Research Study

A New Era for ETH

An Ex-Post Analysis of The Ethereum Merge.

by Fidelity Digital Assets

Introduction

The Ethereum network successfully transitioned from a proof-of-work consensus mechanism to proof-of-stake on September 15, 2022. The event, which was dubbed “The Merge,” has fundamentally changed the Ethereum network as well as the potential investment thesis for its native asset, ether. Here, we’ll recap what took place and how the anticipated post-Merge narratives prior to the actual event have started to play out:

  • A decrease in the network’s energy consumption
  • Higher yields for validators
  • A reduction in issuance rate
  • More consistent block time
  • Increased focus on centralization risks
  • Preparation for the next big update becoming apparent in illiquidity discounts

Check out our recent report on The Merge for a comprehensive overview of what proof-of-stake is, as well as analysis of how and why the Ethereum network chose to transition to it. 

“Sell the News” Price Action

Source: Coin Metrics 09/20/2022.

The actual transition to proof-of-stake, or The Merge itself, was uniformly agreed upon by the crypto community as having taken place successfully. There were no major hiccups and blocks continued to be proposed and settled — only this time by validators on the consensus layer. Despite the successful transition, the price of ether has struggled since The Merge. Ether is down over 10% since The Merge, and though it is worth noting that crypto and risk assets have generally all seen further downside as a result of the CPI release days prior to the event, ether is rather surprisingly also down compared to bitcoin. 

 Source: Coin Metrics, 09/20/2022.

The ETH/BTC ratio reached an important inflection point prior to The Merge. The 0.08-0.09 range has served as a resistance level for over 18 months, and thus far ether has failed to break through these levels. To some, the actual event transpiring meant that the risks associated with changing the network’s consensus mechanism were gone and therefore the event would de-risk the asset. To others, and arguably the predominant narrative so far, is that it was viewed as a “sell the news” event where the anticipation leading up to the event may have itself represented the short-term positive price action, and as the major catalyst passed, so too did the large number of traders who may have only been involved as a result of the newsworthy event. 

Many of the narratives associated with The Merge will simply take time to impact both the perception and functionality of the network. Additionally, new risks that were postulated prior to The Merge appear to have started to emerge, though the sample size has been small considering it hasn’t even been two weeks since the upgrade. 

The Removal (and Transition) of Ethereum Miners

One of the key reasons many found The Merge attractive was its instant impact on the network’s electricity consumption. The Ethereum Foundation’s website has stated that a more than 99.95% reduction in energy consumption did in fact happen. The chart below shows how The Merge was a virtual light switch, not a dimmer, to Ethereum electricity consumption over the course of just a single block. 

Source: Coin Metrics, 09/20/2022.

While The Merge removed all economic incentives for mining on the main Ethereum network, it did not remove incentives for that mining equipment to point their servers toward other similar networks. Ethereum Classic (ETC), which was the result of a network fork in 2017 and continues to operate as a proof-of-work Ethereum alternative, was one such place where hash rate (energy usage) has seen a temporary increase recently. 

 Source: Coin Metrics, 09/20/2022.

While many will point to the movement of hash rate toward other networks as a sign that Ethereum may not have truly reduced the levels of energy consumed by digital asset networks, it seems likely that over time it will. The existing mining equipment will likely find other uses given the wide array of use cases for Graphics Processing Units (GPUs), but the incentive to create additional units for the specific purpose of mining digital assets has been drastically reduced. 

The ESG implications and positive sentiment regarding the network’s removal of its energy intensive consensus will likely take time to impact the structure of digital asset markets. 

Treasury Yields Aren’t the Only Rates Rising

Prior to The Merge, staked ether only received rewards in one way — newly issued ether to Beacon Chain validators. Miners received rewards in three ways — newly issued ether, transaction tips, and maximal extractable value (MEV). Post-Merge, we can already see the impact that the transition to proof-of-stake has had on yields for validators. Miners no longer receive any form of payment but now validators receive yield in the three ways that miners had before. Shown below are the yield validators received from new ether issuance (blue) since the genesis of the Beacon Chain in 2020, and transaction tips (green), which previously accrued to Ethereum miners, that will now be paid to validators. 

Source: Coin Metrics, 09/21/2022.

This has driven yields higher post-Merge and has tied the demand for block space to the yields that staked ether receives, which arguably better ties the value accrual between the usage of the Ethereum network with the returns and overall pricing of ether, assuming that yield is an important component to both returns and how the asset is valued going forward. Lido, the largest validator on the Ethereum network, which passes on 90% of accrued staking rewards to their liquid staked ether holders, paid a yield of 3.8% during the week prior to The Merge. The addition of transaction tips and MEV have driven yields to 5.0% after The Merge.1 That has a meaningful impact on yields, especially when considering that network activity is far lower than normal given the current market conditions.   

Maybe Not-So-Sound Money…? It’s Complicated

One of The Merge’s most notable features was the reduction in the network’s overall rate of newly issued ether, driving some in the Ethereum community to use the term “Ultrasound Money.” Roughly one year prior, an upgrade known as EIP-1559 implemented a burning feature where a large portion of transaction fees, known as the base fee, would be removed from existence. The combination of the EIP-1559 burn and a reduction in ether issuance following The Merge has driven the narrative that the total supply of ether will consistently decrease following the upgrade. To date, this has not been the case. 

Source: Ultrasound. Money, 09/21/2022.

The issuance rate is dependent on the total number of validators. The burn rate is dependent on demand for block space, which pushes the base fee up or down. Thus far, ether issuance has decreased by the expected amount — roughly 90% — however, the lack of demand for block space and relatively lower levels of network activity have led to lower amounts of ether being burned than being issued. Since The Merge, the net impact of issuance and burning has led to over 8,000 ether being added to the circulating supply. This is much lower than what would’ve been issued had The Merge not occurred (over 63,000 ether). Some have pointed to this increase in total ether as evidence that the decreasing-ether-supply narrative is dead. More accurately stated — it’s nuanced. 

If network activity recovers to historically-normal levels, then it appears likely that the net effect will be a long-term reduction in the circulating supply of ether. Despite this likelihood, we view the soundness of money as not just relating to the issuance rate of an asset, but arguably of more importance is the confidence in or credibility of a monetary asset’s issuance schedule and how easy it is to change. Ethereum’s monetary policy schedule has dramatically changed to be much “tighter” but the relevant questions for investors will be whether that schedule is likely to remain, and whether or not it is viewed as a store of value as a result.  

12 Seconds… Exactly?

Transaction fees and speed were not a focus of The Merge; however, block time consistency was, and its impact has been noteworthy. Note the difference between the smooth 12-second average block times since The Merge (after September 15), relative to the far less predictable block times previously. 

Source: Coin Metrics, 09/21/2022.

Ethereum’s proof-of-work model operated similar to other proof-of-work networks. On average, the target block time was being hit. The key words here are “on average,” as one can clearly see by the movement around the average Pre-Merge block times, roughly every 13.5 seconds. Post-Merge blocks are coming in consistently at 12-second intervals. On occasion, blocks have been missed, but this should not cause too much concern and in these cases blocks simply take 24 seconds (or in an unlikely scenario could take 36 seconds). This makes settlement times for custodians and dApps using smart contracts far more predictable. 

Validation Allocation

The change in consensus mechanism fundamentally altered the network’s governance structure and has caused many to point toward the lack of diversity among major staking providers as a red flag. Blockchains that are too centralized risk losing many of the properties which have driven their value throughout the history of public crypto networks and, at some extreme level, become not too indistinguishable from a centralized database. 

Staking ether on one’s own, often referred to as “Solo Staking,” requires 32 ether (~$40,000 today) and technical expertise. This has led to a reliance on a handful of corporations and DAOs to assist in gathering enough capital or technical chops to be eligible to run a validator on the Ethereum network. The concern raised by many, particularly those who prioritize decentralization and censorship resistance, is that a network controlled by too few institutions or individuals could be altered by this small group to benefit themselves or be co-opted by large institutions or government bodies to change the network in a way that users may not view as in the best interest of all participants. 

Source: Etherscan, 09/21/2022.

It is worth noting that the network’s largest staking entity, Lido DAO, which makes up roughly 30% of total staked ether today, is an increasingly decentralized entity. While its governance structure is nuanced, it is a bit of a misnomer to consider Lido akin to a single central entity that controls all of its staked assets for the remaining existence of the Ethereum network. Today, Lido uses over 28 separate operators to run its validators with a goal of further increasing that number in the future. Remember, withdrawals are not available today, but will be in the future. Once withdrawals for staked validator assets are enabled, delegating ETH to validators will be similar to delegating hash rate to mining pools. A few mining pools dominate bitcoin’s hash rate, but the ability to redirect that hash rate if one disagrees with that pool’s way of operating is what removes the centralization concerns. A similar market is likely to develop once withdrawals are enabled for staked ether with validators. A simple smart contract allows an individual who delegates their assets to a particular validator’s services to then withdraw and redirect those assets to a different validator’s service. An increase in competition, and a demand for transparency and trustlessness, will be key to helping reduce the threat of centralization and censorship of the Ethereum network.

Illiquid Staking Remains, but Not Forever

Staking ether requires locking up one’s assets on the consensus layer in exchange for earning a yield. These assets remain locked until a series of separate network upgrades, mainly The Shanghai Hard Fork, takes place. This is part of the reason that liquid staking solutions have become popularized. These assets, which come in varying forms, offer a representative asset that is liquid today and will be redeemable at par for ether once withdrawals are enabled on the consensus layer. As a result, there has been an illiquidity discount associated with the risks and ongoing costs before the network reaches its future-state where these assets are redeemed on a one-for-one basis. 

Source: Yahoo Finance, 09/21/2022.

A New Era for ETH

The Merge was a major technical accomplishment and one of the biggest events in the history of digital assets. Its implications for the Ethereum network and ether asset will likely not be fully realized until the current macro headwinds subside, and a new cycle of crypto adoption, innovation and potential price appreciation takes place. While there are certainly concerns, particularly regarding centralization, there are a number of innovations and improvements which can’t be fully understood until demand for use on these networks returns. The overall energy reduction and ESG-friendly shift has potentially profound implications on ESG-sensitive asset flows, but this may take time to play out. Increased demand for block space amidst a possible new adoption cycle could drive yields higher for validators, as well as drive a net reduction in ether due to base fees rising and more ether being burned. Whatever the end-result of these possibilities, post-Merge is certainly a new era  for ETH. 

Check out our recent report on The Merge for a comprehensive overview of what proof-of-stake is, as well as analysis of how and why the Ethereum network chose to transition to it. 

 

Contributors:

Jack Neureuter, Research Analyst, Fidelity Digital Assets

Daniel Gray, Research Analyst, Fidelity Digital Assets

 

 

1https://lido.fi/ethereum

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