The current overwhelmingly bullish narratives on Ethereum in the market and a generally bullish positioning by market participants going into The Merge raise the question: has the recent 100 percent+ rally been the start of long-lasting outperformance, or is the news now priced in, with the risks slanted to the downside?
The price of Ether has more than doubled since the mid-June lows of under USD 900 as Ethereum developers named mid-September dates for the long-awaited major upgrade (The Merge), which will change Ethereum’s consensus mechanism from the energy intensive proof-of-work to proof-of-stake. Ether has outperformed Bitcoin by 65 percent over this period.
Ethereum founder, Vitalik Buterin contemplated the proof-of-stake consensus mechanism in public posts already in 2014 during Ethereum’s ICO, well before the July 2015 launch of the network. The testnet for the upgrade launched early May 2019, and the new 2.0 chain started running in parallel in December 2020. Since then, repeated delays have dampened sentiment, even as Ethereum successfully cleared further hurdles of testing.
Meanwhile as application sectors took off during the 2020-1 bull market, the Ethereum network became congested with high transaction volume and transaction fees spiked. This allowed competing protocols such as the Binance Smart Chain, Solana, Avalanche, to take market share from Ethereum.
Announcing the expected go-live date for the upgrade removed uncertainty and raised the expectation that Ethereum will be recapturing lost market share. The price of Ether has doubled since, and Ether options surpassed the volume of Bitcoin options for the first time, with the ratio of calls (bullish positioning) to puts on Deribit at around 4 to 5 times vs the same ratio for Bitcoin at 2 times.
What is the upside?
The upgrade will make the Ethereum network much more efficient, with the energy consumption declining by over 99 percent. It will be much cheaper to run also because it will not require major hardware investment by validators.
The upgrade will also make Ethereum less inflationary and possibly even deflationary. The issuance of Ether will decline by approximately 90 percent as with the lower operational costs of validators lower rewards will suffice.
This makes the supply/demand of Ether more attractive, especially as it comes on top of Ethereum’s adjustment of its “monetary policy” last year, introducing a change where a portion of the transaction fees are burnt (destroyed).
In addition, as the proof-of-stake mechanism requires validators to lock up (“stake”) tokens, the liquid supply of Ether will be further reduced.
Proof-of-stake chains are more valuable as the transaction fees remain within the ecosystem and benefit token holders either directly (if they choose to contribute to validator pools) or indirectly (by lowering the liquid supply due to validators’ staking, in addition to burning some of the transaction fees). Contrarily, proof-of-work chains pay the transaction fees and distribute newly issued tokens to external parties, i.e., the miners.
Based on these changes, it would be reasonable to expect Ether to outperform Bitcoin, yet the price of Ether measured in Bitcoin is still 10 percent below the 1-year high it reached last December and 45 percent below the all-time high.
A successful upgrade to proof-of-stake by the second largest blockchain protocol will influence the long-standing debate on the relative merits of the proof-of-stake vs proof-of-work mechanisms, and it may tilt sentiment further away from proof-of-work blockchains (most importantly Bitcoin) which are already strongly criticised for their high energy consumption. This would improve the chances of Ether “flipping” Bitcoin, and potentially becoming the #1 cryptocurrency.
And while Ethereum’s cautious approach to the upgrade has caused significant delays, it also provides confidence that by the time the upgrade goes live, the technological risks will have been significantly mitigated.
What are the risks?
The greatest risk to the price performance of Ether might be a widespread misunderstanding of what The Merge will accomplish. Ethereum is executing on a roadmap, and the upgrade to a proof-of-stake network is just the first step.
The Merge is the first phase of a five-stage upgrade plan, although in terms of the effort required, it is the largest component (55 percent of the work). But it isn’t The Merge that will make transactions faster and cheaper on the network but the next stage of the upgrade, the “Surge” which is expected to go live in H2 2023.
Ethereum transaction fees have fallen this year as network activity declined during the bear market. However, if activity picks up strongly again before the next phase of the roadmap is executed, the Ethereum network will become congested again and transaction fees will spike. This may both, disappoint those who might have expected The Merge to accomplish all those improvements, and it will provide continued opportunity for competitors to take market share and solidify it.
The longer it takes for Ethereum to get to a truly scalable solution, the more time competitors have to improve their tech stack and build their user bases.
Ethereum futures with expiry past the planned Merge go-live date have been trading at a discount to the spot price – the widest discount since the March 2020 crash. This may be interpreted as a sign of market participants being positioned for “buy the rumour, sell the news” type trades which would suggest that the positive news is already priced in.
It is, however, more likely that the backwardation of Ether futures is a consequence of the arbitrage trade (long spot/short futures) that intends to benefit from a planned fork of the proof-of-work version of Ethereum. Prominent miners are intending to maintain the original version of the protocol and issue a new token which Ether holders would receive for free.
In addition to the above, technological risks remain. Despite the cautious approach of the Ethereum developer team to implementing the proof-of-stake upgrade, a new piece of technology always carries the risk of vulnerabilities and bugs.
And while the date now appears confirmed and the risk of further delays very small, should there be an unexpected delay, it would be negative for the price of Ether.
Finally, there is a small risk that regulators would view Ether as a security after the upgrade. This seems unlikely as the majority of blockchain protocols are proof-of-stake at this stage so it isn’t Ethereum that introduces this feature for the first time, and such damaging regulatory action would be out of line with Western regulators’ broadly accommodating and supportive stance. The legal arguments, however, are somewhat murky, leaving the door open to capricious regulatory action.
Is the opportunity greater than the risks?
The greatest risk in the near term is a possible disappointment that The Merge will not make transactions faster and cheaper and that this improvement is still at least a year away. Over the medium-term, however, the opportunity from a well thought through, comprehensive upgrade of the (by a long way) most widely used smart contract platform is tremendous.
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