the staking reward from ~4% to ~7% APR as transaction fees will be distributed solely to the POS validators instead of POW miners. We recently discussed the effects of Ethereum Merge in our 3-2-1 QnA blog here
At the moment, once the validators stake their ETH on the POS chain, it is unavailable for withdrawals until after the Merge (note: withdrawals won’t be activated immediately after the merge but after the Shanghai upgrade post-merge. And also only six validators may exit per epoch i.e. every 6.4 minutes, so 1350 per day, or only ~43,200 ETH per day which will slow down the exodus if it happens). So why would institutions want to lock their assets on-chain when the merge keeps getting delayed? That’s because there are protocols such as Lido and Rocketpool, which offer Liquid Staking of ETH. Thus when you stake ETH with these protocols, they issue a representative token in return such as the stETH token offered by Lido or the rETH token offered by RocketPool, and this allows investors to transfer, and sell, collateralize, or hedge their staked ETH position.
As of July 2022, the total ETH staked via Lido has swelled to 4.137M ETH, accounting for an incredible 31.8% of the total 13.0M staked ETH. By comparison, the combined deposits of Coinbase, Kraken, and Binance represent 3.505M ETH, which is 27.0% of the total staked ETH.
A common misconception is that Lido controls the most staked ETH. However, it is important to note that Lido’s total stake is controlled by 21 whitelisted and reputable validators. Thus the entire 31.8% is not controlled by Lido as the sole validator.
In their most recent Digital Asset Fund Flows July report by CoinShares, James Butterfill, their research analyst, mentions that July saw the strongest inflows this year totaling US$474m of which US$306.3m went into BTC and US$137.9m went into ETH. The weekly inflows in July mark the largest single week of inflows since June 2021 and imply a turning point in sentiment after an 11-week run of outflows. It also suggests that as the Ethereum Merge progresses to completion, investor confidence is slowly recovering.
In a recent research report written by One River Digital Asset Management, Marcel Kasumovich and Paul Ebner wrote,
“The yield from staking generates a real cash flow that is paid in ether. Additional value that is extracted by miners will redirect to staking investors, translating to yields of around 10%. It is equivalent to a perpetual bond. It transforms ether into a low-risk asset inside of its ecosystem, like a banking reserve.”
This is a very interesting point of view. The staking yield (~4%-7%) could set a benchmark rate for yield in the Web3 industry. This will enable us to monitor risks as we do in TradFi markets with risk-adjusted strategies. In TradFi we consider US Treasury yield as the benchmark for comparison with other asset classes. Emerging Market returns are priced at certain points over Treasury yield. Junk bond yields too are priced with reference to Treasury yield. The staking yield in the Ethereum blockchain could be an opportunity for ETH to become that asset.
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 structural trend toward more decentralized finance, social, and gaming economy should, even if only partially realized, underpin a strong period of growth for Ethereum.
Ethereum started as a proof-of-work (PoW) network, which relies heavily on the processing power of computers for mining and consumes copious amounts of electricity. It is hard to ignore the carbon emissions of Ethereum when more people consider climate change as society's most important issue than ever before. Some institutions have stayed away from investing in ETH due to its ESG implications on their portfolio.
However, with the Merge scheduled for September, it may soon reduce its carbon footprint by over 99%! The evolution from proof of work to proof of stake will bring the Ethereum blockchain in compliance with the ‘E’ from the ESG where as the ‘S’ and ‘G’ have already been taken care of. This could open ETH to a swathe of institutional investors who may have been hesitant to jump into digital assets. They might even be incentivized to create applications on top of the Ethereum blockchain.
The Merge is expected to happen on September 15th. With all three testnets of the Ethereum network proving a successful merge, we are closer to the mainnet merge than ever before.
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