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The recent spectacular pump in the price of Ethereum (ETH) is largely a function of the hype that has been consistently building around the upcoming merge event and the oft-repeated prognosis that the world’s second-largest cryptocurrency by market capitalization is about to turn into an almost perfect deflationary asset in a world beset by raging inflation. However, as with almost all things in life, the reality is much more nuanced.
As a refresher, the upcoming merge event will formalize Ethereum’s transition from a Proof-of-Work (PoW) transaction authentication mechanism, where miners expend computational power to win the right to authenticate incoming transactions, to one based on a Proof-of-Stake (PoS) framework, where validators lock up a specific amount of Ethereum in dedicated nodes in order to compete with each other to authenticate transactions and introduce new blocks into the chain.
We’ve explained Ethereum’s deflationary case in detail in a dedicated post. Please do try to go over that article to gain critical insight into the opposite view to the one that will be explained here.
Jordi Alexander is the CIO of Selini Capital and a game theorist. Bankless recently explained his bearish take on Ethereum’s deflationary characteristics in a dedicated newsletter. We’ll add to Jordi Alexander’s analysis in this post.
Everyone agrees that the upcoming merge event will drastically reduce Ethereum’s issuance. After all, a PoS framework is much more efficient than one based on PoW and requires the expenditure of significantly fewer resources. Currently, miners are responsible for the issuance of around 13,000 ETH per day. With the advent of the PoS transaction authentication framework, just around 2,000 ETH per day would be issued in the beginning to authenticate transactions. As the coins staked on the Ethereum network grow, this daily issuance is expected to rise to around 5,000 ETH, still corresponding to a decrease of over 60 percent.
Ethereum’s burn mechanism underpins much of the recent deflationary projections. This mechanism was introduced as part of the Ethereum Improvement Proposal (EIP) 1559 innovation. The overhaul introduced a base fee that was determined in real-time using network congestion as its primary input. This base fee 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. Please go through the YouTube video above for additional clarity.
However, there is a problem here. Elevated burn requires network congestion, which has not existed for quite a while now. In fact, barring a new sensational phenomenon – such as the launch of virtual real estate bidding in BAYC’s metaverse initiative, Otherside, which had last caused Ethereum fees to jump drastically – the base fee, hence the burn, is expected to remain muted. This undercuts Ethereum’s deflationary projections.
This brings us to the last critical element – staking yield and the upcoming onslaught of staked ETH on the network. Ethereum is currently offering an annualized staking yield of 4.04 percent. Messages that Ethereum’s yield will exceed a 25 percent APR in the immediate aftermath of the merge event populate social media platforms. However, this is only expected to be a temporary phenomenon, even if realized. After all, such a high yield is sure to attract a flood of staking activity, which would then reduce the yield, as illustrated in the snippet above. Crucially, the more ETH is staked, the higher is Ethereum’s issuance, which then reduces the coin’s deflationary prospects.
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 of this moment, 13.369 million Ethereum coins have been staked on the Beacon Chain. By applying Buterin’s calculations, the annual issuance of Ethereum based on the current staked level equates to 606,959.54 ETH or 1,662.90 ETH per day. Now, over the past 7 days, 7,099 ETH were burnt, equating to a daily burn rate of 1,014.14 ETH.
As is evident from this simple calculation above, at the prevailing network activity, Ethereum will continue to add 648.76 ETH to its net supply per day, which is far from deflationary. Of course, with the staking activity expected to grow exponentially after the merge, this net addition to Ethereum’s supply will only become more pronounced, barring a dramatic uptake in the overall network activity.
So, why is there such a dramatic discrepancy between those predicting a deflationary future for Ethereum and those urging caution? Well, the issue boils down to the analysts’ assumptions about Ethereum’s base fee. If you are predicting a massive surge based on the recent historical norm, obviously, Ethereum’s burn rate is going to increase, thereby heralding deflationary tailwinds. However, if you expect the base fee to remain at the current levels, then the world’s second-largest cryptocurrency by market cap will continue to remain inflationary.
📊 #Bitcoin, #Ethereum, the #SP500, and #gold are all down considerably on a #bearish Friday for traders. $BTC is back down to a 6-week low after #JeromePowell made #hawkish remarks about the state of the US economy, in spite of a positive #CPI report. https://t.co/hTtPT7nWuN https://t.co/ThliKG6SeY pic.twitter.com/mtlkuEBTtB
— Santiment (@santimentfeed) August 26, 2022
On the sentiment front, as evidenced by the tweet above, Ethereum continues to face major macroeconomic headwinds. In this environment, should Ethereum fail to demonstrate its bandied-about deflationary characteristics, readers should expect a significant price slump as expectations are reset.