The Investor's Guide to The Merge: Understanding and Playing the Opportunity

Key Insights

• In the coming months, Ethereum will undergo a change of consensus mechanism from Proof-of-Work to Proof-of-Stake in what has been called “The Merge.”
• Fundamental improvements that will attract investors include the creation of a more environmentally friendly protocol, the addition of an accessible yield, a net deflationary underlying currency, and increased decentralization/security.
• The most profound short-term impact is the elimination of miners. Miners are net sellers of Ether on a daily basis. This sell pressure is immediately eliminated from the market. If we assume a constant level of buyer demand from pre-merge conditions, it could actually result in structural net buy pressure.
• It seems likely that The Merge will occur between August and September 2022. Markets seemingly have not priced in what a successful transition does for the short- and long-term fundamentals for Ethereum.
• We built a customizable yield and DCF model to further explore the implications of Ether post-merge.

Ethereum is the world’s second-biggest cryptocurrency with over $200 billion in value and billions more in protocols built on top of its network. The Ethereum upgrade from Proof-of-Work (PoW) to Proof-of-Stake (PoS) has been one of the most talked-about events in crypto since it was first discussed in 2014. The implications of this network upgrade for crypto are enormous, but the implementation risks are just as high. An upgrade to a network this size has been compared to changing the engine on a plane mid-flight.

For investors who appropriately assess this investment opportunity, The Merge stands as one of the most interesting risk/reward scenarios we have seen in major markets in the past few years.

The Merge Overview

Ethereum launched in July 2015 as a Proof-of-Work blockchain. Discussions on the transition to Proof-of-Stake actually started in 2014 prior to the launch of the original chain. The ongoing cost in dollars and energy needed to operate Ethereum at scale using PoW would be very costly. To truly operate as the “world’s shared computer” the security solution for Ethereum would have to be the most cost-effective available.

The Merge is the Ethereum mainnet shift from PoW to PoS for its blockchain consensus. Both consensus mechanisms offer rewards to validators for securing the network. The potential for these rewards comes at an upfront cost: PoW takes energy to solve equations, PoS takes collateral that can be slashed. Under PoS, network security will no longer be derived from miners that burn large amounts of electricity but rather by validators that pledge ETH as collateral for obeying the network's consensus rules. While the transition was always in the cards, it has taken much longer to get to the finish line than anyone expected. Persistent technical challenges were accompanied by the grand challenge of incentivizing miners to forgo profitable PoW mining in favor of a PoS hard fork.

To force the miners' into upgrading, the idea was launched to gradually increase the difficulty of the network. This "difficulty bomb" made it so miners faced challenges forking the PoW network as well as providing an informal development deadline. It also would slowly erode miner profitability. It was originally scheduled to go live in 2016 but has yet to be implemented due to The Merge’s aforementioned technical challenges. Once the bomb hits the Ethereum network, we can expect block times to slow from their current time of ~13 seconds. While the difficulty bomb is expected to go live in June 2022, minor effects are already being felt. By the end of August, it is projected that block times on Ethereum will double if The Merge has not successfully been executed or the bomb has not been delayed.

Source: Tim Beiko

The Process

The transition from PoW to PoS is often referred to as “The Merge.” It's called The Merge because two distinct chains are being combined. In December 2020, a standalone blockchain using PoS called the Beacon Chain was launched alongside the existing PoW Ethereum chain, marking the first steps in The Merge. The Beacon chain will merge with the existing PoW chain, becoming the consensus layer of the new network. The Beacon chain will coordinate consensus or agreement among network validators on the state of the network. Block production will be handled by the Execution Layer (what today is the PoW chain).

Post-merge, Ethereum validators will need to run their clients with two layers or modules: one module that handles operations for consensus and one that handles execution. The changes are only at the consensus layer and all the EVM, applications, chain data, and accounts are all done by the same execution engine of the current Ethereum; therefore, the experience for most Ethereum end users will remain the same. Holders of ether will not be required to move, change, or upgrade anything post-merge.

Since the launch of the Beacon Chain in December 2020, users have been able to stake ether to bootstrap the future consensus layer. For this service, they earn a yield. There are already over 12.5 million ether staked on the Beacon Chain, roughly 10% of the outstanding supply. To run your own validator requires 32 ETH. Most individuals chose to delegate their stake through third-party services to get around this high upfront amount. Ethereum does not have delegation options baked into its protocol like some other Layer-1s. Most stakers independently go through centralized options like Coinbase or decentralized options like Rocketpool. Through these providers, staking can be done for almost any amount of ETH.

The final phases of The Merge development began in early 2022 with the implementation of The Merge specification across the clients. A long series of testing was performed, finalizing in “Shadow forks” that simulated The Merge on development networks and were conducted throughout the first half of 2022. The final test phase before The Merge is transitioning the existing test networks. Ropsten is the first testnet scheduled to transition to PoS on June 8. The other testnets, Goerli and Sepolia, are set to go through The Merge by early July. Ethereum developers have indicated The Merge will take place on Ethereum’s mainnet around August 2022 barring any major setbacks.

The Investment Case

The significant fundamental changes introduced by The Merge will also alter the investment case for Ether and the broader Ethereum ecosystem. Ethereum will no longer be perceived as a utopic experiment and should attract investors with a long time horizon looking to add to their portfolios. While the long-term outlook is rather clear, the structural effects from The Merge could also influence the price of ether in the short term. In a nascent market like crypto, price action is dominated by flows rather than fundamentals.

Improvements for the Long-Term

Protocol Energy Reduction

Running the world’s computer using PoW is resource-intensive. Miners use millions of KWH of energy, running resource-intensive computers to solve the mathematical problems needed to win a block reward. PoS significantly reduces a network’s energy consumption by recycling internal resources for protocol security. Transitioning to PoS, consensus goes from the cost of running server farms to the cost of running a laptop. Numerous studies indicate that, even by the most conservative estimates, PoS will reduce Ethereum’s energy use by 99%. Ethereum’s energy usage will become a small fraction of PoW networks like Bitcoin.

Source: arXiv

Climate concerns and subsequently ESG-conscious investing have been at the forefront of investors' minds for the past few years. This concern is particularly acute for institutional investors. The five largest pension funds with a collective $3 trillion in assets have publicly stated ESG is now part of their investment decision-making process. Energy usage by PoW is still a deterrent to many investors. Ethereum becomes ESG-viable following the drastic reduction of energy consumption. This opens the door for additional capital flows and long-term energy sustainability.

Issuance Reduction

Today the Ethereum protocol pays miners 2 ETH per block. In total, Ethereum the network issues miners ~13.5k ETH per day. Post-merge issuance becomes variable based on how many stakers the network has. If we assume the number of ETH staked hits 15 million by the time of The Merge, the protocol will be issuing about 1,750 ETH per day. This is a ~90% reduction in issuance. Or said another way this is a 90% reduction in the network's security expense. Structurally reducing the security expense lowers the daily sell pressure of ETH which has positive price benefits for existing holders

Much is made about the Bitcoin halving cycle in the crypto community. This is because the reduction of bitcoin supply emitted by the network is cut in half, reducing bitcoin inflation and network expenses. Should The Merge indeed reduce Ethereum’s daily issuance by 90%, it would be roughly equivalent to three bitcoin halving cycles occurring simultaneously. Bitcoin halving cycles have correlated to strong price appreciations for the network, so it would not be surprising to see The Merge have a similar effect for Ethereum.

Net Deflationary

In August 2021, EIP-1559 changed Ethereum’s monetary policy to “burn” a subset of users’ transaction fees. Since then, about 85% of all transaction fees have been burnt. The remaining 15% goes to miners as “tips”. For any given block, Ether supply will become deflationary if burnt transaction fees are greater than the network’s issuance. Since issuance per block will be reduced by ~90% post-merge, the hurdle for this net deflationary emission schedule is much lower. The network is projected to have a steady-state deflation of 1–2% depending on the demand for block space.

Source: Galaxy Digital

A net deflationary currency is akin to a stock buyback for traditional investors. Each “share” that is retired allows the existing holders to own a little bit more of the profits of the company or in this case the rewards of the network. You can see the impact this has on yield in the model we introduce shortly. No other project in crypto has achieved these supply dynamics.

Bond-Like Yields

Today, miners receive block rewards, miner or maximum extracted value (MEV), and tips from users. These yields are technically accessible to anyone who can run a mining rig, but the barrier to entry is massively high and revenue is largely unpredictable for what is a high upfront capital expenditure. In PoS, validators will receive block proposal rewards or attestation rewards (serving a similar function to block rewards under PoW) along with MEV and tips. These fees are shared by all stakers in the network increased predictability for yields and increasing democratization of yield access.

If the underlying currency does become deflationary, stakers also receive a sort of “buyback yield” as there are fewer ether in circulation. In PoW, most of the rewards accrue to one or a handful of miners, in PoS the pot is split amongst all staking validators. There are many models estimating the yield post-merge but we think the one below is the most accurate. Depending on the number of stakers and the level of network activity, yields could range between 7% and 13%. We tested our assumptions with Ethereum researchers and key Ethereum community members, but we have the model here if you want to adjust it with your own parameters.

This yield profile becomes attractive for all crypto investors. Since Ethereum blockspace has historically been the most valuable among smart contract networks, its staking yield could come to be seen as crypto’s “risk-free rate” akin to US treasury yields. DeFi protocols are already starting to build out this yield curve for investors.

The introduction of a staking-yield allows traditional financial practitioners to fit Ethereum into their discounted cash flow models. Yields have a direct impact on any estimated price target. Multiple attempts have been made at putting together these sorts of models, outputting a wide range of prices from $3,000 to $300,000 per token. We built our own model here coming out with a range of valuations with a base case of ~$6,000.

Increased Decentralization

There are 400,000 validators on the Beacon Chain already. This is an order of magnitude more than the 2,000–3,000 nodes securing PoW. There is of course room for more decentralization as only about 10% of Ethereum is staked today. The barrier to be a validator, while high at 32 ETH, can be easily accessed through numerous staking pools. There were no such opportunities under PoW. The higher staking yields we discussed above will attract more parties to become stakers. Future upgrades that allow for more readily available liquidity should also help boost numbers. Increased decentralization means more security for the network.

While delegated staking services democratize access to staking on Ethereum, there are growing concerns that large players are actually centralizing the validator set. Lido’s early success has allowed the liquid staking protocol to attract almost ⅓ of the market share of staked ETH. Key Ethereum figures and Lido themselves have identified this issue and have outlined plans to continue to decentralize the overall pool of staking operators.

Slightly Increased Throughput

SLIGHTLY. I hesitated to put this in here because the biggest misconception about The Merge is that it will increase speed. That is not the primary purpose, but throughput will increase by a small margin as a result of the upgrade. Normal block times on Ethereum under Proof-of-Work are around 13 seconds and will be 12 seconds post-merge. A very slight increase in throughput will therefore occur, but this is not how Ethereum will scale long term.

Scalability will not be directly addressed until sharding is implemented sometime in 2023. In the meantime, users will need to utilize rollups to lower gas fees. Still, Ethereum should benefit from the numerous positive tailwinds in the near term despite the further upgrades it has ahead.

Short-Term Catalyst for Price Growth

Sellers Exit the Market

Miners are running a business. They take in issuance and fees from the network and pay for electricity and hardware costs for running their operation. Therefore, miners are natural sellers. On the other hand, stakers are natural holders since a validator’s probability to become the next block proposer depends on their stake in the network. The elimination of miners removes $20–40 million a day (with ETH at $2,000) from daily sell pressure. That is almost $1 billion monthly of sell pressure. This means that ETH needs over $10 billion in new incremental buy pressure for its price to remain at current levels but would be even greater if the price of ETH increases in dollar terms. This dynamic is the opposite of equity markets where structural buyers support prices through automated 401k target date flows as well as company buybacks. If we keep demand post-merge consistent, we actually see ~$20 million in net buy pressure daily — similar to structural equity flows. Again more in our model here.

In traditional equity markets, trading 10% of the daily flows of an asset would create a significant move in the market. Assuming this same ratio of daily volume, ETH would only require $100 million to $200 million to create significant price movement. Given crypto’s younger age and shallower market depth, it’s likely that only $25 million to $50 million buy pressure will have an outsized impact on prices. Market data from Kaiko supports this assumption, showcasing that there is only ~30,000 ETH (or $60 million) within 2% of the market price at any given point. That would be $30 million in offers or open sales across all exchanges. If you were to go to one exchange, the market is much more shallow. In other words, removing the miner sell pressure of $20–40 million per day should be extremely meaningful for Ether price.

Besides the removal of natural sellers, a successful execution of The Merge should lower the risk of staking ETH. If we assume staked ETH reaches levels of competing smart contract networks after this hurdle, the supply on exchanges should decrease dramatically. As more ETH is staked, more is removed from the market. Post-merge, we also have the added dynamic of locked fees for what should be a period of 6–12 months. Protocol issuance fees (not MEV and tips) will remain locked until the Shanghai upgrade in 2023. While the decreased velocity of money may appear to harm the future health of DeFi on Ethereum, the growth of liquid staking derivatives makes overall systemic liquidity in DeFi a non-issue.

Non-Stakers Are Paying Stakers

Issuance today is an expense to the value of current holders under PoW because it increases the supply of Ethereum. Under PoS, stakers receive the network’s yields while non-stakers do not share in the reward structure. Therefore, issuance is revenue for stakers but dilutive to non-stakers.

It is very likely non-stakers will rush to capture yield because not only are they missing out on 6–12% but they are paying a “tax” to stakers in the form of their missed revenue. The door for this opportunity is only so big — only about 1,300 validators can be added to the network per day. There is already a small wait to join the staking process. This will potentially increase the demand for ETH as we approach The Merge and there is a rush to join the queue.

How to Capture the Opportunity

Given the complexities of The Merge, there are a variety of ways to position oneself.

Spot ETH or Liquid Derivatives

You probably didn’t need the subscription for this one.

All jokes aside, you could also buy lido's stETH, which currently trades at a ~3% discount to ETH. rETH from Rocketpool is in a similar situation (~11% discount). These discounts will likely close when withdrawals are unlocked a few months after The Merge, creating an opportunity for believers to score additional returns on spot purchases. An argument can be made that stETH may trade at a premium to spot because it receives the yield of staked ETH while maintaining liquidity.

Options

Options are an easy way for investors to play an upside opportunity with minimal upfront payment. The key variable to consider is timing. If an option expires before the price appreciation event, the opportunity is missed. Paying for an option is nothing more than pricing the volatility of the underlying security. The more implied volatility (IV), the higher the price of the option. Volatile securities or securities with big upcoming events should have a high IV and therefore a higher options price. For example, Gamestop options were trading at an IV of 1000% during the meme stock mania of January 2021. The average implied volatility on a small-cap stock is about 70%.

While The Merge has been delayed numerous times, August or September seems likely at this point. Looking at at-the-money options for Ethereum with a December 2022 expiry, we see clear mispricing for this investment opportunity. These options are being priced similar to standard tech stocks such as Snapchat, Square, and TTD. However, none of these companies are on the verge of generational upgrades. The delta here also tells us the market is pricing in about a 50/50 chance Ethereum is priced the same at the end of the year as it is today.

Source: Deribit

Options are priced as a percentage of the underlying asset. For example, an option on a $2,000 share of TSLA will be more than an option on a $200 share of TSLA. Therefore, the risk of individual options has somewhat been reduced with ETH falling over 50% in the past six months as well. The open interest (i.e., the amount available to trade) is healthy for these options too, with thousands available per strike price.

Protocols That Benefit

Protocols that enable staking naturally benefit from a completed PoS upgrade. There are two main DeFi protocols that capture most of the staking market share: Lido (LDO) and Rocketpool (RPL). These protocols take a share of the staking revenue for delegating users and issue a liquid derivative token that may be re-used across DeFi. These protocols take fees of between 5% and 10% of delegated staking revenue. A recent Messari report on the valuation of Lido has more information here. Other smaller providers like Stakewise (SWISE) are more speculative plays because of their smaller market share.

Alluvial is a new player targeting staking for the institutional space by offering KYC and enterprise-level security monitoring. Allocations there would have to be made on the private side. Other Staking-as-a-Service protocols targeting institutions that are launching in the near future include Swell Network and Obol Network.

Potential Equity Proxies

If these crypto-native options don’t fit your fancy and you prefer to do things in your Merril Lynch or Fidelity account, there are always the equity proxies. There are a few well-known names that have tight correlations to crypto. MSTR, Michael Saylor’s shop, holds ~130,000 bitcoin and has historically had a ~90% correlation to Ethereum.

Coinbase (COIN) is the largest publicly-traded crypto exchange that also offers a fairly tight correlation to Ethereum ranging from 50–90% in most periods. Coinbase also has a partnership with Alluvial, putting them in a good position to absorb institutional staking demand. If ETH and the broader crypto market rallies, these names should follow suit in some capacity.

Risks

• Technical execution risk: The biggest risk to the investment case here is some failure when the chains actually merge. This could be an unforeseen technical error or an attack by an opportunistic party. Attacks on the testnets have already occurred. While the teams are doing everything they can to mitigate this possibility, the opportunity for a negative outcome remains very real. Attack risk is also heightened some period after The Merge as attackers look for vulnerabilities in the new system.
• Further delays: The Merge has been delayed since 2016. Another delay would not be a surprise but would continue to hurt investor confidence. The longer it takes for The Merge to occur, the more time other ecosystems have to eat into Ethereum’s lead in the smart contract space. It also delays the longer-term plans for scaling which cannot be fully focused on by developers until The Merge is complete.
• Maybe it's already priced in: Despite ETH falling over 60% from its highs in November 2021, maybe Eth doesn't rally because of the Merge. Or maybe it doesn’t rally immediately. Maybe it's just a non-event despite the favorable fundamental and flow-based catalysts. This would be an issue if you decide to express a potential favorable price appreciation through options.
• Macro is just that bad: US monetary policy is going to continue tightening for what is likely to be the rest of 2022. This type of environment is bad for risk assets. While ETH will transform from a structural perspective, crypto is still firmly in the risk asset camp.
• Crypto regulation: Having Terra’s $50 billion ecosystem implode overnight without the whole industry going under is going to raise some regulatory red flags. Terra will be a footnote in every bill and directive coming from the Biden executive order. This could potentially be an overhang on the entire crypto ecosystem.
• Miner uprising: This was the primary concern for most of the period The Merge was discussed. This concern has been alleviated with major miners building out staking pools and committing to the new system. The difficulty bomb will also make mining impractical.
• ETH dumping when unlocked: There are concerns of Ethereum being dumped as soon as individuals can unstake from the Beacon Chain. This is unlikely given daily withdrawal limits that will be put in place to constrain staking outflows similar to the daily deposit limits for new stake on the Beacon chain. Still, there could be a sustained period of net outflows putting sell pressure on the token once withdrawals are enabled. There also could be futures selling to hedge staked ETH exposure.

Bottom Line

The fundamental improvements for the Ethereum protocol set it up for long-term success. The short-term flow dynamics make it a compelling near-term play for investors. Combine both of these facets with the current max crypto FUD, and you have what could set up to be an explosive investment opportunity. This time next year we are going to be looking back at the current price for the world’s computer (~$200 billion market cap) trading at the price multiple of an industrial stock, ahead of a generational upgrade, and think…how did we miss that one?

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