How to find excess returns from the upcoming Ethereum merger?

First of all to clarify, I already have ETH-related positions, so there is a possibility that my butt will decide my head:) Please mainly look at my analysis logic. As for the relevant investment advice, you still have to think more and come to the conclusion DYOR.

In general, I think the Merge of Ethereum PoW to PoS is a very important, or even the second most important thing in the development of cryptocurrency after the Bitcoin white paper . In fact, the entire market has been warming up to the Merge event of PoS since the implementation of the Ethereum EIP1559 burning mechanism in August last year, but it seems that the progress has always been slower than expected in the past year. Prices were not much affected by this event.

In my framework, Merge is a positive “gray rhino event” : it is very important and is often mentioned by the market, but the specific progress and medium and long-term impact are not given enough attention by market participants, or they feel that this is only a one-time event, Underestimating it fundamentally changes the supply and demand structure of ETH and brings a continuous inflow of funds. The related assets of ETH before and after the merger may therefore have significant excess returns.

The point at which the Merge completes is an important variable. As a non-technical investor, I try to extract valuable information from public information. My preliminary conclusion is that it will happen in this time window from the end of September to the end of October , for your reference and hope to get feedback.

Finally, I have transformed from a Tradi Fi investor to study Crypto: Crypto research requires a comprehensive knowledge structure, which is very difficult, but there is sufficient public information in the industry that practitioners are willing to share. At the same time, in the early stage of paradigm shift, in-depth exploration of the industry may seize the opportunity of excess returns and bring positive feedback. I would like to share with you all here, I believe whether it is BUIDLER OR HODLER, WAGMI in the industry:)

The main analytical framework of this paper:

1) Merge, What, Why & Wen of Ethereum?

2) Merge’s impact on ETH

3) Related investment opportunities

4) Risk: delay again, merger problems, macro, supervision

  1. Insights after research and further understanding of Ethereum culture

first part:

A)What’s Merge

The Merge of Ethereum is the consensus mechanism that Ethereum will adopt PoS (Proof of Stake) instead of PoW (Proof of Work). Both PoW and PoS are different means of achieving consensus.

In PoS, participants need to pledge 32 ETH to qualify as Validators, which does not require a lot of computing power. Validators are randomly selected to create blocks and are responsible for checking and confirming blocks that they did not create. Validators are rewarded for proposing new blocks and proving blocks they have seen. If you provide proofs for malicious blocks, you lose your staked ETH.

It is called “merge” because ETH merges the beacon chain (consensus layer CL) with the existing chain (execution layer EL) and discards the PoW part of the execution layer.

Ethereum is about to merge, how to find excess return opportunities?

B)Why Merge

Quoting Buterin’s explanation: POS is more energy efficient, has lower security costs to maintain, is easier to recover from attacks, and is more decentralized . https://vitalik.ca/general/2020/11/06/pos2020_zhTW.html

In addition, after solving the technical problem of merging, Ethereum developers can focus more on long-term important things such as scaling, sharding, and state management.

Staking is similar to mining, but differs in many ways. Mining requires significant up-front expenditure, in the form of powerful hardware and energy consumption, which generates economies of scale and promotes centralization. Mining also doesn’t require assets to be locked as collateral, which limits the protocol’s ability to punish bad actors after being attacked. In contrast, the transition to PoS will make Ethereum more secure and decentralized. The more people involved in the network, the more dispersed and less vulnerable it is to attack.

After the merger, PoS can provide higher security at the same cost, in other words, POS pays less block reward for maintaining the same security.

C)Wen Merge

Ethereum is about to merge, how to find excess return opportunities?

Based on the public information collected, I think the end of September to the end of October is the most likely time window for the merger to be completed . On the night of Consensus-layer Call 91 #566 last Thursday (7/14), the core developers gave the specific date for the first time: expected on 9/19 (of course, it should be noted that technical developers are always optimistic, historical mergers The plan was delayed many times)

Ethereum is about to merge, how to find excess return opportunities?

At present, the merger of the Ropsten and Sepolia testnets, which are currently watching the testnet, has been successfully completed, leaving only Goerli as the last testnet before the mainnet launch. The next time is the Goerli testnet, which is expected to open at the end of July and early August.

The effective period of the difficulty bomb in mid-June was extended by about 100 days. By the end of September, if the merger is unsuccessful, the mining difficulty will increase significantly, and the block time will be greatly extended, which will bring security and user experience issues.

The following are some important nodes that I judged from now to before the implementation of Merge. You can judge the progress of Merge according to this:

1) Goerli testnet Merge is first prepared and officially implemented around 8/11, 2) During the preparation of Bellatrix, EF will release Paris and Bellatrix client updates in advance (it is estimated that around 8/18, the recent ACD will be on 8/18) 18th), and communicate the specific upgrade time of Bellatrix (according to slot height of CL) (implying early September); 3) During this period, EF will announce the final official TTD (Teminal Total Difficulty) through Blog; 4) After After the CL hard fork upgrade was completed (early September), Bellatrix waited for the miners’ computing power on EL to reach the announced TTD difficulty threshold, and then the Pairs hard fork upgrade on EL was started; Bellatrix and Paris upgrade under ideal conditions It will only wait 1-2 weeks in the middle; 5) At the same time, the nodes on CL will start to process the transaction packaging on EL after TTD is realized, and the merger of EL and CL chains will officially start. The estimated time is September/19.

The above analysis has many subjective judgments of mine, and the real progress will have many uncertainties. Here it is again emphasized that the historical merger plan has been delayed many times, and it is not ruled out that it will be delayed this time :) But I believe that with the success of many tests and the resolution of the remaining bugs, the final merger is not far from us.

The general coordinator of the merger, Tim Beiko, emphasized that the merger will only be postponed to 2023 if a series of major bugs beyond imagination occur during the testing process . The difficulty of Merge is largely (50%) due to being Instantaneously, analogously to changing the engine of a high-speed plane.

Part II: Merge’s Impact on ETH

1) Impact on the supply side:

After the merger, the new supply of ETH will drop by 90% , which is often mentioned in the industry as the equivalent of completing three halvings. Considering the burning mechanism of transaction fees (85% of the handling fee is burned), the ETH burned by the handling fee after the merger may exceed the newly issued ETH, which will bring about the deflation of ETH. We will therefore see the largest supply-side readjustment of mainstream tokens in Crypto history:

The pre-merge ETH supply increased by 14,500 ETH/day , and the transaction fee burned by 3,000 ETH/day , a net increase of 11,500 ETH/day .

After the Merge ETH supply increased by 1800 ETH/day , and transaction fees burned by 3000 ETH/day , resulting in a net decrease of 1200 ETH/day .

After the Merge, the new supply of ETH is reduced by 90% . At the current level of transaction fee burning, ETH enters deflation (-0.35%)

Ethereum is about to merge, how to find excess return opportunities?

  1. Demand-side impact:

The direct impact of Merge on the demand side of ETH is limited, because the merger will only have a slight impact on Ethereum’s network throughput and Gas Fee, and will not bring about a large change in fee burn. However, its indirect impact will still be obvious, mainly through the higher staking yield (Staking Yield) generated by staking ETH after the merger to attract external funds to buy ETH .

The endogenous staking yield (Staking Yield) of staking ETH after the merger can be regarded as the “risk-free yield” in Crypto, which will be the anchor of Defi’s yield; Defi/NFT Lego will be on top Build richer combinations.

At the same time, the merged ETH will become an interest-earning asset with a stable rate of return , which can be regarded as the highest-quality “perpetual bond” in crypto, which can generate stable future cash flow , so it can be better used by traditional investment institutions. Discounted cash flow to value, understand and configure.

It is emphasized that the pledge income of ETH is also paid with the native Token on the chain like other POS chains, and it is not a direct legal currency cash flow. However, due to the wide application of ETH in cryptocurrencies, especially in the NFT field, it has been used as the basis for pricing, so ETH has certain monetary attributes and can be easily converted into legal currency.

Specifically, Staking Yield consists of three parts:

Staking Yield = ETH block reward return + Priority fee return + MEV return

Ethereum is about to merge, how to find excess return opportunities?

A) The newly added ETH block reward income received by the pledge node (Validators): According to the current growth rate, it is estimated that nearly 14 million ETH will be pledged by the time of Merge, and the corresponding annual newly issued reward is 650,000 ETH , that is, the additional issuance The ** yield is around 4.6%**.

Ethereum is about to merge, how to find excess return opportunities?

B) transaction tips (priority fees) received by staking nodes (Validators)

Proritiy fees for transactions account for about 15% of the total transaction fees (the other 85% are burned to directly reduce the ETH supply), and are earned by miners under the current PoW mechanism. After the merger, the tip will be earned by the PoS pledge node, increasing the node’s income. The revenue of this block is closely related to the transaction activity of the Ethereum network. When NFT was the most active at the end of last year, the total transaction fee of the network as a whole could reach 14,000 ETH/day. However, during the current downturn in market activity, the transaction fee has dropped to about 4,000 ETH/day. sky.

Based on the current total transaction fee, the transaction tip rate attributable to staking nodes (Validators) is about 1.5% . But keep in mind that this rate of return will be closely related to market activity, and trading tips will increase significantly during bull market trading.

Ethereum is about to merge, how to find excess return opportunities?

C) MEV (Maximal Extractable Value) income obtained by pledge nodes (Validators)

The MEV of ETH under the PoS mechanism will also be obtained by staking nodes (Validators). Based on the average MEV value over the past few months, the yield attributable to Validators can reach nearly 1%.

Ethereum is about to merge, how to find excess return opportunities?

D) To sum up, the yield of income pledge is mainly affected by two factors: the total amount of ETH involved in pledge and the transaction fee level of Ethereum (MEV is also closely related to transaction fees) .

In addition, considering that the transaction fee burning mechanism of Ethereum will reduce the supply of ETH, the deflationary factor will also increase the actual yield of staking nodes (0.5% in my model).

In my model in the figure below: the combined staking node’s yield (Staking Yield) can reach an annualized 7.5% , much higher than the current 4% staking yield.

Here, according to the traditional financial valuation method, the investment invested by the pledge node in the pledge can recover the full cost within 13 years at an annual return of 7.5%. Using stocks as an analogy, the price-earnings ratio (P/E) corresponding to the pledged ETH is only 13X, which is cheaper than the long-term 18X price-earnings ratio of the S&P500.

Ethereum is about to merge, how to find excess return opportunities?

Non-pledged ETH cannot obtain the above benefits, and greater growth value must be captured in the entire system to cover the opportunity cost forgone. Therefore, ETH users who have not participated in the pledge will consider whether to participate in the pledge to obtain a higher rate of return. More ETH to participate in staking will reduce the ETH supply in the market.

At the same time, the higher the ETH pledge yield relative to the benchmark interest rate in the traditional financial market, the more likely it is to attract institutional funds to participate in the Ethereum ecosystem to pursue low-risk excess yield (Staking Yield minus USTreasury Yield).

Similarly, funds invested in other Tokens in the Crypto world will also consider the high pledge income of ETH after the merger. It is conceivable that a considerable amount of funds will be migrated from the pledge of other public chains to the ETH pledge with a more favorable risk-return ratio.

Therefore, after the merger, there will be multiple funds flowing into the Ethereum ecosystem to participate in the pledge, increasing the demand for ETH. In the long run, the pledge ratio of ETH may increase from the current 10% to 20-30%, while the Staking Yield will gradually decrease.

Ethereum is about to merge, how to find excess return opportunities?

3) From the perspective of capital inflow:

A) Before the merger, there was a net increase in the supply of about 11,500 ETH every day (POW newly issued 14,500 ETH/day – burning transaction fee of 3,000/day). Based on the current price of $1300, it is necessary to continue to have 15 million US dollars of funds to undertake every day. Keeping the price of ETH unchanged would cost $450 million a month and $5.4 billion a year .

After the merger, the daily new supply will be reduced by 90% . According to the current transaction fee burning volume, the ETH supply will be reduced by about 1200ETH/day . At the current price of $1300, it is equivalent to 1.5 million US dollars per day. The net “repurchase” is 45 million US dollars a month , and 540 million US dollars of “repurchase” a year .

When the bear market is over and the market is rejuvenated, the active application ecosystem on Ethereum will consume more handling fees (average 12,000 ETH/day at the end of last year), bringing stronger “repurchase” support.

B) In addition, the newly added supply before and after the merger is different from the actual selling pressure on the secondary market: POW miners will sell 85% of their ETH rewards on average to cover expenses such as electricity costs ; The fixed fee is very low and there is basically no variable cost, and you must hold ETH to participate in the next pledge, the motivation of the ETH pledge income from selling is much lower ( some studies say that the average pledge node will only sell 10%- 15% staking yield ). Therefore, after the Merge, the selling pressure of ETH actually traded in the secondary market may decrease even more, reaching more than 95% .

C) At the same time, there is an interesting observation that the pressure of the structural new supply of the top two mainstream currencies (BTC and ETH) in the cryptocurrency industry under the PoW mechanism has brought about the strong cyclicality of the industry.

In the long run, the ETH after Merge will experience the largest supply and demand structure adjustment in the history of the industry, and its new supply will be greatly reduced or even deflated, resulting in a continuous inflow of funds into ETH, not just a one-time inflow. Therefore, it is said that It’s a positive “grey rhino” incident .

This may change the strong cyclicality of ETH driven by the supply side, and the impact on the demand side will become more important, and Ethereum has evolved to the prosperity of the application level driven by expansion, which will bring more new users and development of block space demand. stage .

The reasons why Merge is difficult to replicate this time: 1) It is necessary to switch from PoW to PoS to bring about a substantial reduction in new supply, while a large number of other public chains are already PoS consensus mechanisms and will not experience such supply again. At the same time, 2) a large amount of transaction fees are burned in the public chain (the fees of Ethereum are more than 5-10 times that of other public chains ), and the superposition of the two can bring about huge changes in the supply and demand structure.

D) Finally, what kind of incremental funds will buy ETH after the merger?

Based on the above analysis, I think that incremental funds will come from — a) funds pledged in other public chains in the cryptocurrency circle , b) some funds held in BTC are exchanged for ETH , c) traditional finance that pursues stable yields institution .

Ethereum is about to merge, how to find excess return opportunities?

Ethereum is about to merge, how to find excess return opportunities?

Ethereum is about to merge, how to find excess return opportunities?

Ethereum is about to merge, how to find excess return opportunities?

4) Other effects of Merge

  1. The ETH pledged after the Merge cannot be withdrawn in the short term, and it will be realized after the Shanghai upgrade at least half a year later (but transaction tips and MEV income can be withdrawn)
  2. Small impact on Gas Fee; fee reduction requires the use of a 2-layer network (eg Roll up)
  3. Clients are more decentralized
  4. After the merger, the core developers can devote their energy to other important development and construction, such as expansion, sharding, etc.

Ethereum is about to merge, how to find excess return opportunities?

Part 3: Related Investment Opportunities

A) The easiest way to buy and hold ETH and sleep

B) Buying tokens from liquid staking pools, such as Lido (LDO) : After Merge, Lido has undergone tremendous changes in its fundamentals, and there are three positives in terms of protocol revenue–the ETH pledge participation rate has increased, and the pledge yield has increased. As well as the rise in the price of ETH. At the same time, the cost side has been greatly reduced, because the treasury now provides LDO tokens as LP incentives for the Curve Steth-Eth pool. After Merge, stETH can be directly exchanged for ETH, and there is no need to use LDO incentives in the Curve pool.

C) Long ETH Short Alt L1 tokens — Avoid macro risks to earn excess returns from pure ETH Merge events

D) Buy a small amount of ETH Call options or Call spreads that expire before the end of the year (the execution price and expiration date are judged according to the period and influence of the Merge occurrence); note that this is similar to buying lottery tickets to gain asymmetric returns, so invest The amount must be controlled

E) Buy stETH to earn a discount relative to ETH, the discount will gradually disappear after the Shanghai upgrade after the merger

Part IV: Associated Risks:

A) Delay risk : lack of communication between nodes and participants; user errors, client problems, problems with applications and service providers
B) Combining technical risks and attack risks — for example, if there is a big problem in the merger, a hard fork is required The network rolls back to pre-merge, and that’s a big problem.
C) More and more people pledge through liquidity staking pools, leading to the risk of centralization D) Programmers who lack understanding of the overall structure and operation of ETH
after the merger , because they were all focused on CL or EL before E) Regulatory risk and macro risk

Part V: Further Understanding of Ethereum Culture and Other Experiences

Through research on Merge (watching KOLs and core developers’ tweets, bankless videos, relevant analysis reports, listening to/watching the videos and minutes of the Ethereum Developer Conference, and visiting the Foundation’s website), the ecosystem of Ethereum has been improved. Deeper understanding: especially its insistence on decentralization, community diversity and deep thinking on the long-term development of the industry .

The Crypto industry is still in the early stage, and there are still many information asymmetries. As long as we ordinary people are willing to do more research and dig deeper, we can find information that is ignored by most market participants, and can also find opportunities to generate excess returns. For example, I went to Youtube to listen to the Consensus-layer Call conference last Thursday night and looked for the minutes immediately after the conference, and I quickly found out that the first time they mentioned the possible time point of Merge: 9/19

Ethereum is about to merge, how to find excess return opportunities?

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/how-to-find-excess-returns-from-the-upcoming-ethereum-merger/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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