Data interpretation of Ethereum merger economics, the Shanghai upgrade will be the highlight

*Written by: Alan, *WebX Lab

The current annual inflation rate of ETH is -0.02%, and the total supply has decreased by more than 9,500 since the merge.

According to data from Ultrasound Money, the annual inflation rate of ETH fell below 0 on January 15. This means that the ETH being destroyed on the ETH blockchain is greater than the ETH being newly minted.

Nevertheless, as January comes to an end, ETH's gains still lag behind Bitcoin. The most direct reason is that market funds are choosing to hedge, waiting for the market reaction after ETH staking unlocks.

In fact, since the second half of 2021, the ETH/BTC trading pair has entered a sideways phase. Within this range, ETH's market capitalization accounts for about half of BTC's market capitalization, which seems to have become a kind of value balance recognized by the current market.

To break this balance, external forces or new narratives are needed. For example, a surge in activity on the Ethereum chain leading to intensified ETH deflation, or ETH gaining more recognition from traditional finance. However, such signs have not yet appeared, making the relative valuation between BTC and ETH difficult.

Recently, Coinshares, known as "Europe's largest digital asset investment and trading group," released a survey to gain insights into the thoughts and actions of professional investors in the digital asset space.

According to the results of Coinshares' latest quarterly fund manager survey on digital assets, of the 43 fund managers surveyed (with total assets of $390 billion), 60% believe that ETH has the best growth prospects in 2023.

The survey also found that investments in BTC and ETH have been solidified and are increasingly included in hedge fund portfolios, rising from 0.7% to 1.1%. The trend of including digital assets in portfolios is driven by client demand and speculation.

From the recent upward momentum, the BTC rainbow chart has rebounded from the lowest "low-price sell-off zone" to the intersection of the "buy zone" and "accumulation zone," while ETH remains in the lowest "low-price sell-off zone." If the subsequent upward trend in the market is confirmed, ETH's upward elasticity will be greater than that of BTC.

Shanghai Upgrade Selling Pressure

The most critical aspect of the Shanghai upgrade is that it will allow the withdrawal of 16.45 million ETH that has been locked in staking on the beacon chain since December 2020.

If stakers only want to withdraw the consensus rewards earned over the years, it can be processed quickly without queuing. In other words, the total rewards earned from two years of staking (approximately 1 million ETH) can be withdrawn immediately.

If stakers want to withdraw all 32 ETH per node along with the rewards, it involves exiting the consensus layer, which relates to network security and requires queuing. Currently, the total number of ETH nodes is over 500,000, so based on this data, after the Shanghai upgrade, a maximum of 1,800 nodes (57,600 ETH) can be withdrawn daily.

Assuming that 10% of the nodes want to exit, it would require queuing for over a month. It is worth noting that now entering the Ethereum network as a validator also requires queuing, and the daily inflow and outflow are governed by the same algorithm. If calculated with 500,000 nodes, it is also 1,800 nodes per day, which can keep Ethereum's consensus mechanism stable and achieve a soft landing.

Moreover, a significant portion of the currently staked ETH (estimated to be over 60%) is liquid. For example, ETH staked in Lido can earn stETH, which can be freely traded on DEX or other platforms. For validators who do not have a long-term staking intention, they may have already exited the Ethereum staking ecosystem. For the remaining staked ETH, the expected selling pressure is not too great.

From another perspective, once the Shanghai upgrade is successful, the ETH staked on the Ethereum mainnet can be flexibly withdrawn (the queuing time will not be too long). In fact, the ETH staking rate is a dynamic game process. When the amount of staked ETH is low, the staking return rate is very high. From the official ETH staking APR chart, when the total staked amount is 790,000, the APR can reach 17.6%.

However, when high APR attracts a large amount of ETH staking, the APR will gradually decline. When the amount of staked ETH reaches 10 million, the APR will drop to around 5%, which is the current level. However, as the amount of staked ETH increases, the APR decline curve will also become more gradual.

The high certainty and high-interest flexible staking brought about by the opening of ETH staking withdrawals mentioned above will not only stimulate new ETH holders to participate in staking but also make it a more advantageous choice for institutions or whales that are currently staking to continue staking.

Staking Withdrawal Testnet: On February 1, the Zhejiang public testnet allowed Ethereum users to simulate the process of withdrawing staked ETH. The Zhejiang public testnet launched at 10 AM on February 1, giving validators the opportunity to test the withdrawal function on a simulated version of Ethereum, mimicking the Shanghai upgrade process.

At the same time, Ethereum's core developers are monitoring the large-scale use of such functions and making timely adjustments to address any potential issues. It is worth noting that the release time of the Shanghai upgrade has been under review and discussion, mainly due to pressure from significant capital.

Prior to this, Ethereum Foundation developers had been considering March 2023 as a possible time for the Shanghai hard fork. According to recent news from Ethereum core developer Terence Tsao, the Shanghai upgrade may be completed in March or April.

After the Shanghai upgrade is completed, Ethereum developers plan to release EIP-4844 in May or June 2023 --- which could potentially reduce transaction fees by an order of magnitude and increase the scalability of L2 rollups on Ethereum by 100 times.

According to Dune Analytics data from February 2 (with ETH priced around $1,600), among the staked ETH, 35.5% is in profit, while 64.5% is in loss. From this perspective, the motivation for actively withdrawing staked ETH is not very strong.

ETH Merge Economics

According to a recent report by Messari, the merge marks a significant change in Ethereum's business strategy. By transitioning to a PoS consensus mechanism, Ethereum has reduced its environmental impact by over 99%, making it a more attractive investment target for organizations interested in environmental, social, and corporate governance (ESG).

Additionally, it has reduced miners' monthly selling pressure by nearly $500 million and decreased new issuance by 90%. Finally, due to the fee-burning mechanism implemented in EIP-1559 in August 2021, it has become a net deflationary asset with real yield.

Since the launch of EIP-1559 last summer, the Ethereum system has destroyed approximately 85% of all transaction fees, with the remaining 15% distributed as tips to miners. If the burned transaction fees exceed the network's issuance rate, Ethereum's supply will become net deflationary.

The applications contributing the most to the burn are mainly on-chain transfers, DEX trading (Uniswap), stablecoin transfers (USDT), NFT trading (OpenSea), wallets (MetaMask), etc., which have maintained a considerable amount of ETH destruction even during bear markets.

Messari believes that based on demand for block space, the Ethereum network may experience a steady-state deflation of 1% to 2% annually. The yield for 2023 may range between 5% and 7%, establishing a "risk-free rate" for Ethereum's financial system, depending on the number of active participants and the level of network activity.

This yield curve has already begun to take shape for some DeFi protocol investors to track. Although the overall yield is currently slightly higher, Messari expects that as staking becomes easier to access and derivatives like Lido's staked ETH (stETH) become more common, yields will eventually decline and return to normal.

ETH On-Chain Metrics

The total supply of ETH has flattened out since September 2022 and shows a decreasing trend.

In recent years, the balance of ETH on exchanges has shown a continuous decreasing trend, dropping below 5 million (with balances above 20 million in the second half of 2020).

From the daily circulation distribution, the holdings of centralized exchanges account for only about 4%, institutional holdings remain relatively stable, and more ETH is held in on-chain wallets and staked on the beacon chain, which is a positive phenomenon for the development of the ETH ecosystem.