Last week, the excitement around Ethereum’s upcoming Merge was rekindled when Tim Beiko provided a soft roadmap that suggested the Merge will be pressing forward on September 19th of this year. On the one hand, this date can (and almost certainly will) change. On the other, there was enough certainty about the Merge being completed that a precise date could be estimated. After all, the Merge has been on the Ethereum roadmap for years. So it excites the community for the Merge, one of the most anticipated events in cryptocurrency history, to be actually happening after a thoroughly memefied delay (Soon™).
There are two major reasons the Merge is exciting for Ethereum: one is energy usage reduction and the other is a shift in the supply dynamics of ETH. This article focuses on the supply dynamics shift and the downstream effects on the Ethereum ecosystem and DeFi.
What is changing from an ETH supply perspective
One way to view the Merge is a change in block producers on the Ethereum blockchain from miners to validators who stake ETH. Blocks on Ethereum today are produced by computers running software using their time and computation power to process transactions and produce blocks. This is known as “mining” according to the proof-of-work (PoW) consensus protocol.
The Merge will replace the PoW consensus protocol with a proof-of-stake (PoS) consensus protocol for Ethereum’s execution layer. It’s called the “Merge” and not the “Switch” because the PoS consensus protocol already exists as the Beacon Chain, where validators currently runnode software to process transactions and create new blocks on that chain. The Merge will “merge” the new consensus layer the Beacon Chain provides with the existing Ethereum execution layer and stop the use of mining.
Ok, so how does this affect ETH supply?
Currently, new ETH issuance comes from two places:
- Mining rewards ~13,000 ETH/day
- Staking rewards ~1,600 ETH/day (at current staked ETH levels)
After the Merge, the Mining rewards issuance will be eliminated. At a purely mechanical level, the Merge will dramatically cut ETH issuance based on recent estimates.
But another aspect of the circulating supply is a bit more speculative but no less powerful. Post-merge block production will be inherently more ETH-intensive than under a proof-of-work regime.
To illustrate what I mean, imagine the inputs for starting or expanding a mining operation today. You need:
- The hardware necessary to build and maintain a mining rig
- Electricity to run the mining rig
- Depending on the scale, ancillary equipment to support mining (ventilation, energy monitoring, wiring, etc.)
By and large, miners need to convert the ETH they earn from mining to fiat in order to pay for the above, which provides inherent selling pressure from the block production business.
Contrast with what’s needed to receive rewards via staking. You need:
- Hardware that runs both an Ethereum execution client and consensus client while connected to the internet
- Electricity to maintain that hardware
- To deposit 32 ETH
The first three bullets are quite similar, but it’s important to note that the hardware and electricity comparison is night-and-day. Under PoW, there is an incentive to invest in more powerful (and expensive) hardware to increase compensation. This has created a mining arms race for more powerful equipment (that consumes more energy). With the Merge, there are no such incentives for validators, and the software can be run on a simple laptop.
So to add all of that up. Block production prior to the Merge requires upfront investment in expensive hardware. That hardware is generally purchased by larger miners by selling ETH for fiat. After the Merge, block production requires an upfront investment of deposited ETH. Before the Merge, block production requires management of high energy consumption and externalities (e.g. heat ventilation). Also paid for by selling ETH for fiat. After the Merge, maintenance costs do remain but are significantly reduced. The bottom line is that the block production business moves from one that sells a lot of ETH to convert into hardware and energy to one that requires deposits of ETH to start or expand and less ETH conversion to hardware/energy on an ongoing basis. This is less intuitive than “there will be less ETH issuance,” but will have a powerful effect on the circulating supply of ETH.
To summarize, the Merge will (1) reduce the issuance of ETH directly and (2) restructure ETH incentives for block production. You will also often hear or see people talk about ETH becoming net deflationary after the Merge. That isn’t necessarily true or a mechanical certainty based on the Merge. But based on estimates of issuance reduction for ETH and estimates of fee burn from network usage, it appears that may be the case upon a successful Merge.
How will the Merge affect DeFi?
There are no direct consequences of the Merge for the application layer of Ethereum (of which DeFi is a part). But a host of second-order effects can be anticipated from a reduction of supply for the ecosystem’s native asset. However, I want to state that the previous section covered fairly straightforward facts about the Merge and how they alter the landscape for ETH as an asset, the following section is a little more speculative in nature.
Liquid staking protocols
Liquid staking protocols a vertical of DeFi that wouldn’t exist without proof-of-stake as a concept. Liquid staking protocols such as Lido or RocketPool allow users to stake ETH (or other PoS assets) and receive a fungible token representing a share of ETH staked with the platform. That ETH cannot be retrieved unless the Merge occurs successfully. A part of the reason these tokens, such as stETH, trade at a discount to ETH is the risk of an unsuccessful Merge. With the Merge completed, that risk is removed!
Furthermore, the Merge is expected to increase the ETH return due to a reallocation of transaction fees currently accrue to miners. Recent estimates indicate that the APR for staking will increase to ~7%, approximately 50% higher than the base issuance APR (as of June 2022). So there’s also an expected increase in the fees going to these liquid staking protocols and the staked collateral these tokens represent.
ETH as Reserve Asset in DeFi
As mentioned above, the Merge has no direct effects on major DeFi protocols such as Uniswap or Maker. But, ETH’s use as a reserve asset means the effects of supply limitation or reduction will be felt in DeFi. ETH is the primary asset for collateral backing in Maker and the most significant non-stablecoin asset used to balance transactions in Uniswap. A reduced supply of ETH can mean expanded collateral value for the minting of DAI. The DEX impacts are less straightforward but should be considered if the Merge introduces more volatility for ETH.
Rollups and Layer 2
It’s important to note that the Merge will not reduce transaction fees or increase throughput on Ethereum. There’s been a conflation of the Merge with separate Ethereum roadmap plans. But the Merge is not primarily designed to address scaling. However, it is part of a rollup-centric roadmap. Designed to address problems like energy usage and incentives while scaling is addressed on layer 2, and the stage is set for sharding in the future. With the Merge out of the way, this may clear the way for activity to move to L2s as the narrative (and developer attention) shifts from ETH as an asset back to how to accommodate widespread use of Ethereum blockspace.
Possible negative ecosystem effects
There’s also been a suggestion that there will be a supply glut when staked ETH “unlocks” upon the Merge. First, that’s a misconception. Staked ETH will not unlock until an estimated 6-12 months after the Merge when the planned Shanghai upgrade to Ethereum occurs. Second, validator exits (removal of the 32 ETH deposit) are rate limited to mitigate instability. There will be a significant supply of ETH that is newly liquid when the Shanghai upgrade occurs, but given the current rate of issuance of ETH pre-Merge versus total anticipated issuance to stakers, that amount will not be unprecedented for ETH markets. Furthermore, as validators are removed, the APR for validators that remain will rise, incentivizing continued staking.
One of the most exciting events in cryptocurrency history is nearing, and it should dramatically change narratives around Ethereum and the supply of the native asset for its ecosystem. DeFi protocols and users are preparing for the Merge in various ways, but like any major event that affects the markets, only time will tell the full story of the Merge’s impact on DeFi and Ethereum.