Notes 9/8: Ethereum’s Merge and Democratization, Ethereum’s Trends

One of the benefits being touted about Ethereum’s Merge is that it will “democratize” the blockchain by making it possible for anyone to participate in its network. That claim about the event, which will transition the blockchain from an energy-intensive Proof of Work (PoW) mining to the Proof of Stake (PoS) consensus mechanism, is similar to the one made about Bitcoin when it was first introduced to the world.

Anyone could participate in its network and mine Bitcoin, we were told. Of course, as we all know now, that claim proved bunkum. Bitcoin mining has become a prohibitively expensive proposition for individual miners and it is now dominated by large multinational players. Ethereum mining, at least in its PoW avatar, is in a similar state (pun intended). The chances that a shift to PoS will change the situation and make it possible for anyone to earn ether as rewards are slim.

The Bogus Claim of Democratization

The costs – in terms of opportunity and finance – of becoming a validator, who will replace miners, are high.  

For starters, there’s the initial investment of 32 ETH to get started as a validator. At current prices of the cryptocurrency, that translates to an initial investment of roughly $51,000. That figure is hardly chump change. Ether’s price is expected to increase over time as its supply decreases and use cases develop. That means potential validators will have to fork out even more money to get started.  

There are other costs involved in setting up a validator node. These include a dedicated Internet connection and energy costs because a full node is always switched on and connected to the network all the time. The storage costs will rise over time because the data stored in a node increases as the number of transactions and blocks processed rises. The node will also need more bandwidth to fashion blocks out of the data.

Then, there’s the opportunity cost or the time cost involved in setting up the node itself. You need technical chops to set up a validator node. To overcome deficiencies for those who are technologically literate, there are Plug-n-Play machines.

But those solutions are not cheap. For example, DApp node’s HOPR solution costs roughly $1226.88 based on current exchange rates. A more expensive solution that can run many chains is worth $2,015. Open-source alternatives exist but they require technical knowledge and an evaluation of opportunity costs.

A guaranteed return on investment might make the effort worthwhile. According to reports, yields are expected to double to 8% from the current 4%. The problem is that rewards doled out in the PoS consensus mechanism are as uncertain as those in PoW because it is primed to encourage high investments. As I explained earlier, the variable costs – ether price, bandwidth, storage etc. – to begin mining ether are expected to go up over time.

And those costs are necessary because the system penalizes those who are dishonest or provide an incorrect copy of the blockchain for validation. [The latter condition means that you must be always connected and running the latest version of the Ethereum client].

There are ways to get around this uncertainty. You may not be able to stake more than 32 eth but there are no limits on the number of nodes that you can run. Thus, the more validator nodes you run, the higher your chances of earnings rewards in ether, a cryptocurrency that is expected to increase in price, are greater. A PoS Ethereum validation system is best suited to validators able to muster up economies of scale to expand their operations with expected future increases.

A Centralized System

If solo staking is not up your alley, the Ethereum foundation offers the option of staking pools – outfits that stake your ether and pay out an interest in return – or cloud validators. Both those options encourage centralization. An example is cryptocurrency exchange Coinbase, which will become one of the biggest validators in the Ethereum ecosystem.

Other firms have already sensed the profit opportunity inherent in Ethereum’s PoS system and are rushing to offer staking as a service. In the end, a shift to PoS may mean that a plutocracy of wealthy services and investors may end up controlling a system that claims to be democratized.

Ethereum Becomes a Trend   

As the premier cryptocurrency, Bitcoin has set the tone for prices and market movement in crypto markets. Post-pandemic, however, its influence is beginning to wane.

Bitcoin dominance, or the cryptocurrency’s percentage share in crypto’s overall market cap, has slid to 37.9%, as of this writing. Ethereum’s ether, meanwhile, continues to gain ground and has seen its dominance increase to around 21%. Around five years ago, in September 2017, Bitcoin was responsible for around 55% of the overall market capitalization. In 2016, it accounted for more than 95% of the total market cap.

What changed?   

The cryptocurrency, which was once touted as a hedge against inflation and the global economy, has become entangled in the macroeconomic mix. Its price movements now move to the rhythm of government policies and correspond with the entry and exit of big investors and their flirtations with risky assets. The pandemic stimulus fed into its rising prices while rising inflation, interest rate uncertainties, and global turmoil in the form of war with Ukraine have depressed investment into its ecosystem.

Analysts at research firm Bernstein say the original cryptocurrency will become a macro-driven asset in the future i.e., its price will be driven by factors affecting the global economy. Ethereum and other alternative assets are “more of an innovation-driven structural trend” rather than asset classes on their own, according to them.

It is hard to make much sense of this phrase. Is Ethereum a trend? Also, does this mean that technical developments will drive prices for their tokens? Or will the tokens be eliminated altogether from the systems of alternative crypto assets?  

The Example of Bitcoin

In the past, developments in the bitcoin network, such as the Lightning Network, were said to be responsible for its skyrocketing prices. Investors were enthused about its prospects. Or so, we were told.

Technical developments no longer hold a sway on the cryptocurrency’s price movement. In fact, their effect lasted for a very brief period of time. It fizzled out in a month and crypto markets settled in the deep chill of a winter that lasted more than two years.

That is not surprising. The number of major technical upgrades and updates to software systems become fewer as they reach an intended design. After that, it is time to find customers and use cases.  

And so it is that further developments in Bitcoin’s Lightning Network have failed to have any effect on its price. Perhaps, investors are still waiting for the cryptocurrency to deliver on its original promise of being a peer-to-peer payment network. In the meanwhile, they have latched onto a narrative of global economic developments affecting its price.  

It is difficult to envisage an asset like Dogecoin, or for that matter thousands of other coins that are listed on exchanges, becoming a structural trend.

Ethereum’s next major update, after the Merge, will be the Shanghai upgrade which is expected to occur “a few months” after the Merge. [Though, given the Ethereum Foundation’s history of pushing dates around, it may well be delayed]. If the Bernstein thesis holds true, we should see some price action during that time. And, what after that? Ethereum will have to follow the bitcoin route after it reaches maturity and deliver customers and solutions on its network. Unlike Bitcoin, however, it does not have the story to global economic forces to fall back on to sustain its price.

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