ETH’s Supply & Demand Following the Merge

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In several previous editions of this newsletter we have discussed the impact of Ethereum’s merge, providing analyses based on historical on-chain data.

This time around we update these projections with the most recent data, analyze how/why things have changed and the second order effects likely to emerge from ETH’s evolving supply and demand dynamics.

Fees — Sum of total fees spent to use a particular blockchain. This tracks the willingness to spend and demand to use Bitcoin or Ether.

  • On-chain activity for both Ethereum and Bitcoin continues to be on a down-trend

Exchanges Netflows — The net amount of inflows minus outflows of a specific crypto-asset going in/out of centralized exchanges. Crypto going into exchanges may signal selling pressure, while withdrawals potentially point to accumulation.

  • Bitcoin and ETH both saw sizable outflows from centralized exchanges

Now onto the main show.

ETH’s Supply & Demand Following the Merge

With Ethereum’s merge set to take place in less than a month, all eyes are on ETH. This upgrade will have profound implications on the Ethereum network and on Ether the asset. While we have previously written about the blockchain’s fundamental improvements arising from the merge, today we focus specifically on the change it will cause on ETH’s supply and demand dynamics.

Let’s start with the impact from removing miners from the equation.

stETH’s price in ETH terms via IntoTheBlock’s ETH mining indicators

Removed selling pressure — ~$25M worth of ETH is rewarded to miners for securing Ethereum

  • Most of the selling activity coming from this would evaporate as token rewards issued to those staking will be 87% lower than those given to miners
  • Staking rewards (as well as the ETH staked) will continue to be locked following the merge and will only enter the market after the Shanghai fork at a later, still undefined date
  • Temporarily this should remove all of the issuance selling pressure, which makes up about 0.5% of ETH’s on-chain volume at the moment

Simultaneously, demand for ETH is expected to increase along with the yield obtained by staking. Using projections based on the last month, quarter and six months of data, here is what staking rewards will likely be right after the merge.

Based on data from multiple IntoTheBlock indicators. Raw data spreadsheet

Fees down, rewards down — the projected yield for ETH staking has decreased along with Ethereum’s fees

  • Ether staking is likely to start around 6–7% right after the merge, probably closer to the lower end, representing a 50% increase from the current APR
  • These numbers have dropped in half compared to initial projections made in October 2021
  • In bear markets fees tend to drop as demand eases, and this reflects in lower yields since transaction fees not burnt will go directly to those staking
  • Interestingly, the percentage of fees burnt drops as fees decline (i.e. larger share goes to those staking), mitigating this impact and better incentivizing network security

When putting ETH’s decrease in issuance together with the burn mechanism implemented through EIP-1559, it is probable that Ether will become deflationary — at least at first.

To clarify: Net Issuance = ETH Issuance Rewards — ETH Burnt

Based on fees burnt (last 3 months), issuance drop of 87% post-merge and subsequent increase. Raw data and assumptions spreadsheet

Demand spike, then issuance growth — second order effects are likely to make ETH less deflationary in the medium-term

  • ETH’s net issuance is now projected to range between -1.5% to 0.5% based on the last three months of data, compared to -4.5% to -0.5% using Q1-Q2 numbers
  • With the anticipation of the merge, network fees are likely to increase right after the merge as there will be high amount of speculation and greater demand to stake at higher yields
  • This will lead to more ETH being staked, which subsequently increases the amount of ETH issued per block, making it more difficult for ETH to remain deflationary over time
  • The main variable affecting ETH’s inflation, though, is still on the demand side
Via IntoTheBlock’s Ethereum fees metrics

Low demand environment — Even as prices have rebounded over the past month, Ethereum fees remain depressed

  • Ethereum’s weekly fees reached their lowest level since May 2020 before the so-called DeFi summer
  • While this makes Ethereum more accessible to new users, it also means there will be less ETH being burnt, and thus less up-side pressure
  • Based on the last 30-days of fee data, this would make ETH’s inflation rate approximately 0.5%
  • In order for ETH to become consistently deflationary, fees would have to increase above 18 gwei (and higher if more ETH becomes staked as projected)

The dynamics affecting ETH and Ethereum following the merge are highly complex. An 87% reduction in issuance is expected to remove some selling pressure for ETH. Higher staking rewards are also likely to drive higher demand. However, these two conditions will normalize as more Ether becomes staked, therefore increasing issuance while reducing yields.

While the “triple halving” meme has been getting traction, it is worth recalling the failures of the stock-to-flow model: supply is not the only part of the equation. As shown above, demand plays a large role on ETH’s dynamics and it has recently been on a pronounced down-trend. Ultimately, though the supply shock will probably benefit ETH short-term, longer-term network demand will be the defining characteristic.

As always, none of this is to be taken as financial advice.

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