Decentralized finance investors are betting on Ethereum’s overhaul to help unfreeze the market’s two-plus-month crypto winter.
The DeFi sector, where investors earn returns by trading and staking cryptocurrencies without centralized intermediaries, has declined sharply following the collapse of stablecoin TerraUSD, and as soaring inflation puts the Federal Reserve on edge. way to monetary tightening. One of the most significant technical upgrades to the blockchain since its inception in 2015, Ethereum “Merge,” may be one of the few catalysts that could give DeFi a much-needed boost.
Despite multiple delays, major developers have made major progress, and Ethereum co-founder Vitalik Buterin says the upgrade is expected to happen in August. The merger will shift the Ethereum blockchain from a proof-of-work consensus mechanism, where miners use powerful computers to order and validate transactions for users, to proof-of-stake. The new mechanism replaces miners with Ether holders performing the same tasks.
The merger will be by far the biggest event in the crypto space this year, said Vance Spencer, co-founder of venture capital firm Framework Ventures. “If you think about how crypto markets usually move, the biggest event is usually the Bitcoin halving, halving the supply of Bitcoin,” he said. “Here, Ethereum supply is reduced by 90% in an instant.”
From “risk-free” to “risk-free”
Less new Ether issuance, a smaller carbon footprint, and higher returns are among the results of the upgrade that DeFi investors say will fuel an Ethereum rally and boost the industry.
“Our DeFi fund has been risk-free in the market all year and now, for the first time, we are at risk because we have been accumulating Ether every day,” said Wes Cowan, Chief Financial Officer. decentralized at crypto investment firm Valkyrie. “We continue to trade stablecoins such as USDC for more Ether in the fund.”
The transition will also eliminate tens of millions of dollars in fees paid to Ether miners every day. “Ethereum miners earned an average of $42 million per day in 2022,” said Jaran Mellerud, mining analyst at Arcane Crypto.
Ether holders, who will become blockchain validators after the upgrade, are also more likely to keep their Ether rewards and stake them for higher returns, unlike miners who tend to sell their mined Ether for collect or cover operational costs, further reduce the money supply.
“The expenses of a validator are only a fraction of the expenses of a miner,” said Rex Hygate, founder of tech risk analytics firm DeFiSafety. “Because the cost of operations is low, the amount of ether they would issue to cover the cost is reduced.”
Staking rewards, which are what validators receive in return for putting their assets on the blockchain to secure the Ethereum network, will also be higher post-merger as Ethereum’s core developers plan to financially incentivize a greater participation in staking, Hygate said.
Ethereum could also face less selling pressure compared to Bitcoin, particularly if a price drop triggers a fresh round of selling among cash-strapped Bitcoin miners who hold large holdings. Public mining companies such as Riot Blockchain began selling their mined coins for the first time earlier this year.
“If you’re in the middle of the bear market and bitcoin miners are selling off, while ethereum just doesn’t have a latent supply and instead gives users fees, bitcoin will require a lot more inflow to sustain this position than Ethereum,” Spencer said.
The flip side
While the merger is one of the most anticipated events for crypto in 2022, the bullish sentiment surrounding it is unlikely to spill over to the wider market, where interest rate hikes and lows economic outlook has driven investors away from riskier asset classes.
A potential security threat to Ethereum’s beacon chain earlier this week could also push back the timing of the merger. The chain, which is key to introducing the new proof-of-stake mechanism, underwent a blockchain revamp on Wednesday. Ether plunged as much as 11% on Thursday before paring losses to around $1,843, well below its $2,000 benchmark.
The problem may be caused by a network failure such as a bug or malicious attacks by miners with high resources, resulting in a duplicate version of the blockchain and increased security risks.
“As still to be confirmed, the impact on the timing of the merger is still unknown,” said Marc-Thomas Arjoon, associate researcher at CoinShares. “If this is an easy fix, there may not be any delay, but if this issue reveals something deeper, the Ethereum Foundation and the developers will have to discuss it further depending on the type problem.”
Other technical issues on Ethereum’s testnets could further delay the upgrade.
And once the merger takes place, it could even create headwinds for other projects in the DeFi sector, including so-called layer 1 projects. The term layer 1 is generally used to describe a layer blockchain network of base, such as Bitcoin, on top of which other applications are built.
“All of these Ethereum-based projects are going to pick up so much speed,” Hygate said. “In our view, this will suck the air out of a lot of other Layer 1 markets.” For example, some layer 1 projects like Solana and Cardano are often considered “Ethereum killers” because they provide alternative blockchain networks for traders on Ethereum.