The Effect of the Merge on Eth Supply

With the Merge about a month away, I wanted to analyze how we can expect the change to Proof of Stake to impact the circulating supply of ETH.

Why is supply important?

When supply rises, prices fall. When supply falls, prices rise. Water for irrigation will be much cheaper in a place where it rains a lot than in the middle of the desert. If you expect supply to fall you can expect price to increase if demand remands unchanged.

The Merge will end 15,000 Eth a day in sell pressure

Currently miners are paid Eth as incentive to burn computation, and most must sell that ETH quickly to pay power bills and operating costs. This dumps thousands of ETH a day on spot markets, driving down the price.

POS Eth will instead pay validators who stake ETH to secure the network. Currently there are 13.2 Million ETH staked, resulting in payments of 1650 ETH per day. The formula* for this provides diminishing returns as more is staked, so even if 100 million Eth was staked only 4600 would be distributed per day. These stakers also do not have the same economic incentive to immediately sell the ETH they earn, as running a node costs almost nothing and they can restake ETH to continue to add to their gains.

The Triple Halving

The above issuance reduction is sometimes referred to as the triple halving, because it is the same supply drop as if the bitcoin mining reward halved three times. This is of particular note because bitcoin halvings have traditionally been associated with a meteoric rise in price.

Eth might become deflationary

Since the London Upgrade (EIP -1559) just over 1 year ago, an average of 7100 Eth per day in transaction fees have been burned by the protocol. If gas fees remain as high as they have been the past year, more ETH will be burned each day than is released to stakers.

Staking ETH removes it from circulating supply

Depositing ETH on the staking contract locks it into the protocol at least until the next network upgrade. It cannot be sold during this time, and even after the protocol is upgraded to withdrawals, only a certain number of withdrawals will be allowed each day to protect the network.

stETH as an asset

stETH is a derivative asset that some protocols give to represent underlying staked ETH. While the underlying ETH is locked up in staking, StETH can be staked in other protocols and freely bought and sold.

Once staking withdrawals are enabled, stETH tokens are redeemable at a 1 to 1 ratio for the staked ETH they represents. This is what gives stETH its value.

Currently stETH trades at .96 discount to ETH. This is largely due to Merge risks and because stETH is not yet redeemable for ETH, as unstaking will not be enabled until the next network upgrade at an undetermined later date. The staking contract also only allows so much ETH to be unstaked at a time.

After the Merge and subsequent withdrawal enabling fork, it is entirely possible that stETH will trade at a premium to ETH. Why?

The stETH premium

stETH retains much of the utility of ETH, while also giving the user the staking rewards from the underlying staked ETH.

If two tokens are functionally identical, and one pays a dividend of 7% a year while the other does not, we can expect the one that pays a dividend to be more expensive.

Of course, stETH and ETH are not fully identical. stETH Cannot be used as gas for the Ethereum network, and it cannot be exchanged for ETH until a future network upgrade.

It remains to be seen whether stETh will trade at a discount as it does currently, or at a premium if Merge risks disappear and withdrawals are enabled.

The stETH abitrage trade

What if stETH does trade at a premium to ETH due to the staking revenue stream it guarantees?

This would incentivizes people and bots to buy ETH, stake it for stETH, and sell the stETH for profit. This is known as an arbitrage trade: since ETH and stETH are always exchangeable at a rate of 1 to 1, this trade will always profit as long as stETH remains more expensive than ETH.

The arbitrage trade will be limited by the fact that as more and more ETH is staked, the staking reward rate will go down, resulting in a smaller premium in the price of stETH. Eventually enough ETH will be staked to where the profit an arbitrager makes from buying ETH and selling stETH is negated by the gas fees they must pay to the network.

This could result in massive amounts of ETH staked for stETH, further reducing the circulating supply of ETH in the market. For example, imagine if the equilibrium point where it is no longer to buy ETH, stake it, and sell stETH is when the staking rewards drop to 2%. To reach this level 68 Million ETH would have to be staked.

If the equilibrium point is 1.5%, the total ETH staked would be 122 million, greater than the 120 million total current supply.

This has the potential to massively cut the circulating supply of ETH and convert much of the ETH used in DeFi to stETH.

But since gas fees must be paid in ETH, there will always be demand for native ETH as long as the network is being used.

Shout out to u/SquishChaos on twitter for being the first person I saw talking about this. Check out his full 18 page analysis at https://squish.substack.com/p/ethereum-moving-the-gas-underground?s=r

In summary

The Merge will result in much fewer ETH distributed every day, and likely more ETH burned than is distributed.

Depending on the premium for stETH, much of the current circulating supply of ETH could be taken off the spot market and staked.

Most importantly, the Merge reduces ETH's massive carbon footprint and paves the way to future upgrades that will lower the network's transaction fees.

*The full formula for anyone interested: (31556926 / 384 * 64 / 31622 / total_staked ^ 0.5)