How the Merge Flips the Liquidity Premium: Ethereum's Watershed and Beyond

The Ethereum Merge

The September 15/16th 2022 Ethereum merge is perhaps the most significant event for Ethereum since launching the native ETH token, which emerged from an initial coin offering raising around 31,000 BTC equating to around USD 18.3 million in capital at a price of around 0.31 USD/ETH.

• Considering that Ethereum’s 2022 market value now surpasses USD 235 billion making Ethereum the second largest blockchain in the world behind Bitcoin, the upcoming merge is of historical significance not just for Ethereum, but for the entire Blockchain industry.

• The aim of the merge is switching from Ethereum’s current cryptographic based consensus mechanism Proof of Work (PoW) to Proof of Stake (PoS), which is a switch supported by a majority of Ethereum users noting that some dissenting opinions exist from network participants like miners prepping to mine ETH Classic.

The merge basically reduces some of the costs and problems associated with the monolithic PoW crypto trilemma, which is a trilemma similar to the impossible trinity problem in traditional markets. Just like mandating fixed exchange rates, free capital flows and at the same time conducting independent monetary policy is impossible for governments to achieve, the monolithic crypto trilemma prevents blockchains from efficiently maximizing scalability, security and decentralization in the same layer necessary to outcompete centralized institutions like Visa, Goldman and Mastercard from a user perspective.

Scalability is the transaction speed

Decentralization is meaningful distribution of computing power and consensus throughout a network

Security reflects a blockchain protocol’s defenses against malicious actors and network attacks.

• By moving away from the monolithic approach used by blockchains like Bitcoin where core functionalities including consensus, settlement, data availability and execution occur on a singular layer to instead rely on a multi-layer core functionality approach, the merge increases Ethereum’s modular capacity, which reduces energy consumption, clears the path for proposer-builder separation and cuts ETH token issuance by more than 90%.

The Merge...

Expands access to institutional investors with environmental energy concerns

Democratizes the maximal extractable value (MEV) through holders staking ETH

Reduces transaction costs of level 2 roll ups by an order of magnitude

Makes ETH 90% more deflationary (1.6K ETH issued daily instead of 16K)

• Currently, Ethereum miners earn around 14,400 in ETH rewards daily for securing transactions on the PoW network profiting miners with superior hardware the most. In addition, MEV bots and arbitrageurs extract an excessive premium from Ethereum users in return for providing liquidity and post merge that value is transferred to stakers, which will generate more Ethereum adoption.

The transition to PoS also paves the way for future transaction fee reduction on both the main network and level 2 roll ups like the EIP-4844 proposal. Finally, although difficult to predict, the likelihood of institutional capital flooding a more ESG friendly Ethereum network expands vastly post merge.

The Expected Ethereum Roadmap

How Ethereum Will Share the Liquidity Premium

Blockchain technology enables decentralized trust keeping by relying on cryptography and consensus algorithms instead of institutions. Ethereum is therefore emerging as a low cost high security alternative to centralized institutions as a tool for users and business to exchange goods, services, communication and information via Internet. Ultimately, the merge is a major step for Ethereum to create a blockchain network that minimizes the institutional capacity to extract network value from small users, which is what I call harvesting the liquidity premium without taking appropriate risks and is all too common in the centralized economy of today.

• Basically, internet technology has allowed large centralized monopoly institutions to extract excessive fees and information from consumers and business in return for facilitating transactions and providing information security, which drains money from society to a few leading institutional stakeholders.

There will always be a liquidity premium, but the problem is how capitalist oligopolies and governments are incentivized to extract that small fee from users and citizens.

• The liquidity premium includes profiting from harvesting user and citizen information indirectly or money directly. The main problem is that the incentive to not take risk means that sometimes there is no risk associated with the service that is provided by third-party institutions in return for harvesting money.

The true definition of liquidity premium is compensation for taking risk, but harvesting money is providing liquidity without taking risk.

• For example, banks extract liquidity premiums in the form of charging interest for providing services like lending money to homebuyers, which is why the interest rates are higher for homebuyers with bad credit scores. If a homebuyer does not repay the loan then the bank lose money. The key to the definition of the liquidity premium is therefore taking risk, but when incentives are misaligned money is just harvested, which is defined as moral hazard.

• The Great Financial Crisis in 2008 is a textbook example of moral hazard, as bad mortgage loans by big banks got bailed out by the US government through the trillion dollar TARP bill when housing prices dropped so quickly that it threatened the survival of the US economy. That fiscal put money was then in essence harvested by bankers, while US tax payers took all the risk.

Over time, harvesting small fees is like how wasting time lowers economic output

• For example, experiencing slow internet at work one day may lead to a 10 minute productivity loss per worker that day, but if it's 10 min everyday over 20 years, the cumulative productivity loss equals 41 days per worker, which is essentially equivalent to the harm caused to society from the harvested liquidity premium by banks through charging consumers 0.001% for every transaction.

• On an individual level those fees are barely noticeable, but scaling that transaction fee to account for a global population of 8 billion people, you can see why bankers generate excessive profits for just owning government licenses, some software and a central database.

In an efficient decentralized blockchain economy, users share the excess liquidity premium profits proportionally to the amount of tokens staked together with the creators of decentralized applications established on top of the Ethereum network making everybody participating an owner and liquidity provider.

In a pure decentralized Proof of Stake blockchain based economy, these monopoly institutions must therefore develop decentralized services via the Internet on top of blockchains like Ethereum. By providing good services, these institutions will still make money, but they will not harvest a simple liquidity premium like in the past.

Liquidity Premium Extraction is a Problem for Ethereum also!

Consensus Mechanism Difference Between Proof of Stake and Proof of Work

By managing the Casper PoS protocol both for Ethereum’s “main chain” and all future chain shards post the September 15 ETH-merge, the Beacon chain becomes the core consensus layer for Ethereum.

• The transition from PoW to PoS means transferring Ethereum’s entire 0.5 to 1 TB of blockchain data history to the Beacon Chain, which is why the ETH merge is such a huge event.

• Note that prior to enforcing the rules per Ethereum’s PoS consensus mechanism post-merge, the Beacon Chain has already attracted a significant amount of validators by offering staking yield and block proposal power in return for these validators supplying 32 Ethereum as collateral via a smart contract on Ethereum 1.0. The Beacon Chain therefore allows the PoW to PoS transition to flow smoothly.

Without going into much complex detail, a racing competition is a great analogy for understanding differences between PoW and PoS consensus mechanisms.

• Imagine that 8 cars of different quality are provided with the opportunity to participate in two separate racing competitions. The first format is a PoW race and second is a PoS race, but in both formats the winner is awarded with crypto tokens for finishing first.

• In a PoW race, the car with the most resources likely wins both the first race and future races, which means the best car likely earns almost all rewards. However, in a few instances spanning many race iterations, the fastest cars might all break down at the same time during a race, thus letting slower cars earn rewards in a few instances. These PoW racing cars are like miners racing/competing against each other to solve a computational guessing puzzle race. However, instead of fast cars, Ethereum PoW miners use strong computers meaning the strongest computer miners earn all rewards just like the best racing cars.

• Although PoW mining might use renewables to power cars in the future, PoS racers believe having all 8 cars racing incentivizes faster cars is both unfair and increases energy consumption, which pollutes the environment. In addition, PoS racers believe the PoW takes too long to complete a race and is also too expensive hence slowing and making the PoW blockchain centralized.

• To limit energy consumption, increase speed and provide equal opportunity, the PoS racing competition therefore only allows 1 out of 8 cars picked randomly by a randomization algorithm to finish the "short" race. In PoS, the cars are generally chosen based on staking a higher token amount for a longer time and with a high capacity to actually finish the race if chosen. In PoS, staking tokens means fronting collateral like a mortgage in return for yield – so chosen cars failing to finish a race will lose part of their staked token as punishment, which Vitalik Buterin refers to as the slashing incentive.

“The Beacon Chain becomes the equivalent of a FIA referee if above racing competition was Formula 1”

After PoS goes live, the Beacon Chain’s most important management function therefore becomes ensuring that validators validate and propose blocks accurately. If a validator misbehaves, the Beacon Chain will respond by taking some of that validator’s 32 Ethereum held as collateral through slashing or tossing them out entirely.

This MEV premium will hopefully go to users

Ethereum’s Watershed Moment

Although the beacon chain ensures the integrity of the Ethereum network, the largest benefit of PoS is not increased integrity or reduced energy efficiency, but rather the democratization of the miners’ extractable value with liquidity premiums proportionally flowing downstream to end-use stakers.

• Just like physical products undergoes a supply chain process refinement starting with raw material and ending with a finishing touch prior to being sold, the blockchain refines ETH transactions through transaction supply chain process for which each step of the supply chain adds marginal value to end-users.

• As described earlier, Ethereum’s PoW supply chain process extracts excess value from end-users to certain key stakeholders and is therefore blunt and inefficient. Currently, all transactions in the PoW system is first submitted to a memory pool, downloaded and saved by Ethereum miners, then arbitrage bots fight each other for arbitrage opportunities by bundling transactions and placing them in an order to benefit the owner of these bots and finally miners collects all transactions to build a block and earn a reward for doing so. However, these bots and miners can extract value through sandwiching, replay, liquidation and arbitrage from users and that is not good!

Bankless Co-founder, David Hoffman, points out in a blog called Ethereum’s watershed how the move PoS flips the liquidity premium from large platforms with access to expensive hardware and private networks to Ethereum stakers, which are us the end-users!

1. Transaction Origination – memory pool

• When users transact using Ethereum there is an extra fee added to incentivize settlement after the transaction is broadcasted to the Ethereum Network nodes.

• Before being accepted, the data associated with that transaction is downloaded by the Ethereum nodes in a so-called memory pool, which is a limbo state for transactions that have yet to be settled on Ethereum’s blockchain.

• If users pay a priority fee, a form of bribe, or if the transaction is picked up and bundled by a MEV searcher, the transaction is more likely to be accepted and included in a block quickly.

2. Maximum Extractable Value Bots – micro arbitrageurs

• These MEV searchers in turn arrange their transaction bundle in a specific order with the aim of paying the block builder the most attractive fee for transaction inclusion.

• In PoS, the block builder will capture more than 99.99% of the MEV, as these arbitrage MEV seekers compete with each other to have their bundle included by the block builder.

3. Block Builders – macro arbitrageurs

• Block builders then combine bids from bundled MEV searcher transactions and priority fee paying users to pay the block proposer. Before including a bundled transaction by MEV searchers and priority fee paying users, the block builder will simulate all possible transaction bundles to find the most profitable combination and then fill the remaining block space with memory pool transactions.

• In this step, block builders compete through using superior hardware to find the most profitable memory pool transaction and private network order flows, which means Block Proposers capture 99.99% of block builder MEV.

4. Block Proposers – ETH Stakers

• Ultimately, the block proposer accept block builders offers with the highest bid.

• These block proposers are the Ethereum stakers – end-users – and all stakers do is basically choosing the block builder offering the most profitable block!

• Stakers then sign off on the best bidding block builder’s proposal by validating it and collateralizing that signature with a corresponding Ethereum stake!

Just like raindrops trickle-down to watersheds due to gravity, the liquidity premium trickle-down to Ethereum stakers thanks to the laws of economics as MEV searchers and Block Builder fight each other to have their transactions included by the block proposers by bidding competitively. These competitive bids lead to fee compression, which allows economic surplus raindrops to flow downstream to the Ethereum Staking watershed.

The hills are dapps, the clouds are MEV bots, the trees are ideas that are growing and they are all flowing to the Ethereum Stakers.

Conclusion

Blockchains aim to maximize (1) security, (2) speed and (3) decentralization by blending economic incentives with cryptography, but all three objectives are not possible to maximize globally on the same Layer, which is a problem referred to as the crypto trilemma. The Ultimate goal of solving Ethereum’s blockchain trilemma is to remove third-parties from extracting excessive liquidity premiums.

The implications of the trilemma for Ethereum is that marginal improvements to goal (1), (2) and (3) sometimes negatively impact the other 2 goals, but marginal improvements are generally beneficial to the chain overall.

• The current Ethereum State is just a database recording and remembering all account balances and smart contracts deployed and running on its EVM, but the problem is that with each new state, the global state size expands causing block verification (reading and updating from State root) time to increase, which can create decentralization, speed and security problems.

The merge leaps Ethereum in the right direction by solving some trilemma issues and flips the liquidity premium from miners and bots earning excessive returns for owning expensive hardware to ETH Staking validators!

In the future, the merge also allows Ethereum to update its data/state structure/tree cryptography from a hexary Merkle Patricia tree structure to possibly a binomial Merkle tree, but most likely a polynomial Verkle tree to make Ethereum Stateless, as Ethereum goes modular by becoming a data availability and consensus layer, as depicted in the Ethereum roadmap above!