In-depth Analysis: Is the Ethereum Merger Overhyped?

Author: Jordi Alexander , CIO of Selini Capital , Source: Bankless, This article is compiled by DeFi

With less than a month until Ethereum’s merge, Selini Capital CIO Jordi Alexander believes Ethereum’s much-anticipated upgrade may be overhyped.

As the most rational analysis to date, this article explains several reasons why the Ethereum merger may be over-hyped.

Is the merger overhyped?

Photo: Logan Craig

On September 16, the sun began to rise.

Vitalik poured a measured bottle of Malbec into his sencha, gave it a quick stir, and took a sip. “Ah… 15.0%, just the right amount.” The hard fork went through like a knife through butter. The long-awaited moment that critics claimed would never come had finally arrived—and it tasted like happiness.

He excitedly typed out a "Mission Accomplished" tweet, thanking everyone who helped make this moment happen. Millions of "likes" poured in, and the mainstream news on TV broadcast cheers.

The future is here, and the road to 5-digit ETH is within reach, and it will surely arrive at supersonic speed.

A new environmentally friendly way of burning gas ignites the deflationary flames of scarcity, powering the flywheel of an asset the likes of which the world has never seen before.

• The only cycle that rises reflexively is the price cycle

• Driven by a deflationary supply squeeze

• Reward excess actual rate of return

• Leading the Ethereum chain dominance

It sounds amazing! But before we get too FOMO-fueled, let’s take a closer look at the following four claims to see which ones actually hold up under scrutiny.

Myth 1: ETH price will spiral upward and enter a super cycle

Arthur Hayes (co-founder of BitMEX parent company 100x) cited Soros’ theory of reflexivity in his popular article “ ETH-flexible ”, stirring up the merger “bull market”.

He predicts that this catalyst will only accelerate the sharp rebound from the July low of $1,000.

His core argument is that the attention that a merger brings will lead to higher prices. It is well known that a surge in the price of a cryptocurrency will attract more attention. Given that blockchain fundamentals such as users, developers, and on-chain activity are all correlated with attention, this will spiral into a virtuous cycle limited only by the size of the Earth’s population!

While this is certainly an appealing psychological framework, we can see two major holes in it—one short-term and one long-term.

In the short term, as Arthur himself acknowledges, excessive expectations could create selling pressure that could overwhelm any fundamental improvements.

In the long run, the relationship between the attention that price increases garner and the burning of more gas may be much more ephemeral than depicted. A counter-argument that we will discuss later in this article is that the reduction in gas usage we have seen in recent months is structural and requires a rethinking of value accrual on layer 1 blockchains.

Let’s first consider possible price action for Ethereum following the merger:

Time and again, we’ve seen much of the same in the crypto space: when there’s a big shiny catalyst on the horizon, there’s massive dip buying support from event-driven players.

Dip buying is driven by the “I know you know I know” sense of the upcoming event, emboldening calculating buyers. Short sellers are deterred by the asymmetric reflexivity of the upside, while retail investors, who are later in the information chain, make a final push when the headlines finally arrive.

Human attention spans are short, especially in crypto. When the shiny new thing grabs headlines, people start betting on the next on-chain upgrade or token economics tweak.

It’s hard to forget that Bitcoin’s all-time high came when the ETF was launched in late 2021.

Or the continued decline in Coinbase’s stock price after the hype surrounding its IPO. Or the continued decline in Dogecoin’s price after Musk’s appearance on SNL.

These most watched moments seem to leave the market completely one-sided and vulnerable, every time.

While there are many Ethereum holders who don’t want to part with their precious currency, there are also some funds and crypto whales who have entered long positions as a tactical event-based trade. Once the headlines die down, short-term players may find themselves in a game of musical chairs to grab their unrealized profits before the music stops!

Will it be different this time?

Myth 2: The “triple halving” puts ETH into a deflationary supply crisis

In a recent post with thousands of shares, Montana Wong laid out the rationale for the catastrophic supply shortages expected following the merger.

The so-called “Triple-halvening” is a term based on the periodic halving of Bitcoin’s issuance (every four years). It is described as the accumulation of three powerful effects that merge into a singular phenomenon. These three factors are the reduction of issuance, destruction, and the locking of staked ETH.

1. Reduced issuance

By no longer having to pay miners to verify transactions on the network, Ethereum is effectively laying off its best-paid employees. This will result in a savings of 13,000 ETH per day in “proof of work” fees.

Instead, the Ethereum security department will be filled by Staking Officers, who will be paid much less in comparison: their entire budget will start at close to 2,000 ETH per day — although over time, the emergence of more Staking Officers will increase the budget to around 5,000 ETH per day.

Nonetheless, a net saving of 8,000-11,000 ETH per day is indeed a significant catalyst, equivalent to removing $15-20 million of daily selling pressure.

Arguably, cheaper security forces might come at the cost of less censorship resistance — but in terms of pure price impact, this factor is undoubtedly powerful.

2. Destruction

EIP-1559 was a strong catalyst for ETH price when it was implemented in 2021, as most of the gas fees paid by users in each block were burned. This partially helped offset the new issuance fees in the security department's budget.

However, EIP-1559 is already a year old, so it is not only already priced in, but likely overpriced: while early burn was so high that ETH supply could have become deflationary, this is far from the case now.

For the ETH price bull run (not to be confused with the ETH technical bull run), this chart has to be astounding. Not only do the days of 10,000+ ETH being burned seem to be gone for good, but as technical analysts have pointed out — there doesn’t seem to be any support levels at all! We have no idea how low this can go.

In the last 30 days of August, the ETH price increased by more than 50%, and gas consumption was only about 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 high levels, this ignores the one-way structural change that is taking place.

Let's start from the beginning:

During the bull market frenzy, there was so much money flowing into the system that participants were willing to grudgingly pay high fees as the “cost of doing business.”

The first wave of “business” was participating in the early days of DeFi. Soon, the fun and legal financial experiment spawned a new wave of Ponzi schemes that leveraged viral marketing ingredients like sky-high APY% and created a free grab of seemingly valuable “food tokens”.

Until the participants figure out where the free money is coming from.

The food tokens that fund liquidity are effectively worth next to nothing, and without them, being a passive LP in AMMs becomes a loss-making enterprise.

As DeFi exploits and rug pulls increased in 2021, and Pool2 prices fell back, the willingness to pay for block space to participate in these games disappeared.

New variants of the game continue to emerge, but even these are kept off the Ethereum mainnet so that PvP pumps and dumps can take place peacefully without additional gas fees.

The DeFi summer is coming to an end.

But then — just as gas costs started to drop — the NFT craze ignited like a firecracker!

As with DeFi, what started as legitimate digital artists and novel algorithmic art quickly turned into a steady stream of knockoff PFP collections.

Most of these projects were created to meet crazy sudden demand and eventually faded into obscurity. But until the market slowly digests and figures out where value will accrue, new minting will be massively oversubscribed and gas will continue to flow.

So what about the few big winners in the NFT and GameFi wave?

As some projects successfully attract sticky users, they realize that they can accumulate more of the overall value themselves instead of letting it be wasted on ETH gas.

This was clearly demonstrated in the disastrous Bored Ape Yacht Club virtual world land sale, which generated $285 million in sales—and wasted a whopping $176 million on gas!

Great for ETH holders, but not so great for the Yuga community.

The event served as a lesson not only for Yuga Labs, but for any other aspiring NFT hotshot.

Whether these projects ultimately decide to avoid these costs by moving to alternative chains (Layer 2), or remain on the mainnet and optimize the auction to eliminate gas bidding, is currently unclear.

What we can say, however, is that the days of burning ETH as we are used to are a thing of the past and should not be extrapolated into the future:

After DeFi and NFTs, will there be a third wave one day, leading to another intense gas burning cycle?

In reality, it is guaranteed that at some point new innovations will emerge that will attract attention. However, it seems unlikely that new popular applications will need to consume a lot of gas to succeed. Technological innovations 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 Layer 2 and AppChain options coming online in the near future to cater to a variety of different use cases, many applications will find a home outside of the Ethereum mainnet.

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

The hope of burn-maxis is that layer 2 chains will create their new vibrant on-chain ecosystem, resulting in large amounts of ETH gas being burned.

That remains to be seen - incentives determine fate, and once a layer 2 chain gains a large, sticky user base, game theory suggests that native layer 2 users will begin demanding localized value accretion rather than paying tribute to Ethereum (the Empire).

3. The pledged supply will be locked

The third narrative is that staked tokens are locked out of the market and therefore cannot be sold.

After all speculative participants have completed their PoW forks and rushed to the exits, staked participants will not be able to withdraw their tokens until the Shanghai fork in 2023.

Of all the optimistic price narratives, this may be the most ill-timed.

Not only has the (over 13 million) ETH on the Beacon chain been off the market, it has been earning revenue unseen. Historically, both PoW and PoS chains have generated rewards, but only PoW emissions have been allowed to be sold.

By the time of the Shanghai fork, ~30m ETH will suddenly be available for unstaking (+ over 1m in cumulative ETH rewards that can be slashed), creating the potential for unstaking queues and a sizeable supply/demand imbalance.

The fact that there will be an unknown time delay before all of these tokens can finally be withdrawn should not be a reason for celebration.

Markets are always forward-looking, and when the next catalyst turns from a highly anticipated merger to a large token unlock with unknown consequences, this will cause the price floor to become unstable as the Shanghai fork approaches.

Myth 3: Staking ETH will become a “yield seeker feeling”

One of the most notable claims from the merger is that a new super asset has been created in Internet Bond, which even Ethereum supporters, including the Ethereum Foundation, have been calling a game changer.

Source: Twitter

Block rewards — nectar from the gods, once available only to an elite group of miners — will now be securely packaged as risk-free yield for everyone to enjoy.

Clean, raw, real gains, straight from the source.

How can institutional treasurers continue to ignore such a sacred high-yield asset when their balance sheets are earning only 3% annual returns?

First of all, we must quickly put aside the concept of corporate buyers. If there is ETH price risk, ETH yield cannot be "risk-free"!

But even for ETH holders, staking transactions for ETH holders are not as magical as people say. Unfortunately, this is perhaps the most misleading of all the merger claims.

In fact, staking ETH provides a yield only in the short term and only for those who bear the technical risk of the merger and the illiquidity premium of the Shanghai fork.

In the year after these risks disappear, Mall Cops who staked ETH would be lucky to get an annual return of 1-2% after the token inflation, even lower than US Treasuries.

But weren’t those researchers and influencers promising exponential growth? How could there be such a disconnect?

As usual - forecasts are made based on historical data and assume their parameters will not change. We have seen that they have wrongly predicted deflation.

So how did the experts get staking yield wrong?

To truly understand, you first need to be able to visualize the blockchain economy. So I paid an Upwork designer $100 to turn my messy sketch into a clean diagram.

The staked ETH generates income because it is required to run the validator. The three sources of income are as follows:

• Block subsidy: from ETH inflation as security cost

• Gas Tips: from users who want to prioritize transactions

• MEV Rewards: Bribes to structure transactions in a certain way

Let’s look at how they work, as they all contribute to the analyst’s stale predictions.

Block Rewards

Earlier this year, only 10m/120m possible ETH was staked on the beacon chain, not even the Ethereum Foundation staked their ETH due to all the future risks.

However, this 10% stake participation is far lower than proof-of-stake chains (~50-80% participation). As merger risks are sorted, more stakers will quickly emerge and join the queue. Currently, there are already about 14 million tokens staked, resulting in a reduction in rewards to 4.1% per validator.

Once the merger is successful, this number will continue to increase to the maximum limit allowed by the queue: approximately 2 million/month.

It’s just a true fact – even if someone wanted to foreclose on their mortgage right now, they can’t!

The impact of more ETH validation is shown in the figure below:

As more and more ETH is validated, not only will the reward rate decrease, but the annual inflation rate will also increase, resulting in a lower actual yield. If staking 100/120M, the reward rate minus the inflation rate will be 1.81% - 1.71% = 0.1% APY.

In some ways, this is a good thing for Ethereum itself. More ETH staked is cause for celebration, as it means more security.

More ETH staked is something to celebrate as it means more security.

• ✅ Successfully attacking a network requires more resources!

But this also applies to a wider range of ETH stakers:

• ✅ Higher annual inflation rate across the network

• ✅ The yield of staking is reduced.

Actual (net of inflation) staking rewards are only high when a small fraction of the supply is staked. Block rewards are a form of inflation at the expense of those who have not yet staked.

It's a punishment for their laziness/risk aversion/inexperience.

Gas Tips

In addition to the decreasing block subsidy rewards that validators already receive, a lot of the hype has been around Gas Tips and MEV bribes, which will only be enabled after the merger.

However, here too, we find that the hype far exceeds the new reality of the moment.

Just as we saw that structural changes lead to burning less gas, the same is true for Tips and MEV:

• ? AMMs have less liquidity for arbitrageurs

• ? Inefficient popular NFT auctions leading to tipping to get a mint

• ? Flashbots silent bidding auction replaces public gas priority auction

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

MEV

Finally, the most discussed but least contributing section is Maximum Extractable Value (MEV).

In proof of stake, the chosen validator that publishes a block acts as a referee for transactions competing for a spot within the block. The referee can be bribed to rig the contest if there is a more profitable order.

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

Bullish, right?

Well, that was supposed to be the era of the Wild West market and UniV2 dominance. But MEV is now being squeezed from all sides, including at the dApp layer (such as CowSwap using batch auctions).

Today, less than $100 million can be extracted from MEV annually, and in the long run it will be just an asterisk in the rate of return equation.

By 2023, we will see 30-60 million staked ETH:

• ~2.5% APY max validator rewards

• +~0.5% Gas Tips

• +~0.1–0.2% MEV

This gives us an annualized percentage yield (APY) of about 3.2%:

• ? About 1.5% of this is token inflation

• ? 0.25–1% to third-party validator operators (unless you own 32 ETH and are a self-funded validator)

Well, not much left.

It turns out being a “security guard” isn’t that lucrative when 80% of the people in town are doing the same job.

A final note on blockchain benefits and costs:

Token economics and the rules for block subsidies and token burns are really important to create the right user incentives, but at the end of the day, they are just PvP games between stakeholders.

A first principles approach to cutting through the noise is to break down the economics of a blockchain into 3 clear parts:

• value

• Currency Ecosystem

• Loss of value

To make a PoS blockchain truly add value, the formula is very simple:

MEV + Gas Fees > Intermediary Payments

? Seekers, staking pools, liquid staking DAOs, centralized exchanges — they’re all ready to get involved! Anything that ends up on a balance sheet is an entropy loss to the blockchain ecosystem.

Ultimately, the path to sustainable development must be through providing users with utility that exceeds the cost of the block space they consume.

Happy, repeat customers are the engine needed to power the entire economy, and efforts to achieve this will have a greater long-term impact than any PvP revenue game.

Theory 4: One true chain that rules everything

• Stronger community and social layer than Memecoins

• Stronger community and social layer than Memecoins

• Better technology and more decentralized than alternative layer 1

• Super-sound money will make BTC obscure

All three narratives could get a major boost from a successfully completed merger:

• The merger captures people’s attention leading to greater user adoption, coupled with the power of ESG-friendly memes.

• The long-awaited and extremely complex technical upgrade has finally been released, continuing on the roadmap to achieve outstanding performance.

• This significant reduction in supply challenges Bitcoin’s inflation rate and positions it as a better reserve asset.

Now, all three of these statements would make for a delicious snack on their own! Put them in the same bowl and their individual flavors would seriously clash.

After the merger, as the roadmaps continued, the different goals began to fundamentally conflict.

Once things move from the theoretical “roadmap” stage to the stage where rigid decisions need to be made, it becomes increasingly difficult to cover all aspects.

Technologies, memes, and stores of value all have a “different” sweet spot on different dimensions. Here are some examples worth considering:

1. Driving technological innovation and staying the same

As other blockchain ecosystems continue to innovate, Ethereum’s technological lead is not enough for it to rest on its laurels. Other chains will not sit idle for the next few decades.

Technology upgrades reset Linde, leaving a larger potential attack surface

• ✅ Technical upgrades reset lindyness and leave a larger potential attack surface

• ? If technological risk is always present, the concept of hard currency cannot be sticky

• ? The way is a bear market - expectations disappear! Memecoins will thrive.

2. 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 to create perverse incentives that allow for short-term value extraction rather than long-term ecosystem health.

Designing around locked tokens can increase scarcity value

• ✅ Designing around locked tokens can increase scarcity value

• ? If the strongest incentive is to hoard tokens, then usage and innovation will move to other chains because no one wants to spend money.

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

• ? The accumulation of currency value desires more MEV and more gas auctions.

3. Efficiency and censorship resistance

PoS improves efficiency in some areas, but also adds an extra layer of complexity, thereby expanding the attack surface.

• ✅ Roadmap for scalability vision moving forward

• ? Decentralized currency requires ultimate censorship resistance.

It is important to strive to balance the efficiency benefits of obtaining the best liquidity staking protocols with the centralization risks they may bring.

4. Solarpunk vs. Lunarpunk

This is probably the most important conflict of all, and is extremely relevant after the recent Tornado Cash code sanctions.

And ETH: Vitalik's vision is a truly decentralized Ethereum.

If it is sanctioned, it can go underground to maintain its censorship-resistant power, even if that means enabling a user-supported soft fork and losing access to centralized stablecoins like USDC and rebuilding oracles.

Or, Ethereum™ can go completely mainstream. Institutional investment money comes in, and in exchange, everyone obeys when Uncle Sam taps them on the shoulder. The incentives for token holders flock to it, drowning out the libertarian dreams of the cypherpunks.

The merger has brought this conflict to the fore, and it may not be long before a crucial decision needs to be made.

If so, let us hope to make the right choice for our community, our ideals, and all our families.

Summarize

• During this period, there may not be enough liquidity to avoid a “sell on the news” event as many people are in profit-taking mode.

• The value of future savings in miner emissions costs compared to before is roughly double the ETH valuation.

• But fees are falling dramatically for structural reasons, and locking up ETH in collateralized derivatives won’t help.

• Checks have been written that can't be cashed - from forecasts of deflation to internet bonds with attractive yields. Reality shows that some of it was indeed overhyped.

• Ultimately, the focus should shift towards better-designed applications, novel use cases for blockspace, and friendlier on-chain user experiences.

• In the end, be a great Batman, or a great Buddha. Maybe don't try to be both at the same time.