Crypto Deep Dive – 22nd July 2022
Signs of Life on Mars
The most highly anticipated technological development of recent times in the cryptoverse awaits us. The price action would lead you to believe it at least, but it wouldn’t be the first time Ethereum’s merge to a proof of stake consensus mechanism has been pushed back. The hype has continually ebbed and waned through the deliberations and delays, but as the merge becomes inevitable, so its impact has become tangible. Finally breaking the period of stagnation, Ether has climbed 67.8% off its lows of last month – an eye-watering ascent. Is there life on Mars?
A Timeline of Technicalities
Since the Ethereum blockchain was created, a Proof of Work protocol has secured Mainnet. This is the Ethereum blockchain we’re all used to – it contains every transaction, smart contract, and balance since it began in 2015. The Beacon Chain, created in 2020, has since existed as a separate blockchain to Mainnet, running in parallel. The Beacon Chain does not process Mainnet transactions. Instead, it reaches consensus in its own state by agreeing on active validators and their account balances. It has been extensively tested and is rapidly approaching adoption. After the merge, the Beacon Chain will be the consensus engine for all network data, supporting execution layer transactions and account balances. The merge represents this official switch to using the Beacon Chain as the engine of block production. Mining will no longer be the means of producing valid blocks. Instead, the Proof of Stake validators assume this role and will be responsible for processing the validity of all transactions and proposing blocks. 19 September has been suggested as the date of final merge.
Post-merge, Ether inflation will drop from 4% to 0.2%, giving the ecosystem a massive reduction in issuance. Finally someone is doing something about supply-side inflation. This has obvious and tangible implications for any valuation model and has been explored ad nauseum by other scribes. There is another, arguably far larger, feather in the Beacon Chain hat though. The merge will reduce the network’s energy consumption by more than 99%. Ethical relief aside, this too has been well broadcast, but how has this been reflected in Ether price action?
Under the current PoW cryptographic protocol, Ether and other crypto-assets have an outsized carbon footprint – drawing energy usage comparisons to those of mid-sized countries. The community’s response to public criticism of the significant energy consumption has been welcomed in principle, but done little to alleviate policy makers’ concerns. Political and social choices on energy sources and energy consumption levels could lead policymakers to privilege certain productive activities to meet climate
strategy targets and avoid crowding out of limited renewable energy sources. Activities such as cryptographic mining thus put countries’ green transition targets at risk and draw the attention of prudential regulators, such as the EU. Increasing financial sector exposure to crypto-assets with a significant carbon footprint is also contributing to increased climate transition risk for the financial sector, potentially limiting portfolio allocation.
These externalities are unlikely to be fully priced in currently, but as the market matures so its efficiency does too, and we begin to see these transition risks damage valuations. Environmental implications have already reversed Tesla’s acceptance of Bitcoin as a means of payment . Though severe, this poses little existential threat to the industry – high energy usage is a feature of PoW, not a bug. What we have seen though is an increase in PoS market capitalisation as the market has rotated towards more efficient protocols. Ethers run up in price as it shifts from a PoW model to PoS can be seen as a reversal of these concerns – an unwinding of the market’s capture of externalities. There are of course omitted variables at play here pulling the price along too – markets hate uncertainty and a successful merge provides stability, while we have also seen an uptick in whale transactions, a key signal to some. In support of the environmental hypothesis though is the performance of Polygon – the L2 scaling system has implemented changes that make it even more energy efficient and is the only notable token to post comparable gains to Ether during the time period – even outstripping it.
The upwards relief on Ether is dragging the market up with it – on a tick by tick basis it is leading Bitcoin. There’s suggestions that this could even provide the impetus crypto needs to finally decouple from traditional markets – as seen in the falling correlation between crypto and the S&P500, which has fallen to its lowest level in months.
Scepticism should remain high here – although we have seen a calming of macro fears in recent weeks, this has been on the back of little tangible good news. It feels more like the market has fully priced in all bad news and has nowhere left to move down. The backend of the rates curve is pricing in further pain and we can expect to begin seeing the lag effects of quantitative tightening soon. Until the broader market recovers, any attempt by crypto to decouple will be a struggle. All this points towards a bear rally, yet I can never bring myself to be short crypto. My heart tells me to buy mid-dated call spreads on ETH – the $1700 level is key here and the path could be clear after that. The sensible trade though has been, and in my view continues to be, long ETH/BTC. BTC dominance has waned recently, dropping to 42.7% – the lowest since before the implosion of the Terra ecosystem. PoS protocols have gained traction, but this has also been on the back of considerable selling pressure on BTC. Mt. Gox and Tesla have both offloaded sizeable clips on the market and we continue to see liquidation pressure in the aftermath of the crypto credit crisis.
As always, good luck out there!
James Laidlaw – Trader OTC Desk
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