CHAPTER THREE

Ethereum

Market view

Ethereum's Merge of its consensus and execution layers in September 2022 represented a critical turning point for the network as it transitioned from proof of work (PoW) to proof of stake (PoS). The magnitude of that accomplishment cannot be stressed enough. Consider that a task so complex was completed not via a central authority but through the active and organic coordination of like-minded individuals. This is not to elevate the humanistic effort above the technological one, as it is significant that the Merge changed Ethereum from a monolithic to a modular blockchain. It increased the network's energy efficiency and reduced the growth of ETH supply in the process. More importantly, at least from an investment perspective, it reinforced the market's confidence in future upgrades to the platform. Despite the trend towards longterm core protocol ossification, it showed that the community can deliver on ambitious projects, of which there are plenty more. That has partially helped fend off attacks about Ethereum's high gas fees and lower throughput compared to alternative L1s.

Chart 15. Ether (ETH) 2022 events/milestones

On-chain activity has declined since the Merge, reflecting broader crypto market dynamics like a decline in total value locked for DeFi and subdued NFT demand. But network traffic has also held up much better than other chains including Solana, Avalanche, and Fantom. In fact, average daily transactions on Ethereum's base-layer network slipped this year, but not meaningfully - from 1.27M in 2021 to1.13M in 2022 (through end November) compared to larger declines on other layer-1s (see next section on L1s/L2s).

Moreover, even though usage and new launches have slowed down significantly, we saw in October and November 2022 that just a few small bursts of activity were enough to meet the ETH burn threshold and make the token deflationary. That suggests that in a bull market, we could see significant improvement to ETHfs technicals.

Chart 16. Transaction fees (ETH)

There is still a healthy distribution of overall rewards among validators at the moment - keeping per capita earnings high. That staking ratio is low in part because stakers cannot withdraw their ETH until after the Shanghai Fork.

But the reduction in network activity has certainly impacted the transaction fee component of staking yields as well as maximal extractable value (MEV). Fortunately the sum of all effective balances of staked ETH (15.5M ETH worth ~$19.8B) as a percentage of total ETH supply (120.5M ETH) is only around 12.9% as of early December 2022.

As a result, there is still a healthy distribution of overall rewards among validators at the moment 一 keeping per capita earnings high. That staking ratio is low in part because stakers cannot withdraw their ETH until after the Shanghai Fork. Once withdrawals are enabled, we would expect to see a sharp increase in ETH staked, albeit perhaps much less than the 50-75% (of token supply) observed in other alternative layer-1 networks given the relative amount of Ethereum usage.

Future upgrades

The Shanghai Fork will represent the first major upgrade to the network following the Merge, which could happen as early as 1H2023 though no definitive date has been set. The Shanghai Fork testnet (Shandong) was launched in midOctober to let developers experiment with the potential fork. One reason for the uncertainty in the timeline is that the complete list of Ethereum Improvement Proposals (EIPs) that will be included has not yet been finalized. Core developers are debating which additional EIPs belong in Shanghai versus the subsequent Cancun upgrade. Two of the more hotly debated topics are Ethereum Virtual Machine Object Formatting (EOF) and proto-danksharding, which both may warrant more research. But developers have confirmed that the fork will include staked ETH withdrawals (ElP-4895), which has strong demand from Ethereum users. Consequently, this means that supply that has been locked on the market for several years will become liquid again.

The lack of a firm deadline for the Shanghai Fork has been an impediment for some users who want to stake their ETH but don't want the tradeoff between liquidity and yield. Other investors are concerned that once staked ETH withdrawals are enabled, that could potentially flood the market with sellers. But current specs would rate-limit withdrawals to six validators per epoch or a maximum of 1,350 validators per day compared to the ~478,000 validators currently staked.

Also, developers have confirmed that withdrawals will be processed according to the validator index number - unique and permanent identifiers assigned at the start of the staking process - rather than the order of requests in the exit queue. Concerns that the queue could get clogged should be alleviated to some extent by the dynamic nature of staking rewards, as they are inversely proportional to the square root of the total balance of all validators. A decline in net validators causes the protocol to automatically increase inflationary rewards; transaction fees and MEV rewards are also shared among a smaller number of validators. This should in theory increase the overall rate of reward and act as an incentive for ETH holders to stake.

The Shanghai Fork also only represents the next step in the Ethereum development roadmap. Ethereum co-founder Vitalik Buterin has laid out six stages (five additional) for future upgrades including the Merge, the Surge, the Scourge, the Verge, the Purge, and the Splurge (see table 1 below).

Table 1. Ethereum’s future upgrade roadmap

Censorship resistance

Notably, censorship resistance remains a major theme among the blockchain's core developers, and its presence is likely to be felt in everything from the design of future network upgrades to the decisions of Ethereum's validators. On Ethereum and many other smart contract chains, searchers (bot operators performing arbitrage, liquidations, etc.) began to form exclusive deals with miners or validators for prioritization of their transactions ahead of competing searchers. This was a centralizing risk to Ethereum which was addressed by Flashbots, a research and development organization that aggregated most validators and searchers to a single open platform, removing the centralization risk from backroom deals.

After the Merge, Flashbots introduced MEV-Boost, which is optional software that validators can adopt to capture MEV rewards. It is a form of proposer-builder separation (PBS) that has removed the centralization risk of large validators. But although it's a step in the right direction, it has also introduced new potential centralization vectors at the relay and block builder levels. Put simply, block builders aggregate transactions to form blocks and send them to relays. Validators subscribe to one or more relays and propose the most profitable block (without first seeing its contents) from among the blocks they receive from relays.

The challenge is that block builders and relays are able to censor, which could slow down valid Ethereum transactions from being included on-chain. For exampie, around 56% of all blocks on Ethereum (post-Merge) censor addresses sanctioned by the Office of Foreign Assets Control (OFAC), in part because Flashbots' relay abides by OFAC and it holds a dominant position. Although several alternate relays exist, and new non-censoring relays are launching weekly, we believe more diversification is necessary to mitigate this problem.

The Ethereum community is committed to ensuring the network remains decentralized and credibly neutral. In the short term, Flashbots is building an open-sourced upgrade to its software known as the Single Unifying Auction for Value Expression (SUAVE). This would help tackle issues like censorship, private or exclusive order flow, and cross-domain MEV that can give certain builders a dominant position in block production. In the long term, Ethereum core developers are also planning to permanently enshrine PBS into the protocol.

New income streams with re-staking

The growth of validator middleware solutions could be a major theme in 2023 from an innovation perspective, with companies like Obol and Eigenlayer at the forefront of these opportunities. Re-staking by EigenLayer in particular could be a way for validators to secure new features in Ethereum, possibly earning additional rewards in the process. Developers would benefit by having their middleware run and secured by Ethereum's validators, avoiding the more time-intensive alternatives of either changing the Ethereum network or launching their own new protocol.

How it works is validators would potentially stake 32 ETH to validate on Ethereum, but set the EigenLayer smart contract as the withdrawal address for their ETH, thereby "re-staking" it.

Doing so enables the validator to provide additional services 一 like data availability networks, bridges, etc. The validator could then earn additional rewards for performing additional work, but can also be slashed by the EigenLayer network for part or all of their 32 ETH deposit if the validator provides faulty service or maliciously attacks EigenLayer. While this could be a capital efficient solution for adding new middleware services to Ethereum and would not necessitate changes to the Ethereum blockchain itself, the additional slashing risk may temper adoption until EigenLayer is sufficiently battle tested. Over time, popular middleware services that can convince all validators to opt in would in practice provide that particular feature with a level of trust akin to Ethereum itself.