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In recent days, a number of crypto analysts have been postulating that Ethereum (ETH), in its post-merge phase, would constitute an attractive alternative to the U.S. Treasury bonds based on the expected yield differential between the two assets. However, not only is this comparison a bit disingenuous, but it also seeks to reinforce the heightened correlation regime that currently exists between crypto and the rest of the financial sphere, thereby harming the credentials of Bitcoin and Ethereum as near-perfect hedging instruments.
The respected blockchain data platform, Chainalysis, recently published a report on Ethereum’s upcoming merge event, claiming that elevated Ether yields “could make Ethereum staking an enticing bond alternative for institutional investors”:
“Some predict that between staking rewards and transaction fees distributed to validators, stakers can expect Ether yields of 10-15% annually, and that’s before factoring in the potential for the price of Ether itself to rise, which would also increase returns in terms of fiat value (of course, Ether’s price could also fall, which would hurt fiat returns). Those returns could make Ethereum staking an enticing bond alternative for institutional investors. For comparison, yields for one-year U.S. Treasury bonds sit at 3.5% as of September 2022, though that number has been rising over the past year.”
However, this comparison is a bit disingenuous due to a number of reasons. First, Ethereum, Bitcoin, and other cryptocurrencies are fundamentally different from other financial assets as their intrinsic values are not a function of the Federal Reserve’s benchmark interest rates. This benchmark rate feeds into the U.S. equities via the equity risk premium. It also directly affects U.S. Treasury yields. In the case of crypto, however, any feedback loop vis-à-vis the Fed’s benchmark rate is a second-order effect resulting from the broader aggregate demand in the economy. Here too, the effect is muted by the global nature of the crypto sphere. It is for this reason that many analysts were surprised by the recent heightened correlation regime between the crypto sphere and the rest of the risky asset universe, especially as these synergetic dynamics then stripped away the supposed hedging credentials of Bitcoin and Ethereum.
Secondly, we’ve explained in a dedicated post that elevated Ethereum yields in the post-merge phase will likely be unsustainable. As Ethereum transitions to a Proof-of-Stake (PoS) transaction authentication mechanism, its daily issuance is set to plummet drastically from around 13,000 ETH to only around 2,000 ETH. Eventually, as staking activity ramps up, this issuance is expected to stabilize at around 5,000 ETH per day. Ethereum’s intrinsic supply burn mechanism is a crucial factor in generating elevated yields. Here, the base-fee, which is determined in real-time using network congestion as its primary input, is burnt while the validators’ rewards predominantly consist of two variables: the tip fee, which is the cost incurred by a user to prioritize the processing of a particular transaction, and the block subsidy, which is currently fixed at 2 ETH per block and is divided equally among all of the validators. The infographic below details all of the factors required to ensure a high yield on Ethereum.
While everyone agrees that Ethereum yield will sky-rocket in the immediate aftermath of the merge event, this regime will likely prove to be unsustainable as it will attract a flood of new staking activity that would then arbitrage away this phenomenally attractive yield on staking Ether coins. After all, Vitalik Buterin had claimed back in July that the annual issuance of ETH would be equal to 166 times the square root of the number of staked coins after the merge. As staking increases, so will the issuance of Ethereum, thereby moderating the coin’s yield.
Coming back, the upcoming initial thrust in Ethereum staking yield is more symptomatic of junk bonds as opposed to U.S. Treasury bonds, again highlighting the disingenuous nature of this comparison.
Finally, the true intrinsic value of the U.S. Treasury bonds emanates from their risk-free characteristics. Ethereum, as a wholly risky asset, is unlikely to ever enjoy such privileges.
Ethereum, Bitcoin, and other crypto assets derive their utility from the fact that these assets are not under the control of any particular legal jurisdiction. This is why crypto commands value. This is why Ethereum has emerged as the preeminent platform for Decentralized Finance (DeFi) applications. By presenting Ethereum as an alternative to the U.S. Treasury bonds, crypto analysts are reinforcing the correlation between these disparate assets and doing a disservice of sorts to the broader super-asset characteristics of cryptocurrencies.