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The Merge and Its Effects on DeFi

The Ethereum network’s longest-running testnet, Ropsten, successfully transitioned to the Proof-of-Stake consensus algorithm in early June 2022. Its developers celebrated the successful Merge, focusing on deploying the new protocols on the Goerli and Sepolia testnets.

These developments and the completion of other dedicated closed testnet shadow forks will culminate in The Merge, the rollout of the Proof-of-Stake consensus algorithm on the Ethereum mainnet. The Merge is the Ethereum network’s most significant upgrade since its inception. Pundits refer to The Merge as the most noteworthy of the sector’s events since the release of the Bitcoin Genesis Block.

It will kick off Ethereum’s ascent to its status as a scalable and truly decentralized programmable blockchain that can support billions of users simultaneously. The event slated for August 2022 is part of Ethereum’s developers’ attempt to solve the “blockchain trilemma.”

Consequently, The Merge will transition the network from a Proof of Work to the energy-efficient PoS protocol, paving the way for eventual scalability. As per the smart contract network co-founder, Vitalik Buterin, “If Ethereum fails to scale, then Ethereum definitely failed.”

The Ethereum.org site likens the milestone to replacing an engine on an old spaceship while it is in mid-flight. “Imagine Ethereum is a spaceship that isn’t quite ready for an interstellar voyage. The community has built a new engine and a hardened hull with the Beacon Chain. After significant testing, it’s almost time to hot-swap the new engine for the old mid-flight. This will merge the new, more efficient engine into the existing ship, ready to put in some serious lightyears and take on the universe”.

In this analogy, the ‘new engine and a hardened hull’ will come onboard the old Ethereum mainnet spaceship aboard the Beacon Chain. The Beacon Chain has been in independent operation as a PoS network since December 2020. It has its separate account balances, active validators, and smart contracts that leverage the Proof of Stake consensus algorithm.

The mainnet, on the other hand, has used the Proof-of-Work protocol to decentralize and secure its data. The Merge has been years in the making. The Beacon Chain, for instance, has undergone massive testing and reiterations over the last two years. It is now ready to bring transformation to the world’s most popular smart contract network.

During The Merge, Ethereum users will officially switch to the Beacon Chain as their main engine of block production. As a result, mining will cease and, in its place, will be proof-of-stake validators, who will propose new data blocks and validate transactions.

“No history is lost. As Mainnet merges with the Beacon Chain, it will also merge the entire transactional history of Ethereum. You don’t need to do anything. Your funds are safe,” says the Ethereum website.

How will The Merge affect DeFi protocols?

So, what effects will this event have on the larger DeFi network? Well, despite the huge buzz that this event has generated, it does not provide an instant fix to Ethereum’s main challenges. The Merge, for instance, does not address Ethereum’s main usability challenges.

The Beacon Chain will alter the Ethereum mainnet’s block time by a second, moving it from an enforced 12 seconds block time to a 13 seconds block time. As a result, DeFi users will face the old congestion and high gas charges synonymous with Ethereum DeFi platforms.

As the world’s largest and most prolific Proof of Stake network, Ethereum will begin to rely on staked ETH assets for security and decentralization in place of its energy-intensive mining network.

“There are a couple of reasons we want Proof-of-Stake; one is the huge environmental impact of PoW, so ETH contributes a ton of CO2 emissions using PoW… The second big motivation is that PoS gives us more granular control over network security. What I mean by that is in proof-of-work, you can’t really discriminate between miners on the chain.” explains Tim Beiko, the Ethereum foundations AllCoreDevs lead.

While Proof of Stake will not immediately scale Ethereum to Solana-like speeds, it will support the deployment of meaningful upgrades such as sharding that will eventually address its scalability challenges.

Sharding will lower network transaction fees and increase transaction processing speeds. Ethereum devs will implement sharding after the successful execution of The Merge. As per the Ethereum roadmap, sharding should take place in 2023.

That said, The Merge’s changes will significantly affect ETH price, utility, and supply. As an illustration, after The Merge, the network will reward its stakeholders rather than its miners. In addition, Ethereum’s new coin issuance protocols will slow down, creating an ETH “Triple Halvening” event post-merge.

The Triple Halvening will drop the ETH yearly inflation from highs of 4.3% to 0.43%. Then new ether emissions will fall from the PoW daily average of 12,000 ETH to 1,280 ETH. The drop in the annual ether inflation rate, decrease in new token emissions, and the Ethereum burn mechanism instituted by the EIP 1559 will have the effect of three Bitcoin halvenings on ether supply metrics.

Ethereum will ‘burn’ more ether post-merge, removing more ETH from circulation and increasing the coin’s deflationary pressure. As a result, ETH issuance could plunge by 90% post-merge. Over and above that, Ethereum will increase its staking reward, and its staking network will earn the fee revenue that goes to Ethereum miners’ wallets.

Consequently, as per Arthur Hayes, CEO of Bitmex, “The native rewards issued to validators in the form of ETH-based issuance and network fees for staking Ether in validator nodes renders Ether a bond.”

As per Arthur’s predictions, following The Merge, stakers could earn an 8% to 11.5% APR on staked ETH. As a result, if ETH prices were to plunge by 32%, stakers earning an 8% APY would enjoy returns that outshine a decade-long 2.5% interest bond.

Therefore, many U.S. bond investors may begin to seek yield from ETH 2.0 rather than the U.S. bond market. However, the institutional infrastructure facilitating such investments has not been tested or approved.

As more investors begin to hold ETH in their wallets to support network operations and earn staking incentives, ETH will increase its utility as a passive investing asset. Pundits such as Lucas Outumuro, Head of Research at IntoTheBlock, are eyeing a 12% staking APY.

“Through the merge with the proof-of-stake chain, fees previously earned by miners will pass on to being earned by those staking. This is expected to result in staking rewards between 7% and 12%,” he says.

Currently, over ETH holders have deposited over 10 million ether into Ethereum proof of stake contracts. At least 8.3% of all ether in circulation is locked in staking contracts. The amount of staked ether has ballooned by double digits in the last few months as savvy investors take note of The Merge’s bond-like effects on ether.

To this end, exchanges have experienced massive ether outflows as ether accumulators look for positive real yields in a bear market. Most of these outflows are lowing to liquid staking protocols such as Lido that reward depositors with stETH.

Lido offers its ether stakers a 3.9% yield on deposits and holds over one-third of all staked ether. The growth of liquid staking platforms has raised fears of Ethereum centralization, and critics have warned that the issuance of staked ether (stETH) amplifies DeFi systemic risks. The recent 1:1 stETH:ETH depeg and consequent liquidations following the huge $1.5 billion stETH dump by Alameda Capital demonstrate this risk.

On the flip side, the growing popularity of liquid staking platforms is proof that there will be growth in liquidity in decentralized, safe, tried and tested ether deposit-taking and collateralization platforms such as Mimo Protocol post-merge. Accumulators that want to hodl their ether and seek assured returns away from long-term and locked staking smart contracts can borrow PAR stablecoins against their ETH on Mimo.

More institutional investors in DeFi post-merge

Ether is currently wildly popular, and its establishment as an ideal investment vehicle will lead to more hodling. The Merge will make ether a deflationary and store of value asset, a significant bullish catalyst. It will also attract major institutions as its sheds its prior energy consumption criticism.

Ilan Solot, a Tagus Capital Multi-Strategy Fund, says, “I’m quite optimistic. Estimates for post-merge yield are at 10% and above. Plus, moving to proof-of-stake means, it’s easier for institutions to adopt it since they don’t need to defend the energy consumption part of investment argument associated with bitcoin and proof-of-work coins.”

Sygnum Bank, a Switzerland-based bank, now supports institutional staking services. Then Staked, a staking services provider, announced a staked ETH trust in March and will provide an 8% APY on staked ether.

Elsewhere Goldman Sachs is offering its clients exposure to ether via Galaxy Digital Holdings Ltd fund. In addition, Goldman will earn referral fees from Galaxy’s ether fund.

But then, as per CoinDesk’s director of professional content, Galen Moore, there is an inverse relationship between rising ether prices and dropping levels of ether in DeFi. “Demand for DeFi lending services built on Ethereum shows a pattern of inverse relationship to the price of ETH. When ether prices are falling, the amount of ETH locked in DeFi tends to rise”, says Galen.

Galen says this relationship points to circular user adoption of DeFi protocols. The interrelationship between ETH prices and DeFi gains proves that the latter has not “crossed the chasm and drawn new users into Ethereum.”

Galen also believes that the inverse relationship between ether deposit in DeFi and its price indicates that the sector is approaching an adoption limit. All eyes, therefore, are on ether prices post-merge. Should The Merge break or reverse DeFi’s inverse relationship with ether prices, it could be a sign that its protocols establish use cases that will bring Ethereum and DeFi to the wide world.

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