The Ethereum Merge

The Ethereum merge, where the protocol’s consensus moves from Proof of Work (PoW) mechanism to Proof of Stake (PoS) will take place around 15th September. This is called The Merge because the current Ethereum PoW network will merge with a PoS test network called the Beacon Chain.

Here’s how the Ethereum Foundation explains the merge:

Today’s post aims to evaluate the debate surrounding the merge and provides links to sources that can further illuminate the many nuanced issues. Our view leading into the merge is that it is most likely a sell-the-news event rather than an event that will catalyze sustained Ethereum upside. We will explain this view in more detail further below. This is not investment advice.

Positive outcomes of the Ethereum merge

(1) The move to PoS will sharply reduce ETH issuance, possibly making ETH a scarce asset like bitcoin; (2) PoS will provide a yield for token holders who stake their ETH tokens to secure the consensus mechanism. The yield, which will be paid with ETH tokens, will draw new investors into the asset, proponents argue; (3) the move from PoW to PoS will reduce Ethereum’s energy consumption by more than 99%, making the protocol ESG friendly.

The negatives of the Ethereum merge

(1) Possible technical hiccups that cause problems with network function. The move from PoW to PoS is complex, which is why that event has taken years, and with many delays. The recent test merges had issues as this Coinbase post discusses; (2) PoS will lead to a centralization of power. This is because staking is primarily done via staking operations provided by centralized entities like Coinbase, or via liquid staking protocols like Lido. A handful of these staking services could end up controlling the vast majority of ETH staked to support PoS.

There has been plenty of ink used to report on the merge. Some of those articles we have found useful are below 

1. Coinbase institutional with a balanced view of the risks and opportunities in the merge
2. “What is the merge?” by the NY Times
3. Kraken’s, the crypto brokerage, with a PoW vs. PoS guide
4. Coin Telegraph’s Beginner’s Guide to How to Stake
5. Bankless, the equivalent of Bitcoin Maxis in Ethereum, with a bullish take.
6. Bankless also published is the merge overhyped article, which pushes back on the positive outcomes we highlight above
7. Bitcoin Magazine article flags the risks of centralization with the move to PoS
8. Into The Block looks at the post-merge ETH issuance decline and staking rewards here

Merge likely priced in

In the near term, we see merge-hype in the current ETH price. Google search trends is one data point backing that view. Just note that the chart reflects a scale relative to a given search term. It is not an absolute measure.

“Ethereum merge” US Google search trends over the past 12 months

Source: Google Trends

The search trend excitement is backed up by a surge in ETH options positioning that rises to an all-time high US$ value. Speculators are already positioned for a bullish move, we believe.

The ratio of put options to call options shows (chart below) that the rising open interest show above is due to bullish call options.  

In contrast, the bitcoin put/call ratio is currently more than twice as high.

Are positive narratives overplayed?

We also struggle with some of the positive narratives. The issuance reduction could be about as much as what the network experience after the EIP-1559 upgrade in 2021. As this chart from Into The Block shows, issuance declined to zero at various points after EIP-1559. However, bullish projection of issuance sustainably falling has not materialized. The issuance rate has increased in 2022 as network activity has dropped along with the broad crypto asset prices. The initial issuance drop post EIP-1559 did not prevent the macro environment’s negative impact on the asset price.

We are not fully sold on the idea that Ethereum’s mid-single digit percentage staking yield will suddenly catalyze an adoption increase. A 6-7% yield is meaningful if the underlying asset volatility is low. A 6-7% yield is somewhat meaningless if the annualized asset volatility is in the 70-80% range, as it is with ETH. Most of the returns will come from the asset volatility and not the yield.

The above point is highlighted by the two charts below from the MacroTactical newsletter. It highlights the unfavorable yield vs. volatility dynamics of ETH tokens.

Yield vs. Volatility Ratio Chart

Longer term, a successful merge is pivotal to Ethereum maintaining market share within the layer-1 smart contract protocols. Yes, there are potential security compromises that come with PoS, but future adopters are likely to focus on speed and cost rather than worry about centralized control of Ethereum. Many of the layer-1 alternatives to Ethereum are PoS protocols. Ethereum needs the merge to evolve into a more efficient, lower cost, smart contract blockchain protocol. This Cointelegraph article lays out the pathway into 2023 and beyond.

Important Disclosures

This is not an offer or solicitation for the purchase or sale of any security or asset. While the information presented herein is believed to be reliable, no representation or warranty is made concerning its accuracy. The views expressed are those of RockDen Advisors LLC and are subject to change at any time based on market and other conditions. Past performance may not be indicative of future results.   At the time of publication, RockDen and/or its affiliates may hold positions in the instruments mentioned in this newsletter and may stand to realize gains in the event that the prices of the instruments change in the direction of RockDen’s positions.  The newsletter expresses the opinions of RockDen.  Unless otherwise indicated, RockDen has no business relationship with any instrument mentioned in the newsletter.  Following publication, RockDen may transact in any instrument, and may be long, short or neutral at any time.  RockDen has obtained all information contained herein from sources believed to be accurate and reliable.  RockDen makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information or with regard to the results to be obtained from its use.  All expressions of opinion are subject to change without notice, and RockDen does not undertake to update or supplement its newsletter or any of the information contained therein.