Dear Investor,

 

Nearly seven years after its inception, Ethereum remains the flagship smart contract platform. However, the network’s popularity has plagued Ethereum with scalability issues and high fees. 

 

To make Ethereum more sustainable over the long term, the network will fully transition from a Proof-of-Work (PoW) consensus model to Proof-of-Stake (PoS) later this year. This transition, known as ”The Merge,” will dramatically reduce the network’s energy consumption and ETH issuance. 

 

In this month’s letter, we share our views on The Merge (previously referred to as Ethereum 2.0), and the opportunities and risks this upgrade poses to the network and investors.    

 

In April, an Axie Infinity hack made headlines, the US Treasury Secretary gave a speech on crypto assets, and Fidelity Investments announced it would allow 401k plans to invest in bitcoin. 

 

Our Hashdex team also had some big recent news. We expanded our global footprint with the launch of the Hashdex Nasdaq Crypto Index Europe ETP, which trades on the SIX Swiss Exchange under the ticker HASH. We’re excited about the opportunity to give more global investors access to the crypto economy. More on this product can be found here.   

 

As always, our team is here to answer any questions you might have about these markets. 

 

-Your Partners at Hashdex 

 

Market Review

 

April was a challenging environment for risk assets, and the crypto market was no exception. U.S. inflation reached the highest value in four decades[1] and Fed officials began to signal the possibility of more intense monetary tightening than previously predicted, leading to pessimism among investors.

The Nasdaq Crypto Index (NCI), which opened the month at 2,821 points, moved slightly higher early in the month, but this positive performance was short-lived. Despite low volatility, losses accumulated over the month and the NCI closed April at 2,346, down 16.8%[2]. Year to date, the NCI fell 19.9%. The NCI constituents with the best relative performance were Ethereum and Bitcoin, down 15.7% and 16.7%, respectively. The worst performing asset was Axie Infinity, which dropped more than 50% in the wake of the Ronin Bridge sidechain hack and as an increase of around 20% in tokens is expected this month. 

 

Top Stories

 

U.S. Treasury Secretary delivers speech on digital asset policy

 

On April 5, U.S. Treasury Secretary Janet Yellen addressed the topic of digital asset policy at an event held at American University (D.C.)[3], the first crypto-focused speech by a sitting Treasury Secretary. Secretary Yellen defended the need for a balanced regulatory approach that promotes responsible innovation and protects vulnerable individuals. Yellen expressed interest in exploring the possibility of a central bank backed digital currency (CDBC), stating that a digital dollar could one day become "trusted money comparable to physical cash." Her generally positive outlook on digital assets was well received by crypto investors[4]. 

 

North Korea-backed group accused of Axie Infinity hack

Several U.S. government entities issued a joint alert accusing the Lazarus Group of targeting the Ronin Bridge, an Ethereum sidechain built for the popular play-to-earn game Axie Infinity[5]. Over US$600 million was stolen as result of the March 23 hack[6]. Sky Mavis, the game’s developer, promised to recover or refund all Axie players affected by the exploit. Some of the stolen funds have already been recovered through a joint effort with certain exchanges, according to a social media post published by Biance’s  CEO, Changpeng Zhao[7]. According to Sky Mavis, the hack was a product of a social engineering attack, aided by human error, that allowed hackers to validate transactions after gaining control of five of the nine Ronin validator nodes[8]. Despite sanctions levied against the Ethereum addresses linked to the hack, the stolen funds were laundered throughout April, according to cybersecurity experts[9]. 

 

Australia to join shortlist of nations with a spot crypto ETF 

Australia is set to join the select list of nations where cryptocurrency spot ETFs (exchange-traded funds) are available[10]. Australian regulatory authorities revealed the need to postpone the initial ETF launch, scheduled for March 27, while “ standard checks were finalized.” According to specialists cited in the article, the ETFs are expected to attract more than US$1 billion. The U.S. Securities and Exchange Commision (SEC) has rejected all of the spot ETF applications. Many analysts believe the eventual approval of a spot crypto ETF in the U.S. could be a major price driver for crypto assets. 

 

Fidelity set to allow 401k plans to invest in Bitcoin

 

Fidelity Investments, the largest retirement-plan provider in the U.S., announced that its clients will soon be able to invest up to 20% of their 401ks in Bitcoin[11]. The U.S. Department of Labor, responsible for pension plan oversight, reacted to the announcement with skepticism, promising to “cast a critical eye” on plans that opened their doors to digital assets while stressing employers duty to act in the best interests of their employees by selecting prudent financial products[12]. 

“We are thrilled to be the first to offer employers exposure to bitcoin for the core lineup of 401(k)s that reflects our commitment to meeting their evolving needs and our belief in the promise of blockchain technology for the financial industry’s future.”

• Dave Gray, Head of Workplace Retirement Offerings and Platforms at Fidelity Investments

 

The Merge: Ethereum’s transition to PoS and more

Ethereum, the world’s most popular smart contract network, has consistently faced scalability issues as more users interact with the network. Because Ethereum’s two main features are security and decentralization, scalability cannot be easily attained without resorting to more complex technologies. To date, improved scalability for Ethereum has been mainly driven by sidechains—parallel chains capable of running Ethereum applications—which allow faster and cheaper smart contract execution and data storage. However, sidechains have some drawbacks, including lacking Ethereum’s level of security. 

 

The Merge will fully transition Ethereum from PoW to PoS, making mining obsolete and reducing the network’s energy consumption to a fraction of its current level. This event alone will not lead to less network congestion and lower transaction fees, but is a cornerstone for future updates to increase Ethereum’s scalability. 

 

This transition will also likely drive a huge decrease in the liquid supply of ETH, which could lead to significant price appreciation. This is mainly due to two factors:

 

1. The London hard fork, which took place on August 5, 2021, marked the activation of EIP-1559[13], a new transaction-pricing mechanism that includes fixed-per-block gas fees that are burned and dynamically expands/contracts block sizes to address Ethereum network congestion. This is a major effort to make transaction costs more predictable to the end-user, while also creating a burning mechanism that discounts part of newly issued ETH on a daily basis.

2. Post-merge, Ethereum will no longer include a two-ETH reward for every new block mined under today’s PoW consensus mechanism. Instead, ETH will be awarded to PoS validators based on a dynamic issuance schedule that is adjusted depending on how much ETH is staked. With the new issuance policy, if the current level of staked ETH (~11.4M) were to be kept constant after The Merge, the annual rate of emission will change from today’s ~5.25M ETH to ~525,000 ETH, a reduction of ~90% in the supply expansion rate.

 

These two factors together create a completely different mechanism of monetary expansion on the Ethereum network, with some likely scenarios even predicting that ETH supply might start decreasing after The Merge, implying that Ethereum may become a deflationary network.

 

Figure 1: Scenarios for the supply of ETH over time. We assume The Merge happens on July 1, 2022, providing four different scenarios for the average number of daily burned tokens post-merge: 10%, 25%, 50% and 100% of the average daily burn since the activation of EIP-1559 (~8400 ETH), assuming 20M ETH are staked[14]. The red curve shows a scenario where the ETH supply keeps increasing post-merge, even though at a slower pace; the yellow curve pictures a scenario where burning cancels out daily emissions, with the ETH supply flattening over time; the green and blue curves illustrate to likely scenarios where burning is more important than the daily emission, implying an ETH supply that starts decreasing over time.

 

With mining becoming obsolete, it is also likely that the liquid supply of ETH will further decrease due to: (i) the operational cost of validating blocks under PoS being drastically lower, reducing the natural selling pressure that miners exert on the market to cash out profits and pay for electricity and hardware expenses; and (ii) since staking is the mechanism allowing one to mint new blocks on the chain, once PoS is working at full steam, there is potential for a lot more ETH to be taken out of circulation and locked by validators in their validation node.

 

This switch to a new consensus mechanism will enable a more distributed network operating Ethereum with a very low computational cost, allowing most users to participate in the validation and execution of transactions, targeting a future where Ethereum may become the large-scale decentralized world computer it has aspired to become. For more on our perspective on The Merge, including its opportunities and risks, read our analysis here. 

 

Looking ahead 

 

The Merge is the biggest blockchain upgrade in history. We believe it is an important step towards delivering a highly scalable and environmentally friendly framework, allowing users to interact with dApps living on a very secure and decentralized platform, while also paying low transaction fees and experiencing a less congested network. 

 

Regardless of the impact of The Merge on the price of ETH, this transition is an incredibly important milestone for Ethereum that will make the network more valuable and maintain its position as the dominant smart contract platform for the foreseeable future. 

 

As always, we welcome your thoughts and feedback. 

[1] U.S. Bureau of Labor Statistics Consumer Price Index Summary, April 12, 2022.

[2] Nasdaq data March 31, 2022 to April 30, 2022.

[3] Yellen, Janet L. “Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets.” U.S. Department of the Treasury, 7 Apr. 2022.

[4] De, Nikhilesh, and Jesse Hamilton. “Treasury Secretary Janet Yellen Calls Crypto 'Transformative' in Wide-Ranging Speech.” CoinDesk, 7 Apr. 2022.

[5]  “TraderTraitor: North Korean State-Sponsored APT Targets Blockchain Companies.” Cybersecurity and Infrastructure Security Agency (CISA), U.S. Government, 13 Apr. 2022.

[6] Sarlin, Jon. “After a $625 Million Hack, the Party Must Go On.” CNN, Cable News Network, 4 Apr. 2022.

[7] Malwa, Shaurya. “Binance Recovers $5.8M Linked to Axie Infinity Hack.” CoinDesk, 22 Apr. 2022.

[8] Gordon, Nicholas. “How Axie Infinity Suffered One of the Largest Crypto Heists in History.” Fortune, 1 Apr. 2022.

[9] Newmyer, Tory, and Jeremy B. Merrill. “U.S. Hasn't Stopped N. Korean Gang from Laundering Its Crypto Haul.” The Washington Post, WP Company, 25 Apr. 2022.

[10] Vickovich, Aleks. “Crypto ETF Race Narrows to ETF Securities, Cosmos.” Australian Financial Review, 20 Apr. 2022.

[11] As seen on https://www.fidelityworkplace.com/s/digitalassets.

[12] Bernard, Tara Siegel. “The Labor Department Wants to Investigate Crypto in Retirement Plans.” The New York Times, 10 Mar. 2022.

[13] EIPS – Ethereum, EIP-1559: Fee market change for ETH 1.0 chain, accessed April 11, 2022.

[14] Glassnode, Ethereum Issuance, and Vitalik Buterin, Quick Python code for computing staking reward rates from total ETH staked, accessed April 13, 2022.

 

 

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