Ethereum‘s move to proof of stake (“PoS”) is one of the most anticipated events in crypto. It’s expected to increase security, reduce latency and improve energy efficiency.

Many are concerned that a significant amount of Ether will unlock once the Beacon chain goes live. There are concerns that the increase in supply on the market could add to the existing adverse price pressure from the Federal Reserve’s hawkish monetary policy.

This article will analyze some pertinent factors that may have been overlooked by many, that could create a bullish outcome once the merge takes place.

Article Outline:

• ETH 2.0 Background
• The Bear Case
• The Bull Case
• Post Merge Prospects
• Risks
• Closing Remarks

ETH 2.0 Background

Ethereum launched on July 30th, 2015 using a Proof of Work (“PoW”) mechanism. This is the same method that Bitcoin uses to validate transactions. However, there are environmental concerns around the energy costs used by the miners to solve these complex problems to validate the transactions. Many other more recent blockchains (Solana, Avalanche, Cardano) use PoS, which uses significantly less energy to secure the network and validate transactions.

Ethereum plans to transition to PoS by September 19th, 2022 - This is otherwise known as “the merge”. Where the live transactions from the existing PoW chain move to the new PoS (Beacon) chain. The chains are currently being run in parallel while the Beacon chain is tested.

The following diagram illustrates the recent transition well:

The PoS mechanism will randomly select validators relative to the total amount and time their Ether has been staked. This moves away from the energy intensive PoW mechanism.

So with the high level background set, why are people concerned about negative price action in Ether despite a positive change for the Ethereum blockchain?

The Bear Case

Let’s take a look at the statistics behind the Ethereum 2.0 (“ETH2.0”) staking and understand why investors have concerns over the price action of Ether.

There is approximately 12.7m Ether ($19.8b USD) locked up in the ETH2.0 staking contract (according to Dune Analytics), which equates to 10.4% of the circulating supply.

Investors are concerned that those staking their Ether in the Beacon chain will dump their unlocked Ether on the market once the merge takes place. ETH2.0 staking commenced in November 2020 when the price of Ether was $415. The current market price for Ether is $1,555 (as at 3pm July 19th, 2022) so it’s natural for some investors to want to take profits of a 3-4x on their initial staked investment.

However, while there will likely be some investors who want to take profits, it is unlikely that a significant amount of Ether will be dumped on the market for several reasons - let’s take a look.

The Bull Case

1/ Long Term Ether Bulls

While there is a possibility that some investors will take profits upon unlock, it is also probable that many will continue to stake their Ether to secure the network and receive a competitive yield for taking on this risk.

In fact those that locked their Ether up in the ETH2.0 staking contract for a two year period are bullish Ether long term and hence would be counterintuitive for a huge selloff to occur. Particularly during a macro bear market when we’ve already recently had a draw down of 70% from all time highs.

2/ Means Tested

While there are ways of staking in the ETH2.0 contract with less than 32 Ether, it is estimated that 80% is staked by those with more than 32 Ether. This equated to $13,280 in November 2020, when the Beacon chain staking contract went live. This would be an extremely speculative investment for your average retail investor. Most retail got into crypto in early 2021, with the blow off top hitting that November.

As such those who had locked their Ether for a two year period are likely to be long term bullish on Ether. One would assume they are experienced with risk management and therefore unlikely to require the funds for urgent living expenses. They are likely to be well educated investors waiting for stronger positive price action before taking profits.

3/ Queuing System

Staked Ether within the Beacon chain staking contract cannot be un-staked at once. In fact according to @korpi87 we can see that this could take as long as a year based on calculations of the maximum number of unlocks per epoch (6.4 minutes each):

4/ Fundamental Supply and Demand Shift

The price of Ether is currently perceived through the supply and demand of the asset. But we will see a fundamental demand and supply shift in how it operates after the merge.

It is anticipated that there will be a reduction in daily Ether emissions once ETH2.0 is live. Compounding this with the deflationary mechanism from the EIP-1559 upgrade (which went live in August 2021) means that we could see further reductions in supply.

5/ Mining Economics

We also need to look at the behaviour of the miners. Under PoW mechanisms, miners tend to sell a portion of the yield to cover the issuance costs (electricity). There may also be large sell pressure when mining operations shift location or need to shut down. One example of this was when China banned Bitcoin mining in May 2021 leading to a large amount of sell pressure from relocation costs incurred from these mining companies. This combined with several other events saw the price of Bitcoin tumble in mid-2021.

But if miners do not need to incur these expenses, then the current net sell pressure could flip to net buy pressure. The new PoS mechanism will dramatically reduce these costs leading to many ETH2.0 stakers reinvesting more of their yielded Ether. After all, why would you divest an asset that is arguably outperforming many other assets in the market?

We are beginning to see the impacts of Ether mining operations being wound down, with miners incurring losses over the past few months. The driver being reduced Ether prices, reduced network usage and the imminent “difficulty bomb” to be implemented prior to the merge. The following shows the correlation between miner revenue and Ether price:

The large spike in miner revenue around June ‘22 was due to frantic Ether sales activity as the wider macro conditions deteriorated. Reduced activity followed with an uncertain macro envionrment and tumbling Ether prices. Hash rate has since dropped consistently with Ether price, linked to reduce on chain activity.

6/ Perspective Shift - Tech Company / Infrastructure

Ethereum is currently perceived by many investors as a speculative asset, with the capital appreciation being the main driver for investing. However, the demand and token burn has increased with growing application of its smart contract functionality.

There are cashflows that can be attributed to the staked Ether, in return for securing the Ethereum network. The return is received for placing capital at risk, with emissions weighted based on the value of Ether staked.

Once we understand the business model, we can make an informed decision about whether or not to invest. The same holds true for other productive assets with something driving its success and cashflows received by holders of the asset. We could see Ether as the underlying infrastructure - the lifeblood of all applications that are built on top of the blockchain. Many of these Ethereum based applications could become fundamental to ensuring their businesses continue to operate. Could we argue that a new decentralized form of a tech company?

With this in mind, why wouldn’t an investor that purchases stock in Apple, Google or Microsoft, not consider Ether? After all, the price to earnings (P/E) ratio would be a much more appetizing investment than your traditional tech stock.

It is estimated that the yield for staked Ether could go as high as 12%, an increase from circa 5% on Ethereum mainnet for existing Beacon chain staking. With profit margins estimated to be already around 90% for PoW miners, this could increase to 99% with the new PoS model given the reduction in issuance costs, such as electricity.

• Ether = 32 to stake
• Yield = 4.2 Ether (12%*32 Ether)
• Profit = 4.158 (99%*4.2)
• P/E = 7.7* (32/4.158)

*Assumes no slashing costs incurred as part of operations and also assumes a steady Ether price. If this calculation was to be performed in fiat and one assumes the value of Ether would rise also, then the forward P/E ratio would be a lot higher.

If we compare this to the global average PE ratio for software companies, then Ether is severely undervalued based on those forecast returns.

Typically a PE ratio of less than 10 would be considered a value stock, is profitable and unlikely to have strong growth in the future. However, we know that Ethereum smart contract real world applications are nascent. So we could argue that despite Ether having strong earnings for its current price, there could be greater up side to come.

The revenue received from Ethereum dwarfs the other Layer 1 chains. Combining this with increasing developers one could argue activity is likely to grow on the chain meaning a greater number of fees to be distributed to validators.

As is the case with any opportunity, if it is lucrative then the number of validators / staked Ether could increase leading to a lower distribution of fees amongst miners. This will likely fluctuate over time, however the more validators / staked Ether then the more secure the network becomes.

7/ Sustainability Improvements and Perception Shift

The post merge shift to PoS will have a positive impact on the environment given the reduction in energy required to run the network. In fact ETH2.0 is estimated to be 2,000x more energy efficient according to Digiconomist:

To put the Giga Watt numbers into context, the Ethereum foundation has included a well illustrated diagram:

Energy consumption has been a contentious issue raised by many governments in discrediting cryptocurrencies. This upgrade undermines this argument and therefore could facilitate more regulatory acceptance and institutional adoption, driving demand up for the digital asset.

Post Merge Prospects

1/ Layer 1 Scalability - Sharding

What happens once the merge has taken place? Next in the Ethereum pipeline is “Sharding”. This is the process of splitting a database horizontally to spread the load and will work in harmony with Layer 2 solutions, like Polygon. The intention is that it should reduce congestion which in turn will reduce latency/increase efficiency or scalability.

2/ Layer 2 Solutions

In 2021, it is worth noting that Vitalik Buterin stated that the base layer of Ethereum wouldn’t be a quick upgrade - the scalability of the Beacon Chain (Sharding) would only come in the last major phase of ETH2.0. As such it is likely we will see most of the scalability coming from Layer 2 solutions, like Polygon or Arbitrum.

3/ Strong Developer Community

Ethereum continues to maintain the strongest developer community. According to Electric Capital, Ethereum has 25% of the Web3.0 developer community.

It’s exciting that the number of developers transitioning to Web3.0 is increasing and the fact that many are choosing Ethereum suggests that we can predict a greater number of applications for end users, which in turn drives activity on the network.

First mover advantage has played a large part in Ethereum sitting at top spot. Nonetheless this established leading position is difficult for competing chains to take market share, without a strong value proposition. Ether is also the base pair on most top performing liquidity pools which would take a lot of competitive development to disrupt. An established ecosystem also has the added benefit of offering grants to help foster further development. Many of these points add additional barriers to entry for new competing chains.

The move from the existing Ethereum Virtual Machine (“EVM”) to the new Ethereum Web Assembly Machine (“eWASM”) could further improve adoption by developers as the new machine is intended to facilitate improved performance and throughput.

Risks

1/ Execution Risk

Execution risk is the biggest concern when it comes to the merge. There has already been several delays. While the merge is scheduled for September 2022, there could be unforeseen events that cause a further setback. The market expects that the merge will go ahead as planned, so any further delays could have several knock on effects which could cause negative market sentiment and adverse price action:

• Loss of developers to other chains
• Reduced security of mainnet as miners already wrap up operations in anticipation for the transition to PoS
• Smart contract / protocol failure if the merge is rushed and not sufficiently tested ahead of launch

Needless to say the Web3.0 community will be watching closely as the updates are implemented and the market will react swiftly as news breaks as to its progress.

2/ Expectations Gap

There may also be an expectation gap between users and developers. Users may anticipate drastic reductions in transaction fees and speed, however the scalability element (on layer 1) is not expected until sharding is implemented. There has been a lot of hype about the upgrade so many investors and users may have over estimated the impact it will have on its scalability.

3/ Counterproductive Slashing Impacts

Validators who are staking their Ether could be subject to slashing penalties. This is intended to incentivize behaviour that is beneficial to the network and penalize bad actors. Slashing takes place when validators act against the best interest of the blockchain, and as such a portion of their stake is destroyed. Being offline causes an offline penalty, which doesn’t result in slashing. This novel functionality is a beneficial addition to the network, however there could be counterproductive impacts if validators are penalized unfairly.

4/ Competing Chains

At the current point in time Ethereum is the top performing smart contract enabled chain. However, this may not always be the case given the rate of technological change.

Other chains may be better fits for different use cases or applications may become chain agnostic. Interoperability is becoming increasingly viable so as to reduce the requirement for there to be a single dominant chain. Omnichain tech is something that Layer Zero labs are leading development for chain agnostic assets. While Polkadot facilitates cross chain communication for seamless interoperability. It is likely the future will contain several leading chains, potentially in an oligopolistic format.

5/ Regulation

Regulation frequently poses a risk for new technology. Governments generally step in when they see retail consumers being exploited or activity that can harm society/ disrupt the status quo.

While it will be difficult to shut down a fully decentralized ecosystem that transcends national borders, governments can certainly make it difficult to transact and slow the rate of adoption.

The recent hawkish government action has meant all risk on assets have seen sharp declines in prices, including crypto.

Closing Remarks

There are a number of considerations that need to be taken into account to predict the impact of the merge. On balance I’d expect a bullish outcome in the long term, although expect volatility in the short to medium term as the market reacts to price in development updates. The fundamental shift in the supply/demand mechanics, coupled with increased developer and user adoption of the network, is extremely bullish.

There are however a number of risks in a continually evolving technological environment. The macro economic conditions will likely need to play out for significant up side for Ether, given it is a risk on asset. Execution risk and continual development from competing chains poses a threat to Ethereum’s number one spot as the smart contract enabled blockchain. With several delays already it is not unlikely that another delay could be on the cards. There is also likely to be several chains competing for different use cases in the future - certainly not a single chain to rule them all!

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