It’s 2023 - Here’s What You Wish You Knew About Ethereum in 2022
2021 was an eventful year for Ethereum, but an unpredictable year of price action for $ETH as it underperformed many other new Layer 1 tokens like $SOL, $LUNA, and $AVAX. However the latest data we lay out in the following article supports $ETH outperforming other smart contract tokens in the coming year(s).
The Ethereum Story
Ethereum is possibly the World’s greatest open source software achievement. Ethereum has evolved from a revolutionary idea when Vitalik Buterin published the whitepaper in 2014, and has grown to a behemoth in terms of financial returns (1,096,674.19% return from ICO price), daily active users (~550,000 users), and deployed smart contracts (over 2 million).
Ethereum’s vision and demonstration of open and secure finance protocols has captivated the attention of millions, freed many from the chains of corporate control and predatory banking, and unlocked new forms of creative expression. Ethereum also holds a special place in most crypto OG’s hearts as it went on an epic bull run from 2016–2018 and helped bootstrap many successful decentralised applications we use today.
The power of smart contracts was evident from the moment Vitalik’s whitepaper was completed, but the development roadmap has been full of twists and turns, contentious debates, hacks, and forks. Finally, the community agreed to transition the growing Ethereum blockchain from a Proof of Work consensus mechanism to Proof of Stake.
$ETH, the native token of the Ethereum blockchain, is the second largest crypto asset by market cap, and leading smart contracts platform by total value locked (>$127b at publishing). In a now more mature industry, liquidity exists for large institutional buyers and custody solutions to enter the market, and regulatory risk has been significantly reduced. ETH is an asset that functions as a currency within its own/other chains’ economies, is required to pay for gas to add transactions to the chain (blockspace is limited), and ETH is integral to the network security with proof of stake.
32 $ETH: The Ethereum Bond
The Internet Bond, a report by Collin Myers & Mara Schmiedt, models staked ETH as a revolutionary new internet native asset type, or bond. By staking ETH you are locking up your ETH in the network to receive the protocol interest rate. Stakers participate in proof of stake (PoS) that underlies Ethereum’s consensus mechanism, to be selected for validating transactions and receive the Network inflation rewards.
This is essentially the “Risk Free” rate of return on ETH. There is no counterparty risk, as the protocol itself accounts for the ETH yield through inflation. DeFi contracts, despite being mostly non-custodial, involve some element of counterparty risk/ contract risk.
32 is the number that allows you access to the Network’s staking rewards where ETH accelerates as a productive asset and perpetually generates income. This creates even more of a premium on the asset, as ETH can be transformed into staked ETH, a yield bearing asset which is inherently more valuable than the former.
As more participants wish to join the validator set, there are less allotments of 32 ETH available to be taken from the supply. ETH is a scare asset, despite having no supply cap (more on that later). Currently, Ethereum can theoretically support approximately 3,737,340 validators, however, there is no way this happens because of DeFi utility, supply on exchanges, ETH for transaction fees, and idle ETH.
The above chart reflects the cost of entry to secure your spot in the validator set. The trend supports an increasing cost of 32ETH/1 validator as the capital requirements increase. As the barrier to entry is rising over time, the profile of participants is changing. Securing a spot is now most likely reserved for higher net worth individuals or institutions, which is similar to how the profile of miners in the Bitcoin network evolved over time.
ETH Accumulation Ahead of the Merge
The transition of the Ethereum blockchain from Proof of Work to Proof of Stake has been coined “The Merge,” and it will be a significant catalyst for a reduction in circulating ETH supply. Akin to the psychological effects of Bitcoin’s 21 million supply cap, there is an ongoing race to accumulate 32 ETH before it’s out of reach. This can be seen in the ‘addresses with >32 ETH’
This shows the number of unique addresses holding at least 32 ETH. This is the number of potential validators for ETH 2.0. Only Externally Owned Addresses (EOAs) are counted, contracts are excluded.
We observed steady, yet rapid, accumulation of ETH in advance of the ETH2 staking contract deployment (The Beacon Chain), as investors aimed to secure enough ETH to run an independent validator. This metric peaked at the launch of the Beacon Chain (Q4, 2020), when the ETH2 deposit contract went live. What’s Interesting is that the decline in addresses holding 32 ETH coincides with an increase in ‘The total number of transactions to the ETH2 deposit contract.’ Ethereum Proof of Stake validators went live and ETH deposits continued to grow.
When the Deposit Contract went live and accepted deposits of 32 ETH from this pool of potential unique validators, you see a decline in (GREEN) as the same addresses joined the validator set.
The steady increase of validators (BLUE) joining the Beacon Chain can only go up until ‘the Merge,’ but this will continue to increase as the type of participant to be staking early are long term Ethereum holders, and withdrawals won’t be enabled for several months later.
>32ETH addresses (GREEN) bottomed at 105k and has resumed an uptrend supporting that accumulation is still happening at this price level, while deposits are increasing. The increased capital requirements now likely are majority high net worth individuals, institutions, and custodians (exchanges) looking to offer yield products.
Each Transaction is an allotment of 32 ETH meaning approximately 10,935,648 ETH have been deposited into the Beacon Chain. Astoundingly this is 9.1% of the ETH supply and about $37.1 billion at today’s prices.
Currently, there is a queue of roughly 10,042 validators waiting to launch on the Beacon chain. That’s 321,600 ETH or $1.19b of staking demand! Also, note there are already 326,676 active validators supporting Ethereum’s proof of stake chain. None of the other proof of stake networks come close to Ethereum in terms of decentralization and security. The closest contender is Avalanche, with 1,392 active validators, while other proof of stake networks are typically on the order of 10–200.
ETH Locked in DeFi
The early technical development risk and higher technical requirements to solo stake suggest the profile of a current staker is one who is long term aligned with Ethereum’s growth, and unlikely to exit after the merge. Staked ETH will still be subject to the future withdrawal queue and be illiquid while staked (ignoring staking derivatives). ETH committed to staking isn’t the full picture. While staking capital is locked and illiquid until after the merge, DeFi is more fluid.
DeFi provides opportunities for investors seeking higher returns than the risk free rate of ETH staking. DeFi allows investors to leverage ETH and other assets through composable smart contracts and multiply yield, especially early on in a protocol’s lifecycle. The trade off with DeFi is higher risk from smart contract bugs, economic exploits, or bad actors.
ETH locked in DeFi has remained a very high proportion of the total supply due to the growth of various DeFi protocols across the multichain world. ETH is locked in Ethereum smart contracts and bridges as wrapped $ETH is a valuable asset across other chains. 32.5% of the ETH supply is locked in DeFi. As long as DeFi provides higher yield opportunities than the risk free rate of staking, investors will continue providing $ETH as collateral. Moreover, decentralized staking pools like Rocket Pool and Lido are providing stakers with a liquid staking receipt that can be used across DeFi. rETH and wsETH liquid staking derivatives are forms of superfluid collateral and combine the best of what ETH staking and DeFi have to offer.
The Merge and Supply
The Merge is Ethereum’s transition to Proof of Stake (POS) consensus from Proof of Work (POW). In POW as it currently operates, miners compete using hardware for the chance to solve the next block and cryptographically prove that a specific computational effort has been expended. This requires huge amounts of energy that scales as with difficulty as more miners join the network to compete for the reward.
In POS, validators in Ethereum’s system put up a ‘stake’ (risk in the form of ETH as collateral), and propose or attest to new blocks in the chain. The computational requirements are lower because instead of raw computational power for security, the ETH stake provides economic security. This aligns incentives as malicious behavior, such as double signing, which results in a validator’s stake being slashed, (you lose some ETH). Protecting the Network and validating according to the rules will reward stakers with ETH.
Once Ethereum’s Proof of Work chain is deprecated, miners will either need to move to other networks (e.g. Ethereum Classic), or run validators to earn ETH yield. There will be no more miner sell pressure, and Ethereum stakers have minor operational costs to support the validators (electricity, Internet, laptop). In Proof of Work, due to the energy requirements, miners sell the vast majority of miner rewards to cover the operational costs and turn a profit.
Currently, Ethereum’s Proof of Work block rewards are 2 ETH per block, roughly every 10 seconds, which translates to approximately 12,800 ETH per day. Justin Drake, an Ethereum researcher, has modeled ETH issuance will be reduced to 1,640 per day, or a 87% reduction in new ETH supply. The combination of drastically lower emissions and fee burning should reduce ETH sell pressure by 7 million per annum.
Nikhil Shamapant wrote the infamous Triple Halving, an extensive thesis about the upcoming ETH supply shock due to the combination of EIP-1559 and the Merge, which he compares to three Bitcoin halvings.
Net issuance reduction in Proof of Stake
The issuance for staking yield is significantly lower than the issuance currently in POW. Not only are inflation and sell pressure lower, ETH itself is locked up to generate that yield.
Currently at just over 10 million ETH staked, a reasonable assumption will target 25% of ETH supply staked by 2023–24.
Exchange Outflows, net flow
ETH on centralized exchanges is at its lowest level in three years and continues to fall. Only 17.97% of ETH is on exchanges.
ETH has been leaving centralized exchanges consistently since crypto’s Black Thursday COVID crash. The proliferation of DeFi and buy pressure from both retail and institutional buyers are the major culprits.
Fees and Burning
Over 2 million ETH have been burned with the implementation of EIP-1559 last summer, 2021. This translates to $6.7b at the time the article was written. Due to the high amount of activity on the blockchain, new ETH emissions have been reduced by 64% thanks to the fee burning mechanism.
from https://watchtheburn.com/
The fee burning acts as a counterforce to the inflationary nature of Ethereum. It is very likely ETH becomes deflationary when blockspace is in high demand (many simultaneous transactions on the network). Ethereum’s first deflationary block happened in September 2021, and there have been many others since then, all of which would have been deflationary under Ethereum’s Proof of Stake!
The major contributors to ETH burning have been NFT mints (35%) and DeFi (33%). Ethereum has become the defacto NFT chain due to the success of OpenSea, and creators and NFTFi/DeFi builders have congregated.
As transaction fees continue to rise, many existing and new Ethereum protocols are launching on Layer 2 rollups like Optimism, Arbitrum, Metis, and Zksync. The portion of fee burns from L2s will continue to rise as liquidity moves from Ethereum mainnet to Layer 2s via bridges and through centralized exchange integrations.
MEV
Miner extractable value (MEV) is a fancy way of saying bots have ways of taking advantage of traders by front running / sandwiching orders. This gives the trader a worse price on buying or selling, as the asset-agnostic MEV bot cuts them in line, the trader pays more, and the bot takes a profit. After the Ethereum merge, MEV is shared by Ethereum validators.
ETH Withdrawals
There has been a lot of misinformation regarding a “massive unlockening of staked ETH” at the Merge. This is false, as there is no way for the Beacon contract to distribute all of the ETH at once since there’s a maximum number of 900 validators entering or exiting the set.
The Merge will not coincide with ETH stakers’ opportunity to withdraw their staked ETH from the Beacon contract. This will require a hard fork that is likely ~6 months after the Merge. This means there will not be any mass unlock of liquid ETH for the first 6 months of the proof of stake chain, and once withdrawals are enabled, only a maximum of 900 validators per day may exit.
EIP-1559 ETH burns + new validators staking + DeFi — 87% in new ETH = Supply Shock
The Merge Status and Ethereum’s Future
The Kiln Testnet has successfully completed the merge from proof of work to proof of stake, and the chain finalized. The testnet chain is active and bugs are being worked through. There’s no guarantee when a Mainnet release candidate will be ready, however, this Reddit post is quite convincing that the Merge should be ready by late Q2 or early Q3.
Ethereum’s energy usage will drop by 99% once the proof of stake transition is complete, and Layer 2 scaling is creating a fast, low cost, and secure UX for developers and users to innovate. Layer 2s (optimistic and zero knowledge rollup technology) will continue to see new DApps deployed and billions of dollars in liquidity secured as centralized exchanges create crypto onramps that save users time and money.
Final Thoughts
The Triple Halving thesis was a clarion call on Ethereum bulls to dream bigger, focusing on the structural forces around flows driven by supply and demand. The thesis is still intact, but the timeline around the merge was wrong. The Beacon chain has been live for over a year and the Merge is closer than most skeptics think. Many detractors still claim that Proof of Stake itself will never launch and always be “5 years away.”
The narrative of ETH as a competing money and store of value is not to be underestimated. The focus around ESG and the drastically smaller energy footprint, post-Merge, will maintain and encourage a lot more activity from the NFT sector.
The issuance reduction as a result of the POS transition and EIP1559 will cause a supply shock of which the effects will be seen not long after. These phenomena will be further accelerated by the ever greater circulating ETH supply being locked in staking and DeFi. The successful implementation of PoS will cause a dramatic narrative shift causing a flood of sidelined capital & builders who stayed away due to execution risk.
Ethereum is a credibly neutral, global financial settlement layer. The chain settled over $7 trillion worth of value over the last year, and still settles over $20 billion per day since the recent market pullback.
It is a store of value with an intrinsic bond structure, making it a unique asset that does not fit into traditional asset classes; $ETH is a Triple Point Asset.
It is an internet protocol for almost anything to be securely built upon due to its economic security. Every new application increases the asset’s network value (Fat Protocol Thesis).
It’s not difficult to believe $ETH can be valued in the multiple $trillions, especially when compared to existing public companies on the S&P500.
We see Ethereum as the innovation, liquidity, and security hub in a world of growing smart contract enabled blockchains. The Merge is a major catalyst for an $ETH supply shock, and is the next significant software achievement in its shorty and dynamic history. There will be more to this enchanting adventure called Ethereum about freedom, social coordination, diversity, and self-sovereign wealth creation.
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