The Ethereum Merge

The September 15/16th 2022 Ethereum merge is perhaps the most significant event for Ethereum since launching the native ETH token, which emerged from an initial coin offering raising around 31,000 BTC equating to around USD 18.3 million in capital at a price of around 0.31 USD/ETH.

• Considering that Ethereum’s 2022 market value now surpasses USD 235 billion making Ethereum the second largest blockchain in the world behind Bitcoin, the upcoming merge is of historical significance not just for Ethereum, but for the entire Blockchain industry.
• The aim of the merge is switching from Ethereum’s current cryptographic based consensus mechanism Proof of Work (PoW) to Proof of Stake (PoS), which is a switch supported by a majority of Ethereum users noting that some dissenting opinions exist from network participants like miners prepping to mine ETH Classic.

The merge basically reduces some of the costs and problems associated with the monolithic PoW crypto trilemma, which is a trilemma similar to the impossible trinity problem in traditional markets. Just like mandating fixed exchange rates, free capital flows and at the same time conducting independent monetary policy is impossible for governments to achieve, the monolithic crypto trilemma prevents blockchains from efficiently maximizing scalability, security and decentralization in the same layer necessary to outcompete centralized institutions like Visa, Goldman and Mastercard from a user perspective.

• Scalability is the transaction speed
• Decentralization is meaningful distribution of computing power and consensus throughout a network

  • Security reflects a blockchain protocol’s defenses against malicious actors and network attacks.

    By moving away from the monolithic approach used by blockchains like Bitcoin where core functionalities including consensus, settlement, data availability and execution occur on a singular layer to instead rely on a multi-layer core functionality approach, the merge increases Ethereum’s modular capacity, which reduces energy consumption, clears the path for proposer-builder separation and cuts ETH token issuance by more than 90%.

The Merge...

Expands access to institutional investors with environmental energy concerns
Democratizes the maximal extractable value (MEV) through holders staking ETH
Reduces transaction costs of level 2 roll ups by an order of magnitude
Makes ETH 90% more deflationary (1.6K ETH issued daily instead of 16K)

• Currently, Ethereum miners earn around 14,400 in ETH rewards daily for securing transactions on the PoW network profiting miners with superior hardware the most. In addition, MEV bots and arbitrageurs extract an excessive premium from Ethereum users in return for providing liquidity and post merge that value is transferred to stakers, which will generate more Ethereum adoption.

The transition to PoS also paves the way for future transaction fee reduction on both the main network and level 2 roll ups like the EIP-4844 proposal. Finally, although difficult to predict, the likelihood of institutional capital flooding a more ESG friendly Ethereum network expands vastly post merge

How Ethereum Will Share the Liquidity Premium

Blockchain technology enables decentralized trust keeping by relying on cryptography and consensus algorithms instead of institutions. Ethereum is therefore emerging as a low cost high security alternative to centralized institutions as a tool for users and business to exchange goods, services, communication and information via Internet. Ultimately, the merge is a major step for Ethereum to create a blockchain network that minimizes the institutional capacity to extract network value from small users, which is what I call harvesting the liquidity premium without taking appropriate risks and is all too common in the centralized economy of today.

• Basically, internet technology has allowed large centralized monopoly institutions to extract excessive fees and information from consumers and business in return for facilitating transactions and providing information security, which drains money from society to a few leading institutional stakeholders.

There will always be a liquidity premium, but the problem is how capitalist oligopolies and governments are incentivized to extract that small fee from users and citizens.

• The liquidity premium includes profiting from harvesting user and citizen information indirectly or money directly. The main problem is that the incentive to not take risk means that sometimes there is no risk associated with the service that is provided by third-party institutions in return for harvesting money.

The true definition of liquidity premium is compensation for taking risk, but harvesting money is providing liquidity without taking risk.

• For example, banks extract liquidity premiums in the form of charging interest for providing services like lending money to homebuyers, which is why the interest rates are higher for homebuyers with bad credit scores. If a homebuyer does not repay the loan then the bank lose money. The key to the definition of the liquidity premium is therefore taking risk, but when incentives are misaligned money is just harvested, which is defined as moral hazard.
• The Great Financial Crisis in 2008 is a textbook example of moral hazard, as bad mortgage loans by big banks got bailed out by the US government through the trillion dollar TARP bill when housing prices dropped so quickly that it threatened the survival of the US economy. That fiscal put money was then in essence harvested by bankers, while US tax payers took all the risk.

Over time, harvesting small fees is like how wasting time lowers economic output

• For example, experiencing slow internet at work one day may lead to a 10 minute productivity loss per worker that day, but if it's 10 min everyday over 20 years, the cumulative productivity loss equals 41 days per worker, which is essentially equivalent to the harm caused to society from the harvested liquidity premium by banks through charging consumers 0.001% for every transaction.
• On an individual level those fees are barely noticeable, but scaling that transaction fee to account for a global population of 8 billion people, you can see why bankers generate excessive profits for just owning government licenses, some software and a central database.

In an efficient decentralized blockchain economy, users share the excess liquidity premium profits proportionally to the amount of tokens staked together with the creators of decentralized applications established on top of the Ethereum network making everybody participating an owner and liquidity provider.

In a pure decentralized Proof of Stake blockchain based economy, these monopoly institutions must therefore develop decentralized services via the Internet on top of blockchains like Ethereum. By providing good services, these institutions will still make money, but they will not harvest a simple liquidity premium like in the past.