Is the Ethereum Merger Overhyped?

By Jordi Alexander

Source: bankless

On September 16, the sun began to rise.

Vitalik pours a small bottle of Malbec into his sencha, stirs it quickly, and takes a gentle sip. "...The alcohol content is 15.0%, which is just right."

Hard forks go as smoothly as a knife through butter. The long-awaited moment that detractors claim never came has finally arrived - and it's the smell of happiness.

He tweeted excitedly about a mission accomplished, thanking everyone who helped make this moment happen. Millions of "likes" poured in, and mainstream news on TV joined in the cheers.

The future is now, and ETH's road to five figures is already in sight, and it will definitely arrive at supersonic speed.

The environmentally friendly new way of burning gas will ignite the scarcity-deflation fire, powering the flywheel of an asset with a power the world has never seen before.

Reflexive price cycle that only goes up but not down

Driven by deflationary supply

Reward Excess Real Rate of Return

Leading the way to Ethereum chain dominance

Sounds amazing!

But before we get into a FOMO panic and start scraping change from couch cushions to squeeze out the last gwei we can afford, let's break down these four claims and see which ones really stand up to scrutiny.

Buy when the rumor is confirmed, sell when it is confirmed: ETH price spirals upward and enters the super cycle

Arthur Hayes, in his popular article “ ETH-flexive ,” invoked Soros’s theory of reflexivity, fueling the enthusiasm of consolidation bulls.

Far from a respite after the merger, he predicts that the catalyst will only accelerate a strong rally from lows around $1,000 in July.

His central thesis is that attention to mergers will lead to higher prices. As we know, the price increase of cryptocurrencies will bring more attention. Given that blockchain fundamentals like users, developers, and on-chain activity are all tied to attention, this will spiral into a virtuous circle, limited only by the size of the planet's population!

While this is indeed a fascinating frame of mind, we can spot two major holes in the price-adoption flywheel—a short-term hole, and a long-term hole.

In the short term, as Arthur himself admits, excessively built-up expectations could create “sell-when-confirm” pressure that can overwhelm any fundamental improvement.

In the long run, the relationship between attention to rising prices and burning more gas may be much more fleeting than depicted. Another point we will discuss later is that the reduction in gas usage we have seen in recent months is structural and requires a rethinking of value accumulation in layer-1 blockchains.

Let's first consider the possible price movement after the merger:

Time and time again, we see the same thing in the crypto space: event-driven players buy the dip when there is a big near-term catalyst.

Buying the dip emboldens tactical buyers, fueled by the impending "I know you know I know" event. Short sellers are put off by the asymmetric reflexive nature of the upside, while retail investors late in the information chain make the final dash when the headlines finally emerge.

Human attention spans are short, especially in crypto. Bored with the old, the new hits the headlines, and people start betting on the next chain upgrade or token economics tweak.

It's hard to forget that Bitcoin hit a new all-time high when the first U.S. Bitcoin futures ETF launched in late 2021.

Or that Coinbase’s IPO hype led to a period of downturn.

Or… Dogecoin Price Sliding After Elon Musk’s Saturday Night Live Appearance.

These most-watched moments appear to leave markets completely one-sided or vulnerable. Every time.

There are plenty of Ethereum supporters who don't want to exit their precious tokens, and there are funds and crypto whales who have entered long positions as event-based tactical trades.

Once the headlines die down, short-term players find themselves playing a game of grabbing chairs to snatch their share of unrealized profits before the music stops!

Will this time be different?

Going into a period of what many expect to be an extremely challenging macroeconomic backdrop, it seems possible that at least the "sell when confirmed" Reaper remains undefeated.

'Triple Halving' Pushes ETH Into a Deflationary Supply Crisis

In a recent tweet that has been retweeted thousands of times, Montana Wong laid out the catastrophic supply shortages expected after the merger.

The so-called reference to Bitcoin's four-year production cut is described as the accumulation of three powerful effects, fused into a singular phenomenon that will make ETH scarce.

Let's take a closer look at these three effects.

reduce circulation

No longer needing to pay miners to validate transactions on the network, Ethereum is effectively laying off its highest paid employees.

This will result in a savings of 13,000 ETH per day in "proof of work" fees.

Instead, the Ethereum security department will be made up of Staking Officers, whose salaries are much lower: their full budget will start at close to 2,000 ETH per day - although over time, more and more Staking Officers On post, their budget will increase to about 5000 ETH per day.

Still, the net savings of 8000-11000 ETH per day is indeed a significant catalyst as $15-20 million of selling pressure per day is removed!

Arguably, cheaper security forces may come at the cost of less censorship resistance -- but in terms of pure price impact, it's powerful.

destroy

EIP-1559 is a strong catalyst for Ethereum price when implemented in 2021. A large portion of the gas fees paid by users in each block is burned, which partially offsets the new issuance paid to the security ministry budget.

However, EIP-1559 is already a year old, so not only is it already priced in, it may be overpriced: while early burns were so high that ETH supply could turn deflationary, the situation is far from in this way.

For an Ethereum price bull market (not to be confused with an Ethereum technical bull market), this chart has to be stunning. Not only do the days of 10,000+ ETH burnt seem long gone, but as technical analysts point out - there doesn't seem to be any support levels yet!

In the past 30 days in August, the price of ETH has increased by more than 50%, and the gas burn is only about 1300 ETH per day:

While ETH bulls will claim that this is simply due to the cyclical nature of cryptocurrencies, with fees paid eventually returning to their highs, this ignores the one-way structural change that is taking place.

Let's start from scratch:

During bull manias, so much money flows into the system that participants are willing to grudgingly pay exorbitant fees as a "cost of doing business".

The first wave of "business" was to participate in the early boom of DeFi. Soon, the fun and legitimate financial experiment spawned a new wave of Ponzi schemes, using elements of viral marketing like sky-high APY % to create a free grab for seemingly valuable food tokens.

In 2020, the DeFi summer is coming to an end.

But, just when gas costs started to drop, NFT mania ignited like firecrackers!

Like DeFi, what started as a project with legitimate digital artists and novel algorithmic art quickly turned into a steady stream of copycat PFPs.

Most of these projects sprung up to meet a frenzied sudden demand, only to die or fade into obscurity. However, until the market slowly digests and figures out where the value lies, new minting will be massively oversubscribed and gas fees will continue to flow.

So, what about the few big winners in the NFT and GameFi wave?

As some projects successfully attract sticky users, they realize they can accumulate more value instead of wasting money on ETH gas fees.

This was demonstrated in the Bored Ape Yacht Club's disastrous metaverse land sale where a whopping $176 million of the $285 million sale was wasted on gas fees!

Great for ETH holders, not so good for the Yuga community.

This is a lesson, not just for Yuga Labs, but for other aspiring and popular NFT projects as well.

It is unclear whether these projects ultimately choose an alternative chain (Layer 2) to avoid these recurring costs, or stay on mainnet and optimize the auction to eliminate gas bidding.

What we can say, however, is that burndown days as we are used to are a thing of the past and should not be extrapolated into the future.

After DeFi and NFTs, won’t there be a third wave one day, creating another intense gas burning cycle?

In fact, eye-catching new innovations are guaranteed at some point. However, it now seems unlikely that a new popular application would need to consume a lot of ETH gas fees to succeed.

Code efficiency is improving rapidly, even in existing heavily used applications. For example, OpenSea transactions are now 35% more efficient and burn a lot less gas.

With a plethora of Layer-2 and AppChain options coming online in the near future for a variety of different use cases, many applications will find a home outside of the Ethereum mainnet.

For projects that stay on L2, it will become cheaper over time to write state updates from Ethereum L2 on L1 using EIP 4844 ( proto-danksharding ).

Stake supply will be locked

Staking tokens are locked out of the market and therefore cannot be sold.

After all speculative participants have completed their PoW forks and exited hastily, stakers cannot withdraw their tokens until the Shanghai fork in 2023.

Of all the bullish price narratives, this one is perhaps the most inappropriate.

ETH (over 13,000,000+) on the Beacon Chain has not only been taken off the market, but has been earning gains. For a long time, rewards have been generated on both PoW and PoS chains, but only those on PoW can be sold.

By the time of the Shanghai fork, there will be ~30 million ETH suddenly unlocked and pledged, which could create an unlocked pledge queue and a considerable supply-demand imbalance.

There will be an unknown time delay before all those tokens are finally withdrawn.

The market is always forward-looking when the next impending catalyst changes from a highly-anticipated merger to a massive token unlock with unknown consequences, which will lead to a destabilizing price floor as the Shanghai fork approaches.

Staked ETH Will Be a "Yield Chaser"

Block rewards — the nectar of the gods once reserved only for the elite miners — will now be securely packaged as risk-free returns for all to enjoy.

Clean, pure, genuine benefits straight from the source.

How can institutional treasuries continue to ignore such a hallowed high-yielding asset when their balance sheets are returning a measly 3% a year?

ETH yield cannot be risk-free if there is ETH price risk.

Staking transactions for ETH holders are also not as magical as people say.

The pledged ETH will generate income because it needs to run the verification node. There are three sources of income:

• Block subsidy: from ETH inflation, as a security cost
• Gas tip: from users who want to complete transactions first
• MEV Rewards: Bribing in the way transactions are organized

block reward

Earlier this year, only 10M/120M possible ETH was staked on the Beacon Chain due to all the future risk. Not even the Ethereum Foundation is staking their ether.

However, this 10% staking participation is much lower than the proof-of-stake chain (~50-80% participation). More stakers will quickly appear and join the queue.

Now that about 14 million ETH has been staked, the reward per validator has been reduced to 4.1%.

Needless to say, after a successful merger, this number will continue to increase to a maximum limit: about 2 million coins/month.

Even if someone wanted to unstake, now they won't be able to!

The effect of more ETH verification is shown in the figure below:

As more and more ETH is used for validation, not only will the reward rate decrease, but the annual inflation rate will increase, resulting in a lower real rate of return. In extreme cases, if 100 million/120 million tokens are pledged, the final rate of return minus inflation will be 1.81% - 1.71% = 0.1% APY.

In a way, this is also good for Ethereum itself...

More ETH being staked is cause for celebration, because it equals more security: more resources are required to successfully attack the network.

But it’s also cause for celebration for more ETH stakers: higher annual inflation across the network; lower staking returns.

Real (after inflation) staking returns are only high if a small percentage of the supply is staked. Block rewards are distributed to stakers in a form of inflation at the expense of those who have not yet staked.

This is their punishment for being lazy/risk averse/inexperienced.

Gas tip

In addition to the dwindling block subsidy validators already receive, much of the hype revolves around gas tips and MEV bribes, which will only be enabled after the merger.

Here, though, we also find that the hype far outstrips the current new reality.

Just as we saw that the structural change resulted in less gas being burned, so did tipping and MEV.

From more than 50,000 ETH per month in the heyday, the Gas tip in recent months has dropped to 20,000 ETH per month, and it may continue to spiral downward.

MEV

Finally, the most discussed - but least contributed part - maximum extractable value.

In Proof-of-Stake, the chosen validators who publish the block act as referees for transactions competing for a position within the block. Referees could be bribed to fix the game if more lucrative orders were available.

While this sounds like a malicious dynamic, it's actually better than creating an unstable system alternative. Flashbots is developing a product called MEVBoost to make these bribes transparent and accessible to all referees, which will mean ETH stakers are more likely to get their “fair share.”

Bullish right?

But MEV is being squeezed from all sides, including at the dApp layer (e.g. CowSwap which uses batch auctions).

A more realistic situation would be:

In 2023, we will see 30-60 million ETH staked:

~2.5% APY max validator rewards

+ ~ 0.5%Gas tip

+~0.1–0.2% MEV Boost

This gives us an annualized return of about 3.2%:

About 1.5% of this is token inflation

0.25–1% to third-party validator operators

Then there is not much left.

A final note on blockchain benefits vs costs:

Token economics and rules for block subsidy and token burns, these things are really important in creating proper user incentives. But at the end of the day, they're just PvP games between stakers.

The only true chain that rules all

Stronger community and social layer than memecoin

Alt-L1 Technology Better Technology and Higher Levels of Decentralization

The ultra-sound currency that will make Bitcoin obsolete

All three ETH narratives could get a huge boost from the successful completion of the merger:

Focus on consolidation leads to greater user adoption, coupled with the power of ESG friendliness.

Finally, a long-awaited technological upgrade of immense complexity continues on the roadmap towards exceptional performance.

Significantly reducing supply, challenging BTC's inflation rate and positioning as a better reserve asset.

Now, all three narratives make for a delicious snack on their own! But put them in the same bowl and their respective flavors can seriously clash.

You don't want to mix them up and chew them up.

After the merger, as the roadmap continued, the different goals began to conflict fundamentally.

Once things move from the theoretical "roadmap" stage to the stage where rigid decisions are required, it becomes increasingly difficult to work for everyone.

Technologies, memes, and stores of value all have different sweet spots along different dimensions. Here are some examples worth considering:

Driving technological innovation vs. staying the same

With the rest of the blockchain ecosystem also innovating, Ethereum’s technological leadership is not enough to satisfy the status quo. Other chains are not going to sit around doing nothing for the next few decades.

Value Accumulation vs. Good User Experience

While users and holders are not disparate groups, the combined token holders have greater influence in decision-making.

This can create perverse incentives in myriad ways that allow short-term value extraction to override long-term ecosystem health.

Efficiency vs Censorship Resistance

PoS improves efficiency in some ways, but it also adds more complexity, which expands the attack surface.

It is important to try to balance the efficiency advantages of "winner-take-all" liquid staking protocols with the centralization risks they may introduce.