For the past few weeks, the crypto community has been abuzz with excitement about the forthcoming “Ethereum Merge” in mid-September. The long-anticipated Merge refers to a technical transition meant to increase the Ethereum blockchain’s processing capacity and improve its security in an energy efficient way. It has big implications for investors, too. JPMorgan has called the transition “one of the most significant events in the history of the cryptoecosystem,” noting that the switch is “transformational on a number of levels.” Specifically, the migration from one protocol to the other will allow investors to earn “yield,” or rewards, on their ether holdings. That yield-generating opportunity, known as staking, should help push crypto further into the mainstream, according to JPMorgan. It also opens up a big opportunity for crypto equities like Coinbase . “The Ethereum Merge is a seminal 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 reduces the opportunity cost of investing in Ethereum and as such we expect it could draw more retail and institutional investors to Ethereum specifically and the crypto ecosystem broadly.” The transition is currently scheduled to take place on Sept. 15. Here’s what you need to know about it. Earth-friendly yield potential Many expect that for crypto to grow as an asset class, institutional money has to come in at scale. That’s not likely to happen until crypto can remove the idea that its mining processes are bad for the environment. The Merge is expected to cut 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, like high-end graphics cards, to validate transactions by solving highly complex math problems. Whichever validator does so, gets a reward. This process requires a ton of energy to complete. The other model is called proof-of-stake. It lets owners of proof-of-stake tokens — like ether will be after the transition — act as network validators, but without the need for fancy computers. To do so, investors lock up a portion of their funds for a period of time to earn a position as a network validator. That means they do the work of verifying and processing transactions, hence the reward. Rewards vary by network but generally the more you stake, the more you earn. Average returns for staking ether currently can run between 1.5% and 4% depending on the platform investors are using. JPMorgan expects to see that rise to about 8%, Worthington said. “Ethereum could be a particularly high yielding asset following the Ethereum Merge,” he said. “While the yield will flex around the participation levels in staking, the yield initially could be about 8%, although we expect that yield to flex lower as more stakers seek to capture the yield.” “If we are correct,” he added, “Coinbase will opt-in nearly all of its retail Ethereum assets to staking, thus increasing the amount of ether staked and thus dropping its yield.” Opportunity for exchanges The process of validating network transactions is simply impractical for investors on both the retail and institutional side. That’s where Coinbase, Kraken, Gemini and other exchanges can come in. “Most retail holders of ether are not going to stake themselves, they’re going to give their stake to a staking service that will then do the staking on their behalf,” said Avichal Garg, a managing partner at venture capital firm Electric Capital. “This will be a great revenue business for exchanges like Coinbase, for example.” JPMorgan estimates Coinbase has about 15% of the market share of Ethereum assets and estimates the company will opt its clients into staking and related services. That could drive a 95% retail participation rate, Worthington said, compared with the industry’s current 50% to 70% staking rate. The firm also estimates a 70% payout for Coinbase retail clients, as well as a 20% to 25% Coinbase take rate for retail customers. That 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 in lending, but smart contracts come with different risks. With lenders like Celsius and BlockFi, a lot of the yield was coming from borrow demand, which ultimately went into leverage. “The real issue was that companies were giving under-collateralized loans without doing proper risk assessment and as a result, people lost a lot of money.It was actually a recreation of 2008 by companies, not a failure of the underlying crypto rails,” Garg said, likening the situation to the financial crisis. In the world of Ethereum, the source of return is different. There aren’t humans on the other side promising returns, but rather the protocol itself paying investors to run the computational network. However, there is the technical risk of bugs in the code. There’s also market risk. “You’re getting new ether issued to you as a reward for processing these transactions. But if there’s no one using applications built on the Ethereum network, then there’s no buy demand for ether,” Garg said. “So essentially you’re … diluting your ownership via the new issuance.” More volatility With the value of cryptocurrencies falling in the first half of the year, investors have been especially keen to see a rally around the time of the Merge. Ether has been outperforming bitcoin for weeks, advancing almost 70% in July alone compared with bitcoin’s 27% gain. Garg said he expects lots more volatility after the Merge, comparing potential integration issues to the Y2K computer systems updates more than two decades ago. Everyone knew the code had to be fixed to avoid computers breaking on Jan. 1, 2000, but the process of doing so was tricky, it was difficult to foresee how applications would interact with each other until after the update was complete, he explained. “There are DeFi apps and NFTs and all these applications built on top of Ethereum – that’s where I think there’s potentially a tremendous amount of risk,” he said. “We don’t really know how those apps will interact with each other on the other of the proof-of-stake update, and given that many of these applications are very intertwined with each other, there could be unexpected integration issues.” “Between the potential for challenges in the base layer update, the potential integration issues, the threat of a proof-of-work-based fork, and broader macro market volatility, I expect significant volatility around the Merge,” he added.
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