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Ethereum’s Merge: a simplified precis for 2023

Ethereum’s Merge has given it ESG credentials alongside its Metaverse potential. But staking and the second-gen optics could be headwinds for 2023.

ethereum Source: Bloomberg

Ethereum's Merge was finally completed on 15 September, transitioning the second-largest cryptocurrency from a proof-of-work to a proof-of-stake consensus. And despite investor fear and a few hiccups, the process has gone relatively smoothly.

Of course, Ethereum is down 60% over the past year to circa AU$2,400 apiece.

But fundamentally, the altcoin is now a different proposition than what it was initially designed to be. And this makes price predictions for 2023 even more complicated than for Bitcoin or its alternatives.

Ethereum price 2023

ESG credentials

A key aspect of the Merge was moving Ethereum’s underlying blockchain to proof-of-stake consensus. Previously running on highly energy-intensive proof-of-work mechanisms which depend on crypto miners to verify transactions, Ether now only requires validators to hold a certain number of tokens to participate.

Prior to the Merge upgrade, the energy consumption of Ethereum ranged between circa 46TWh and 94TWh. But this energy consumption has now decreased by more than 99.9%.

This matters because one of the key complaints about cryptocurrency, and one that still applies to bitcoin, is that its high energy usage is both wasteful and environmentally destructive. But Ethereum is now far more environmentally friendly, and this will put it on the radar of ESG investors, especially those who are prepared to forsake some profits in exchange for green credentials.

Web3 Labs CEO Conor Svensson argues that ‘if you’re a corporate looking to invest in cryptocurrencies, given the ESG narrative I imagine a lot of them will be slightly hesitant about getting exposure to Bitcoin when there’s this other asset which doesn’t use huge amounts of power.’

According to Bloomberg Intelligence, ESG fund AUM are expected to reach $41 trillion by the end of the year.

The second-generation problem

Ethereum has long been hailed the ‘bitcoin killer.’ With a market cap of circa $190 billion compared to Bitcoin’s $390 billion, there is still some way to go before the flippening — when ETHER overtakes BTC— can happen.

However, the Merge has left Ethereum with an optics problem. Bitcoin can claim to be the first cryptocurrency and keeping its proof-of-work status means it can put some water between itself and other cryptocurrencies. MicroStrategy founder Michael Saylor alludes to this as the key reason why he views bitcoin as a hard commodity and the rest as securities.

Meanwhile, third-generation altcoins, such as Cardano, Polkadot, or Ripple can claim to solve specific usage cases to a better degree than Ethereum can, such as smart contract functionality. Note, this doesn’t even necessarily need to be true, but investor psychology could well turn against Ethereum in 2023 in favour of alternatives.

metaverse Source: Bloomberg

Metaverse potential

The Metaverse is a polarising investment concept, but one with huge potential despite the current downturn. Citi research indicates it could be a $13 trillion opportunity by 2030, and Ethereum could be a primary beneficiary.

Meta Platforms, owner of Facebook, Instagram, and WhatsApp, is investing circa $1 billion a month into its Reality Labs division, including nearly $4 billion in the last quarter alone. And the embattled company thinks that ‘Reality Labs losses in 2023 will grow significantly year-over-year.’

Despite a depressed share price and considerable investor unrest, CEO Mark Zuckerberg maintains control of the company through class B voting power. With the data of billions in his hands, the investment could benefit Ethereum without costing the altcoin anything.

While the different Metaverses utilise their own native tokens, what’s little understood is that these usually operate on the Ethereum blockchain, including those inside the Sandbox, Decentraland, and Axie Infinity.

In total, over 40% of the top 100 cryptocurrencies are built on the Ether blockchain, attracted by its first-mover advantage, smart contract functionality, and falling transaction fees as the result of the Merge.

Staking and the SEC

The Merge has brought in significant upgrades to the Ethereum network. Transactions are significantly sped up, while transaction fees have sunk dramatically. This makes the use case of Ethereum as a currency rather than just as an investment vehicle more promising.

More importantly, some investors are now being invited to stake a minimum of 32 Ethereum to activate validator software to get a return on the blockchain (staking reward). Yields are likely to be generous, as the amount of ETHER being issued has been slashed by more than 90% on an annual basis, hugely reducing the available supply.

In fact, Ethereum is now deflationary. This could help with price support, even as the Federal Reserve presses ahead with monetary tightening. Citi analyst Joseph Ayoub notes that ‘Ether looks like it could be moving towards a deflationary future as it exhibits periods of deflation amidst low network activity.’ As activity rises it could maintain a deflationary supply having ‘already shown deflationary tendencies post-Merge in a low-burn environment.’

Of course, staking for returns sounds fairly similar to receiving dividends on an equity, a fact not lost on SEC chair Gary Gensler. Bitbank analyst Yuya Hasegawa has already warned that all ‘PoS crypto may fall under SEC’s scrutiny.’

The regulator was already moving to regulate the crypto sector, with Gensler noting that investors should enjoy ‘similar protections’ afforded to equity investors.

Of course, the Merge feeds into the wider debate over whether all crypto, or just some altcoins, function as securities or commodities. Interestingly, the SEC indicated through a comment in a recent lawsuit that Ether transactions relevant to the case ‘were validated by a network of nodes on the Ethereum blockchain which are clustered more densely in the US than in any other country. As a result, those transactions took place in the US.’

The implications for what is supposed to be a decentralised currency could be significant.

However, Finbold data from March 2021 shows there were only 2,559 Ether nodes in the US out of the 6,806 globally. The country only possesses a plurality, not a majority, weakening the regulatory case, and all that may entail.

This leaves Ethereum investing a complicated venture for 2023.

This information has been prepared by IG, a trading name of IG Australia Pty Ltd. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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