Eth2.0: What happens to staking yields after the Ethereum Merge?
The consensus of the Ethereum community around the Merge has turned decidedly bullish after the largely-successful March 15th merging of the Kiln testnet with the main proof-of-stake Beacon Chain, which is the prototype Ethereum 2.0 chain that’s expected to subsume today’s Ethereum Mainnet this June.
The success of the Kiln/Beacon merge was a big deal for a community that’s been conditioned for disappointment after repeated Eth2.0 push-outs. There are no major roadblocks facing the merging of the remaining Ethereum testnets (Goerli, Rinkeby, Kovan and Ropsten) with the Beacon Chain.
What does the Merge mean for an arm’s-length Eth investor?
The Merge’s main changes to Ethereum are:
- Turning transaction validation from “Proof of Work” —> “Proof of Stake” (personally I find this terminology confusing, and think of it as “proof of compute” —> “proof of collateral”)
- Elimination of mining and the “computational race” in Proof of Work.
- Keeping overall network seigniorage stable, while reallocating miner rewards to validators
- Increase the demand/supply ratio of Ethereum (and thus the price) by diverting large amounts of Ethereum offline into staking
What does the merge not do?
- Change network transaction costs charged to end-users.
- Change the user experience of the Ethereum network, relative to other alt-L1’s like Terra or Solana
- Change the relative consumer value proposition of Ethereum
“The Merge” is the second of a series of milestones that represent Ethereum’s “Serenity upgrade,” the series of innovations which, if successful, will allow Ethereum to maintain its commanding market share as the dominant smart-contract blockchain. The first milestone was the London Fork, also known as Ethereum Improvement Proposal 1559 (EIP-1559), which was successfully implemented last August. The milestones subsequent to the London Fork have been nicknamed “the Merge, Surge, Purge, Verge, and Splurge.” For this post, we’ll focus on the Merge only.
Financializing transaction validation
In ETH Mainnet today, seigniorage is paid to miners to mint new transaction blocks. Miners will be replaced by validators after the Merge.
As we can see from Beaconscan, 10.4M ETH has been staked on the Beacon Chain so far, translating into a 4.8% gross staking reward. However, validators also get their piece of Ethereum’s daily fees. At 10M of ETH staked, a validator could expect a total net staking yield of around 10.8% (5% validation + 7% fees, minus 10 percent of total for outsourcing staking to someone else), or a bit under 11%.
However, post-Merge, it isn’t realistic to expect ETH to be staked at its current level (10.4M ETH, or 9% of all ETH outstanding). Today, an unsophisticated staker can only stake via irrevocable smart contract. The Beacon Chain is operating under fairly illiquid conditions relative to the post-Merge scenario, even though stETH mitigates this for more sophisticated crypto users (addressed below).
I would expect 20-30M ETH to be staked post-Merge, which would yield a net validator return (staking return) of 4.2-6%. That would place ETH at a moderate premium to the other competitive, self-sufficient chains, such as SOL (5.8% net yield), Terra/LUNA (7%), AVAX (9%), BNB (8%), and ADA (5.8%).
ETH validator rewards @ 20M total ETH staked.
ETH validator rewards @ 30M total ETH staked. Link
I would expect around 25M ETH to be staked on the Beacon Chain, due to liquidity preferences (most people want their ETH freely liquid and usable), the opportunity cost of foregoing stablecoin risk-free rates (7-8%), and other factors. But many people expect the percentage to be higher.
One interesting variable in future ETH staking is the composability of staked ETH (stETH). This instrument, apparently pioneered by Lido Finance, turns your stETH into eligible borrow collateral. Of the 10.4M ETH staked on the Beacon Chain today, just over 2M has been rehypothecated into stETH already.
stETH trades at no discount to vanilla ETH today. In effect, you are exchanging Eth1.5 liquidity for Eth2.0’s ~11% annualized net staked yield. If we assume that the Beacon Chain will go live appx. 90 days from this writing, ETH1.0 trades at around a 2.7% liquidity premium to stETH (you collect a 2.7% staking yield for staking your ETH on the Beacon Chain for 90 days today, vs nothing for holding ETH in your Metamask wallet).
Post-Merge, stETH will trade at a varying discount to ETH (Lido themselves previously wrote that they expected a 5-25% discount) depending on how long it takes to unstake your ETH from the Beacon Chain (it might take hours to weeks). The longer the staking lockup and the more ETH users elect to stake and utilize stETH, the wider the stETH discount will be to ETH.
What does this mean for the relative value of ETH?
The Merge is a huge milestone in ETH’s development. It clearly reduces the circulating supply of ETH, while also increasing the return on holding ETH (i.e. also increasing the relative demand for ETH). It does not address the core competitive issues of ETH relative to other alt-L1’s: high transaction costs and difficulty of use (which have not been materially altered, as of right now, by the growth of rollups; the rollups have instead cannibalized higher-value transactions on the Ethereum network and reduced overall protocol revenue).
As we invest further in the research side of the newsletter, we’re eager to hear from you about projects where you’d like a deeper research dive. Please contact us at [email protected] for any research requests or general comments.
Thanks for reading,
Recovering TradFi Chad & the Staking Rewards team
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[List of all Eth2.0 staking variables]
[Official Eth2.0 economics primer]