Abstract

The Merge - which was put into motion on the exact date of September 15, 2022 - has been the most profusely innovative engineering amelioration thus far in the history of the giant Ethereum blockchain. It marked the well-rehearsed transition of the second largest decentralized blockchain removing itself from the energy-draining Proof-of-Work consensus mechanism to dip both of its feet in adopting a different approach: the Proof-of-Stake scheme. It did so by first instigating the Beacon Chain and let it play out on several testnets before confidently incorporating the Beacon Chain (PoS-driven) with the Ethereum Mainnet (PoW-driven). Ethereum Foundation claims that the energy their chain consumes can now be cut down by an absolute-approaching percentage of 99.95% thanks to the governance of PoS algorithm. However, the most highly anticipated outcome of the narrative, which this dissertation will dissect in minute detail, lies in the native ETH token's deflationary status - which came to pass for a short while throughout the volatile FTX-induced November, yet shortly afterwards got overturned by a repeated inflation curve.

Ergo, the following analysis aims to answer 2 prominent questions:

1. Is it too elusive and unattainable for ETH to maintain its grip on the much-hyped deflationary throne or is the change a temporal reflection of the less demanding market during this bear season?

2. What does the future look like for deflationary/ low-inflationary Ether and the broader crypto trading outlook?

As far as theoretical applications are concerned, it is our intention to contribute an au courant abridgment of the gradual evolution traced by the most favored smart contract chain in terms of trading volume, thus streamlining a broader view of a decentralization future.

Relevant Timeline

Let’s examine Ethereum network’s development timeline together to first understand why The Merge was introduced, which would hence help us connect the dots of impacts that The Merge has brought about.

 

2014-2020

It was as early as 2014 that Vitalik Buterin - one of the co-founding fathers of Ethereum - first raised the possibility of having Ethereum veer away from PoW and towards PoS [0] although nothing solid came out at the time.

In 2016, together with Vitalik, researcher Vlad Zamfir put forward a motion in transitioning Ethereum to PoS consensus called “Casper CBC” and Vitalik “Casper FFC”. Casper CBC evolved to encompass studies of pure PoS model family while Casper FFC was a hybrid PoW/PoS system decided by “consensus by bet” as explained by Vitalik and as today we have come to know of after The Merge.

Despite the sensational publicity, implementation took so many boring years (and several promise delays) that the community started pondering if they were being led down the rabbit hole and ended up at a mystical wonderland in search of “PoS Ethereum”.

However, 2020 dispelled the understandable skepticism with the launch of Ethereum-backed PoS Beacon Chain - on which 13M ETH coins (worth $20B) had been locked in place. To follow the long-term vision Vitalik mapped out, developers would later have to merge this chain with the existing Mainnet glitch-free, botch-free, and hack-free. Such colossal task drained another 2 years out of them, stirring both curiosity and confusion when the exact release date seemed virtually imposssible to be fixed. But as September 15 2022 came as it should, the rest went down in history.

Nevertheless, aside from the macrosystem, what investors were actually concerned about above all was how ETH - the native token on Ethereum - was playing with inflationary fire - the condition when there are more ethers circulating than they are needed. We have summed up 3 main reasons for this phenomenon below:

(1) Unlike Bitcoin, which is a deflationary currency thanks to its limited supply at 21M tokens, Ether does not set its supply cap. This has caused the supply number to surge, hence the prolonged inflation for 2 years [1].
(2) In addition, prior to The Merge, in order for the chain to sustain under the operation of PoW mechanism, rewards for miners can possibly go as high as 13,000 ETH/day [2].
(3) Another factor that further exacerbated the inflation status of the largest altcoin and the second largest cryptocurrency was the Beacon Chain genesis event on December 1, 2020, which added more ETH on top of the system because PoS issuance was running parallel with the PoW at the time and accounted for approximately 1,600 ETH/day [3].

As we continue to track down the event logbook, it will become easier to see how the pent-up inflationary tension has gradually become eased up and eventually pushed Ether to the much-anticipated verge of deflation.

August 05, 2021

The EIP-1559 upgrade took effect and modified the way ETHs in each unit of gas per transaction are calculated and where those ETHs go on Ethereum network.

Gas fees (aka network transaction fees) play a critical role in transaction process of every blockchain. Pre-EIP-1559-update, whenever users sent a transaction to the system for verification, they were required to place a fee bid against others who simultaneously wished for their transactions to be pushed through. Since miners were allowed to prioritize which transactions went to which block, factoring in the limited number of transactions going into 1 block per unit of time, higher bids would most likely result in your transaction being mined more quickly.

However, the system was not one without flaws because under a low network load, users usually risked an overpriced bid. In contrast, under a high network congestion or in heavy network crashes such as in May 2022, transactions spiked uncontrollably, resulting in an absurdly swollen amount of gas fees paid by users. As a result, EIP-1559 was born to fix this operational error, lining out 2 flexible parameters:

MAX FEE = THE BASE FEE + THE TIP

- The Base fee is automatically calculated by algorithms and inherently depends on the network load, which translates to the fact that more congested traffic will lead to higher base fees, a possible surge of around 12.5% [4].

- The difference between the former system and when EIP-1559 took over is that the baseline is visibly affecting all network users instead of hiding in the shadow, letting users partake in the involuntary “The Price is Right” Gameshow and bidding their ineffective money away.
The fact that Base fee varies on the network usage still worries traders as they cannot possibly control that. But what they can now control is the amount they are willing to pay for Max fee - the cap ETH quantity one wishes to pay per unit of gas to process their transaction.

- If your Max fee is lower than the Base fee, the chance of your transactions being completed is 0, until the Base fee cools itself down to the value lower than your Max fee; that is to say when there is less transaction process demand.

MAX PRIORITY FEE = THE TIP

Since the tip serves as an expedited path for transactions to be processed, the higher priority users place on speed, the higher cap amount of tip they are expected to chip in to incentivize the miners. This is the only place where the auction format from the former system is still present, albeit with a more strategic cost allocation.

It’s also worth noting that EIP-1559 upgrade initially set one of the first stones for ETH deflationary predicament to be realized by introducing the Burning mechanism.

Before August 05, 2021, transaction fees (now base fees & tips) were rewarded to miners completely so that they could cover their own cost of operation. However, EIP-1559 stipulates that after each transaction is hashed into a block, base fees are going to be burnt while miners take all of the tip, as explained in the 3-step process [5] below:

A. The base fee is deducted from the max fee.
B. The tip, aka the max priority fee, is deducted from the remaining of (A).
C. The remaining of (B), if any, is refunded to the transaction sender.

January 2022 & May 2022

Since the EIP-1559 implementation, over 2.7 million ETH worth $8.75 billion [6] has been removed from circulation. Yet, although EIP-1559 gleams a beacon of hope in the face of deflationary supporters, on-chain data by Glassnode indicated that Ether only experienced deflation in as few as a few days in 2 separate months as of 2022.

 

September 15, 2022

The Merge was finally launched after much-hyped anticipation from Ethereum users worldwide. Under the upgraded rules of consensus, PoW is no longer functional as the pipeline for block production. Instead, a wider pool of users will be able to gain access to block validation through the fulfilled PoS operation. Figure 3 shows a side-by-side transition made by Ethereum from a PoW-operated Mainnet to a PoS-operated Chain with the nature of each type of consensus at the core:

 

As read from Figure 2 in which PoW simulation is displayed by the orange line and PoS-only hypothetical outcome is displayed by the blue line, it is evident that the PoS system would succeed in taking down a surplus amount of ETH supply, resisting inflation to a greater extent, and ultimately leading to a scarer and more valuable currency that Justin Drake, a core Ethereum Foundation researcher, called “ultrasound money”.

In order for the inflation or deflation rate of ETH to be determined, 2 basic metrics are taken into consideration: issuance and burning. Issuance of ETHs is the procedure of minting new ETHs that were not previously in circulation - in the case of The Merge, newly minted tokens are utilized as staking rewards, whereas ETH burning is to cut off some circulated ETHs from the network by sending them to unknown wallets.

Each method has their own contributors to fall back on. With issuance, the exact number relies on the tally of ETHs staked, which translates to the existing number of validators since each validator is required to deposit an equivalent staking capital (32 ETH = ~$41K at press time). In terms of how much ETH is burnt, network activity should be the indicator for traders to look into, and probably keep an eye out for any groundbreaking market-spinning news.

To break the situation down in a simple mathematic solution, it would look like this:

- Pre-Merge issuance = 13,000 mining + 1,600 staking - 1,600 burning
- Post-Merge issuance = 0 mining + 1,600 staking - 1,600 burning

⇒ Deflation is expected to happen post-Merge

November 9 to December 1, 2022

1 month after The Merge was implemented, there were a total of 443,403 validators, reflecting a 4% increase since The Merge [10]. This means that issuance could be on the rise, which was proven true when the same month saw ETH annualized inflation rate (AIR) reach its peak on Oct 8.

55 days after the Merge, Ether started entering the deflation zone - the point when the number of tokens burnt oversized that of staking incentives. The incidence can be explained to have aligned with activity spike on the network after the FTX crumble flooded the news. A few scenarios came to mind: either users forcefully fled the centralized exchange and sought shelter in decentralized financial protocols or the unpredictable variation in price during this showdown had caused a majority of spot traders some sleep. The culmination of deflation happened just 1 day after FTX announced that they had filed for Chapter 11 Bankruptcy.

As recorded on November 16, findings from Ultrasound.money (Figure 4) indicated that the supply of ETH had been reduced by ~6000 ETH after The Merge; moreover, the average ETH issuance per year (603K) was markedly lower than the average ETH burn per year (2,136K) which led to the supply growth turning negative at 1.25%. It is evidently seen from the supply graph that the annualized net issuance rate dropped excessively to -0.029%. If the trend rolls into the future sustainably, ETH will eventually become a deflationary asset and ultrasound money.

 

The Curveball of Inflation

The deflationary pattern carried on for a whole November, strengthening the entrenched belief of enthusiastic ultrasound money zealots. Immediately when December knocked on the door, however, the touting of inflation-resistance narrative was suddenly turned down with the AIR perching at 0.004% as of writing time (Figure 5).

 

To top it all off, the number of ETH burnt daily does not put its pedal to the metal recently, rather the other way round, which leaves hopes for a switch back to deflationary values hung out to dry.

A possible reason given by Nick Hotz, vice president of research at the digital-asset management firm Arca, in an interview with CoinDesk was the obvious lack of demand:

“Immediately post-FTX, there was tons of demand to swap on both centralized and decentralized exchanges due to volatility,” Hotz told CoinDesk. “In the weeks since, that has faded and now there is very little demand to use neither centralized nor decentralized exchange.” [12]

Low-Inflation, Maybe?

Net issuance rate, commonly referred to as inflation rate, is measured by having the new supply divided by the existing supply. According to Lucas Outumuro, head of research at crypto data and analysis firm IntoTheBlock, the annualized number was about 3.5% [11] for Ethereum prior to The Merge. Simulations of Ultrasound.money (Figure 6) corroborated the same belief if Ethereum kept pursuing PoW protocol - which indicated a costly 3.579% every year, higher than the current annualized 1.716% inflation rate of BTC itself. As of December 15 2022, it seems that PoS-run ETH has an upperhand in this reverse inflation competition as it is currently sitting at …basically, zero.

 

All of these indicators, however, do not seem to serve as deterrents for the army across the field to shift their stance. Others from the other side of the fence have argued that Bitcoin issuance is predictable and unchangeable - the essentials of identifying one currency as “sound money”. On the contrary, ETH issuance relies heavily on the degree of network usage which causes the supply to be susceptible to volatility. Correspondingly, the Ethereum issuance rate can possibly reach higher than the burn rate at any given time, as exemplified during December 2022.

The problem of whether ETH can actually become ultrasound money is still a debate and could remain so for the near future.

Shanghai Update

As per our Weekly Recap released last week, the Shanghai update was disclosed to have been tentatively scheduled for March 2023. Yet, with the not so spot-on track record of Ethereum developer team in terms of time arrangement, investors are advised not to put too much hope in it, though Ethereum developers are certain to make it happen, just not exactly when.

How does the Shanghai Update have anything to do with The Merge?

Remember Beacon Chain, the consensus layer that engulfed two years of diligent work from developers who built up the PoS algorithm, developed testnets, ran countless tests and bot detection, attended virtual meetings every now and then, and finally launched it at the end of 2020? Since its birth, the chain has been designed to assume the role of an effective one-way storage unit for staked assets, even after The Merge. To put it simply, until the Shanghai update is launched next year, Ethereum validator balances are latched on Beacon Chain, not on the usual Ethereum Mainnet where blocks are proposed and found.

In addition, since the genesis of Beacon Chain and The Merge, though it is a given that validators are unable to tap in their funds during the committed staking period, 100% funds from these accounts have also been barred from withdrawal. This has caused some unsaid inconvenience for retail validators, to whom 32 ETHs and 4% protocol rewards are not of small value. Therefore, it is imminent that the Shanghai update prioritizes opening up the withdrawal portal for stakers, allowing them to choose to exit and cash out their entire validator balance if they wish to. However, to ensure that the network is not rigged, Ethereum has put a cap to the number of validators leaving simultaneously. Varied by the total ETH staked at the given time, the figure is estimated roughly around four to six validators who may exit in a given epoch (6.4 minute period). On the contrary, since the tip & MEV earned during block proposals are already available on execution layer and do not need new issuance from the consensus layer, these ETH balances are still liquid - withdraw-able and transferrable [13].

Outcomes to Remember The Merge By

A. Energy Consumption

One conspicuous effect for which The Merge has won total media plaudit and mitigated criticism from environmental groups is no other than the reduced power squandering. Gas fees are not to be brought down until more rollup parameters are added after The Merge, but gas consumption sure is.

Besides establishing Ethereum as a more environmental-friendly sphere, less energy consumption also translates to heightened cost effectiveness, at least for the blockchain. PoS recruited validators, in turn obliterating miners together with their girthy mining rigs that guzzle a large portion of their operation cost. Compared it to the 32 ETH requirement for validators, PoS proves to be a more suitable candidate for a scalable future.

Owing to the substantial power usage, possibilities of banning the PoW mechanism underpinning Bitcoin and ex-Ethereum have sometimes been raised. Last April, the EU and Swedish officials made it clear that they support the motion of a bitcoin ban, citing environment-threatening reasons [14]. Ethereum switching to PoS will enable individuals bound by those jurisdictions to continue sticking to their guns on node operation. And who knows this could serve as a precursor to a wider mass adoption of Ethereum itself?

B. Access

Beyond the monetary aspect of the matter, another huge barrier that has been deterring quite a large majority of crypto users from joining the mining force in the era of PoW Ethereum was specific technical skills and crypto acumen to entry. In a Proof-of-Stake system, the barrier was significantly lowered since a layperson can easily operate exactly three programs that demand virtually next-to-none technical proficiency [15], instead of the intimidating magnitude of softwares that have branded PoW all along.

C. Centralization

If we had an (Ether) penny for every time centralization causes heated debates in the crypto community, we’d be where Bernard Arnault is right now, or at least where Elon Musk is. (if you know what we mean).

As widely acknowledged by crypto investors, it is the self-sustaining autonomous system governing digital assets that makes on-chain trading worth its money. Any measures taken to go against this current is deemed counter-intuitive. Ergo, it is not implausible for debates over this topic to keep sprouting following any rain of speculations and possible implications towards the crypto industry being at the whims of powerful, central entities.

The Merge of Ethereum did not escape this reality, either. To the effect of improving their odds in winning the computational marathon created by the PoW consensus, miners used to gather their resources together in organized rings and share their associated rewards. The more wins they gained, the more centralized the network is. The transition from PoW to PoS on Ethereum was lauded as a way to defeat the issue, effectively making it harder for tamperers to game the Ethereum ledger [16].

Unfortunately, the same phenomenon could also be observed on the PoS consensus mechanism. Data extracted from Dune wizard @hildobby about Beacon Chain Staking Depositors suggests that some “deep-pocket investors” [17] such as Lido, Coinbase and Kraken is holding up to 56.4% - more than a half - of the PoS staking pool collectively (Figure 7). This case supposedly stems from the fact that very few users can acquire enough financial capital to become independent validators and they are more prone to employ third parties who accommodate a less-hassle means of staking and earning rewards.

 

The fact that these significant stakers reserve large space in the pool can lead to some consequences:

- they could be attacked and left with no choice but to freeze users’ assets
- they are granted absolute power to refrain from writing certain transactions that have been sanctioned by regulatory jurisdictions, such as ones from the crypto mixer Tornado Crash, which is on the other end of cryptocurrency ethos of privacy and decentralization spectrum.

Dave Schwed, chief operating officer at crypto security firm Halborn, nevertheless, has quite a positive outlook on the situation as a whole. When interviewed by Decrypt on the matter, he straight up cleared the fog that it would not worry him that much:

“When a block is proposed by a validator, it must then be attested by a committee of validators, at least 128. That minimum of 128 would assume that a few bad validators can’t override the will of the good ones. […] There is another concept called finality which requires a two-thirds majority to vote on a checkpoint block every 32 slots. Once that vote happens, it’s finalized and immutable.” [18]

He also gave confidence in the amount of unstaked ETH - whose ratio against the total ETH supply in circulation is at 13% at press time (Figure 8) as there could be wild chances that it could out-stake the centralized players in the future.

 

Another downside caused by the PoS transition is the notable risk named “staking yields” - which is framed to resemble a bond in a traditional market, potentially starting to draw attention from the U.S. Securities and Exchange Commission. [19]

D. Security

With the foregoing factors combined, enhanced security on the blockchain is inevitable as expanded access and hopefully reduced centralization lead to more users, thus raising the number of operating nodes on the blockchain. [20] A bad-faith actor will find himself in a nearly improbable predicament to compromise more than 50 percent of the network as the number of distributed nodes grows larger.

Walk into the Future with Deflationary / Low-Inflationary Ethereum

Several experts have been consulted across the media to envision what the future holds for Ethereum as its native token stays closely borderline to deflationary state.

M3TA wishes to recapitulate our deep dive with some of the most noticeable distinct slipstreams mapped by these experts as belows:

1. Retail users who use staking services will pull out of Ethereum staking pools as staked ETH withdrawal is unlocked due to lower staking return compared to other platforms.

“I think that users with funds locked in ETH staking services will likely draw back when these deposits can be unlocked because the interest rates aren’t highly attractive,” Armanino head of blockchain services Noah Buxton said. [21]

As of press time, Ethereum staking pools are offering returns of 4.02% for Validators-as-a-Service and 4.46% for Independent Validators, according to Staking Rewards. Meanwhile, in the event they deposit ETH on lending platforms like Nexo and other protocols, the current yield goes up to 10-16%, according to DeFi Rate.

2. Provided that the long-term vision of Ethereum entails goals such as improving transaction throughputs and attempting to bring down the transaction fees overtime, centralization will not hinder developers from building on the blockchain.

“I guess the other point, and what I see from clients, the ‘what chain do we launch or mint on,’ has everything to do with cost of operations and existing network participation from retail and other projects,” Buxton said. “The decentralization of a network is a secondary, if not forgotten, measure in this decision-making process.” [22]

3. Ethereum can turbocharge the trust of investors in itself and in the crypto industry as a whole.

"Ether may continue to outperform bitcoin as ETH's annual issuance continues to fall rapidly. Therefore, thanks to the transaction fee burn mechanism, any increase in on-chain activity should bring Ethereum firmly into deflationary issuance territory and may have a substantial outsized effect on [ether’s] price,” Josh Olszweicz, head of research at digital asset fund manager Valkyrie Investments, told CoinDesk. [23]

“If Ethereum becomes deflationary, we could see a lot of institutional money invested into ETH in the next couple of years,” said Maximiliano Stochyk Duarte, head of marketing at ChainPort and crypto investor since 2014. [24]

Shiliang Tang, chief investment officer at crypto hedge fund Ledger Prime, said ether's deflationary appeal would get stronger overtime, attracting investors. "A lot of sidelined capital is more attracted to ETH storyline than BTC at the moment," Tang said. "I expect ETH to maintain lead over BTC, as ETH's deflationary nature will slowly be felt over time." [25]

4. As the end goal of these upgrades is for more users to migrate to Layer 2s and the Mainnet to serve L2s only, there should be no black and white in deflationary and inflationary status.

Nick Hotz, vice president of research at the digital-asset management firm Arca believes that the mechanism is neither net inflationary nor net deflationary, but rather, it creates “a credible and steady supply of ETH” and sees “more adoption of Ethereum through layer 2 activities.”

“It's a lot like what the Federal Reserve does with the U.S. economy: It reduces the supply of money when the economy is hot, and vice versa,” he added. “That’s what EIP-1559 does. That’s kind of the idea, especially after the Merge.”- CoinDesk reported. [26]

5. Other macroeconomic elements could make Ethereum’s road to become the hedge against inflation a bumpy one.

“This means macroeconomic factors such as inflation have been and could continue to exert pressure on ETH’s overall price. In inflationary environments, many investors will retreat to commodities like oil and gold and tend not to be as interested in riskier investment vehicles like tech stocks and cryptocurrencies.” - Forbes reporters reckoned. [27]

References

[0] Vitalik Buterin. “Launching the Ether Sale”. Ethereum Foundation Blog, July 22, 2014

[1] Andjela Radmilac and James Van Straten. “Research: Is ETH inflationary or deflationary after the Merge?” Cryptoslate, September 24, 2022

[2] [3] “How The Merge impacted ETH supply”. Ethereum, December 02, 2022

[4] [5] Daniel Simon. “How EIP-1559 changes the transaction fees of Ethereum”. Liquidity AG, August 05, 2021

[6] David Mihal. “ETH Burned”. ethburned.info, December 15, 2022

[7] “Ethereum's energy expenditure”. Ethereum, December 14, 2022

[8] [15] Holland & Knight LLP. “The Ethereum Merge: What It Is and Why It Is Important”. Lexology, September 15, 2022

[9] “The Ethereum Merge: Derivative Market Opportunities & Changes to Supply/Demand Dynamics”. Cumberland

[10] Abiodun Oladokun. “Evaluating Ethereum [ETH] PoS network a month post-merge”. AmbCrypto, October 15, 2022

[11] [12] [26] Jocelyn Yang. “Ether Turns Inflationary as Network Usage Slows”. CoinDesk, December 06, 2022

[13] “The Merge”. Ethereum, December 15, 2022

[14] Jack Schickler. “Sweden, EU Discussed Bitcoin Proof-of-Work Ban: Report”. CoinDesk, April 21, 2022

[16] Xinyi Luo. “Ethereum Already Showing Signs of Increased Centralization”. CoinDesk, November 08, 2022

[17] Shubham Pandey. “Ethereum Becomes Ultra Sound Money But Remains Vulnerable to Censorship”. Be In Crypto, November 11, 2022

[18] [21] [22] Stacy Elliott. “Has Proof of Stake Made Ethereum More Centralized?” Decrypt, October 09, 2022

[19] [24] Jocelyn Yang. “Ethereum Merge Vaults Cryptocurrency Past Bitcoin in Hard-Money Allure”. CoinDesk, September 28, 2022

[20] Daniel J. Barsky. “The Ethereum Merge: What It Is and Why It Is Important”. Holland & Knight, September 15, 2022

[23] [25] Omkar Godbole. “Ether Sees Biggest Weekly Gain in 3 Months, ETH-BTC Rally to Continue”. CoinDesk, October 31, 2022

[27] Michael Adams, Farran Powell. “Why Is Ethereum (ETH) Going Up Today?” Forbes, October 26, 2022