For the past few weeks, the crypto community has been excited about the upcoming “Ethereum Merge” in mid-September. The long-awaited merger refers to a technical transition aimed at increasing the processing capacity of the Ethereum blockchain and improving its security in an energy-efficient manner. It also has big implications for investors. JPMorgan has called the transition “one of the most significant events in the history of the cryptoecosystem,” noting that the switch is “transformational on multiple levels.” Specifically, migrating from one protocol to another will allow investors to earn “yields” or rewards on their Ether holdings. According to JPMorgan, this yield-generating opportunity, known as staking, should help propel crypto further into the mainstream. It also opens up a huge opportunity for crypto stocks like Coinbase. “The Ethereum merger is a pivotal event in the history of the cryptoecosystem,” JPMorgan’s Kenneth Worthington said in a note this week. “We see an Ethereum yield as potentially a big deal as it lowers the opportunity cost of investing in Ethereum, and as such we hope it can attract more retail and institutional investors to Ethereum specifically and the crypto ecosystem Generally”. The transition is currently scheduled to take place on September 15th. Here’s what you need to know about it. Earth-friendly return potential Many expect that in order for crypto to grow as an asset class, institutional money will have to come on a large scale. This is not likely to happen until crypto can eliminate the idea that its mining processes are bad for the environment. The merger is expected to reduce Ethereum’s energy consumption by more than 99%. There are two main protocols used to secure cryptocurrency networks. The first, called proof of work, requires specialized computing equipment, such as high-end graphics cards, to validate transactions by solving very complex mathematical problems. Any validator who does so receives a reward. This process requires a large amount of energy to complete. The other model is called proof-of-stake. It allows owners of proof-of-stake tokens, as ether will be after the transition, to act as network validators, but without the need for fancy computers. To do this, investors lock up a portion of their funds for a period of time to gain a position as a network validator. This means they do the work of verifying and processing transactions, hence the reward. Rewards vary by network, but generally the more you bet, the more you win. Average returns on Ether staking can currently be between 1.5% and 4%, depending on the platform investors use. JPMorgan expects to see that increase around 8%, Worthington said. “Ethereum could be a particularly high-yielding asset after the Ethereum merger,” he said. “While the yield will flex around the stake participation levels, the yield initially could be around 8%, although we expect the yield to flex lower as more participants look to capture the yield “. “If we’re correct,” he added, “Coinbase will accept almost all of its retail Ethereum assets to participate, thereby increasing the amount of ether staked and thus reducing its yield.” Exchange Opportunity The network’s transaction validation process is simply impractical for both retail and institutional investors. This is where Coinbase, Kraken, Gemini and other exchanges can come into play. “Most retail owners of ether will not stake, they will give their stake to a staking service that will then do it on their behalf.” said Avichal Garg, managing partner at venture capital firm Electric Capital. “This is going to be a huge revenue business for exchanges like Coinbase, for example.” JPMorgan estimates that Coinbase has about 15% of the market share of Ethereum assets and estimates that the company will opt for its customers in betting and related services. That could drive a 95 percent retail participation rate, Worthington said, compared to the current industry participation rate of 50 percent to 70 percent. The company also estimates a 70% payout for Coinbase’s retail customers, as well as a 20% to 25% Coinbase take fee for retail customers. This take rate drops to 1.5% for institutional clients. Different risks This year’s crypto contagion may have been the death of easy money and 20% returns on loans, but smart contracts come with different risks. With lenders like Celsius and BlockFi, much of the performance came from loan demand, which eventually picked up. “The real problem was that companies were giving loans with insufficient collateral without doing a proper risk assessment and people lost a lot of money as a result. It was actually a re-enactment of 2008 by the companies, not a failure of the underlying cryptographic rails.” Garg said, comparing the situation to the financial crisis. In the Ethereum world, the source of return is different. There are no humans on the other side promising returns, instead the protocol itself pays investors to run the computational network. However, there is the technical risk of errors in the code. There is also market risk. “You get new ether as a reward for processing these transactions. But if there is no one using applications built on the Ethereum network, there is no demand to buy ether,” Garg said. “So you’re essentially … diluting your ownership through the new issue.” More Volatility With the value of cryptocurrencies falling in the first half of the year, investors have been particularly keen to see a rebound around the time of the merger. Ether has been outperforming bitcoin for weeks, advancing nearly 70% in July alone compared to bitcoin’s 27% gain. Garg said he expects a lot more volatility after the merger, comparing potential integration issues to 2000 computer systems upgrades more than two decades ago. Everyone knew that the code had to be fixed to prevent computers from breaking on January 1, 2000, but the process of doing so was complicated, it was difficult to predict how applications would interact with each other until after completion the update, he explained. “There are DeFi and NFT applications and all these applications built on top of Ethereum – that’s where I think there’s a huge risk,” he said. “We don’t really know how these apps will interact with each other beyond the proof-of-stake update, and since many of these apps are so intertwined with each other, there could be unexpected integration issues.” “Between the potential for challenges in updating the base layer, potential integration issues, the threat of a proof-of-work fork, and broader macro market volatility, I expect significant volatility around the merger,” he added.
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About the Author: Chaz Cutler
My name is Chasity. I love to follow the stock market and financial news!