For July, we will discuss the upcoming ETH merge and some of its implications.
July was a bullish month for digital assets as there was a broad recovery. The aggregated digital asset market capitalisation is now back to over $1 trillion, and it grew 26% in July. This growth appears to be caused by a change in macro sentiment towards risk-on assets. The NASDAQ was up ±12.5% over the same period and, in general, there is still a strong correlation between digital assets and the broader macro environment.
However, what is promising in digital assets is that assets are beginning to react to independent news and not only trade in unison. In our view, a vital sign of the digital asset credit risk reducing (and the worst of the bear market being over) is when assets in the market start to move independently.
One of the biggest winners of the last month was Ethereum, which has made a strong recovery. Two elements fuelled Ethereum's rally: firstly, Three Arrows Capital, Voyager and other bankrupt companies have sold their ETH holdings and ETH-related debt. Most of this happened in the last weeks of June, removing this overhang for July.
Secondly, the market has become increasingly focused on the upcoming ETH Merge, which has several potentially positive implications for Ethereum. This post will discuss these in more depth, starting with what the Merge means.
The Merge is when Ethereum will move from being a Proof of Work (PoW) chain to a Proof of Stake (PoS) chain. The PoW chain will merge with a PoS chain, known as the Beacon chain, that has been running since December 2020. Technically, the Merge is incredibly complex and challenging. The multiple billion-dollar market cap of Ethereum is at risk, so there have been delays during the extensive testing period.
Technical risk aside, Ethereum will reduce its yearly issuance from 4.3% to 0.43% once the Merge is completed. This reduction is possible because PoS is more efficient than PoW. Currently, the network's security is ensured by miners, who perform work and spend significantly on electricity to do so. In return, these miners are paid with freshly issued ETH. In turn, these miners sell much of what they receive to fund their operations. Miner selling has a downward pressure on Ethereum's price. Modellers predict that miners sell ±90% of all Ethereum they receive.
In a PoS system, the cost of security is only the opportunity cost of the capital, as stakers must lock up capital and cannot do anything else with it. The cost of running a node is negligible, so the network can also reduce the overall network issuance by 90%.
Ethereum has also introduced EIP-1559, which changed how Ethereum manages transaction fees. Based on demand, much of the fee is burnt instead of paid to miners. This burn remains the case with the Merge, which has bullish implications for Ethereum — using the last 30 days of fees, the predicted emission, and the estimated price, we can predict how profitable Ethereum will be after the Merge.
Thus, the Merge will make the Ethereum blockchain profitable at current fees. This is very promising considering that in the last 90 days, the fees' rewards have decreased by 70%. If Ethereum returns to its bull market usage levels, it will be highly profitable. This revenue means the protocol would burn $4m worth of ETH daily. Said differently, after the Merge, any time the gas fees on Ethereum are greater than seven gwei, the rate of ETH burnt will be higher than the rate issued, making ETH deflationary. The graph below shows the median gas price and how often ETH would be deflationary in the last month.
Median Gas Prices on Ethereum over July. Source
Aside from being deflationary, the other benefit for token holders is environmental. The Ethereum foundation predicts that the energy usage of Ethereum will drop by 99.5% compared to PoW.
For token holders, the idea of an asset that is deflationary and energy efficient is highly attractive, and as such, investors have been buying it aggressively in the last month. However, there are a few short-term price risks:
Technical: The technical integration is complex and may cause the blockchain to crash or fail. This has a very low probability but would have a severe impact.
Fork: There is a growing camp of Ethereum miners who want to keep running the PoW version of the blockchain, causing a fork. Any issue with the Merge would empower this group further.
Post-Merge Uncertainty: Any uncertainty around the winning chain could cause the price to fall.
However, for the fork to occur, exchanges need to support the PoW fork. If exchanges refuse to list it, its chance of having a severe impact becomes small. During the build-up and as the Merge occurs, we suspect the market will be volatile and will look to trade it where possible.
Overall, the Merge is an exciting step for the industry, and we wish Ethereum success. It is exciting that teams are developing and improving fundamental blockchain technology as this needs to occur for the sector to grow.