New opportunities and new narratives in the context of ETH 2.0

TIPS

• In the approximately 9-month small cycle of Merge - Shanghai Upgrade, the amount of ETH in circulation continued to decrease monotonically;

• In the long run, ETC and other Ethhash POW Tokens will see several times the increase in computing power;

• The decentralized GPU computing power network may open up the next narrative of GPU mining;

• In the future, Lido and CEX will still be the main players in staking, but various decentralized staking protocols and other types of staking service providers will also flourish.

• Protocols such as Obol Network are important for maintaining the stability and decentralization of the validator network operation;

• If the ETH staked on the beacon chain can be withdrawn, the risk of users engaging in revolving loans will be greatly reduced due to the increase in the cash-out channels of stETH;

• The separation of ETH staking income and tipping income actually provides rent-seeking space for liquidity staking protocols such as Lido and node hosts;

• In the future, there may be a large number of income and trading products based on ETH notes emerging;

• Based on its instinct to continuously expand its business scope and squeeze out competitors' markets, the DeFi protocol will be motivated to engage in ETH liquidity staking.

1 Changes in ETH fundamentals

In the POW stage, ETH will generate 2 ETH as block rewards for each block. According to the estimated block time of 15s, about 4.2 million ETH will be generated per year. However, after the completion of the Merge, the ETH staking reward will be dynamically adjusted according to the total amount of ETH staked on the beacon chain. At present, the annual increase in the number of ETH is about 4% of the total amount of ETH staked, that is, about 500,000 ETH will be issued per year. With the increase in the ETH staking rate in the future, the proportion of the increase in the total amount of ETH staked will gradually decrease. When the ETH staking rate is 30%, the annual increase in ETH may reach 1.2-1.5 million. However, with the support of EIP-1559, ETH is very likely to achieve deflation in the future. During the bull market stage when Gas soared last year, about 20,000 ETH could even be destroyed in one day, so the entire token economy of Ethereum will undergo a qualitative change after the Merge.

If the large cycle after Merge is divided into two cycles, Merge - Shanghai Upgrade and Shanghai Upgrade - Infinite, the token structures of these two cycles are completely different. Shanghai Upgrade is also called Post-merge Clean. Its main feature is that the ETH staked on the beacon chain can be withdrawn in an orderly manner. Before the upgrade is completed, all staked ETH, including assets in liquidity staking protocols such as Lido, cannot be retrieved. Therefore, in the small cycle of Merge - Shanghai Upgrade of about 9 months, the ETH in circulation continues to decrease monotonically.

The specific reasons are summarized as follows:

• The burning effect of EIP 1559;

• The amount of ETH staked on the beacon chain continues to increase but cannot be withdrawn;

• The staking rewards of nodes on the beacon chain cannot be withdrawn, that is, all the newly issued ETH in this cycle is in a locked state;

• The MEV and various tip income obtained by the validator from the execution client can be used by the validator at will, but this part of the income essentially belongs to the ETH stock and does not affect the overall circulation of ETH.

After Shanghai Upgrade, as the staked ETH and the staking income can be withdrawn, the token structure that was originally completely beneficial to ETH holders will no longer exist. As the ETH staking rate reaches a stable level, the circulation of ETH will be determined by both EIP-1559 and the additional issuance reward.

2 Mining machine recycling and the future of mining

Before the merger, the ETH mining industry can provide a computing power of 910 TH/s, which is about 20-30 times the computing power of ETC. The POW algorithm used by both is Ethhash. Mining machines that can run the Ethhash algorithm can easily switch freely between ETC, ETH, and other tokens that support the Ethhash algorithm, such as Conflux. Mining machines are divided into GPU mining machines and ASIC mining machines. The former is universal and adaptable to different mining algorithms and can also be used for other purposes, while the latter is only suitable for specific algorithms. It is precisely because of the difference in universality between GPU mining machines and ASIC mining machines that ASIC mining machines are more efficient than GPU mining machines. There is currently a lack of detailed data on the computing power of AISC mining machines and GPU mining machines, but it is estimated that about 40% of the computing power comes from ASIC mining machines. Since ASIC mining machines can only be used for Ethhash mining, when ETH switches to POS, some of these mining machines will switch to ETC and other POW Tokens that support Ethhash, and the other part will undergo ETHPOW fork. Forking is a relatively complicated matter, requiring the joint promotion of multiple forces including miners, trading platforms, developers, and internal projects of the ecosystem, and there will be a period of confusion after the fork.

In the long run, ETC and other Ethhash POW Tokens will see several times the increase in computing power. Although the relationship between computing power and POW Token value has not yet been found, the $30 million ecological fund launched by Bitmain is essentially a great benefit to ETC. The value of the ETHPOW fork chain ecosystem still needs time to test.

Compared with ASIC mining machines with narrow applications, GPU mining machines have a wider range of destinations, and some GPU mining pools have already found a way out for the running mining machines in advance. Hut 8 and HIVE Blockchain have acquired data centers and plan to put some mining machines into data centers after ETH 2.0. On the other hand, considering the scrapping of GPU mining machines, the proportion of turning to other token mining such as BTC, and the ETHPOW fork, there are still a large number of idle GPU mining machines, and these idle mining machines can be used for various networks that require GPU computing power after transformation, such as Akash Network, Flux, Render Network, Liverpeer or ZKP GPU mining.

The decentralized GPU computing network may open up the next narrative of GPU mining. From the perspective of GPU equipment manufacturers, after ETH switched to POS, GPU equipment manufacturers urgently need to find the next GPU demand industry with the scale of ETH mining industry; from the regulatory level, the borderless global GPU computing network will not pose the same threat to national financial sovereignty as BTC and ETH. The same is the way to rent GPU network computing power and use decentralized networks to conduct GPU utility mining to obtain benefits in tokens, while the centralized GPU computing platform obtains benefits in fiat currency. There is no essential difference between the two. Therefore, the future of the mining industry may continue to exist in the form of GPU utility mining.

3 Pledge Track

3.1 Liquidity Staking

https://www.stakingrewards.com/

Data from September 14

The security indicators of POS public chains include the pledge rate of public chain tokens and the market value of the public chain tokens. According to the pledge data of other POS public chains, it can be roughly estimated that the pledge rate should be in the range of 30-70% under normal circumstances, while the current Ethereum pledge rate is only 11.8%, so the pledge track will see at least 200% growth in the future.

Staking is a track with a low entry threshold. Currently known players include:

• Existing mining pool: F2pool

• DeFi leading protocols make their own staking protocols: for example, Frax Finance

• SaaS Provider (Hosted validator for users holding 32 ETH)

• Liquidity Staking Protocol

• Centralized institutions

• Solo Staking

The specific pledge data is as follows:

Currently, ETH’s liquidity pledge accounts for 33% of the market share, of which 30% is in Lido, 30.8% in CEX, and 26.4% in Others (of which 22.2% is held by whales).

From the above data, it can be seen that decentralized staking currently only accounts for about 3% - 10% of the share, and the vast majority of ETH has entered staking protocols with a strong centralized color, such as Lido. At present, the staking track is still in a relatively early form. In the case of imperfect infrastructure, users will choose Lido, which has a higher degree of centralization, based on the demand for fund security and stability. Major CEXs have also entered the staking track based on their own ETH deposits. Lido and CEX have formed a monopoly based on their first-mover advantage. However, Staking is a track with very fierce competition but low threshold, and the entities participating in ETH staking services such as CEX, SaaS service providers, node custodians, individuals, Liquidity Staking protocols, etc. often have a cooperative and competitive relationship. CEX and Liquidity Staking solve problems on the capital side, while node custodians and SaaS service providers solve problems on physical machines. However, CEX can also provide node hosting services, and SaaS service providers can also attract users with large amounts of funds but lack the ability to run nodes. This complex competitive and cooperative relationship will continue to reach a dynamic balance with the addition of new players. In the future staking track, Lido and CEX will still be the main force of staking, but various decentralized staking protocols and other types of staking service providers will also flourish.

The transformation of Ethereum POW to POS has introduced a new narrative for the development of the entire Web3 industry, namely, a deeper demand for decentralization. This demand and aesthetic for decentralization will also promote the decentralization of the application layer and the protocol layer in the future. Based on this judgment, decentralized liquidity staking protocols will usher in high growth in the future incremental market.

The Ethereum Foundation has officially provided a system for evaluating liquidity pledge protocols. This system is generally applicable to all liquidity pledge protocols. Specific indicators include:

• Security: BUG rewards, audit or not;

• Diversity of clients;

• Liquidity of the notes and stability of the exchange rates;

• Private key security: private keys are not managed by humans;

• Anyone can participate in running a node, which is a contribution to the decentralization of the entire Ethereum network.

For ease of understanding, here is an example comparing Lido and Rocket Pool:

• Client diversity: Client diversity means that the proportion of various clients should be balanced;

• Note liquidity and exchange rate stability: Lido's liquidity note stETH is mainly on Curve. Although it is possible to build a stETH:ETH pool at a ratio of 3:1 to improve capital efficiency, it is prone to price fluctuations under special circumstances. Rocket Pool's rETH is mainly on Uni V3, and its price is more stable.

• Private key security: Lido and Rocket Pool started developing almost at the same time, but Lido was launched earlier. Rocket Pool did not launch the staking function until the function of smart contracts being able to be used as withdrawal private keys for ETH deposits was launched. Previously, Lido had been co-hosting users' withdrawal private keys by multiple institutions (currently also upgraded to smart contracts). Therefore, Lido's first-mover advantage over Rocket Pool mainly lies in the time advantage;

• Contribution to decentralization: Rocket Pool supports everyone to participate in running the client, while Lido entrusts the client's operation tasks to institutions such as CEX. Rocket Pool is conducive to the decentralization of ETH 2.0, while Lido does not play a substantial role in decentralization.

3.2 Further efforts to stabilize and decentralize the validator network

ETH 2.0 validators have two private keys. The first one is the withdrawal private key, which has the right to withdraw the 32 ETH staked. The 32 ETH staked by the user is absolutely safe. Even if the withdrawal private key is leaked, the user will not lose the ETH assets. This is because the withdrawal private key is bound to the user's address. If a hacker obtains the withdrawal private key through various means, the hacker can only withdraw the ETH from the pledge contract and deposit it into the address that the user originally bound to the contract. The second private key is called the validator private key, which is used for consensus voting and signing. When the consensus is correctly participated in, that is, the signature is correct, the validator can get the reward, but if the client is offline or votes incorrectly, the ETH originally staked by the validator will be confiscated. Therefore, ensuring the stability of the operation of the validator network will be a priority for various staking service providers and individual validators.

There may be some discussion about the decentralization and centralization of the staking track. The two private keys generated by ETH staking represent asset ownership and consensus participation rights respectively. Asset ownership can exist in a centralized form, but if the consensus participation rights, that is, the validator private keys, are distributed in a decentralized manner, can this solve the centralization problem of the staking track to a certain extent?

SSV Network and Obol Network have made efforts to solve the above two problems. Both of them are achieved by redundantly splitting the validator's private key. Taking Obol Network as an example, redundant splitting means dividing the validator's private key into n redundant parts and handing them over to n Operators in Obol Netwrok. When the POS network needs the validator's private key to sign, any f of the n Operators can complete the signing process online.

This has multiple benefits:

• Eliminate the risk of single point failure of the validator and reduce the probability of being slashed;

• Pledge service providers of different sizes can collaborate with each other to reduce the harm caused by excessive monopoly;

• The control of the POS network by the centralized staking service provider has been assigned to decentralized protocols such as the Obol Network, which has enhanced the censorship resistance of the POS network to a certain extent;

3.3 Application expansion of ETH liquidity pledge notes

When users deposit assets into the ETH liquidity pledge pool, they will receive a note as a certificate of ownership of the assets deposited in the pledge pool, which is similar to a large deposit in a bank. Lido's ownership certificate is stETH, and the corresponding Rocket Pool's liquidity certificate is rETH. In the future, there is at least 200% growth space in the liquidity pledge track, which means that the existence of ETH pledge notes such as stETH will greatly enrich the asset categories available to DeFi, and therefore will bring more gameplay to DeFi applications.

3.3.1 Revolving Loan

Liquid pledge notes such as stETH currently have a relatively narrow application scenario in DeFi and are often used as collateral for lending agreements. The sharp depreciation of stETH in May this year is related to this. The common strategy used by institutions is to conduct ETH-stETH circular lending and arbitrage ETH pledge income in this way. However, this arbitrage model is based on the premise that the price of stETH is stable. When stETH encounters a liquidity crisis and causes a price drop, the ETH-stETH circular lending is likely to face a series of liquidations.

The underlying reason for the stETH depegging incident is that the ETH staked on the beacon chain cannot be withdrawn and stETH cannot be destroyed. The only way to cash out stETH is to use the existing DEX. Moreover, the liquidity pool of stETH and ETH is built on Curve, and is built according to the ratio of stETH:ETH = 3:1. This leveraged trading model cannot withstand the massive selling pressure of stETH, causing stETH to depreciate significantly. However, if the ETH staked on the beacon chain can be withdrawn, the risk of users engaging in revolving loans will be greatly reduced due to the increase in the cashing out channels of stETH.

Let's do a simple calculation. If an ETH holder has 1 ETH, the liquidation line of the lending agreement for stETH is 90%. The ETH holder borrows cyclically at an 80% borrowing rate, and the amount of each loan is 1, 0.8, 0.64..., and the total ETH pledge exposure is 5 ETH. When the annualized ETH pledge is about 5% - 8%, the annualized pledge income that can be obtained by the revolving loan is 25 - 40%. It is worth noting that before the Shanghai upgrade of Ethereum next year, in addition to considering the possible decline of ETH, it is also necessary to pay attention to the possible serial liquidation problem of ETH bills.

3.3.2 Fundamental judgment of ETH liquidity pledge notes

The income obtained by validators from participating in the validator network includes two parts: ETH staking income and tip income (including MEV). These two parts of income are separate. The staking income will be sent to the ETH deposit address, and the tip income will be sent to the tip address corresponding to the execution client. This separation of income actually provides rent-seeking space for liquidity staking protocols such as Lido and node custodians. ETH staking income will undoubtedly be returned to the holders of ETH bills. However, for tip income, its distribution among ETH bill holders, liquidity staking protocols and node custodians is still unclear. Therefore, another potential criterion for judging the pros and cons of liquidity staking protocols is the clear distribution method of tip income.

The difference in the way the tip income is distributed will affect the fundamentals of different ETH liquidity pledge notes at the micro level, while the existence of revolving loans and the future Shanghai Update will affect the value of ETH liquidity pledge notes at the macro level. Currently, almost all ETH liquidity pledge notes are discounted to ETH, even though the ETH note has accumulated a lot of value in the beacon chain. Since ETH notes cannot be cashed and we are now in a bear market with a significant liquidity premium, it is normal for ETH notes to be discounted. But when the Shanghai Update is completed and ETH notes are available for cashing, we may encounter ETH notes reversing the discounted state and generating a positive premium to ETH.

The change of ETH notes from discount to premium is a clear arbitrage opportunity in the market. A few months ago, Three Arrows Capital planned to launch the GBTC arbitrage fund, hoping that the SEC could approve the GBTC ETF to change the fundamentals of GBTC and turn GBTC from discount to premium, but in the end, it failed because the GBTC ETF has not been approved. This time, it may produce a different result.

3.3.3 Development of derivatives based on ETH notes

Derivatives are a very large financial category, not just limited to options, futures and structured products. There are endless types of derivatives in traditional finance, involving all aspects of trading and asset management. In a narrow sense, if derivatives are to be simply classified, they can be roughly divided into two categories: primary derivatives and secondary derivatives. Primary derivatives are financial products or notes derived from native assets, and secondary derivatives are derived from primary derivatives. If the above concepts are explained in the blockchain field, ETH is the native asset; ETH is another certificate minted after being processed by a certain protocol, such as stETH, which is a primary derivative of ETH; and the certificate or product minted by reprocessing stETH is a secondary derivative. At present, primary derivatives can be seen everywhere in the blockchain industry, including atoken minted by AAVE for LP, stETH, and LP Token minted by DEX for LP. These primary derivatives in a narrow sense have a common feature, that is, they are all Yield-bearing Assets. These yield-bearing assets have their own risks and returns. Combining and packaging these primary derivatives or dividing the risks and returns can derive a variety of financial products. The above narrative seems to be in great demand, but it seems that no protocol in this track (Element Finance, Sense Protocol, etc.) has a breakthrough effect.

The specific reasons may include the following three:

• The number of DeFi users on the chain is still small and most of the users on the chain lack DeFi awareness;

• The excessive fragmentation of primary derivative assets makes it difficult for the protocol layer to maintain liquidity for multiple secondary derivatives;

• The volatility of yield-bearing assets is too low for derivatives to work;

Although it is still in the early stages of the development of on-chain derivatives and user awareness is not in place, the gradually mature leveraged trading model and the emergence of ETH notes have solved the problems of low yield volatility and poor liquidity of derivatives. Taking interest rate swaps as an example, the leveraged trading model can amplify the yield volatility of yield-bearing assets, magnifying the original 1% volatility to 5-10 times the original, thereby giving rise to trading demand. In addition, from the perspective of liquidity, the traded yield-bearing assets and their underlying assets need to have deep liquidity to be suitable for development. ETH notes such as stETH are a typical example. Liquidity pledge agreements will account for about 30% of all pledged ETH in the future, that is, at least 10 million ETH notes will be able to enter the DeFi ecosystem in the future. Since ETH notes can be exchanged with ETH instantly in the future, for such a single yield-bearing asset with high market value and high liquidity, it can be foreseen that a large number of income and trading products based on this asset will emerge in the future.

4 Integration of DeFi leading applications and liquidity staking

Finance is naturally monopolistic, which means that whether horizontally or vertically, DeFi protocols have the instinct to continuously expand their business scope and squeeze out competitors' markets. Therefore, for the staking track at the asset source end, the leading DeFi protocol will have the motivation to become a liquidity staking protocol, attracting users' ETH deposits by providing ETH Staking services, and using ETH deposit notes as the asset source to fill the TVL of the protocol itself. This can improve asset utilization on the one hand, and on the other hand, expanding the business scope to achieve upstream and downstream sharing can also increase the protocol's revenue and increase the value of the protocol itself. From this perspective, the ETH Liquidity Staking track in the future will not only have Liquidity Staking protocols, but some old DeFi projects may also enter the market to share a share. However, no matter how the upstream Liquidity end changes, the interests of SaaS service providers or node custodians will not be harmed, and they may even make a profit. Some Liquidity Staking protocols are themselves big customers of SaaS, and the vicious competition on the upstream Liquidity end is essentially beneficial to the downstream validator node custodians. Currently, Frax is developing the ETH Liquidity Staking business and intends to use the fraxETH note as the collateral asset for Frax minting. Using ETH notes as Frax's minting asset can also solve the problem of Frax's over-reliance on centralized stablecoins such as USDC.

5 Public products brought by ETH2.0: Portal Network

The light client of ETH 2.0 is also called a stateless client. It only needs to store block header data, not block status. Therefore, it can only perform transaction verification with the help of a full node. There is no need to stake 32 ETH to run a light client, and it cannot participate in the consensus of ETH 2.0. In the ETH 1.0 version, Infura and Pocket Network provide light client services. The full node has an open IP address, and the light client can connect to the full node to obtain all block data. The Portal Network is a light client node network that Ethereum officials intend to build using non-economic incentives, and is committed to providing a public light client API interface. It is precisely because of the lack of economic incentives that the Portal Network has not yet been launched.

The network layer of Portal Network is integrated through Client\Server, which can provide stateless client. Stateless client allows users to run a very small personal node and query the on-chain data for personal use, making the acquisition of on-chain data by users in the ETH 2.0 stage more Web3. The machine performance required to access Portal Network is extremely low, and even mobile phones can access it. The disadvantage is that it cannot handle large-scale JSON and RPC API data calls. Therefore, personal use scenarios for Portal Network include: personal RPC port, low latency, and more secure connection between Dapp and wallet.

6 Conclusion

The above is just the tip of the iceberg of the narrative in the context of ETH 2.0. Other tracks that have not been mentioned include MEV and cross-chain interoperability protocols. MEV is a well-discussed issue in the POW stage. Both the protocol layer and the client layer have given certain solutions to MEV, and gradually standardized the disordered MEV market. However, after Ethereum switched to POS consensus, the participants in the division of MEV on the chain changed from the original single miner group to major Layer2, CEX, Lido, verification node custodians, etc. The participation of multiple parties also makes the MEV problem of ETH 2.0 more complicated. After the implementation of Danksharding's PBS (Proposer-Builder Separation), the MEV problem can be solved at the bottom layer under the assumption of perfect competition. However, from now to Danksharding in the next few years, MEV still needs a transitional solution, and starting from the application layer and the client is a common approach.

In addition, cross-chain bridges and interoperability protocols will become extremely important ways of cross-shard transactions and communications after ETH 2.0 implements Danksharding. In the original concept of Sharding 1.0 state sharding, transactions between different shard chains can be directly confirmed through the cross-linking of the beacon chain and the shard chain. However, in the Danksharding architecture, Ethereum will implement data sharding, and the execution will be completely handed over to Layer2. Then Layer2 will store the Rollup data in the data shard in the format of Blob, and the data shard will be connected to the beacon chain through cross-linking. If you still rely on the beacon chain as a direct medium for cross-shard communication at this time, you will face two re-encoding and decoding of Blob data, which is not as efficient and convenient as the cross-shard interoperability protocol.

The advancement of the entire ETH 2.0 plan is, to some extent, directly driving the development of the blockchain industry. Every small change in the mechanism may have a profound impact on the trends and patterns of different tracks, and this impact is also invisibly reshaping the entire industry.