The Impact of the Merge on Institutions

Crypto adoption among institutional investors has been on the rise. Over the last two years, many leading institutions have taken meaningful steps into the DeFi and Web3 ecosystem by pivoting their business model to focus on Web3, and by deploying capital into the ecosystem. According to a CoinShares report, institutions invested $9.3B into the crypto market in 2021, up 36% from 2020.

The increasing institutional interest in crypto can be attributed to the growing maturity of the technology, as well as the changes in the ecosystem that have had a profound impact on institutional adoption. One such fundamental change, called the Merge, to the Ethereum ecosystem is set to occur mid-September.

The Merge will transition the Ethereum blockchain network from the energy-intensive Proof of Work (PoW) consensus mechanism to the more sustainable Proof of Stake (PoS) consensus mechanism. The move to PoS will increase the security of the Ethereum network, and set it up for future scalability. This is likely to make institutions more keen to engage with the Web3 ecosystem.

In our recently released ‘Impact of the Merge on Institutions’ report, we discuss in detail the opportunities that the Merge will create for institutions in the world of Web3. Written by MetaMask Institutional and the ConsenSys Cryptoeconomic Research team, the report also explores the factors, such as network activity, security, and valuation, which are setting Ethereum up for long-term growth and success. You can find the full report here.

In this post, we take a look at how the Merge will impact institutions.

Reduced Carbon Footprint

The shift to PoS means a 99.95% decrease in energy consumption due to the removal of PoW physical GPU (graphics processing unit) node processors and their replacement by lightweight servers running validator clients. The reduction of Ethereum’s carbon footprint will be significant for institutional investors, especially traditional organizations who need to meet certain environmental, social, and governance (ESG) mandates in their portfolios. After the Merge, there will be an opportunity to obtain real yield without compromising on sustainability goals.

Through this lens, transacting on Ethereum may look more attractive than on other Layer 1 chains that do not offer the same energy efficiency.

New and Attractive Staking Opportunities

Staking contracts will continue to follow the staking vs total value locked (TVL) % earning curve. Individuals and institutions can earn rewards through staking for participating in network consensus. Investors are likely to obtain positive real yield, estimated to be between 5.5-13.2%. In a world of negative real yields, the positive real yield will make ETH staking a particularly attractive opportunity. In addition, liquid staking opportunities created by centralized services like Lido will continue to lower barriers to entry by allowing investors to stake their ETH while retaining liquidity in the form of ETH derivatives.

Figure 1. Total ETH Staked vs Estimated APR Source: Staking Rewards

Deflationary Supply of ETH

Reduced ETH issuance and increased burns not only caps, but systematically reduces ETH supply. The reduced supply will put deflationary pressure on ETH and diminish the risk of token price dropping to zero. For institutions, ETH may become a more attractive asset, as reduced supply may lead to an increase in value.

Improved Security

Enhanced Decentralization

The democratized participation of the PoS system produces enhanced decentralization, and thereby a dramatic increase in the cost of attacking the Ethereum blockchain. As of August 2022, more that 13.3M ETH had been staked by over 415,000 validators—This ensures the near impossibility of attack. With these numbers, a 51% attack would cost over $11B.

Cross-team Ecosystem Collaboration

The Ethereum network is fueled by a diverse ecosystem of participants building together on an open-source framework, on a global scale. Collaboration across the protocol ecosystem leads to fewer centralized points of failure. This ensures confidence in the community to build and execute.

These points each provide stronger security guarantees for both institutional and retail participation.

Ecosystem Growth

On-chain applications and Layer 2 (L2) solutions will likely leverage the above improved security conditions and multiply on top of Ethereum. This could produce another explosion in the number of applications deployed, and opportunities created for institutions.

Client Diversity and Interoperability

Ethereum is the network with the highest number of live client instances that can fully interoperate. Integration can occur with any major coding language and in collaboration with different companies. The breadth of options will allow institutions to choose how they want to interact with Web3. Each one can choose to rely on client(s) that fit with their precise requirements.

Beyond these general outcomes, we expect to see the Merge impact different kinds of institutions in different ways.

Crypto funds are likely to diversify their investment strategy with protocol staking for base returns. ETH and ETH derivatives, such as for liquid staking, offer liquid yield returns in addition to other farming strategies funds may deploy.

Trading firms are likely to see short-term gains with high-volume trades and position adjustments leading up to the Merge. Volatile markets provide opportunities for market makers.

For pension funds and endowments, 401k spot exposure to cryptocurrency assets may expand to tokens representing derivatives of these assets. There may be an adjustment of positions for long term returns.

If L2s and other protocols use ETH to settle their transactions to Ethereum, then these projects may have already been buying ETH through the bear market in order to operate on the network for future launches. At the time of this report, this demand may have already been priced in.

As ETH dramatically reduces its carbon footprint, traditional organizations and financial institutions may look into opportunities to get exposure to DeFi services. This may start with NFT drops or embedding wallet features into banking applications for stablecoin custody and conversion. Further, financial institutions may add stablecoins onto their balance sheets and attract portfolio managers to build exposure to yield farming opportunities on DeFi protocols launched on Ethereum.

Conclusion

A look at Ethereum’s roadmap makes it clear that the community is building the network and its technology for the long term. The Merge is a step in the right direction. However, it is only the first one in the journey towards a better Ethereum. We discuss the planned upgrades to Ethereum that will follow the Merge in the full Impact of the Merge on Institutions report.

On September 12th, the key contributors will discuss the report’s findings on our “Breaking Down the Merge for Institutions” webinar. You can register for it here.

A commitment to continuous improvement of the network and the technology powering Ethereum is a powerful way that it is able to attract increasing institutional interest. Strong institutional appetite for the ecosystem despite current geopolitical and macroeconomic factors, and the recent market volatility points to that fact.

Financial institutions—investment banks like Goldman Sachs and Barclays, hedge funds like Citadel Securities and Point72 Ventures, and retail banks such as Banco Santander and Itau Unibanco—are putting their money in crypto, or furthering their plans to offer crypto investment options to their clients. As the Ethereum community continues to build through the bear market, we believe that the future is bright for institutional DeFi.

Disclaimer: ConsenSys Software Inc. is not a registered or licensed advisor or broker. This report is for general informational purposes only. It does not constitute or contain any individual investment advice and is made without any regard to the recipient’s objectives, financial situation, or means. It is not an offer to buy or sell, or a solicitation of any offer to buy, any token or other investment, nor is it intended to be used for marketing purposes to anyone in any jurisdiction. ConsenSys does not intend for any person or entity to rely on any facts, opinions, or ideas, and any financial or economic commentary expressed in this report may not be relied upon. ConsenSys makes no representations as to the accuracy, completeness, or timeliness of the information or opinions in this report and, along with its employees, does not assume any responsibility for any loss to any person or entity that may result from any act or omission based upon this report. This report is subject to correction, completion, and amendment without notice; however, ConsenSys has no obligation to do so.