Ethereum mergers are overhyped? Expand with these four narratives

The sun will rise on September 16th in the crypto world, Vitalik said after swishing his Malbec and taking a sip, everything is just right. Smooth as a knife and fork through butter, the moment that critics claimed would never come has finally arrived. Vitalik typed a mission accomplished tweet, officially announcing the successful completion of the merger, thanking everyone who contributed to the arrival of this moment, and millions of crazy fans flocked to it as mainstream media spread the news.

The future is here, and 5-digit ETH is just around the corner, coming at supersonic speed. Driven by inflation, ETH prices are entering a spiral upward cycle. Stakeholders will receive huge actual returns, and Ethereum will become a hegemonic existence in the crypto industry.

This scenario is playing out in the minds of countless people, but before we start preparing funds or even looking for private money from sofa cushions to buy ETH, let us first look more closely at the following four narratives and think about which one is closer to the actual situation.

Narrative 1: News and rumors abound: Ethereum price will spiral into a super cycle

Arthur Hayes once expressed his opinion in the ETH-flexible post, singing the praises of the Ethereum merger. He used Soros's reflexivity theory to predict that the benefits brought by the merger would not stop with the end of the merger, but would accelerate the sharp rebound of ETH prices from the July low of around $1,000.

His central argument is that the merger will lead to higher prices for ETH, and the surge in the cryptocurrency will attract more attention. Users, developers, and on-chain activity are all related to attention, so Ethereum will enter a virtuous cycle of global scale.

Although this is a seemingly reliable theoretical framework, when we look at this inference from both short-term and long-term perspectives, we will come to different conclusions.

In the short term, as Arthur Hayes said, market expectations and the promotion of good news will lead to a sharp rebound in the market. But in the long term, although the price of ETH has risen sharply, the gas fee burned has continued to fall, which makes us rethink the value accumulation of L1 blockchain.

First let’s consider the possible trend of ETH after the merger:

We see the same thing happen again and again in the crypto market: when there is a huge positive news, a large number of participants buy in. Buying on the dip is driven by the expectation that the event is about to happen, short sellers are scared off by the big rise in the market, and when the event occurs, the lagging receivers in the information chain make the last buying action.

However, people’s attention span on the same thing is short, especially in the crypto space. When the shiny new thing makes the headlines, the next upgrade or token economics adjustment has already begun. When the market reaches maximum saturation and attention, the market will be completely one-sided and prone to reversal every time. There are already crypto funds and whales that have started to hold long positions based on this historic event.

When the merger is over and the news dies down, can the short-term players capture their unrealized profits when the music stops? In a macro backdrop that many expect to be extremely challenging, it is extremely difficult to maintain the myth of continuity.

Narrative 2: The “Triple Halving Effect” puts ETH into a deflationary supply crisis

In one of the thousands of recent reposts related to the deal, Montana Wong suggested that there would be catastrophic supply shortages following the merger.

The so-called “triple halving effect” means that similar to Bitcoin, its supply will be halved every four years. Ethereum will superimpose three powerful effects into a single phenomenon, which will make ETH more scarce.

Effect 1: Reduced issuance

After the merger, Ethereum will gradually "lay off the highest paid employees", and the Ethereum network will no longer need to pay miner fees to verify transactions on the network. This will result in a daily saving of nearly 13,000 ETH. Instead, the security of Ethereum will be guaranteed by stakers, who will have much lower salaries, with a daily budget of only 2,000 ETH initially, and will increase to 5,000 ETH as more stakers are added. A net saving of 8,000-11,000 ETH per day is indeed an important positive news, as nearly $20 million in market selling pressure has been eliminated.

Effect 2: Increased Gas Fee Consumption

The implementation of EIP-1559 in 2021 was a powerful catalyst for the rise in ETH prices at the time. Most of the gas fees paid by users in each block were burned, which helped offset some of the inflationary issuance of new tokens. However, the inflation-offsetting effect of gas fee burning after the deployment of EIP-1559 may have been overestimated.

As can be seen from the chart, the days of more than 10,000 ETH burning per day seem to be gone forever, and as technical analysts point out, there is currently no support line. We are also unable to determine where the bottom is. In the past 30 days, the price of ETH has risen by more than 50%, while the gas fee consumption is only 1,300 ETH per day.

While ETH bulls will claim that this is simply due to the cyclical nature of cryptocurrencies and that fees paid will eventually return to highs, they are ignoring the one-way structural change that is taking place.

During the bull market frenzy, a large amount of money flows into the system, and even if participants are not very willing, they will still pay high fees to participate in the activities. The first wave was the early development of DeFi, where creative and legal financial innovations used viral marketing strategies such as high APY prices to trigger a new wave of Ponzi schemes and create a seemingly hot airdrop and liquidity mining feast.

The party won’t end until participants figure out where the free money is coming from. If they don’t become passive LPs in AMMs, the tokens that fund liquidity are actually worthless, and the project will eventually become a loss-making enterprise. With the frequent DeFi vulnerabilities in 2021, hackers making huge profits from the protocol, and the decline in the price of the second pool, the market’s enthusiasm for such activities has gradually dissipated, and the DeFi summer has ended.

However, just as gas fees were decreasing along with the decline of DeFi activity, the NFT craze suddenly hit, and similar to DeFi, what started as legitimate digital artworks and novel algorithmic art quickly became the target of plagiarism by a steady stream of PFP copycats.

Most of these projects were started to meet the market's enthusiasm, and most of them gradually dissipated from the enthusiasm of the opening, and finally fell into obscurity. Before the market selects truly valuable NFTs, new project NFTs will be oversubscribed in large quantities, and a large amount of gas fees will continue to be consumed.

When the few winners in the NFT and GameFi wave succeeded in attracting sticky users, they realized that they could accumulate more value themselves instead of wasting it on ETH gas fees. The phenomenon of gas fee consumption was clearly reflected in the Bored Ape Yacht Club virtual world land sale, which sold $285 million in land and had a gas fee of $176 million. This is good for ETH holders, but cruel for the Yuga community. This sale is a lesson that needs to be learned for Yuga Labs and other popular NFT communities.

While it is unclear whether they will eventually move to an L2 blockchain to avoid this recurring cost, or stay on the mainnet and optimize the auction process to eliminate gas fees, we can be sure that the days of high burn fees like in the past may not be seen in the future.

Imagine that after DeFi and NFT, will there be another new wave one day that will lead to high gas fees again?

In fact, innovations that attract attention are bound to appear at some point. However, if new popular applications need to consume a lot of ETH Gas to succeed, the project will definitely find a way to avoid high Gas fees through technical innovation. Make block space less scarce:

• Even in existing high-usage applications, code efficiency is improving rapidly. For example, OpenSea transactions are now 35% more efficient and consume much less gas.

• With countless L2 and application chains coming online in the near future to cater to a variety of different use cases, many applications will find a new home outside of the Ethereum mainnet.

• For those who stay on L2, writing state on Ethereum L1 on L2 will become cheaper over time using EIP 4844 (proto-danksharding).

L2 blockchains may create new vibrant on-chain ecosystems, leading to large amounts of ETH gas fees being burned, but this remains to be seen. Once L2 blockchains gain a large and sticky user base, users in the ecosystem will begin to demand localized value-added rather than transferring value to the Ethereum network.

Effect 3: Staked Supply Will Be Locked

Once ETH is staked, it will not be possible to sell it off-chain. After all speculative participants have completed the fork, participants who participated in the stake will not be able to withdraw their tokens until the Shanghai fork in 2023.

Of all the optimistic price narratives, this is probably the most false. Not only has the (over 13M+) ETH on the beacon chain been unstaked, it has been earning yield unseen. Both PoW and PoS chains generate rewards, but only PoW rewards are allowed to be sold. By the time of the Shanghai fork, ~30M ETH will suddenly be unstaked (+ over 1M of cumulative ETH rewards flowing out at the same time), creating the potential for a sizable supply/demand imbalance.

The market is always forward-looking, and when the next catalyst turns from a highly anticipated merger to a large token unlock with unknown results, it will greatly increase the probability of price breaking through the lower limit.

Narrative 3: Staked ETH will become an important bargaining chip for those seeking beneficiaries

One of the loudest narratives from the merger is the creation of a new super asset in internet bonds, which even Ethereum supporters including the Ethereum Foundation have been calling a game changer.

Source: Twitter

The much-anticipated block rewards, once available only to the mining elite, will now be securely packaged as risk-free yield for all to enjoy. How can institutional treasurers continue to ignore this sacred high-yield asset when their balance sheets are earning a paltry 3% annual interest?

First, quickly discard the notion that corporate buyers are subconsciously taking on ETH price risk, and that ETH yields cannot be risk-free! But even staking deals for ETH holders are not as magical as they are represented to be. Unfortunately, this is probably the most misleading of all the Merge narratives, and it can quickly turn into disappointment. Internet Bondooors will eventually be forced to remember the most basic rule: there is no such thing as a free lunch.

What do the anonymous security guards expect when the risk is gone? They don’t seem to have done any useful work and have no skills. They just bought the tokens and clicked the stake button on the website. This only works in the short term for those who take the technical risk of the merger and the illiquidity premium of the Shanghai fork. Over the past year, staking Ethereum has earned 1-2% APY after token inflation, which is even lower than US Treasuries.

Why is there such a disconnect? It is risky to make predictions based on historical data and assume that parameters will not change. We have seen that they have incorrectly predicted deflation due to incorrect estimates of gas consumption.

Because staking ETH requires running a validator, it will generate income. The sources of title yield are composed of three:

• Block Rewards: New tokens from ETH inflation

• Gas tips: from users who want to trade first

• MEV Rewards: Organizing Transactions as Bribes

Now let's see how they work?

Block Rewards

Earlier this year, due to concerns about all the risks ahead, only 0.083% of ETH was staked on the beacon chain. Even the Ethereum Foundation did not stake their ETH . However, this less than 10% stake participation is far lower than other proof-of-stake chains (~50-80% participation). As the risk of mergers decreases, more stakers will quickly emerge and enter the staking queue.

This is where the main dilution in the returns comes from, with around 14M tokens now staked, the rewards per validator are reduced to 4.1%. Needless to say, after a successful merge is released, this number will continue to increase to the maximum allowed by the queue: around 2M/month. It's just a fact that even if someone wanted to unstake now, they couldn't.

The impact of more ETH staking is as follows:

As more and more ETH is staked, not only will the reward rate decrease, but the annual inflation rate will also increase, resulting in a lower actual yield. In extreme cases, if 100~120M is staked, the reward rate minus the inflation rate will be 1.81%-1.71%= 0.1% APY. In some ways, this is good for Ethereum itself, more ETH staked equals higher security, and it costs more to attack the network.

The real (net of inflation) staking rewards are only high when a small fraction of the supply is staked. The block reward is a form of inflation that rewards stakers at the expense of those who haven't staked yet. It's a punishment for being lazy, risk-averse, and immature.

Gas tips

Aside from the dwindling block subsidy rewards that validators have been receiving, a lot of the hype has been around the other part of the equation: Gas Tips and MEV bribes, both of which will only be enabled after the merger.

However, we also found that the hype far exceeds the current status quo. Just as we saw structural changes leading to burning less gas fees, the same is true for Tips and MEV:

• AMM liquidity decreases, arbitrageurs bid first to be removed

• Inefficient popular NFT auctions lead to minting at low fees

• Flashbots Silent Bidding Auction Replaces Public Gas Fee Priority Auction

From over 50,000 ETH per month in its heyday, Gas tips have been below 20,000 ETH per month in recent months and may continue to spiral downward.

MEV Rewards

Finally, let’s discuss the part of the equation that contributes the least but is the most discussed, MEV rewards. In Proof-of-Stake, the selected validators who publish blocks act as referees for transactions competing for a position within the block. Referees can be bribed to manipulate the competition if there is a more profitable order.

While this sounds like a malicious dynamic, it’s actually better than the alternative that creates an unstable system. Flashbots is creating a product called MEVBoost to make these bribes transparent and available to all referees, meaning ETH stakers are more likely to get their “fair share.”

This may seem like a bullish catalyst, but MEV is being squeezed in various areas including the dApp layer, such as CowSwap which uses batch auctions.

The value that can be extracted from MEV today is less than $100 million per year, and in the long run it is only a tiny part of the yield equation.

A more real case

By 2023, we will see 30-60 million ETH staked, which will have a 2.5% APY maximum validator reward, 0.5% Gas tips, and 0.1%-0.2% MEV boost, which sums up to about 3.2% APY. This also includes 1.5% token inflation and 0.25%-1% third-party validator operator costs. There really isn't much left.

A Final Note on Blockchain Revenues and Costs

Token economics and the rules for block subsidies and token burns are indeed important for creating proper user incentives. But at the end of the day, they are just PvP games between stakeholders. The first way to see through the essence is to break down the economics of a blockchain into 3 clear parts:

• value

• Token Ecosystem

• Loss of value

For PoS blockchain to truly add value, MEV + Gas fees > intermediate payments need to be met. Ordinary users, staking pools, liquid staking DAOs, centralized exchanges, etc. are all ready to participate, and anything that ends up on the balance sheet is an entropy loss to the blockchain ecosystem. To maintain sustainable development, users must be provided with utility that exceeds the cost of the block space they consume. The continued use of users is the engine that drives the entire economy, and achieving this goal will have a longer-term impact than any PvP revenue game.

Narrative 4: A true ecological blockchain will be born

The merged Ethereum is expected to have a stronger community and social layer than meme tokens, better technology and more decentralization than Alt-L1s, and its price will rise rapidly and may even surpass BTC. All expectations come from a successful merger. For example, after the merger, many users will adopt the Ethereum network. Ethereum will also continue to move forward on its roadmap of superior performance, while its supply will be greatly reduced, and it is expected to challenge BTC to become a better reserve asset.

Each of these stories seems very plausible, but when they are compared side by side, serious conflicts arise.

Technology, Meme, and Savings Value, each has a best story from their respective dimensions, here are some examples to consider.

Driving technological innovation and maintaining the status quo

As other blockchain ecosystems continue to innovate, Ethereum's technological leadership is not enough for us to rest easy. However, technological upgrades and resets will leave greater potential loopholes, making it easy for hackers to cause losses. If technology sharing continues, the concept of hard currency will not be credible.

Added value and good user experience

While users and holders are not entirely distinct groups, combined token holders have increasing influence over decision making. There are countless ways that perverse incentives could be created that allow for short-term value extraction rather than long-term ecosystem health:

• Designing around locking up tokens can increase scarcity value

• If the strongest incentive is to hoard tokens, then the value of usage and innovation is greatly reduced.

• Technical improvements aim to reduce MEV and lower gas fees through more efficient code and transaction dApps such as Cowswap.

• Token value accumulation requires more MEV and more value auctions.

Efficiency and censorship resistance

PoS improves efficiency in some areas, but also adds additional complexity, thereby expanding the possible attack surface.

• Memeing about 99.9% ESG returns are astounding

• Roadmap for Scalability Vision Moving Forward

• Decentralized currencies will face the ultimate censorship resistance.

How to strike a balance between the efficiency advantages of winner-takes-all liquidity staking protocols and the potential centralization risks is a question worth pondering.

Centralized or decentralized?

This is perhaps the most important conflict of all, and one that has gained particular attention following the recent Tornado Cash sanctions. If Vitalik’s vision of a truly decentralized Ethereum is realized, then Ethereum will have the dynamism to remain censorship-resistant, even if that means users could initiate a soft fork and lose access to centralized stablecoins like USDC and rebuild oracles.

Or Ethereum becomes a fully mainstream centralized blockchain, and institutional investment money will pour in, but in exchange, everyone will have to obey when the sovereign government taps on the shoulder. The incentives of token holders will converge towards the libertarian dream of the cypherpunks.

The merger has brought this conflict to the fore, and it may not be long before a decision is needed, and of course we all want to do the right thing for our community, our ideals, and all our families.

summary

There may not be enough liquidity during this period to avoid selling pressure from bad news, as many people are already in the profit-taking stage. The valuation of ETH that saves miner selling pressure is about twice as much as before. Due to structural problems, gas fees are falling sharply, which ultimately makes ETH useless as a collateral derivative. Due to expectations of deflation, the expectation that Ethereum will become a super bond with very attractive yields is indeed somewhat exaggerated. Rather than price, the end point should turn to better designed applications, novel use cases for block space, and more friendly on-chain user experience.

The wise say, be a great Batman, or a great Buddha, but don't try to be both at the same time.