Aug Market Review: eth merge reignites censorship debate
Ethereum’s merge to Proof of Stake serves as a fascinating crypto focused event in the face of tough trad-fi macro conditions, which have dragged the broader crypto markets lower in August. Eventual implementation of the complex adjustment from Proof of Work to Proof of Stake may be exciting but it also leaves numerous question marks for censorship, incentives and the role of energy. We continue to view ETH as a complimentary high-beta asset to BTC reserve asset qualities.
HIGHLIGHTS
BTC fell 14.7% in August 2022, while ETH fell 3%, outperforming ahead of the much-anticipated merge
Tight trad-fi liquidity spilled over into crypto in August as the S&P500 fell 4.2%
Dollar strength will pressure economic growth, asset prices, tax receipts and the Fed but it is a wrecking ball for risk appetite in the short-term
PoS increases censorship risks on ETH and censorship resistance is critical to a non-state monetary network
Merge reaffirms ETH’s place as an interesting experiment and complimentary asset to BTC
Merge creates numerous uncertainties that will take time to iron out
In August's note "Marathon not a sprint" we said,
"These are great levels for long-term investors to build allocations. However further volatility should be expected over the coming months...There are tones of obstacles to overcome, including interbank stresses in trad-fi, weak on-chain demand and leverage. There is a real possibility that active traders and funds are pushing hard in the hope of making up for losses incurred earlier in the year and there could still be some pain and false starts."
August was indeed a more challenging month in the markets. BTC was down 14% and ETH was down 7.6%. The correlation between crypto and equity markets remains strong so it is no surprise that the primary driver of the weakness was reduced global risk appetite and a lack of central bank liquidity. After a 9.5% rally in July, the S&P500 was down 3.5% in August.
Last month we argued that bitcoin is in the process of bottoming and the Fed is heading towards capitulation, but we are not quite there yet. The equity market rally in July, gave the Fed a little more runway to tighten and, as a result, the market has reduced its rate cut expectations for 2023 from >80bps to 30bps.
Source: Trading View
We continue to expect a turnaround in macro conditions in the coming months but a trad-fi liquidity squeeze remains a concern. The recent rise in 10-year bond yields back above 3% and the strong run in the dollar confirms the acuteness of this risk. The EUR is below parity and looks as though it could test even lower, while the USDJPY has screamed into the 140 territory - the USD has strengthened 26% vs. the JPY in 2022 which is an absolutely phenomenal rally on a major currency pair. A strong dollar is a wrecking ball for global economic growth, tightening liquidity and restraining risk appetite. The strong dollar will eventually cause too much pain for the Fed to handle, negatively impacting economic growth, asset prices and government tax receipts.
The strong dollar will also lower CPI pressures, giving the Fed the room to loosen monetary policy.
Even during the inflationary 1970s, a strong dollar dampened inflation substantially.
For now one does not want to stand in the way of the dollar, even if the pendulum is close to its apex. The broader strategy remains unchanged. Levels below $20K on BTC are great for long-term allocation but short-term pressures may remain intact until the Fed finally capitulates.
The Merge further differentiates ETH from BTC
On the crypto specific front, the ETH merge remains the focal point - transitioning ethereum’s consensus mechanism from Proof of Work (PoW) to Proof of Stake (PoS). There is much excitement about ethereum ability to eventually execute on this long awaited upgrade, which is driving ETH outperformance vs. BTC. However, I believe that a degree of scepticism is warranted due to both the macro conditions and the implications of this structural upgrade.
I view BTC and ETH as differentiated and complimentary assets so the optimist in me thinks that altering ETH's consensus mechanism could further differentiate ETH from BTC, which may allow for a continuation of the symbiotic relationship with BTC primarily focused on sound, secure, decentralised, censorship resistant money and ETH focused on wider digital scarcity use-cases in Defi, NFTs and DAOs.
However, I have reservations with Proof of Stake which is the consensus mechanism to which ETH is changing.
PoS experiment introduces censorship risks
Contrary to the opinion of many PoS proponents, PoW mining does not waste electricity. A shift from PoW to PoS will neither solve challenges with the environment nor the energy industry.
PoS will not solve transaction scaling (ETH developers plan to use sharding and rollups to scale the network)
PoS introduces centralisation risks because validators tend to make use of validator pools, rather than running a node from home. A significant portion of these validator pools sit in the US, potentially making ETH susceptible to the whims US regulators. While I am not advocating for a confrontation or disagreement with US regulators, political neutrality is an important feature of a public blockchain, allowing for censorship resistance. It is undesirable to introduce a new attack surface into an important public blockchain, which could undermine censorship resistance.
Eric Wall explains that PoS provides ethereum with the ability to penalize staking pools that succumb to political interference through slashing. ETH founder Vitalik Buterin and ETH developers favour this approach:
Source: https://vitalik.ca/general/2020/11/06/pos2020.html
However, slashing could further undermine ethereum's neutrality, creating a political tug-of-war between the compliant and non-compliant versions of the network. Nic Carter's recent article “If Ethereum starts slashing, it burns” articulates this position:
A newly imposed slashing rule spirited from thin air, imposed against the crypto world’s largest financial institution no less, would be far more damaging. Skeptics could justifiably point out that Ethereum will have completely surrendered the moral high ground, with leadership acting expediently.
So Ethereum’s reaction to nation-state sanctions would be to impose sanctions of its own. It’s an identical desire to the one that drives the U.S. government to sanction so aggressively: to use purportedly surgical financial weapons to fight enemies, foreign and domestic, without firing a shot.
But Ethereum leadership must rise above this urge, which would make the network no better than the system it seeks to replace. One of the distinct advantages public blockchains have over their legacy counterparts is their genuine neutrality. To impose a slashing rule – in such an arbitrary and slapdash manner, with no prior codification – would undo that advantage completely.
It may take many years before the full ramifications of this shift in the consensus mechanism and its implications for censorship is fully understood. For example, political interference and censorship are not a problem until you and or your community becomes a victim. In the short-term it will probably have very little impact. But by the stage that it matters, it may be too late to do much about it. It is difficult to quantify this type of asymmetric risk in advance.
Are incentives distorting ethereum’s technical judgement?
So, why is the transition to PoS appealing then? I have mentioned the differing opinions related the mining energy consumption. Additionally, PoS lays the technical groundwork for future upgrades, which should enhance scalability. We will have to wait for future upgrades to realise these potential benefits. In the shorter-term, potential value accrual to ETH holders could be an important driving force behind the shift to PoS.
ETH could have a deflationary supply after the merge, which could be bullish for price. The merge will result in a drop in issuance because validators will be paid less than miners. Additionally, staked assets will be locked up post merge only will only be redeemable after the next technical protocol update. Lastly, a portion of transaction fees are burnt under EIP1559, which could further contribute towards a deflationary supply.
While the drop in issuance is almost certainly true, one should note that staked assets will eventually be unlocked and the quantity of burnt ETH transaction fees are falling so this deflationary supply narrative has its cracks to contend with. For further detail, I recommend reading Jordi Alexander’s article “Is the Merge overhyped?” A deflationary supply asset is ‘all-else-equal’ positive for price appreciation potential, but it is questionable whether this is the best strategic decision given ETH’s focus on use-cases, as opposed to BTC’s store of value. For example, lower oil supply growth supports oil price appreciation but steady reduction in actual supply could lead users to seek out alternatives because oil must be readily available for usage.
Regime change renders ETH’s Data history less useful
The change in ETH’s underlying consensus mechanism calls into question the historical data since it's founding in 2016. One could make the argument that ETH2 is a whole new blockchain and thus the pre-2022 data history is no longer relevant. This is a challenge for investors like us who use historical data to assess the performance of an asset and its relationship to various financial variables.
Similar to many of the viewpoints above, this is not a death-nail for ETH. It just raises the broader question, “why change to PoS at all?” There is a strong argument for ETH to scrap the shift to PoS and remain on PoW - the strongest component being the reduction in censorship risks. From Nic Carter again,
Stake exposes consensus to government will through regulated financial institutions, which are slated to dominate validation, whereas PoW is far more distributed and covert. Switching mining pools is instant and trivial; with PoS, it’s cumbersome. The validator set churns constantly in PoW…
However, it appears very unlikely that ETH will change its path at this stage. Remember, PoS was on the roadmap since ethereum’s launch. The community appears wedded to this path (which is another concern to bear in mind). The merge is now set for mid September 2022.
As an investor, I continue to view ETH as an interesting experiment, a complimentary asset to BTC and a high-beta asset vs. bitcoin’s clear reserve asset qualities. The merge is further accentuates this viewpoint because there are a number of uncertainties that will only be ironed out post merge. There are times in the past when I have held close to 50% of my trading portfolio in ETH in order to take advantage of ETH’s ability to outperform BTC. Despite the potential for further price outperformance due to the merge narrative, there are a host of uncertainties that discount prospective ETH allocation. Furthermore, current macro conditions are not ideally suited for high-beta assets.
