Ethereum merger is imminent, will the history of supply and demand dynamics be rewritten?

The Merge — This is the most important upgrade Ethereum has ever seen. Big events like this are often just short-lived “hype”, and some say $ETH will be no different, but I disagree. This post will explain why $ETH is going to be a completely different beast after the Merge.

The merger removes the Proof of Work (PoW) consensus mechanism from Ethereum and replaces it with the Proof of Stake ( PoS ) consensus mechanism. But for this article, we will ignore the technical details and focus only on the price of $ETH. The price of every asset is determined by the forces of supply and demand. What factors will change the supply and demand dynamics of $ETH after the merger?

• Three times the amount of half;

• ETH staking annualized rate of return (APR);

• ETH (unlock) lock;

• Institutional needs;

1. Triple halving

Through PoS, $ETH issuance is reduced by 90%: This is the same supply reduction that would require BTC to halve three times. What Bitcoin took 12 years to do, Ethereum did in one go this year. But this is more than just a 90% reduction in selling pressure, it means more.

• In PoW, $ETH is issued to miners who run high-cost operations. They are forced to sell large amounts of ETH to pay high electricity bills.

• In PoS, new ETH flows to validators, who only need to worry about minimizing electricity and hardware costs, and they are no longer forced sellers.

Additionally, Bitcoin miners don’t have to be BTC longs, they invest in hardware and electricity to mine, not Bitcoin. In contrast, Ethereum validators must stake $ETH, so they are usually long-term holders. If they see ETH price increase, why would they sell their staking rewards?

2. ETH Staking Annualized Rate of Return (APR)

There is currently $11.4 million of ETH staked, with an annualized yield of 4.6%. This ETH-denominated yield comes only from staking rewards. In PoS, stakers will also receive gas fees that now belong to miners, which will increase the APR by 2 times or more. \

The annualized staking rate of return (APR) can be thought of as a near-risk-free return on $ETH. When it rises, it will attract more ETH to be staked because it becomes an attractive alternative to other money-making opportunities in DeFi. More ETH staked means less supply on the market, and may even trigger a rush to buy.

3. ETH (un)lock

Currently staking $ETH is a one-way operation as stakers cannot withdraw their ETH and rewards. Many seem to believe that the Ethereum merger will make withdrawals possible and that "when 12 million staked ETH is unlocked, ETH will sell off en masse." I've noticed that some people believe that the merger is a negative price catalyst, with ETH unlocking and flooding the market, which is completely wrong.

1) Staked ETH will not be unlocked during the merge

The ETH merge will not enable withdrawals. This is another Ethereum upgrade planned to take place 6-12 months after the merge. That is, neither the staked $ETH nor the staked rewards will enter circulation for a long time. When withdrawals are finally enabled, only 30k ETH will be withdrawn per day, and there will not be a large unlocking volume.

(II) Unlocked ETH will be released slowly

Even with withdrawals enabled, all staked $ETH is not immediately available. There will be an exit queue mechanism that could take more than a year in the worst case, and several months in normal cases. To withdraw $ETH, validators must exit the active validator set, but there is a limit on the number of validators that can exit per epoch. There are currently 395k validators (active + pending), and if no new ones are established (highly unlikely), it will take 424 days for all of these validators to exit.

3. Pledged ETH is usually a stack that is never sold

Who would voluntarily lock up $ETH for months without even knowing when they can withdraw it? Without a doubt, the people who are most bullish on ETH. Most ETH stakers are long-term investors. They are not interested in selling, especially not at current prices. Short-term $ETH stakers would rather use liquid staking options (like @LidoFinance) so they can sell their tokenized stake at any time.

I used Nansen and Etherscan to look at the distribution of staked ETH by stake type: liquid stake is only 35%.

Additionally, 30% of the staked $ETH comes from addresses that are not marked as exchanges or staking pools. It probably represents a validator that is run individually. Running a validator is not an easy task, so it is usually done only by true ETH believers. They won't sell it, right?

All in all, I don't believe we'll experience any exaggerated sell-off as $ETH unlocks. It will happen slowly over several months and many stakers won't sell anyway.

IV. Institutional Demand

Why does the PoS transition arouse the interest of institutions?

• The DCF model (discounted free cash flow model) will be applied to value $ETH, which shows that ETH is undervalued;

• ETH as “internet bonds” will become an alternative to US Treasuries;

• ETH is environmentally friendly, which is a good narrative;

• EIP-1559 burns $ETH on every transaction;

1. DCF Model Valuation of $ETH

The DCF model is a popular valuation method in TradFi. It has been used for decades by institutions that control trillions of dollars of global wealth. PoS will use the DCF model for valuation and will eventually apply to the value of $ETH. Why is it so important?

By predicting future cash flows, the fair value of $ETH can be assessed, which is necessary for institutional investors to approve multi-million dollar investments. And, as you may have guessed by now, ETH is severely undervalued. Because based on DCF and P/E valuation techniques, the fair value of $ETH is definitely higher than $10,000. After the successful transition of PoS, institutional investors will be interested in ETH. And now we can get ahead of these mechanisms by purchasing ETH.

2. $ETH converted into Internet bonds

Staking income turns $ETH into Internet bonds - a viable alternative to U.S. Treasuries. Although ETH is more volatile than bonds, it guarantees a higher yield, and if the ETH price does not plummet, the actual yield will still be better.

3. ETH Environmental Narrative

Transitioning to PoS will reduce the Ethereum network’s energy usage by 99.98%. Energy-intensive PoW will receive a lot of hateful looks when the issue of climate change is prevalent. Whether or not this criticism is justified is irrelevant, the narrative is what matters. While $BTC supporters have to fight back against continued attacks on PoW and go to great lengths to justify the Bitcoin network’s energy consumption, $ETH holders will bask in the new narrative of an environmentally friendly blockchain. Changing a narrative is easier than winning a war.

4. EIP-1559 Burning $ETH

In short, institutional demand will surge. If that wasn't enough, we also have EIP-1559 which burns $ETH on every transaction! So far, it has burned over 2 million ETH in 8 months. That's almost 6 ETH/minute! At this burn rate, the supply of ETH will decrease by 2.2% per year. ETH = money that continues to increase in value!

Everyone is talking about $ETH being burned. Indeed, it is exciting. Is ETH already deflationary? No, it has a lower inflation rate. Will it become deflationary? I am pretty sure it will. Let me share some useful resources to track ETH becoming valuable currency. After the merger, we don’t even need a bull market for ETH to become deflationary. Gas prices have been very low in the recent bear market. However, EIP-1559 will still burn more ETH than after the merger. The merger will mark a peak in ETH supply.

We don’t need an economics degree to understand what happens to the price of an asset if the supply of the asset decreases and the demand increases. Yes, the numbers go up. I think that’s exactly what will happen to the price of $ETH after the merger (long-term trajectory). Maybe you’re saying “but, everything is already priced in!” Really? The crypto market is extremely inefficient. I even think “few people understand” all of the above dynamics. Remember when EIP-1559 started burning a lot of $ETH and everyone was surprised? They will be surprised again after the merger.

Furthermore, institutional demand has not yet reached vigorous levels. Many corporate risk committees will not approve an asset with "huge execution risk" in the future - how the PoS transition is often described. Only after the merger will $ ETH become an investable asset. Right now the bears are in control of the market and price action is completely ignoring fundamentals.

In summary:

• The merger has not yet been factored into the price;

• We can buy $ETH before institutions to run the PoS mechanism;

• You don’t have enough ETH, and neither do I;