These common myths about Ethereum's 'Merge' could trip up investors

Published Sat, Sep 10 20229:02 AM EDT

The highly anticipated Ethereum merge is right around the corner and even after the many months investors have spent preparing for it, suspense in the market is still building. Excitement around the merge has ballooned, and injected some optimism into the market as cryptocurrencies alongside stocks continue on their rough ride for the year. Ether, the native token of Ethereum, is up almost 66% from June 30, shortly after risk assets sunk to their lows of the year. It's outperformed bitcoin by about 63% at its peak, according to Glassnode data. And many are calling the merge the most important moment in crypto's (albeit short) history. "The merge is very important, but how to justify this 63% outperformance is another thing," said Owen Lau, senior analyst at Oppenheimer. "There are a couple of misunderstandings about the merge." The merge refers to a technical transition meant to lower energy consumption by almost 99.95%. That alone could lower the mental hurdles keeping institutional money out of the crypto markets and it is something pretty much everyone in the crypto community can get behind. 'It's not the end game' The merge is also expected to set the stage for further technical upgrades that will help increase network capacity and reduce fees — two of the crypto industry's biggest criticisms of Ethereum and the reason alternatives like Solana and Cardano have cropped up and risen in popularity. Some investors may be getting ahead of themselves though, Lau said. "People think it will substantially lower the gas fees, APR will go up a lot, and that it will transform to a much faster network. But the answer to that is not yet," he said. "The merge is just part of the end game, it's not the end game." The merge is scheduled to take place Sept. 13-15. But as investors get ready for the big week ahead, there are some misconceptions that need to be put to rest. Ethereum is transitioning from an energy intensive protocol known as proof-of-work, which requires specialized computing equipment to validate transactions, to the more energy efficient proof-of-stake, in which holders of ether do the validating manually. Ether is the second largest cryptocurrency by market cap, after bitcoin. Still, it is notoriously slow and expensive to use. As a result, it's mostly used to pay for "gas fees," tolls for transacting and processing on the Ethereum blockchain. It may stay that way for a while after the merge, which is merely a first step. The event will be disappointing to those expecting a shiny new platform come next week. "The merge will not do anything on its own for Ethereum's throughput, they have other kinds of solutions in the works that are trying to address essentially making transactions happen faster and cheaper. The merge itself is not really designed to solve that," Michael Rinko, venture associate at AscendEx. Lau echoed that sentiment and suggested investors interested in ether take a long view on the cryptocurrency. "It will only set the stage for further upgrades in 2023 and 2024, but in terms of immediate benefits, we may not feel them right after the merge," he told CNBC. "Yes, we save a lot of energy, but for fast transactions and lower gas fees, we may not feel it right away." Plus, there are bound to be some basic difficulties on the way there. Many have likened potential integration issues following the merge to the Y2K computer systems updates more than two decades ago. "It's going to be, as all big transitions are, a little bit rocky at the beginning," FTX CEO Sam Bankman-Fried said on CNBC's "Squawk Box " Friday. "There's going to be some messy activity around when it happens — that's sort of inevitable — but long term, and probably even medium term, I think it's going to be healthy." Yield expectations are too high The process of manually validating network transactions is impractical for most humans and many are likely to take advantage of services offered by companies like Coinbase in order to participate in the network and earn rewards, or yield, for doing so. Ultimately, the yield-generating opportunity, known as staking, could help push crypto further into the mainstream. Although becoming a yield-generating asset may excite investors in a time of high inflation and depressed stock prices, widespread market expectations for a tripling in the yield are a little high, Lau added. "The APR for validators is expected to increase following the merge, but it is not likely to triple," he said in a note this week. "Note that the increase in APR comes from the reallocation of transaction fees from miners to validators, not from new ETH issuance. The Ethereum Foundation estimates that ~10% of gas fees being paid go to miners in the form of a tip, and the rest is burnt." "Extrapolating this 10% fees to average recent network activity, the foundation estimates that the APR will increase to ~7%," he added. (For more on how transactions get validated and how the merge will create staking opportunities for investors and revenue opportunities for exchanges, check out our previous Deep Dive here .) Supply limits will make ether more attractive In addition to higher yields, investors can expect an increase in the ether price itself because the merge will reduce the amount released into the market, Rinko explained. Everyday new ether is emitted into the market and if demand doesn't match the supply level, the price goes down, he said. After the merge, there will be less supply in the market, and if demand stays constant, the price should rise. "Ethereum had this very big upgrade a few months back, which burns a fraction of every transaction fee," Rinko said. "So couple lower supply with a constant burn and a lot of people think that post-merge, ether will become a deflationary asset — meaning the supply over time will begin to decline (as opposed to increase, which is historically what it's always done.) A deflationary asset is a bit more attractive to own for investors." A potential fork and a popular trade Those who have been watching this unfold are waiting to see if there will be a forked version of Ethereum, or several, driven by proof-of-work miners who will no longer be able to serve the network after its migration to proof-of-stake. "Once it's merged to proof-of-stake, and those people are no longer needed, they have a vested interest in kind of shifting things back to the proof-of-work model so all their expensive equipment can continue to essentially earn them money," Rinko said. "There's now this big parlor game as to whether or not the fork will happen and how many forks will happen," he said. "Part of the game is trying to figure out which fork the market will coalesce around and exchanges will support post-merge." In August, a group of miners launched a campaign to fork Ethereum to maintain the proof-of-work mechanism as a separate network and token, called ETHPoW. That means when the merge is completed, there may be a forked version of Ethereum – and if you're currently an ether holder, you automatically get ETHPoW for free through an airdrop. Since around then, traders have been betting on that fork happening, by buying spot ether and shorting ether perpetual futures. "They're looking at this as almost a dividend type of play," Rinko said. "So they don't have price exposure, but with any fork that happens they'll get the token airdropped because they own the spot ether, and then they'll probably just immediately sell that fork and realize those gains." Funding rates on ether perpetual futures contracts have been extremely negative recently, he added, suggesting there's high demand to short them. Lau also highlighted the recently popular trade. "Some traders set up a strategy to buy ether going into the merge and sell futures so they can hedge the price risk of ether," Lau said. "Going into the merge they get the so-called the forked version of ether, and then they can stay in the market or – I think people will unwind the trade and you may see ether underperform bitcoin."