The Crypto Burrito (Volume I): Ethereum Merge
We are at the end of 2022 - a year full of surprises. From the highly anticipated Ethereum Merge to the nasty fall of industry giants, The Crypto Burrito By Bitget Academy will make a recap of the top news stories of the year, one by one.
We Have Waited Since 2015 For The Ethereum Merge
The Ethereum white paper was published in 2014 by Vitalik Buterin, the mastermind behind the idea of Ethereum, the ‘visionary and spiritual leader of the Ethereum ecosystem’. Around one year later, Ethereum’s first mainnet Frontier went live on July 30, 2015, operating with the Proof-Of-Work (PoW) consensus mechanism. As reported by Fortune, the plan for a shift to Proof-Of-Stake (PoS) had been in discussion since the inception of the blockchain, with Mikhail Kalinin being the lead contributor to The Merge. In November 2020, he published the ‘Executable Beacon Chain Proposal’, which establishes the base for the PoS Ethereum and specifies the following changes:
• ‘Network bandwidth’: This means the maximum capacity of data processing. An improved network bandwidth will result in an increase in block size; Kalinin’s proposal is designed to ‘enlarge the size of executable data’ by up to 60% ‘depending on the block utilization’.
• ‘Block processing time’: Kalinin explains that processing time could take as long as the PoW Ethereum if there is a ‘relatively large validator set and crosslink processing’, but the average throughput is 12ms (millisecond) per each Beacon block compared to 200ms per each PoW Ethereum block.
• ‘Solidifying the design’: The proposal makes it harder to ‘introduce more executable shards’, where each shard contains a unique portion of the network’s database and is independent of each other, so that ‘problems like cross-shard communication, sharing account space and some others’ are closely monitored.
In short, the Beacon Chain - the first step to fully functional PoS Ethereum - is designed to allow for better data processing in terms of both capacity and speed, thereby optimizing the transaction execution.
The Beacon Chain went live in the next month on December 1, 2020, marking the beginning of Ethereum’s grand transition to PoS. Six upgrades and two delays later, the Ethereum Foundation finally agreed on the schedule for Ethereum Difficulty Bomb - a concept introduced by former CCO Stephan Tual in 2015. The Difficulty Bomb is a function that increases the difficulty levels of Ethereum mining algorithm ‘exponentially’ to completely paralyze the network of the PoW mechanism and usher in the age of PoW. So apparently, Ethereum is set to shift to PoS right from the start.
Everyone was thrilled to celebrate the milestone when the Difficulty Bomb went off at the terminal total difficulty of 58,750,000,000,000,000,000,000. However, there wasn’t really much to talk about this very moment. It was so quiet you might have thought something must’ve gone wrong, but it was indeed a smooth ride - that’s some splendid work by Kalinin and the developer team.
Of course, the community had its own, unique way to capture this piece of history. The final NFT (minted for ca. 31.5 ETH) on the last block of the PoW Ethereum blockchain looks like this...
… And the first NFTs on the PoS chain were minted for a whopping 36 ETH. Named ‘The Transition’, this collection consists of 100 panda-featuring tokens that ‘recognize two privileged addresses’ of Vitalik Buterin and the Ethereum Foundation, meaning these two addresses can claim the not yet auctioned editions at any time. That is how 0xTransition paid tribute to Ethereum creators. Below is the Edition 1, a.k.a the very first post-Merge NFT:
The open interest (OI), i.e. the number of unsettled positions on exchanges, of Ethereum reached the peak in the earlier months: US$7.937 billion on January 02, US$7.934 billion on January 04, and US$7.983 billion on April 03, 2022. After April 03, speculative activities around the biggest altcoin took a dive relentlessly until the end of July, when markets started to show signs of recovery after the Terra (LUNA) and 3AC fiasco, which will be discussed in the next issue of The Crypto Burrito.
Over the same period, Ethereum lost as much as two-thirds of its value, OI was down by 57.9% at its lowest, and exchange reserve was on the rise as fear took over, causing a sell-off. The official announcement by the Ethereum Foundation regarding The Merge schedule livened up derivatives markets a bit after some quiet days in August, but there was kind of a blackout phase in September - people wanted to see how everything goes with the new consensus before making any (new) bet. We could’ve ended the year decently had it not been for FTX, another debacle also covered in this series.
Let’s talk about the fundamental changes that come with Ethereum’s PoW-to-PoS shift. Three main aspects here include energy consumption, blockchain design, and tokenomics.
Crypto mining activities are criticized for their high energy consumption (0.4% global electricity use) and deemed not sustainable. With all the tensions between Russia and Western countries, EU member states are preparing for a harsh winter this year; hence the industry may have to stop their activities in Europe when required. Converting to PoS is intrinsically more eco-friendly (see the plunging below, 99.99% saved!), and less subject to disruptions (due to external factors), suggesting that it will comply with regulations better.
In addition, becoming a validator has become easier because no understanding of mining equipment is needed; there are several staking options available that allow any user to earn the rewards, thus boosting the adoption of Ethereum.
Energy is not the only reason for Ethereum Merge. Equally important for this major blockchain is to improve its scalability (as in the ability to handle an increasing number of transactions). The PoW Ethereum’s capacity was limited to ca. 30 transactions per second (TPS), causing a huge inherent issue of network congestion and high gas fees. With Ethereum being home for the majority of DApps, the market desperately needed a scaling solution.
Ethereum TPS has not been considerably improved, nor have fees been reduced after The Merge. Still, the Beacon Chain lays the foundation for the Ethereum Foundation to improve the situation, first of all for Sharding. This upgrade breaks down the database into smaller chunks for faster and cheaper transactions. Sharding should be launched in 2023 - so (theoretically) we are getting there, but a significant development is not observable immediately after the merge and in the next few months.
Previously, new Ethereum tokens were created in the form of rewards on the former Mainnet in parallel with the Beacon Chain. After The Merge, only Beacon Chain continues to work and issues rewards for validators, putting a brake on the ETH issuance.
ETH issuance rate is estimated to be approximately 4.61% p.a. pre-Merge (4.09% for miners, 0.52% for stakers). The staking issuance rate will change congruently to the total amount of ETH staked on the Beacon Chain, which hasn’t seen any radical changes and remains at 14 million ETH. ETH inflation, therefore, stays at 0.52%, showing an 88.7% reduction compared to the pre-Merge period.
Meanwhile, the burning function exerts a negative influence on the ETH supply. Burning is a mechanism adopted by inflationary-by-nature tokens in order to control their inflation rate. ETH burning will wipe out all newly issued ETH when:
When simplified, it becomes:
At the current inflation level of 1,700 ETH issued per day, the net daily ETH issuance rate (newly issued minus burned) will turn negative when the average daily gas fee is 16 gwei or more.
The annualized supply growth of ETH since September 15 has been hovering above 0%, which is not a good proof for the ‘deflationary ETH’ theory. When we take a closer look at the base fee chart (this base fee is what gets burned to reduce ETH supply) versus ETH price, notably after The Merge was completed, it’s safe to say that burning did help ETH land in the green after a local low every now and then, for example, Price USD 1,107.40/Base Fee 12.09 (November 21, 2022) to Price USD 1,139.61/Base Fee 14.02 (November 22, 2022). Albeit one single case isn’t convincing enough; most of the time, base fees shot up whenever there was a panic sell.
Ether holders obviously find the idea of deflationary ETH exciting, as it should make ETH scarcer and more valuable with time. However, informed market participants for sure will act on what they know to influence the net issuance rate of Ethereum’s native token in their own interest.
Ethereum Comes Out Stronger
ETH deflation is not coming soon, but was ETH able to pull off a nice performance this year?
ETH and its forks
As the countdown for Ethereum Merge got closer to zero, many began talking about a fork since, as ETC miner Sebastian Nill put it, ‘The possibility of a hard fork has always been there. People are always going to prefer to be able to mine Ether rather than having to buy it.’ And actually, there have been two Ethereum forks: EthereumPOW (ETHW) and EthereumFair (ETHF). Throwing in the six-year-old Ethereum Classic (ETC), and we have three forks, although Ethereum Classic (ETC) has its own thriving ecosystem of DApps and is still in the Top 30 cryptocurrencies by market cap. Here is a comparison between the profits of the four tokens (ETH, ETC, ETHW, and ETHF) on a 3-month basis.
In general, ETC still did well when the market was good/not too bad (Q1 and Q3), while ETH was definitely a staple in difficult times. Extremely hyped in the first days post-Ethereum upgrade, but ETHW and ETHF couldn’t even stay strong till the end of September. ETHW lost 77% after 38 days of trading; ETHF is even worse - 89% after 16 days of trading. How did that happen?
EthereumPOW users reported accessing issues on the same day the project went live, which turned out to be the result of an attack on this fork. Unclear future plans, a white paper meme with absolutely no useful content, and an inactive Github repo do not make a great recipe for a brilliant investment. EthereumFair doesn’t even have a white paper, and its ecosystem is even less prosperous than that of EthereumPOW.
Furthermore, data from 2miners.com shows that ETHW and ETHF hash power combined makes up less than 20% of ETC’s hash rate. Hash rate measures the computational power used on a PoW network and therefore is an indicator of one blockchain’s health, security, and difficulty. At its peak, the OG Ethereum saw a hash power of 1,126.67 TH/s, which is nearly 10 times ETC’s, 70 times ETHW’s, and 300 times ETHF’s. They still have a long way to go to become a match for ETC, let alone for Ethereum.
ETH and BTC
What about the race between the two largest cryptocurrencies? Below are the rolling correlations between ETH and BTC price for the year 2022 (up until December 20). Rolling correlation allows us to see changes in the correlation over time, here with 7 days, 30 days and 90 days lookback. For the short run (one-week basis), the correlation between ETH and BTC price was much less reliable; the 7D correlation dropped to as low as less than 0.25 in January and several times below 0.75, reasonably because of upgrades, Difficulty Bomb delays and other news pieces related to the ecosystem. More consistent trend is observed over the one-month window; that ETH and BTC prices were more likely to move in tandem (around 80-90% of the time) on a monthly basis.
Granted that longer time frames show better reflection between the two assets’ prices (noises cancelled out), both two coins ended the year losing two-thirds of their value after May and November crashes. Bitcoin held on a little bit better, with a return of minus 65% compared to Ethereum’s minus 68%.
2022 is definitely not a good year for Ethereum when it comes to wallet activities:
• Active addresses: On average, the number of Ethereum active addresses daily is 490,648 in 2022 versus 538,163 in 2021 (-8.83%).
• Unique addresses: The difference between this year's and last year’s average of daily increase is wider (-32.31), plunging to 96,472 in 2022 from 142,517 in 2021.
• Bonus 1: The average daily transaction value for 2022 on Ethereum is US$585,534 against 2021’s US$1,080,340 (-45.80%). Calculations used data as of December 20, 2022 from Blockchair.
• Bonus 2: The total searches for Ethereum and ETH in 2022 stand at 3,677, down 23% from 4,806 in 2021. Calculations used data as of December 20, 2022 from Google Trends.
The thing is, Ethereum Merge gave Ethereum-based protocols a boost in revenues, together with a cutback in costs. Below are the cumulative earnings of blockchains from the last 180 days and 90 days (as of December 20, 2022). The biggest change is Ethereum went from second worst pre-Merge to best performer post-Merge with US$15.5 million in 90-day cumulative earnings.
Source: Token Terminal
Similar to the case of ETH and ETC, Ethereum might not be the best gainer in green markets, but it’d hand down see less blood being shed than the so-called ‘Ethereum killers’ in bears. The six selected coins are the native token of L1s with the highest Total Valued Locked (TVL) on December 20, per DefiLlama. TVL on Ethereum alone (US$13,531,736,320) was 43% higher than the aggregate TVL of the remaining five (US$9,468,263,680).
Besides, we dare say that Ethereum’s popularity will rise exponentially given that non-crypto natives will soon be able to buy, sell and store Ethereum directly on their Paypal account thanks to the new partnership agreement between MetaMask and the digital payment giant. MetaMask users already have painless on-ramp as they can pay for their crypto purchases with debit cards, Visa credit cards, MasterCard credit cards, and Apple Pay.
Ethereum Liquid Staking Derivatives
One of the big words for 2023 would be liquid staking derivatives (LSDs). A form of derivatives, which means its value is derived from another asset, LSDs allow DeFi users to stake their assets on a platform to earn yields and still be able to obtain extra utility from the staked tokens.
To make it easier to comprehend, let’s say we have ETH that we want to stake on the Beacon Chain. Suppose that we go to Lido, delegate our ETH to the corresponding pool, and receive stETH as a claim on our original ETH. Similar claims used to be illiquid and had almost no utility except for redeeming ETH. stETH and other LSDs, on the other hand, can be used as collateral on Aave for borrowing, for yield farming (ETH/stETH pool) on Curve, and so many more. That way, we can deploy two income-generating schemes at the same time: via staking and via DeFi activities.
Ethereum Merge brings in the prosperity of liquid staking markets for not everyone wants to be a solo validator with 32 ETH locked on the Beacon Chain. Lido offers one of the first pooled staking options with stETH and has indeed become the biggest validator on the Beacon Chain, dominating the market at nearly 67%. In the case of ETH liquid staking derivatives, each token is pegged to ETH at the 1:1 ratio.
Source: Dune Analytics
Also in the Top 3 are Coinbase and Rocket Pool, so two decentralized entities and one exchange. cbETH (Coinbase’s tokenized ETH liquid staking positions) emerged only after the Ethereum Foundation confirmed The Merge schedule on August 25.
Sometimes we see headlines such as ‘stETH loses peg’ and wonder, does the peg really matter? LSDs show some resemblance to wrapped assets in that users and holders are putting their faith in the integrity of issuers. As a validator, LSD issuers can be slashed, i.e., penalized, if they fail to maintain their validating responsibilities with good behavior. Validators may lose their entire stake on Ethereum as a consequence of slashing and, for that reason, can no longer redeem LSDs. Aside from that, LSDs losing peg will put DeFi borrowers at an awful liquidation risk as the loan isn’t considered guaranteed anymore. In that case, LSDs will be sold automatically, and you may now kiss your staked ETH goodbye.
On the flip side, if LSDs consistently trade at a premium to ETH, the pool won’t have enough ETH to pay back to stakers, especially if a large amount of LSDs are to be redeemed at the same time.
stETH experienced a prolonged period of discount from May to September following the collapse of Terra (LUNA), then crypto lender Celsius. Since The Merge's completion, it has reclaimed its peg. cbETH is almost constantly trading at a discount, at times as low as 8.38%, though that should be less of a problem for their holders, who are more of a centralized nature and do not care much about on-chain activities. In early 2022, rETH (issued by Rocket Pool) value dropped by 10% but saw an undisturbed appreciation towards the second half of the year.
When we zoom in on the last quarter, we can see that stETH appears to be the most stable, whereas its two peers seem to be moving further away from each other as time goes by. This stability looks mesmerizing, staking with Lido feels like the best choice, right? Think about it again. With Lido’s dominance on the Beacon Chain hitting 67%, can we expect Ethereum to be decentralized? Abuse and censorship are among the concerns discussed by researchers of the Ethereum Foundation.
Yield-bearing LSDs are a nice addition to the ecosystem of complex products and derivatives; they are expected to grow even more rapidly into the year 2023.
Enough about the PoS hype. One downside of this shift is the definition of ETH: Is it a commodity? Is it a security? The Securities and Exchange Commission (SEC) Chair Gensler hinted, around the time when The Merge took place, at the possibility of PoS ETH becoming a security. The Commodity Futures Trading Commission (CFTC) still holds the view of ETH having the quality and characteristics of a commodity, for now, but with the SEC and even Senator Cynthia Lummis, an outspoken advocate of crypto, referring to ETH as a security, it sounds like more regulatory scrutiny is on the way.
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