Ethereum Merge Was a Historic Event:
Some Popular ETH Misconceptions Debunked
Yesterday we saw a historic event in the crypto sector, with Ethereum, the $200bn market cap crypto network second only to Bitcoin in size terms, moving from a ‘proof of work’ consensus mechanism to the significantly less energy-intensive ‘proof of stake’ approach. This highly anticipated event was not without risk, with the Economist likening the complexity of this upgrade to “swapping the engine of a spaceship in mid-flight”!
In the event, I am happy to report the upgrade was executed flawlessly. There were very few issues with liquidity or protocols that some commentators in the crypto sphere had feared. The participation rate was way above the needed 66% with c.97% of validators participating. Finalising blocks on Ethereum remained very stable throughout and in fact once the Merge went ahead, it was even more stable than before.
It is important to understand that this was a 7-year process, with painstaking planning and testing taking place ahead of yesterday. This level of professionalism probably isn’t the kind of thing anyone who is not familiar with the space expects!
In my opinion, it’s actually remarkable that one of the biggest network upgrades of all time — not just in crypto but in traditional finance technology as a whole — on a network worth hundreds of billions of dollars went live without any errors. In fact, many people using the network didn’t even know that it had even happened because the change was so seamless. Credit must go to Ethereum founder Vitalik and his team. This is also a significant achievement for the sector as a whole and speaks to the calibre of talented developers like Tim Baiko now working in the space.
Although a successful Merge was the most likely outcome and therefore priced in, the real benefits in investment terms will only start to accrue over the coming months. The short-term traders who had “bought the rumour” and are currently “selling the news” are missing the big picture here: as macro fears take centre stage, crypto prices are being heavily influenced by the current turmoil and large drawdowns in other financial markets like the Nasdaq. So today I would like to point out the positive fundamental changes that the Merge represents as well as debunking some of the widely held misconceptions about Ethereum.
In short, the Merge is an important network upgrade coming on the heels of the EIP upgrade last year because it totally transforms the tokenomics for the Ethereum network (i.e. the supply and demand dynamics for the tokens, which is an important factor in price performance). Without the need to reward miners, the block rewards are being burned instead. After the Merge, only c.10% of the number of Ethereum tokens that used to be issued in the past will need to be issued now. Meanwhile, there is likely to be far greater demand for the tokens — for example from institutions who stand to receive far higher staking rewards — of now anywhere between 8–13% — on their Ethereum tokens.
The likelihood is that the Merge puts Ethereum on a path to being the first truly ‘deflationary’ (i.e. with falling supply) digital asset, in stark contrast to the huge money printing we have seen in fiat currencies like the dollar. In the sector, Ethereum is now frequently dubbed “supersound money”, a ‘hard asset’ with controlled supply like “sound money” gold but one that generates a yield too! How deflationary Ethereum becomes is related to the demand for the tokens. The inputs into prediction models are based on how much certain gas fees (paid in Ethereum and burnt) will surpass the drastically lower issue of tokens (now that Ethereum don’t have to pay high proof of work mining rewards). There are widely different scenarios modelled with these varying supply/demand inputs. Possibly the best site to keep track of how the real-world supply/demand picture is looking on Ethereum is https://ultrasound.money/:
It is obvious that a vast improvement in tokenomics — which the Merge represents — is very likely to be a positive over the medium term for the Ethereum token price. The best-case scenario is based on demand for Ethereum significantly picking up steam as we emerge from the bear market. So in that sense, these vastly superior fundamentals will only probably be recognised in the ETH token price once we reach a better financial market and macroeconomic picture generally.
Now that we have reviewed what took place yesterday and why it’s significant, I would like to dispel six key misconceptions about the Ethereum Protocol:
1. ETH has an unpredictable / infinite supply
People have long held the view that the disadvantage of Ethereum is that unlike Bitcoin, Ethereum’s monetary policy does not hard code a supply cap on tokens issued. Some investors even talked of “perpetual tail issuance,” a misconception that ETH’s supply was trending to infinity. This emphatically cannot be true anymore following EIP-1559, which was a new token burn mechanism introduced in June 2021, where base gas fees previously paid to miners are now burned. This new burn rate counter-balanced ETH issuance and was designed so that long-term equilibrium would be reached, where burn and issuance exactly cancel out. The Merge actually improves this supply/demand picture further.
Source: Consensys
Another common argument against ETH is that the supply issued is unpredictable. Specifically, its monetary policy has changed over the years via the social layer rather than programmatically (like Bitcoin’s halving every four years). This is true and a conceded point. The goal of crypto as a whole is unbiased monetary policy. Take out the humans and let the robots dictate it. Fortunately, this is what the Merge will lead to. Monetary policy from the social layer (which led to the issuance being “manually” decreased) will be out, and market-driven, programmatic monetary policy will be in. With the Merge, the future supply for ETH depends on two market-led forces only: 1) the cost of money for staking (compensated for with issuance) and 2) demand for blockspace (transaction fees). Therefore, the future ETH supply can be now modelled on ultrasound.money with two simple sliders, one capturing issuance, and the other capturing the burn.
2. Ethereum cannot be both money and a smart contract platform
Over the years, there have been a lot of applications — from DAOs, to ICOs, to DeFi, to NFTs — built on top of Ethereum. With this, critics claim that Ethereum is constantly changing its narrative based on latest trends. But it’s important to understand these are strictly the applications that are built on top of Ethereum. It’s not what Ethereum the network itself actually is, which has always been and continues to be a settlement layer for digital value. The Ethereum network is designed to settle economic transactions and it continues to do so across all these new and growing use cases.
To draw a parallel, this is like saying the internet tries to do too many things. The internet is a digital communication layer for the world, and it has an ever-changing and growing range of applications built on top of it ranging from video streaming, social media, email, e-commerce, etc.
In addition, Critics often argue that Ethereum is simultaneously trying to be a settlement layer and a money. And that if it wants to be successful, it can’t be both. Instead, it needs to focus on one of these things.
But it’s actually the opposite: if you want to be successful at either, you need to be successful at both. In order for billions to trust Ethereum as a safe and secure settlement layer for the world’s economic activity, you need trillions of dollars of economic security.
With 13.7M ETH staked, an attacker could launch a 51% network attack by buying what corresponds to roughly $21 billion. A large nation state could pull off such an attack and shake confidence in Ethereum as a global settlement layer. You therefore need trillions of dollars of economic security so that no nation state could ever control Ethereum. Money and settlement are not binary — If you want to become a global settlement layer, you need a native money that is valued in trillions.
3. Proof of Stake (PoS) means only “The rich get richer”
One of the biggest misconceptions with PoS is that it’s only the rich that get richer. This is clearly false as in PoS, everyone gets the same APR. It doesn’t matter if you stake a $1M of ETH or $100 of ETH, it’s an even playing field and same percentage return for everyone. In addition, the barrier to entry is also very low — especially when compared to Proof of Work (PoW).
Under PoW, you have to spend millions of dollars to reach economies of scale on hardware and energy to have a remotely competitive (and profitable) system. The bigger you are, the cheaper it is to mine with proof of work. In contrast, staking protocols like Rocket Pool and Lido allow anyone to access the same yields as the person running $100M worth of validators. It becomes extremely accessible for everyone. PoS is in fact a more democratic system.
4. Higher ETH price means more expensive gas fees
This is a common misconception. People think that because fees are paid in ETH that if ETH prices go up then fees must also go up. The reality is that there are two different markets at play: the ETH market (denominated in USD per ETH) and the gas market (denominated in ETH per gas).
We can be in a situation where 1 ETH is worth $1M but gas is low enough (a fraction of a Gwei) that a transfer only costs $0.01. Not only is this total bifurcation of the ETH and gas markets possible, but this is actually where we are directionally heading!
Granted, there is some correlation — especially on smaller timescales — between ETH price and gas price. As a rule of thumb, during bull markets people are willing to pay more, and in bear markets people are willing to pay less. That said, there is fundamentally nothing that forces these short and medium-term correlations to dictate the long-term trend of ETH and gas markets.
Note too that this criticism does not yet take into account the emergence of Layer-2 blockchains which are working to scale Ethereum by moving transactions off the mainnet.
5. Scalability reduces the burn
The argument here is that if Ethereum scales then per-transaction fees will go down, leading to a lower total ETH burn. This is a common take, even within the Ethereum ecosystem. But the truth is that even if transaction fees drop on an individual basis, Ethereum is now processing more fee-paying transactions. In aggregate, the total burn could decrease or increase with scalability — both are possible.
Another important concept here is induced demand. That is, the more a system improves, the more usage the system sees.
A real-world example of induced demand is traffic. If you have a motorway with two lanes and there’s always traffic, the city could decide to add a third lane. But soon after the third lane is built, traffic builds up again as more people decide to commute on the highway because of the new additional lane.
This is true when looking at Ethereum’s historical data. In fact, since genesis, the Ethereum network has scaled by ~50x while total transaction fees have scaled to billions of dollars per year. At genesis, the block gas limit was set to 3 million gas (the maximum gas Ethereum transactions can consume in one block). As of writing, the average gas consumed per block is 15 million gas. That’s already a 5x increase in scalability.
But there’s another, more subtle, 10x in scalability: smart contract gas optimisations. In the early days of smart contracts, developers were deploying extremely gas-inefficient contracts on Ethereum. Over the years, developers have gotten better and more efficient at writing efficient smart contract code.
When you combine the increase in the gas limit and smart contract gas optimizations, you get that rough 50x. Now… despite this scalability increase, has the total transaction fees gone down?
Nope — it’s been up only for over 7 years. It started with ~$10 per day in transaction fees. Now Ethereum is processing millions of dollars every day in transaction fee revenue.
6. ETH is just a tech stock
One could argue that Ethereum is like a tech company and that ETH should therefore be valued like a tech stock based on cash flows. This is partially true, but the situation is more subtle and bullish than it may seem.
When looking at Ethereum cash flows (burn = revenue from transactions, issuance = expenses for security) and profit margins, Ethereum has a ~32 P/E ratio — on par with Google or Apple.
But this is only one part of the story. It neglects ETH use as a low-velocity collateral money, and therefore neglects ETH’s potential to accrue monetary premium. You can use ETH as collateral in DeFi, and as collateral to secure the network via staking. But you can’t do either of these things with AAPL stock!
As more of the ETH supply becomes illiquid through these mechanisms, monetary premium will accrue to ETH on top of the “base” cash flow valuation. If over time most ETH is used as collateral (which it should because that’s what ETH is optimised for, especially after the Merge), then most of the ETH marketcap may well be monetary premium.
For example, if 90% of all ETH is collateral money, only 100% — 90% = 10% is liquid and relevant to a cash flow valuation, and the “fair” monetary premium factor is 1/10% = 10x.
PTLIB is CIO of Dragonfly Asset Management.
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
