Thoughts on the Merge and Regulation

Merge Update

If you recall, several potential catalysts for this year were highlighted during our 2022 preview. A major one was the proposed transition of Ethereum from its current Proof-of-Work (PoW) to a Proof-of-Stake (PoS) architecture through a process colloquially termed the “Merge.” This is a catalyst that we felt the market was heavily discounting due to Ethereum developers’ track record of delays (Some thought this would take place five years ago).

We have periodically updated clients with the latest happenings related to the Merge. Still, we have not had as conclusive evidence of a move towards completion as the event that transpired yesterday, as Ethereum developers merged the Ropsten Testnet with the Beacon Chain. This could best be considered a dress rehearsal for the Mainnet Merge. By all indications, the undertaking was a success and brought us one step closer to the real thing.

Supply Dynamics Post-Merge

From a fundamentals perspective, if the Merge occurs as planned, the effects on the network will be a (1) reduced issuance rate and (2) an immediate reduction in daily selling pressure.

To elaborate on the points above:

• Reduced Issuance Rate – the inflation rate of supply will decline. At a high level, this is because the block reward required to incent PoW miners is substantially higher (due to hardware costs) than the reward needed to incentivize PoS miners. Presently, both PoW miners and ETH stakers (who are not producing blocks) are receiving new ETH on every block produced. Once the Merge is complete, the dark blue line in the chart below will no longer be around, and the only source of inflation will be the light blue line at the bottom. Note that these annual issuance rates do not include any fees burned, which could very well result in deflationary supply dynamics.

• Reduced Selling Pressure – this concept dovetails with the point above. If the starting point for revenue available for miners to sell is lower, then inherently, the overall sell pressure from miners will decline. But additionally, one must consider the change in cost profile for miners. The maintenance and energy costs that force miners to sell their ETH for working capital are significantly reduced in a PoS model. Further, there is a short-term consideration that we think is perhaps the most bullish element of the merge – those who stake their ETH before the Merge will be unable to unlock their ETH for at least six months post-Merge. This means that once the transition is complete, selling pressure from miners will be locked at zero.

Next Steps

Now that the Ropsten testnet has been merged with the Beacon Chain, developers will assess the test merge’s performance and make any required adjustments. Then, two more testnets (Goerli, Sepolia) will be merged with the Beacon Chain over the next couple of months. If all goes well with these two events, then comes Mainnet merge.

Based on our conversations and observations, we think that late August through September is a reasonable time to expect this to occur.

Are Markets Pricing the Merge In?

The obvious question from a portfolio management perspective is whether the Merge is “priced-in.” In the spot market, the short answer is no. Decentralized networks have a challenging time pricing catalysts ahead of time because they are three-dimensional. While events in the equities world can be succinctly modeled via cash flows and discount rates, the value of some tokens accrues exponentially due to their utility component. Since demand for Ethereum blockspace is relatively low, it is unlikely that we will see speculative buying in the spot market until we get closer to the completion of the Merge.

However, if we look at derivative markets, we can see that some market participants are starting to pace their bets on the Merge. Below we can see a spike in forward implied volatility for ETH in September. Options traders may be starting to speculate on the completion of the Merge during this timeframe.

Similarly, we see a massive jump in monthly options volume in September and October. The jump is likely due to generally muted volumes during the summer months coupled with the current macro landscape, which clouds things in the immediate term. Still, it’s possible that in a similar vein to the chart above, speculators are starting to trade around this event.

Digging a step deeper into the options data, we see that the most popular instruments purchased on Thursday (1-day post-Ropsten Merge) are OTM calls for September. This lines up with the expected timeline for the Merge nicely and suggests that long-tail bets are being placed now.

Finally, we can look to alternative data sources to corroborate the growing optimism. Polymarket, a crypto-enabled project that allows users to place bets with stablecoins on the occurrence of certain world events, now features a market on the timing of the Merge. While liquidity is somewhat limited, this is an interesting social indicator of sentiment around the event.

This market is currently pricing in a 26% chance of the Merge transpiring before September and a 65% probability of it happening before October. This falls in line with our expectations noted above. 

Merge Summary

In summary, the Ethereum network achieved its most significant milestone along with its roadmap to a PoS network. While there are fair criticisms of this endeavor, we think the completion of the Merge would be a significant catalyst for ETH and the wider crypto industry. Despite a history of delays, it seems like Mainnet Merge could be right around the corner.

Bipartisan Crypto Bill

This week, a highly anticipated bipartisan bill was introduced by Senators Cynthia Lummis (R) and Kirsten Gillibrand (D). The bill aims to create more legal clarity around cryptoassets, particularly regarding the definition of securities, the timing of taxable income, and the regulatory bodies that will shoulder the regulatory burden. For a quick breakdown of the major points in the bill, this is a useful summary.

We are not going to pretend to be legal scholars but below are some of our thoughts:

• This is a net positive for the industry. While many are reluctant to bring more regulation to digital assets, compliance departments around the world are waiting for legal clarity in the U.S. to get more involved in digital assets. Once there are more clearly defined guardrails, we might see a vast amount of additional capital inflows in the industry. The bill is also bipartisan, which should provide added momentum for the final version of said legislation.
• This is not the final version of the bill. As with most pieces of legislation, there will be numerous revisions. Therefore, any suboptimal wording or provisions will be contested before this has a chance of passing.
• This bill would broadly empower the CFTC rather than the SEC in the regulation of digital assets. We think this makes sense given that digital assets are mostly commodities that share elements of utility and governance.
• The bill stipulates that any mining income (whether from PoW or PoS) is not taxable until the disposition of those assets. This is huge for any mining firm that wishes to participate in the industry but does not want to be stuck with a tax bill that exceeds asset balances.
• There is language surrounding the stablecoins that we think is encouraging. There is a push to create a transparent and frictionless framework for issuing stablecoins.

Overall, we think this legislation is a great first draft. In discussions with some legal experts in the industry, there are some unworkable elements of the bill. Still, from our experience, we find that further education for elected officials often fixes these types of things. We will continue to monitor the bill’s progress as it moves through Congress.

Strategy

This month is a busy one for the economic calendar. The market’s reaction to QT, rate hikes, and CPI should lend some firmer guidance on how the second half of this year will look. Despite signs of seller exhaustion, our near-term outlook remains cautious. To reiterate our current stance, we maintain that it is wise to reduce exposure to altcoins and hedge long exposure in the immediate term (1-month). However, we are still constructive on cryptoasset prices in 2H. Importantly, we think this is the time for medium and long-term investors (1+ year) to consider allocating to bitcoin more aggressively.