Opinion: Why the Ethereum Merge will be a game-changer for DeFi?

The upcoming Ethereum upgrade known as “The Merge” is creating a lot of excitement in the crypto market, and for a good reason. Wei believes it will be looked back on not just as the most important industry event of 2022, but as a major inflexion point in the history of the space.

“The Merge refers to the fusion of Ethereum’s Mainnet, the execution layer currently secured by an energy-intensive proof-of-work system, with the Beacon Chain, a separate consensus layer based on a proof-of-stake mechanism. Once complete, blocks of transactions will be added to the Ethereum blockchain exclusively via proof-of-stake verification, eliminating the role of miners and their heavy carbon footprint. There are many different aspects to the Merge which touch on all different parts of the crypto world, and it’s only the first step in a detailed roadmap for the Ethereum described in shorthand as “The Merge, the Surge, the Verge, the Purge and the Splurge”. The upshot is that these changes will massively expand the Ethereum ecosystem’s scalability.”

Like with any big event driving the crypto narrative, there has been significant price action in ETH on many exchanges as the expected mid-September completion date of the Merge approaches. ETH holders need to understand that this is not just a turn-key upgrade, but the beginning of a long-term process. That being said, one important outcome is that there will be greater interest in Ethereum from the financial sector.

The first big reason is ESG. The shift from an energy-consuming asset to an energy-neutral one is a huge deal for institutional investors, who are more focused on ESG factors, with environmental impact first and foremost. Concerns over the carbon footprint of proof-of-work-based cryptocurrencies (which also notably include Bitcoin) have been one of the most important obstacles to large institutions deploying more capital in the space. The Merge means that, at least in the case of Ethereum, that particular object will be completely neutralized. Second, the nature of the proof-of-stake mechanism will significantly enhance ETH’s attractiveness to large financial investors by introducing a yield-like characteristic to ETH holdings.

“To understand why, you need to know a little bit about how proof-of-stake works, and how it will be implemented on the Ethereum blockchain going forward. Post-Merge, Ethereum transactions will be verified not by miners performing computations, but by validators locking up (staking) their own money (in ETH form) as collateral to ensure that they perform the verification diligently and honestly. In return, validators that successfully add blocks to the blockchain earn monetary rewards for their work. In the Ethereum context, running a validator node will require staking 32 ETH – over US$50,000 at current prices – although the creation of staking pools also allows smaller ETH holders to participate collectively.”

This new system, therefore, creates the ability to directly and securely earn a yield on ETH holdings. This is a big deal for investors, and it could prove attractive to money managers whose main concern is generating stable returns with good upside.

Finally, ETH staking will also provide a boost to the entire decentralized finance (DeFi) space. The size and credibility of the Ethereum network will make it almost like the crypto world’s equivalent of the market for US Treasuries. ETH staking will become a de facto “risk-free” rate for crypto, serving as an underlying rate which all sorts of DeFi yield-generating projects can be benchmarked against.

The Merge and future Ethereum upgrades, coupled with the development of Layer 2 blockchains that enable massive scaling up while inheriting the base layer’s security guarantees, will result in a proliferation of infrastructure being built on top of the new proof-of-stake based Ethereum.

Based on the combination of all these factors, Wei is bullish on Ethereum and its ecosystem, and even more so on the DeFi space.

“ It’s a great time to be building in this space”, said Wei.

The Merge is about long-term value, not short-term price appreciation 

A classic Wall Street maxim instructs traders to buy the rumour and sell the news. But investors should be wary of seeking short-term profit around the Merge event in September.

It is worth considering another significant crypto market event, the most recent Bitcoin “halving”. Every four years, the reward for mining Bitcoin is cut in half. The third instance occurred in May 2020 and was accompanied by lots of discussion about how the price would be affected. As it happened, the price of Bitcoin didn’t change much in the run-up to the halving. Several months later, the next Bitcoin bull run got its start, powered by a narrative of Bitcoin as digital gold.

Similar dynamics could be at play with Ethereum. The Merge is not about the chance for a one-time event-driven price spike. Instead, it is about understanding the fact that it is the first in a long line of improvements that are going to upgrade the network and allow players in the ecosystem to unlock huge value by building on top of it. It will take some time for the narrative to catch up with events on the ground, and then for a meaningful inflow of capital into this asset to happen. But I am convinced that the future is bright for the ecosystem as a whole.