Ideal investment strategy during Ethereum merger

Liquidity staking protocols will be the biggest fundamental beneficiaries of this merger (even more than ETH).

The merger will cause a massive structural shift in Ethereum as fees will effectively drop to zero. This shift will create the first massive structural demand asset in the history of cryptocurrency. This article highlights the positive aspects of Ethereum's core model and some key fundamentals such as supply reduction and staking ratio after the merger.

The biggest change since December is a significant drop in fees denominated in ETH. However, while fees have dropped, active users have been trending steadily upward since late June.

This may seem inconsistent, as more users should lead to higher gas fees. However, we believe this dynamic is caused by recent efficiency optimizations in various popular Ethereum applications. For example, Opensea improved gas efficiency by 35% when migrating the Seaport protocol. This led to a decrease in gas, but was not associated with a drop in on-chain activity.

In fact, multiple indicators show that despite low gas readings, on-chain activity has been increasing recently. This raises an interesting question: What is the optimal operating fee rate for Ethereum? Higher fees mean more ETH is consumed, and when combined, they are also associated with higher staking rates, but these higher fees also limit Ethereum adoption.

As we saw in 2021, when fees get too high, some users flee to other L1 ecosystems. Ethereum should be able to achieve high fees and sustained adoption when properly scaled. It's interesting to think about the optimal portfolio in the current environment. We believe the best fit would be fees high enough to burn all newly issued tokens. This would keep ETH supply stable while keeping fees low enough to not inhibit adoption. Interestingly, recently, fees have found a balance. Lower fees also appear to be having a positive impact on gaming adoption, with active users starting to increase after a long downward trend.

While we appear to be close to an optimal fee run rate, reduced fees do have a negative impact on the outputs of various models. This impact is not material, however, as at the current run rate the burn is still large enough that ETH will be slightly deflationary after the merger. Importantly, the current run rate will continue to drive structural demand, as the majority of issuance is unlikely to be sold, and the fees used must be purchased on the open market.

The post-merger staking ratio will increase by about 100 basis points, from 4.2% to 5.2%. However, this does not properly capture the true impact. To fully appreciate this shift, we must evaluate the actual yield, not the nominal yield. While the nominal yield is currently about 4.2%, the actual yield is close to zero because 4.4% of new ETH is issued each year. In this case, the actual yield is currently about 0%, but will increase to about 5% after the merger. This is a huge shift and will create the highest actual yield in cryptocurrency by a large margin. The only other comparable yield is BNB, which has a real yield of 1%. ETH's 5% yield will be market-leading. What is the significance of this yield?

Stakers will receive a net 5% interest rate, which is equivalent to 100/5 = about 20 times the return. This multiple is much lower than the return multiple because the staking participation rate is low, which means that stakers receive a disproportionate share of the total rewards. From an investment perspective, this is one of ETH's key advantages.

There are many other uses for ETH throughout the crypto ecosystem, and most ETH ends up being locked in these applications rather than being staked. This in turn allows investors to earn super high actual yields.

In terms of flows, ETH will transition from ongoing structural outflows of ~$18m/day to structural inflows of ~$300k/day. Our estimate of the reduction in ETH-denominated supply is actually larger than before. This is due to the fact that the price drop from the highs was not accompanied by a corresponding drop in hash rate. As a result, miners' profitability has dropped significantly and they may sell close to 100% of their ETH.

For the sake of calculation, I assume that 80% of miner-issued tokens have been sold. In this scenario, ETH finds an equilibrium where miners sell approximately 108k ETH ($18m) per day. Given that average fees are around $2m, this would result in a net outflow of $16m. After the merger, this selling pressure will drop to zero, and a structural inflow of approximately $300k/day is expected after the merger.

In summary, while many of the data have changed significantly over the past 8 months, the conclusion remains largely the same: ETH will go from needing $18 million in new money entering the asset to prevent prices from falling, to needing $300,000 in money exiting the asset to prevent prices from rising.

In summary, collateralization rates and structural demand are down from 6 months ago. However, this is to be expected during a period of slowing economic activity, and if economic activity continues to rebound, these rates will rise. The main investment case remains the same, and there is a huge opportunity to get ahead of the largest structural shift in the history of cryptocurrency.

Another point that is often overlooked is that the merger is not just a shift in supply and demand. It is also a massive fundamental upgrade for Ethereum as the network becomes more efficient and secure in many ways. This is one of the differences between the merger and the previous BTC halving.

Finally, there are two factors worth discussing.

The power of yield and time

Before addressing how the merger relates to ETH, it’s important to first lay some background foundation.

Why has the S&P 500 (SPX) or almost any US/global stock index been such a long-term profitable and stable investment vehicle? Most people believe that this trend is almost entirely driven by earnings growth and P/E expansion. They would assume that if economic growth slows, or if multiples stop expanding, these investments are unlikely to have positive returns in the future. This is incorrect.

The primary and most reliable source of price growth for these indices is time.

Here’s an example to illustrate this point. Lemonade Stand = Business, Lemon Token = Lemon Stock, Earning $1 per year. There are 10 shares of Lemon Stock outstanding. Lemonade Stand has no cash or debt on its balance sheet. The market currently values ​​$1 of earnings ex-growth stock at 10x. How much is Lemonade Stand worth now? What about each Lemon?

If we assume that the lemonade stand will continue to make $1 per year next year, and the market is the same multiple, what will the lemonade stand/lemon token be worth in a year? Take a minute to think about the answer.

If you answered $10/$1 to the first pair of questions, you are correct. If you answered $10/$1 to the second pair, you are wrong. In the first part, Lemonade Stand is worth $10 because the market values ​​its $1 of earnings at 10 times and the value on its balance sheet is $0. In the second part, the market still values ​​$10 for $1 of earnings, but importantly, it also assigns $1 to the $1 of cash on the balance sheet of Lemonade Stand. Lemonade Stand is now worth $11, with each share worth $1.10. When a company makes money, the money doesn't disappear, it flows into the company's balance sheet and its value flows to the owners of the business (equity holders). Despite zero growth and zero multiple expansion, the Lemon Tokens appreciated 10% in one year due to the earnings they generated.

This is the power of yield and time.

Cryptocurrencies have not benefited from this dynamic at all. In fact, cryptocurrencies have actually been affected in the opposite way. Since almost all crypto projects have expenses greater than their revenues, they must dilute their holders in order to generate the necessary funds to make up for their negative net income. Therefore, unless earnings grow or their multiples expand, the price per token will decline. The most notable exception I can think of is BNB, which is currently the only L1 with revenue greater than expenses.

It’s no surprise that the BNB/BTC chart is up in nature, having recently broken its highest historical price (ATH).

When ETH transitions to PoS, it will enter this exclusive category. The combined ETH will generate a real yield of about 5%. This yield will be very different from almost all other (non-BNB) L1s, where the investment yield comes solely from inflation to offset the yield. ETH holders, all else being equal, will receive 5% per year. For 99.9% of other projects, time will be the catalyst.

This will also change the psychology of holders, incentivizing them to adopt a stronger long-term buy-and-hold strategy, effectively locking in more illiquid supply. In addition, the "real yield" thesis and the fact that ETH will be the first large-scale real yield crypto asset will be particularly attractive to many institutions and should help accelerate institutional adoption.

The merger panic

Over the past few months, investors have been extremely skeptical about technology risks, edge cases, and timing risks.

A recent edge case that has received attention is the possibility that a PoW fork of Ethereum will continue to exist after the merge. Some PoW maximalists (miners, etc.) prefer PoW ETH and believe that the current forked version of ETH is superior to ETC, which already exists as a PoW alternative. We don't think there is much value in forking, but our views on this issue are not particularly relevant.

The important point is that this fork will have no impact on the merged PoS ETH. All potential risks are either easily manageable or not a risk at all. For example, replay attacks will most likely not be a problem because it is unlikely that the PoW chain will use the same chain ID. In addition, even if they maliciously choose to use the same chain ID, this can be managed by not interacting with the PoW chain or sending assets to the split contract first.

Finally, even if a user were to be hit by a replay attack, it would only affect that user’s personal assets, not the health of the chain as a whole. What the PoW fork does do is provide dividends to ETH holders, further increasing the value of the merger. If there was any value in the fork, ETH holders would be able to send it to exchanges and sell it for additional capital, much of which would be recycled back into PoS ETH. While we believe this is positive for the investment case associated with the merger, many are concerned about the potential risks and a host of other edge cases. We weighed each of the risks and concluded that the pros far outweigh the cons.

Still, these concerns have sidelined many long-time Ethereum believers.

As we get closer to the merger, many of these issues will be resolved. Eventually, many Ethereum skeptics will "come around," creating momentum for continued capital inflows as the merger approaches, and ultimately a large number of buyers will buy ETH on the day the merger is successful. This should help offset any "sell-off" dynamics.

Just last month, less than a third thought the merger would happen before October. Now, that date has been confirmed as mid-September, but the market still sees only a two-thirds chance of it happening before October.

Against this backdrop, how should we expect prices to move as the merger approaches?

First, we acknowledge that despite the merger, macroeconomics will continue to have a significant impact on absolute price levels. However, it is also important to consider how merger-related alpha will develop in the coming weeks. It is always difficult to take the first step, but the bridge will be straight.

Short-term traders

Despite the narrative that has built up around this merger, positioning remains fairly relaxed among the more casual segments of the market. Perpetual funding has been negative throughout much of the rally since June, suggesting there are more bears than bulls in the perpetual market.

Another notable discretionary ETH exposure, Bitfinex’s long position, was recently reduced to a low.

In my opinion, this lower positioning may be because many of the larger players believe this is a "bear market rally" and therefore want to hedge if we continue higher.

Historically, there is a large group of investors who tend to favor the direction of BTC maximization and always want to downplay the consolidation narrative. Their arguments mainly revolve around one of two central points.

The first is: “It’s been 6 years and 6 months since the merge.” The second is about technical/execution risk. Earlier this week, after the final testnet Goerli was successfully merged, the core developers set a target for the mainnet merge on September 15-16. All that’s left is coordination.

While many are concerned about execution risk, upgrades have been extremely rigorously “stress tested” for years and cross-checked by many teams. In addition, one of Ethereum’s core pillars is resilience. This is why there are so many different clients — like a safety net to protect against a single edge case or bug. It would take multiple (usually more than two) unrelated fluke events to occur simultaneously to affect the protocol.

With this inherent resilience, the most accomplished development team in the field, and years of preparation, technical problems (although risky) are unlikely to arise.

Given investors’ cautious positioning and the continued desire for “fade” trades, I expect the next four weeks to follow similar market conditions as the previous four weeks. There will be clear periods of fear when people overanalyze extreme situations. However, I do not expect the price declines during these periods to be as large as there are many underexposed institutions looking to add exposure on any weakness. Additionally, almost everyone who sells ETH in the coming weeks is only selling strategically with the plan to buy back at some point before or after the consolidation occurs.

This dynamic implies a measured net outflow. On the other hand, I expect the hype around the merger to be amplified as the merger date approaches and mainstream media reports on it. I believe this article is very convincing to both institutional and retail capital, and I expect inflows to accelerate as the merger approaches, creating higher highs and higher lows.

What will happen once the merger actually happens? Normally, one would think there will be a risk of a "sell on the news" reaction; many investors are concerned about technical risk and plan to buy after the merger. They believe they will get the structural effect of the merger without the technical risk. The post-merger period will also depend on how much FOMO is generated as we approach the merger and position.

We expect a lot of buying and follow-through after the merger because the merger effectively "de-risks".

Medium-term traders

We expect a period of range-bound trading as short-term traders sell off, and this selling flow will be absorbed by structural demand and larger, slower-moving institutional accounts. Price action during this period is less predictable and depends on the macro environment. As I said before, macro is hard to predict.

The macro environment for cryptocurrencies is driven by one core metric: whether adoption is growing, stable, or declining. This metric is influenced to some extent by the broader macro environment, but ultimately it's the adoption metric that matters most. The reason this metric influences price is that adoption in the space also drives capital inflows or outflows over the long term. Simply put, when users adopt cryptocurrencies, they also typically commit new capital to the crypto ecosystem, which is what drives the macro. When adoption is declining, the macro is hostile, when adoption is flat, the macro is neutral, and when adoption is growing, the macro is accommodative. So, what is the macro situation like today?

For most of the last 8-9 months, we have been in an environment of declining adoption, with a net outflow of users leaving the ecosystem.

Daily active users were trending downwards from May 21st through the end of June. Over the past 6 weeks we have seen a nascent recovery with users steadily increasing. These are green shoots of recovery and suggest a possible thaw in the macro environment. We were in a declining adoption phase and now we are at least entering a steady adoption phase and likely an increasing adoption phase. There have been a few other “green shoots” recently.

After weeks of redemptions, Tether slowly began minting new tokens, and new money began to enter the space after a long period of capital outflows.

This effect is not unique to the Ethereum ecosystem, AVAX has also recently seen an increase in daily active users.

NFT users and transactions have been stable recently.

Some online search results for cryptocurrency have begun to show positive results.

This is not a huge surge, like the exponential growth we saw at the beginning of the bull market in 2021. That's why I call them "germination phases". Because they are still young and fragile. They can die at any time, but if they are carefully cultivated, they can become influential.

We believe that the broader macro environment will play a key role in determining whether these “green shoots” live or die. For us, inflation is the most important macroeconomic variable. Therefore, if inflation slows and allows the Fed to adjust and ease monetary policy, there is a good chance that these “green shoots” will become stronger. However, if inflation remains high and the Fed is forced to continue tightening policy, they will most likely “suffocate and die.” After evaluation, we believe that slowing inflation is the most likely outcome, which should give these “green shoots” a chance to bloom.

Another advantage in favor of a more durable bottom is that a large amount of investment that was initiated by projects over the past 24 months has now been absorbed. In addition, with most projects down 70-95%, the USD notional outstanding for all future vestings has also been significantly reduced. These two dynamics combined should help to meaningfully reduce the total daily supply that the crypto space must absorb.

Finally, we believe the last variable influencing this equation is consolidation. Investors underestimate the impact of consolidation on the macro environment of the entire space. There is some uncertainty as to the extent to which supply reductions caused by previous Bitcoin halvings drove subsequent price action, rather than just coincidentally aligning with natural cycles in human sentiment and monetary policy. We sympathize with these uncertainties and believe there was an element of luck in the timing. However, we believe supply reductions also had an impact, and the truth is likely somewhere in between. Another common criticism is that supply changes do not drive price, it is changes in demand that matter. We disagree with this idea. A supply reduction is no different than an increase in demand.

Let's assume that miners are selling 10k ETH/day, and instead of getting rid of this selling pressure, we simply add 10k ETH/day of buying pressure. This will have the exact same effect as removing miner selling pressure, but it will be a change in demand, not a change in supply. Clearly, both options have the same impact, and therefore, we don't see why one is more important than the other.

If we believe that the Bitcoin halving has impacted crypto macro, then consolidation will also impact the macro picture. While Ethereum’s dominance was significantly lower than BTC’s at the last halving, the impact of consolidation was almost as large as the impact of the previous BTC halving on the total crypto market cap as a percentage of total market cap, and significantly larger on an absolute basis.

The combined cryptocurrency will have about $16 million less in daily supply. This is not an insignificant number. To appreciate this, one needs to consider the cumulative impact.

We think a TWAP (time weighted average price) of 70k ETH per week will have an impact on the market. This is the effective impact that the merger will have, unless it stops after a year. Or continues forever. This has the potential to have a positive impact on the entire crypto space as positive flow effects flow into other parts of the market. This will provide an additional macro wind direction to help nurture the "germination stage" we mentioned earlier and increase their chances of survival.

There is a good chance then that what initially began as a rebound from a capitulation bottom will evolve into a more sustainable, organic recovery, and consolidation should aid that process.

Long-term traders

In the long term, the future becomes easier to predict because structural flows are most important and easier to predict in this timeframe. This is where the impact of the merger is most significant. We believe that as long as Ethereum continues to see network adoption, structural demand will continue to exist and further capital inflows will also exist. This should lead to sustainable and sustained appreciation for many years to come, especially compared to other tokens. We expect Ethereum to surpass Bitcoin as the largest cryptocurrency in the next few years because we believe that flow is the most important variable in cryptocurrency. Ethereum will always have a tailwind after the merger. Bitcoin will always face headwinds. See the BNB/BTC chart for possible changes.

BNB/BTC has steadily grown in this bear market and created multiple new paths despite little narrative momentum. We believe this is primarily because BNB is the only L1 with structural demand. The merged Ethereum will have greater structural demand than BNB both on an absolute and market cap weighted basis.

Investment Strategies for Winning Mergers

1. ETH/BTC

We believe that PoS is a fundamentally more secure system. First, PoS has a lower cost per unit of security. To understand why PoS provides more effective security than PoW, we first need to explore how these consensus mechanisms generate security. The security of a consensus mechanism is equivalent to the cost of a 51% attack on it. The efficiency of the system can then be measured by the cost (token issuance) required to generate a unit amount of security.

In other words, how many dollars does the network need to pay to get $1 of protection from a 51% attack. For PoW, the cost of a 51% attack is primarily the hardware required to get 51% of the hash rate. A related metric is how much it costs a miner to invest $1 in mining hardware. The calculation tends to be close to 1 to 1, meaning that miners need a 100% annual return on their investment, or in other words, they need to issue $1 of tokens per year for every $1 they spend on hardware and utility. In this case, the network needs to issue about $1 of supply per year to generate $1 of security.

In the case of PoS, stakeholders do not need to purchase hardware, so the question becomes what return do stakeholders need to lock up their stake in the PoS consensus mechanism?

Generally speaking, stakers require a much lower rate of return than the 100% rate of return that miners typically require.

The main reason is that there is no added cost expenditure and their assets do not depreciate (mining hardware usually depreciates close to 0 after a few years). The required interest rate should generally be in the range of 3-10%. As we calculated earlier, the current estimated 5% combined holding rate falls right in the middle of this range. This means that to obtain $1 of securities, PoS needs to issue $0.03-$0.10 of tokens. This is 10-33 times more efficient than PoW (20 times higher in Ethereum's PoS).

To sum up, this means that a PoS network can issue about 1/20 of what a PoW network issues and be just as secure. In the case of Ethereum, they will actually issue about one-tenth of the issuance, and the security of the network will be twice as high as during PoW.

This efficiency isn’t the only advantage. Both consensus mechanisms share a common problem in that the security of the chain is correlated to the price of the token. This has the potential to create a self-reinforcing negative feedback loop where a reduction in the token price leads to a reduction in security, which leads to a reduction in confidence and drives a further reduction in the token price, and then repeats. PoS has natural defenses against this dynamic, while PoW does not. The attack vectors of PoS are much safer than those of PoW.

First, to attack a PoS system, you must control a majority of the stake. To do this, one must purchase at least the same amount of tokens as are held on the market. However, not all tokens can be sold. In fact, a large portion of the supply has never been traded and is effectively illiquid. Also, and most importantly, with every token acquired, it will become harder and more expensive to acquire the next one.

In the case of Ethereum, only about 1/3 of tokens are liquid (have moved in the last 90 days). This means that once a steady-state staking ratio of close to 30% is reached, it becomes very difficult to attack the network, no matter how much capital one has. An attacker would need to buy up the entire liquidity supply, which is impractical and nearly impossible.

Another important feature of this defense mechanism is that it is relatively insensitive to price. Because the limiting factor for the attack is the liquidity supply, not the currency, it is not easy to attack the network at a low price. If there is not enough liquidity supply (measured as a percentage of total tokens) to buy, it does not matter how cheap each token becomes because the limiting factor is not price. This price-insensitive defense mechanism is important to stop the potential negative feedback loop that price declines can create.

In the case of PoW, there is no such defense mechanism, other than being 20x less efficient. Each hardware unit may be harder to obtain than the next, but there is no direct correlation between them, and even if there is a correlation, it is weak. Importantly, as the number of hardware units required decreases linearly with price, and the supply of hardware units does not change, it becomes easier to attack at lower prices.

It is not as “reflexive” as PoS liquidity supply defense.

Other advantages of PoS include better energy efficiency and better recovery mechanisms/Another misconception about PoS is that it drives centralization by rewarding large stakers over small stakers. We believe this is incorrect.

While large stakers receive more staking rewards than small stakers, this does not drive centralization, which is the process by which large stakeholders increase their staked percentage over time.

This is not the case in a PoS system. Since large stakers have more stake to begin with, greater rewards do not increase their share of the pool. For example, if there is 10 ETH between two counterparties, counterparty X has 9 ETH and counterparty Z has 1 ETH. X controls 90% of the stake. After a year, X will receive 0.45 ETH and Z will receive 0.05 ETH. X received 9 times the reward as Z, but X still controls 90% of the stake and Z still controls 10%. The proportions did not change, so no "centralization" occurred.

Most people think of ETH and BTC as completely different assets because they think of ETH as a decentralized SoV (replacing gold) and BTC as being like gold. We believe that Ethereum is better suited to be a long-term SoV than Bitcoin in many important ways. Before we compare the two, it is first necessary to assess Bitcoin's current security model and how it will evolve over time.

As mentioned before, the security of the system comes from the cost of a 51% attack. As a PoW network, this cost is determined by the amount of money required to purchase enough hardware platforms and other equipment/electricity to control 51% of the hashing power.

This is roughly equivalent to the cost required to recreate the mining hashrate that currently exists on the network. In an efficient market, the total hashrate is the product of the issuance value miners receive. Bitcoin is only as secure as its issuance price. As mentioned earlier, this security is both inefficient and lacks the self-reflexive defense capabilities of a PoS system.

What would happen if the issuance of Bitcoin halved every four years? Assuming all other variables remain constant, the security of the system would drop by 50%. Historically, this has not been a big problem because the value of issuance (and therefore securities) is a function of two variables: the number of tokens issued and the value of each token.

Since the price of the token more than doubles every half cycle, this makes up for the reduction in issuance on an absolute basis. The absolute security of the network increases with each cycle, despite the number of tokens issued halving. However, this is not a sustainable dynamic long term for a number of reasons. First, it is unrealistic to expect the value of each token to continue to more than double with each cycle. Mathematically, exponential price increases are impossible to sustain in the long term.

To put this into context, if the price of Bitcoin doubles every halving, then in about 7 more cycles, the price of Bitcoin will exceed global M2. Eventually, the BTC price will stop rising at this rate. When it does, each halving will significantly reduce its security.

If the Bitcoin price drops around the halving cycle, the drop in security will be more significant and could trigger the negative feedback loop mentioned earlier. This security system is fundamentally unsustainable as long as the price is capped. The only way to solve this problem is to generate meaningful fee income.

This fee income can replace part of issuance and continue to provide incentives for miners, thus providing security even after issuance decreases. The problem with Bitcoin is that fee income has been negligible and declining for a long time.

In our view, the only viable way to gain long-term security is through significant fee income. Therefore, to be a sustainable SoV (alternative to gold), a system must generate fees. The alternative is emission, which will certainly lead to inflation that undermines the utility of the SoV.

Long-term security is the most important characteristic of a SoV. For example, gold will account for the majority of the SoV market as long as almost all market participants believe that gold will remain legal for a long time to come.

For a cryptoasset to be a successful SoV, it must also convince the market that it is extremely secure and its legitimacy is guaranteed. This is only possible if the protocol's security budget is sustainable in the long term, which essentially favors a PoS system with a large and persistent fee pool. We think the most likely candidate for this system is ETH. It is one of only two L1s with a significant fee pool. The other, BNB, is extremely centralized.

Credible neutrality is the second most important characteristic of a successful SoV. Gold has no loyalty or dependency on anything. This independence is what makes it successful as a SoV. For another asset to gain widespread adoption as a SoV, it must also be credibly neutral. For cryptocurrencies, credible neutrality is achieved through decentralization. Today, the most decentralized cryptocurrency is undoubtedly Bitcoin. This is mainly because Bitcoin has very little development work and the protocol is mostly rigid, but despite this, it is still the most decentralized protocol to date. If you wanted to kill Bitcoin today, it would be extremely difficult. If you tried to kill ETH today, it would still be extremely difficult, but probably easier than BTC.

However, Ethereum has a clear roadmap, and we believe that while we are currently only in the middle of this roadmap, eventually (I estimate 8-12 years) this roadmap will be completed and the core development team will become less important.

At this point, ETH will be more decentralized than BTC, in addition to having far superior long-term security.

Contrary to popular belief, PoS naturally promotes decentralization more than PoW. Larger PoW miners gain clear benefits from economies of scale, which drive centralization. For PoS, scale is much less relevant because it costs far less to set up a node than PoW equipment, and because the electricity required for PoS is over 99% lower than PoW equipment, there is no real benefit to large-scale electricity. Economies of scale are an important factor for PoW, but not PoS.

There are currently 400,000 unique ETH validators, with the top 5 holders controlling only 2.33% of the stake (excluding smart contract deposits). This level of decentralization and diversity separates ETH from all other PoS L1s. Additionally, compared to BTC, today the top 5 mining pools control 70% of the hashrate.

While some critics will point out that liquidity staking providers control the vast majority of Ethereum staked, we believe these concerns are overblown. Furthermore, we expect these concerns to be addressed by the liquidity staking protocol and that additional checks will be put in place to further guard against these issues.

To summarize, PoS is fundamentally a better consensus mechanism for crypto SoV. This is why the merger will represent a major milestone on Ethereum’s roadmap, marking a key node in its journey to becoming the most attractive crypto SoV.

The underlying reasons discussed above are why we support the ETH/BTC trade for the long term, especially around the merger. However, liquidity, especially structural flow, will be the most important factor in determining price. It is the structural shift in transaction flow triggered by the merger that makes this trade so attractive and why the merger is such a big catalyst. Historically, the structural flows of BTC and ETH have been very similar.

Despite ETH's smaller market cap, its issuance has been about 3x larger on a market cap weighted basis. This larger issuance makes it difficult for Ethereum to surpass Bitcoin in market cap, as it would require Ethereum to absorb 3x the daily USD-denominated supply. The chart above clearly shows a strong relationship. The values ​​on the chart are the result of token issuance and token price. What happens if you reduce the token issuance variable, but want to retain that correlation? You have to increase the token price.

So, what should we expect when we reduce the token issuance variable of Ethereum by 90%? It is not that the price should offset this decline by 10 times, because the impact is not necessarily linear, but the relationship between them is worth considering.

All in all, after the merger, the passage of time will always be a helping force for Ethereum and a headwind for Bitcoin. We believe that this direct reality will be the main driving force for the final reversal.

2. Pledged derivatives

Since Ethereum is a large ecosystem, many other areas will be indirectly affected by the merger. As an investor, consider the second and third order effects of certain catalysts in order to find opportunities that may not be effective pricing in the market. Regarding mergers, there are many options such as L2, DeFi and liquid staking derivatives (LSD) protocols.

After a comprehensive review of the different alternatives, we concluded that the liquidity staking agreement will be the biggest fundamental beneficiary of this merger (even exceeds ETH).

This argument is simple. The revenue of the LSD protocol is directly affected by the ETH price and multiple other mergers. In addition, shortly after the merger, their biggest spending, i.e. subsidizing the liquidity pool between their holdings of derivative tokens and native ETH, actually zero. At a higher level, I expect a 4-7-fold merger to drive the growth of the ETH protocol revenue (assuming the ETH price only increases slightly) and a 60-80% reduction in the maximum spend. This is a unique and powerful fundamental impact.

We have to study the benefits and expense models of these protocols. Take Lido as an example, because it is the largest of the LSD protocols.

Note that these principles also apply to other players, as they are often very similar. Lido's revenue comes from the percentage of pledge rewards for its liquid staking derivative stETH. Lido receives 5% of all generated pledge rewards. If the user saves 10 ETH for 10 stETH and generates an additional 0.4 stETH over a year. User retains 90% of 0.4, validators retain 5%, and Lido retains the remaining 5%. It can be seen that Lido's revenue is purely a function of the staking returns generated by its LSD.

These staking rewards are functions of four independent variables: ETH total staking, ETH staking rate, LSD market share, and ETH price.

Importantly, the staking reward is the product of all four variables. If multiple variables are affected, the output will be affected. In other words, if you double one and triple the other, the impact on the staking returns is 600%. Except for market share, all variables are directly affected by the merger.

The total staking of ETH may increase significantly from the current 12% to nearly 30%, i.e. an increase of 150%. As mentioned earlier, the staking rate may increase from 4% to 5%, i.e. an increase of 25%. There is no reason to think that the merger will significantly affect the market share of LSD, so we can assume that this is constant and has no impact. Finally, we assume that the price of ETH has increased by 50%. The combined effect of these different variables is 250%*118%*150%= 444%, i.e. an increase of about 4.4 times.

Spending has also dropped significantly. The biggest overhead of these LSD protocols is to incentivize liquidity pools between LSD and native ETH. Given that there is no withdrawal situation yet, it is extremely important to create deep liquidity to manage large-scale flows between LSD and native ETH.

However, once withdrawals are available, these incentives are no longer needed. If there is a significant difference between the two, arbitrage will occur and natural market forces will make them relatively pegged as arbitrage buys LSD on dips. This will allow the LSD protocol to significantly reduce its issuance (fees), which will also greatly reduce the selling pressure of the token.

In the pre-merger data, LDO's transaction revenue was about 144 times, but in the post-merger data, this would drop to about 31 times. While this is not cheap by traditional measures, it is attractive for high-growth strategic assets in crypto areas where valuations are generally higher. Importantly, this is the actual revenue the agreement will earn.

There is a widespread concern among LDO critics that the revenue will not be returned to holders. For this reason, they often compare the agreement to Uniswap.

While the current earnings are indeed not passed to token holders, we do not think this is a reasonable concern, and we do not think Uniswap's comparison is correct - just because token holders do not receive cash flow today does not mean they will not receive it in the future.

We believe that someday this revenue will be returned to holders. We also know that multiple major stakeholders agree with this issue. In addition, we believe that Lido should not return cash at the moment, and if they return cash, Lido will actually be very concerned about the management’s capabilities. This is a very early stage business and is still in the early stage of growth. They need to raise cash regularly and are currently burning money on a run rate basis (this will change after the merger).

It is unwise to raise funds from investors to cover losses and then distribute the agreement revenue to token holders, thereby increasing the losses. It is like a startup still distributing early returns to investors when revenue is not enough to cover fees. This situation will never happen in traditional capital markets because it is irrational.

Many cryptocurrency players are also concerned about Lido's dominant market share. They have 90% of LSD market share, while stETH accounts for 31% of the total ETH stake. While we think the concerns surrounding centralization have been exaggerated, we still believe that Lido should remain under 33% to eliminate any doubts about Ethereum's credibility neutrality. In terms of the investment case of the agreement, we don't think the market share cap of 33% is worrying. In our opinion, there are many other growth carriers to pursue in addition to market share, and investment is already quite compelling in terms of current share.

All in all, Lido is a key infrastructure in the Ethereum ecosystem, which has established product market matching and dominant market share and will continue to maintain incredibly rapid growth in the market. In our opinion, the concerns about the protocol are either wrong or false. Furthermore, given its past and expected future growth prospects, it is priced at a reasonable price and is therefore one of the most worthwhile assets in the field.

While Lido is the market leader and largest player, there are two LSD protocols, Rocketpool (RPL) and Stakewise (SWISE), that are worth considering. Each LSD has many unique aspects, as well as complex details that can be expanded. However, for ease of understanding, we will focus mainly on the main differences and further refine them in future discussions.

Both the RPL and SWISE liquid staking agreements should benefit from any share Lido has given up due to centralization issues. While we believe that any loss from Lido shares will be moderate, even moderate losses will equate to huge gains for smaller companies.

For example, if LDO loses 4% of the market share, RPL will gain 2.5% of it, SWISE gets 1.5%, LDO will lose about 12% of the market share, but RPL will increase about 50% and SWISE will increase about 125%

Rocketpool (RPL), the second largest player in the market, has a unique staking mechanism and token economy. To stake through RPL, validators must pair RPL with native ETH and need to maintain a minimum ratio between the two. With the increase in ETH staking participation and more validators adopting the solution, this dynamic creates predictable and guaranteed demand for RPL.

Another benefit of RPL is the practice shared by validators with other users, allowing the required ETH to set up a staking node from the normal 32 ETH to only 16 ETH. This reduces the minimum, allows smaller operators to set up nodes, and further incentivizes decentralization. This makes RPL a perfect complement to LDOs, which should be a catalyst for RPL market share, as they will be the main beneficiaries of Lido’s effective market share.

Finally, risk management is another interesting alternative to LDO. Their model is very similar to that of LDO, but they are increasingly focused on institutional adoption, which should put them in a favorable position in the combined market. They also benefit from a highly driven and professional team that continues to execute well. It is worth noting that they discuss the token economy plan that ultimately achieves a “token holder-friendly”, where token holders will directly receive additional protocol revenue.

Additionally, SWISE has been striking, with larger customers looking to diversify their pledged products (DeFi insurance project only approved a proposal that would increase their TVL by 20-25%). Because they are the smallest players with the highest valuation, they are probably the most risky/reward investment in the category.

In short, it is difficult for us to distinguish the value within the team. LDO is the cheapest and safest, but its market share rises the least. SWISE is the most expensive but has the largest market share rise, while RPL is in between, with the advantages of a unique token economy and decentralized staking mechanism. The relative valuation is reasonable, which shows us that the market is effectively pricing different opportunities.

We chose to own these three protocols. This is because we believe that LSD tokens are the highest returns in Ethereum merger-related investments. They may outperform ETH, but investors should expect higher volatility and lower liquidity.