The Merge

The Merge

The Merge is one of the most important development milestones in the ETH 2.0 roadmap, that has been planed since the beginning of Ethereum. After the successful Goerli testnet, the way is clear for the merge but what exactly is the Merge and what are its implications?

What Is The Merge?

When we talk about the Merge, it’s about the Ethereum blockchain currently using Proof-of-Work (PoW) to secure the network and changing that to Proof-of-Stake (PoS). This process already started in December 2020 when Ethereum launched the “Beacon Chain”. It is a PoS chain that lives in parallel to the Ethereum PoW chain and is only used for staking. The term “Merge” comes from the fact that these two chains are brought together. In this process, the consensus layer of the PoS chain is merged with the state of the PoW chain. After a successful merge, the Proof-of-Work consensus is no longer used.

Why Proof-Of-Stake Instead Of Proof-Of-Work?

There are numerous debates that have been held around the topic over the years. We you present you the two most obvious advantages of PoS.

Reducing The Energy Usage

While in Proof-of-Work consensus mechanisms miners risk their capital by spending on energy, in Proof-of-Stake they use their capital in form of locking ETH in a smart contract. As a result, the energy consumption of the Ethereum Blockchain drops by 99.95% and is more comparable to the daily use of a computer. The arguments that the use of DeFi or NFTs will destroy the planet can thus be put to an end. A pathway for Ethereum to be considered ESG compliant is thus cleared and Bitcoin will have to fight the battle on its own to demonstrate the benefits of PoW in order to justify its energy consumption to the public consensus.

Reducing The Issuance And Getting Ultrasound Money

As PoS is a more cost-efficient mechanism to secure a blockchain, the Merge will result in the issuance of new ETH by about 90%. Since there is not as much incentive on the miner side necessary anymore, the ETH Issuance will go down which avoids unnecessary dilution. The cost of Proof-of-Work can be understood as a fiat nominated fixed cost of the ecosystem. As miners are forced to sell their coins, there is a consistent sell pressure on the ecosystem. This sell pressure disappears with Proof-of-Stake. The term triple halving is often used in this context because the event basically has the same impact on the supply side as three Halvings. The ultrasound money meme comes into play because, in combination with the lower network costs expressed by the lower issuance, EIP-1559 was introduced last year. Since then, the improvement proposal has meant that the base fee, which corresponds to the majority of transaction fees, has no longer been given to the miners but has been burned and thus taken out of the supply. Burning tokens means that every person in the ecosystem who holds the asset can benefit from the ecosystem's revenue. Besides the positive impacts of the burn the miners and Proof-of-Stake validators only receive the tip for transactions, new issuance and MEV from the transactions. The following picture shows a simulation of the supply at an average gas price of 48 Gwei.

The real yield of the ecosystem as actors spend more money on blockspace than needed for running the ecosystem is visualized by a decreasing supply in Ethereum. However, in our view, the costs of a PoS system are often misrepresented. While new issuance is not a cost to the overall ecosystem, but an opportunity cost for unstaked coins, a PoS system with an inflationary coin supply can also generate a real yield for stakers. In Ethereum, however, this real yield becomes visible to everyone for the first time, as it ends up not only with the miners/validators but also with each token holder due to the high use of the system. Many fund managers are starting to plot discounted cash flow models in terms of the high dollar net value capture in ETH, often forgetting that it is exposed to ETH/USD volatility. Even if a dollar-dominated DCF model can help to better classify the market cap, in our eyes it should rather be used dominated in ETH. If you are a long term investor you will realize that you are buying a fastly growing ecosystem that generates a real yield of over 5% as a staker.

But What About Those PoW Hard Forks?

Although it was known from the beginning that Etheruem will switch to PoS, the miners still have their hardware and will miss future revenue. For miners, there is no downside to announcing a fork to either squeeze the lemon again or double down on fundamental values. EthereumPoW (ETHW) has already been announced and a derivative of it is tradable on several exchanges. The social consensus around Ethereum has long been decided in favor of Proof-of-Stake, and stablecoin issuers have also publicly positioned themselves behind this decision. However, their wording also leaves room for speculation. Circle, for example, can be quoted with: “Circle intends to fully and solely support the Ethereum proof-of-stake (PoS) chain post-merge”. Chainlink’s announcement that their protocol will not support PoW forks makes DeFi basically unusable due to the lack of infrastructure. People who are not interested in ETHW can see the event as a dividend which they can sell back in ETH or other currencies.

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Moonrock Capital

Moonrock Capital

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Moonrock Capital is a Blockchain Advisory and Investment Firm, incubating and accelerating early stage startups since 2019. https://www.moonrockcapital.io