The upcoming Ethereum merge is not priced in, according to its founder.

He is right; how could the merge already be priced in if most market participants have only a vague understanding of what it is? This post is intended to quickly bring you up to speed on what the Ethereum merge is and the different scenarios that might arise in its aftermath.

As this is a lengthier post, it will be divided into four sections for clarity.

I   Rebellion of the miners

II   DeFi shadow economy

III   Trader’s delight

IV   OFAC, we are in danger!

Before diving into details, here are the basics you need to know:

• The Ethereum network is switching from an energy intensive proof of work (PoW) consensus mechanism to a proof of stake (PoS) one that consumes almost no energy

• The tentative plan is that on September 15-16th, 2022, the “execution layer” that is the current Ethereum PoW chain will be “merged” with the PoS beacon chain “consensus layer”, completing Ethereum’s transition to running on PoS consensus

• NYALA plans to only recognize the PoS version of Ethereum in our indices post-merge, barring any unforeseen circumstances

• Post-merge, ETH’s annual supply inflation rate will drop from its current ~4.5% to somewhere between 0.5-1.5%, depending on how much ETH is staked[2]

• Unlike PoW miners that need to sell some of their proceeds to cover expenses, PoS validators have virtually no operational overhead that would force them to sell to cover ongoing expenses

• Ever since Ethereum Improvement Proposal (EIP) 1559 was enabled in August 2021, a portion of each Ethereum transaction fee paid has been permanently burned instead of being paid to miners

• Due to these factors, Ethereum could plausibly become a deflationary currency with a shrinking supply post-merge

• Ethereum transaction fees will NOT be reduced by the switch to PoS; in fact the USD price of transaction fees goes up if the deflationary tokenomics work as intended!

• Scaling transaction throughput to reduce transaction fees is planned to be achieved with “sharding”, which is at least a couple of years away from implementation on Ethereum

I   Rebellion of the miners

From the point of view of existing Ethereum miners, the switch to PoS is a disaster. They lose their raison d’etre and source of income as a result of the merge. The miners being deprecated have nearly every incentive to push for a contentious hard fork, engineering a final profit opportunity that they are likely to milk for the coming years.

A contentious fork of a blockchain occurs when there is too much disagreement over a change being made and the blockchain “forks off” into multiple independent blockchains that conform to the desires of the different camps. Each forked blockchain has its own version of the original token, so the holder of a single pre-fork token will be able to claim and spend multiple forked tokens. In defiance of logic and traditional economic thought, the combined market capitalization of the forked tokens often exceeds the market capitalization lost by the original chain being forked.

The “last stand” mentality of Ethereum miners with nothing to lose is likely to result in popcorn-worthy outcomes during the merge. Insider information and coordination can make forks extremely profitable events for instigators that can control events and are looking at their last chance to cash out. Chandler Guo, an influential figure in the Chinese Ethereum mining community and important driver of the Ethereum Classic fork, is promising to fork Ethereum again.

II   DeFi shadow economy

Another reason to expect drama is Ethereum’s massive size. We simply have never seen a $200bn+ USD market capitalization blockchain hosting thousands of smart contracts that collectively control ~$40bn USD in assets undergo a contentious hard fork. History and futures markets tell us that the ETHPoW forks will have a market capitalization of at least a few billion USD but what will happen to the DeFi economy on them? Circle and Tether have already announced that only USDC and USDT stablecoins on the PoS chain will be valid but smaller DeFi and stablecoin projects may deviate by not moving over or retaining unexpectedly high residual value on the PoW forks.

If ETHPoW tokens have value, then maybe CRV tokens on ETHPoW still have value too. This means that liquidity provision could still be incentivized and Curve liquidity pools could continue to function on ETHPoW. Even if Chainlink oracles will not function on the PoW chains, other types of oracles will and can suffice for most purposes in the beginning. Will we see parallel DeFi economies running on ETHPoW forks? It’s likely.

Now that certain NFTs cost more than luxury real estate, it is also worth thinking about whether an NFT on a PoW chain could have any value. If the NFT points to the same IPFS link from every fork, which is the real NFT? In light of questions like this, it is safe to say that copies of NFTs on forked ETHPoW chains will have some value and we should expect to see marketplaces pop up for holders to sell their “knockoff” NFTs on ETHPoW forks.

III   Trader’s delight

So how exactly can one benefit from these forks? You must be holding spot Ethereum at an address to which you control the private keys. If you leave your Ethereum on an exchange or with some other custody provider, there is no guarantee that they will credit you the forked tokens. Once the fork occurs, you will need to find a reliable wallet provider that supports the forked token and import your account there, before sending the forked token to an exchange or elsewhere.

Those who are a little bit more sophisticated could consider holding spot Ethereum to collect the forked tokens but hedge their price exposure by selling short the equivalent amount of ETH futures contracts or stETH tokens. Exchanges like Poloniex and BitMex already offer trading of ETHPoW futures contracts, so one can already see the market’s estimate of the fork’s value before deciding whether to pursue a strategy.

Another strategy to consider is borrowing ETH with stablecoins such as USDC and USDT with a DeFi protocol on Ethereum, such as Aave. On any PoW fork on which the ETHPoW token has value and DeFi protocols are operational, you will be able to sell your ETHPoW tokens for a profit and possibly repay your version of the loan on that chain with worthless stablecoins at essentially no cost. This is a much more complicated strategy that is dependent on timing; we should expect to see on-chain ETH borrowing to spike shortly before the merge is supposed to occur for this reason.

This is not financial advice, do your own research and consult your financial advisor before making any financial decisions.

IV   OFAC, we are in danger!

The potential issues that could arise from the merge do not stop when the merge is completed in September. The Ethereum Beacon Chain was launched in Dec 2020 with the intent to test Ethereum PoS consensus in production and accumulate sufficient staked ETH to secure the chain. At the time of this writing, there are more than four hundred thousand validators active on the beacon chain but this number is misleading because each validator’s stake is capped at 32 ETH. This means that someone who wants to stake 320 ETH will need to create ten validators. The validator count statistic thus does not inform us how many actual entities amongst the validator set, nor how their stakes are distributed.

When we look at the data with other tools, we can see that validator concentration is actually quite high. Lido, a decentralized liquid staking protocol, controls around 30% of staked ETH and Coinbase + Kraken + Binance control another combined 30%. The risk of collusion is elevated.

This concentration of the validator set is particularly concerning in light of the US Treasury Department placing the mixer, Tornado Cash, on the OFAC sanctions list recently. Tornado Cash is a tool used to obfuscate the origin of assets sent on the Ethereum network. To comply with American regulation, cryptocurrency companies and applications must not allow American users to interact with individuals and entities on the OFAC sanctions list. The reaction by most cryptocurrency apps and companies in cutting off Tornado Cash and addresses linked to it was blunt and swift.

Some apps and companies even went overboard with enforcement. An activist and/or prankster sent 0.1 ETH tainted by interaction with Tornado Cash to many prominent members of the crypto community with known addresses. The recipients soon found that they were blocked by the Aave front-end from interaction with their loan position due to an update that the Aave team quickly shipped to their front end. After complaints, this blanket enforcement measure was temporarily rolled back.

These events make it clear that Ethereum is at a heightened risk of regulatory capture in this tender moment of its evolution. If regulators demand that Ethereum PoS validators do not include transactions linked to OFAC-sanctioned addresses in blocks that they validate and the majority of staked ETH is controlled by staking pool operators with significant US business exposure, as it is today, the expectation is that they will comply and the dissenting validators will be unable to effectively resist.

An OFAC-compliant Ethereum would be received as a hostile takeover by most of the crypto community and would certainly lead to an additional fork, a second PoS Ethereum chain that would claim to be credibly neutral by refusing to censor transactions. The most pragmatic long term solution would be to try and diversify the validator set with an influx of new, independent participants before this scenario materializes but the convenience offered by staking pool providers makes concentration of tokens into their control seem impossible to overcome.

Another option is slashing. Ethereum’s current PoW consensus does not make it immune to demands by regulators to censor certain transactions, but it at least is not possible to seize the tokens of others for not doing so. In Ethereum’s PoS version, validators can lose their staked tokens for acting against the rules or interests of the network. This act of seizing the tokens is called slashing. Slashing can also be initiated via social consensus; both sides of this hypothetical battle are likely to use slashing as a threat or weapon against the other side to try and win. The Ethereum community has repeatedly asserted that it could coordinate a social recovery of the network in such scenarios by invoking slashing of the transaction-censoring validators' tokens through social consensus.

There is so much built up expectation and capital riding on the upcoming Ethereum merge that it is likely to be a source of drama for the rest of the year in the crypto community. After multiple successful merges on Ethereum testnets, the Ethereum community generally has faith that the merge will be smooth and turn ETH into a deflationary, ESG-friendly, yield-bearing asset that institutions will invest in heavily. On the other hand, many traders see a messy merge as likely and are positioning themselves to profit accordingly. These viewpoints cannot be reconciled easily; who will be right? The best heuristic of what will happen in crypto is to imagine what the most absurd outcome would be. I leave it to the reader to imagine these scenarios, confident that no matter what you think of, you will be surprised by the events of the Ethereum merge in September.

Good luck to all who partake!

^[1^] https://twitter.com/Blockworks_/status/1552581167550963712

^[2] https://docs.ethhub.io/ethereum-basics/monetary-policy/

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