Unless you’ve been living under a crypto rock, you’ll know that Ethereum’s long awaited, much discussed transition from a proof-of-work consensus mechanism to proof-of-stake is poised to happen this month.
The Merge, as it’s known, is the most consequential alteration to a blockchain protocol in the history of cryptocurrencies. The question for investors is whether the market for Ethereum’s native token, ether, is pricing in this momentous shift.
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I argue that it is not, primarily because of the value that institutional investors will eventually find in “Ethereum 2.0.” (Note: my expectation for a higher ether price does not necessarily mean Ethereum 2.0 will perfectly adhere to the purest principles of decentralization. They are two different things.)
Before we go into that, let’s look at the factors behind ether’s price declines of the past couple of weeks, which removed a short-lived, Merge-driven premium. That should help us assess the bears’ case.
Factor #1: Doubt
Like the townsfolk in Aesop’s fable, “The Boy Who Cried Wolf,” investors in Ethereum have years of historical precedent to be doubtful that this thing can go ahead.
Even if the Merge does proceed, there’s a high prospect for glitches and failures in this exceedingly complex and inherently contentious shift. And if that happens, DappRadar has warned, there could be negative knock-on effects for decentralized finance (DeFi) protocols and other systems built on top of Ethereum.
But while we should respect the wisdom of the crowd, there’s one crowd whose opinions matter most: the vast Ethereum developer community, which has been kicking the tires on this project for years. And as Bankless founder David Hoffman noted in a rebuttal to a contribution on that media outlet’s service from Jordi Alexander this week, “the people who are experts on the details of the Merge are more bullish on its success than the [broad community of] people responding to [Twitter polls on the matter.]”
You could even argue that all the false starts give greater weight to the probability of success now. Developers are an obsessively cautious, risk-averse breed, which resulted in all the previous postponements in the proof-of-stake transition. That they’re moving ahead now suggests an extremely high degree of quality assurance has been carried out.
Factor #2: Regulatory risks
The U.S. Treasury Department’s move on Aug. 8 to sanction the mixing service Tornado Cash has caused great concern in the Ethereum community. Companies and foundations running Ethereum-based services quickly moved to block wallets with exposure to tokens that had passed through Tornado Cash.
The response has fueled concerns that corporate providers of staking pool services will also be under regulatory pressure to exclude tainted on-chain transactions in blocks, which implies an end to the vital principle of censorship-resistance.
These are real and important concerns. (Hence my earlier caveat distinguishing between prices and principles.) But restrictions on sanctions-tainted tokens could, counterintuitively, be a motivation for compliance-obsessed institutional investors to buy ether. And for the many who rightly need privacy in their transactions, the Treasury Department’s move is simply going to spur all manner of alternative solutions to bubble up.
Factor #3: Macro conditions
The main reason ether has fallen these past two weeks is exogenous to Ethereum. It’s because Federal Reserve Chair Jerome Powell warned that interest rate hikes will go on longer than people had hoped. That led investors to dump all “risk assets,” a category to which crypto currently belongs in their minds.
But if you’re looking for a story around ether decoupling from other assets dragged down by macro factors, then The Merge offers you one.
That story starts with traditional finance (TradFi) institutions. Those are the guys whose “risk-off” instincts in the face of tighter monetary policy led them to dump digital assets and exacerbate the current crypto winter. They’re the same guys who will help lead us into spring.
We know that despite the moribund state of markets, many hedge funds, family offices, venture funds and even pension funds and endowments are looking seriously at the long-term benefits of including crypto in their portfolios. Below I lay out why post-Merge ether could figure prominently in their future allocations.
The institutional case
- ESG compliance: Look, as I’ve frequently stated, I think the anti-Bitcoin spin among many environmentalists wildly misses the opportunities for promoters of renewable energy to partner with miners to fund and build demand-response solutions that help make grids greener. But the reality is that until those solutions become ubiquitous, Bitcoin’s proof-of-work system will continue to produce a massive carbon footprint, making it a pariah among entities looking to meet environmental, social and governance (ESG) standards. Major institutions will be constrained from investing in bitcoin by their internal investment committees and, soon, by regulations coming from the Securities and Exchange Commission. Ethereum’s shift to a massively less energy-intensive proof-of-stake mechanism will make ether, by comparison, much more attractive.
- Staking as “fixed” income. Proof-of-stake systems allow holders of the token to passively and predictably earn additional tokens by participating in blockchain validation. Although the dollar value of ether will continue to swing, that income model looks a lot like the fixed-income patterns of bonds, an asset class on which institutions are steeped. With sophisticated DeFi hedging and stablecoin solutions coming, institutions will likely avail themselves of some unique new financial instruments that bring reliable returns to their portfolios. The staking boom is coming.
- Scarcity function. According to the current Ethereum 2.0 specifications, the Merge comes with a significant, multi-year phased reduction in the rate of new ether issuance. This will make ether comparatively scarcer than it was and, by extension, underpin its market value. Institutions are going to like the long-term outlook in that.
- Positive narrative. There’s a can-do aspect to all this that can’t be overstated. It is truly impressive that a hurly-burly, disparate community of open-source developers could pull this off while a blockchain supporting around $200 billion in total value continued to operate. It’s a grossly underappreciated example of humanity’s capacity for innovation and collaboration. That’s a positive story (assuming the Merge goes ahead as planned) that will boost confidence in Ethereum and, by extension, attract new and old investors.
Might the bears prove me wrong? Of course. And, as I said, the bull case I articulated comes with challenges to decentralization and a validation of wrongheaded ESG reasons to support proof-of-stake over proof-of-work. But, no, I don’t think the Merge is priced in.