Shift to PoS Will Reduce ETH Issuance and Impact Staking Yields
The moment has finally arrived. Ethereum is poised to execute the most historic upgrade in its eight-year history. And the DeFi community is giddy with anticipation that the shift to Proof-of-Stake consensus will revitalize the blockchain network’s usefulness and value.
Richard Craib’s response? Meh.
“I’m not really paying attention to The Merge,” the founder of the blockchain-based hedge fund Numerai told The Defiant in a DM. Indeed. He said he’s sold all his ETH, which he had bought at $0.26 per token in the Ethereum crowdsale in 2014.
Not the Only Skeptic
Craib may be part of a minority in DeFi this week as the countdown to The Merge ticks down to zero-hour on Thursday. Yet he’s not the only skeptic who believes the hype has gotten a bit out of control. Mainstream media have been running segments on The Merge, searches for the event are trending at an all-time high, and Google has set up an online countdown clock.
What may be lost amid the hoopla is how The Merge will impact DeFi. Ethereum, after all, is the backbone of the decentralized finance proposition. And DeFi, in the grip of a bear market and tarnished by ceaseless exploits and the meltdown of Terra’s ecosystem in May, could surely use a feel-good story.
If The Merge is as profound as everyone seems to believe then everything should be about to change for the better, right?
Well, yes and no. What is certain is that crypto investors and users will confront a raft of new developments that may shape the future of the space for years to come.
The Merge will take place when Ethereum’s Beacon Chain, an experimental network predicated on Proof-of-Stake processes, fuses with Ethereum’s old school mainnet. Ethereum developers have been painstakingly preparing for this moment for months with a series of tests.
Since its inception, Ethereum has used the same method Bitcoin does to maintain its blockchain — Proof-of-Work (PoW). It relies on mining outfits to process and add blocks of data to the chain as fast as possible, a race that consumes mammoth amounts of electricity. Bitcoin is eating about the same amount of power as Pakistan on an annual basis, according to the Cambridge Bitcoin Electricity Consumption Index. That’s not only bad for the planet, it’s expensive.
Post-Merge, Ethereum’s blockchain will be maintained by the Proof-of-Stake (PoS) algorithm. Under this approach, ETH holders may stake their coins to validate blocks of new data to be added to the chain. No more mining, no more contests to be first to hash. The upshot: an almost 100% reduction in electricity usage, according to the Ethereum Foundation.
“People should be excited!” Leighton Cusack, co-founder of Pool Together, a no-loss savings protocol, told The Defiant.
Well, they are. Ether has skyrocketed 73% since hitting a 12-month low on June 19 compared to an 18% jump by Bitcoin.
Yet The Merge is also set to reduce issuance of ETH, which is distributed to miners under the current proof-of-work system, by 90%. This reduction may turn ETH into a deflationary asset, as a previous upgrade, EIP-1559, changed the Ethereum protocol to burn ETH with every transaction. This could have serious implications for investors because it will change the supply and demand dynamics of ETH.
There’s plenty of other developments: There’s the question of what happens to ETH on the PoW chain, which may continue to run after the Merge.
More Than 70% Of Stakers Are Currently Nursing Losses
There’s a debate of how high staking yields are going to be after The Merge. Then there is the danger of liquid staking protocols like Lido controlling too much ETH.
That’s not all. There’s also a question of whether the Merge will be a “sell the news” event as traders have piled into the derivatives market for ETH. The token may fall sharply after the event, especially if it’s deemed to be inconsequential. The Merge, it bears saying, is not designed to make Ethereum faster in terms of transaction speed, or cheaper to use.
“I think the event itself will be more unremarkable for the retail user than expected,” Foobar, a well-known Ethereum developer, told The Defiant.
The Merge has been a long time coming. Ethereum hit mainnet in July 2015 as a project known to only a small circle of crypto geeks. ETH hovered around $1 for the rest of the year before breaking the $20 mark in 2016, right before the infamous DAO Hack.
The project recovered and ETH tracked Bitcoin for the next few years right through the bull run that started in April 2020. Yet even as Bitcoin emerged as a market phenomenon and drew legions of new investors and exceeded $1T in market capitalization, Ethereum plotted its own course.
Numerous DeFi protocols hit the market in 2021 in tandem with the birth of nonfungible tokens, NFTs, which caught fire with celebrities and became crypto;s first genuine pop culture phenomenon. Many piggybacked on Ethereum’s blockchain network even as upstarts such as Solana, Cardano, Polkadot and others challenged the network’s supremacy.
With gas fees exploding and Ethereum capable of processing just 15 transactions per second, the network’s promise as a new mass-market technology seemed far-fetched, to say the least.
Yet Ethereum’s community have always operated on their own time, and not the schedule imposed by market pressure. And true to form, developers started rolling out the precursors to Ethereum 2.0 with the advent of the Beacon Chain in December 2020.
Quietly and steadily, devs conducted a series of tests as they eyed the switch to PoS. In August, the Goerli testnet successfully transitioned to PoS in a dress rehearsal for The Merge. Then on Sept. 6, the Bellatrix fork went live and the Beacon Chain was ready to be joined to Ethereum’s mainnet.
“The Merge should go smoothly, probably some price volatility surrounding it, but the UX won’t change much,” Foobar said.
Plenty else will.