The Ethereum Tightening
The Fed is Tightening, but the Ethereum Network is Tightening More
The most under-discussed impact of the Merge (Ethereum’s switch from Proof of Work to Proof of Stake) is that it creates an equivalent of a “Risk Free Rate” (RFR) for Ethereum. This is probably the most meaningful impact in terms of both spot ETH pricing, and in terms of the consequences for the “ETH Economy” — especially for DeFi yields. Ethereum will basically act like a small emerging market central bank that, in a single 13 second block of time, jacks up their rates from 0% to somewhere between 5% and 10% (or more). There have been plenty of discussions looking at ETH as a commodity (issuance reduction post merge combined with fee burning from 1559 implying bullish price action), or as almost an equity (it’s “cost center” of paying PoW miners replaced with “dividends” and “buybacks” in the form of staking yields and fee burning), but today we’re going to look at post-merge Ethereum through a different lens:
The Ethereum network is an emerging market central bank, and the Merge is a violent tightening of ETH monetary policy.
And I want to be clear here: a lot of those other frameworks for looking at ETH are really valuable. I’m not saying they’re not good lenses into understanding the asset, just that they largely miss this whole dynamic and this should be factored into a holistic picture of the Merge as a market event.
Before we start, caveat emptor, caveat lector: This is not investment advice. And, because surprisingly many people I discuss this with say “no return is risk free”: yes, duh. “Risk Free Rate” is only a theoretical concept. In order to have a proxy “Risk Free Rate” to calculate what is discounted in risk premiums, and to price currency forwards (discussed later), you have to use an existing market. As I will discuss below, whereas that is treasury bonds for USD, it’s probably staking yield for ETH.
What’s an RFR and Why Does It Matter?
As I’ve discussed in my Web 3.0 Yield Curve article, and a whole bunch of tweets, for any fiat economy with a central bank there is a “risk free rate.” What I mean by a “risk free rate” is the yield you can earn that is backed by payments from the entity that prints the currency in which those payments are denominated. For USD, it’s treasuries: a loan to the US government. For ETH, it’s staking: a deposit in the Ethereum network itself.
This is “risk free” only in the sense that you know you will get your dollars from the US government, or your ETH from the Ethereum network. You might not know what the purchasing power of those dollars will be, but you know that the US government will have the dollars to pay you back — because they make the damn dollars. The same is true for the Ethereum network: it makes the damn ETH.
An interesting feature of RFRs is that they are basically always the lowest available yield. Why? Because anyone who doesn’t literally print the underlying currency has to compensate capital allocators for the risk of not getting paid back the dollars, or ETH, or whatever, they are theoretically owed. Every other borrower in the economy has to pay you the RFR + some “Credit Spread” that compensates you for the risk of not getting paid back. The higher the risk, the higher the spread the market will demand.
This is why changing the RFR is the primary tool of monetary policy: a higher RFR means I can make more money without taking any additional risk, so I’m less likely to loan to other counterparties, which means less borrowing, which means less spending, which slows down economic activity (it also has direct a impact on all assets denominated in the same currency, but I discuss that more here).
Let’s first discuss the impact of rate differentials between currencies (i.e. the impact this could have on ETH prices), then the impact of tightening like this on other ETH denominated assets (the impact this could have on DeFi), and finally a forward look at the future of post-merge monetary policy for ETH.
Rising ETH Rates Impact on ETH
Changing rate differentials between currencies tend to affect their spot exchange rate. At a base intuitive level, this makes sense: if I get paid a higher RFR to hold a currency, I’m more likely to hold it.
The relationship is actually even deeper than that. RFR differentials quite literally price in future appreciation/depreciation. Let’s talk through that dynamic.
One way to think of an RFR is the exchange rate between money now and money later. If the RFR of dollars is 1%, that means I can basically convert 1 dollar now to 1.01 dollars next year. The exchange rate between 2022 dollars and 2023 dollars is 1:1.01.
Now let’s change our example. Let’s say the RFR on USD is 0%. This would mean that
1 2022USD = 1 2023USD
I go and invent a coin called MisterKeeganCoin (MKC) and it’s current price is $1. I offer an RFR on MKC of 100%.
1 2022MKC = 2 2023MKC.
This set of exchange rates also implies an exchange rate of 2023MKC to 2023USD:
2 2023MKC = 1 2023USD.
The interest rate differential implies a 50% depreciation of MKC vs USD in the next year! Unless I believe that MKC will depreciate 50% vs USD, I can make money borrowing and selling USD for MKC today.
In traditional markets, there would actually be direct market between future MKC and future USD I can trade: Currency Forwards. If the currency forward market doesn’t match up with the interest rate differential (“interest rate parity”) I can actually close that arbitrage by buying the asset that is undervalued vs interest rate parity and hedging it back in the forwards market. Sometimes these arbitrages actually appear in traditional markets! Often it would be caused by heavy flows of hedging FX risk by huge pools of capital: as an example it appeared in the mid 2010s when huge Japanese pension funds (some of the largest pools of capital in the world) and companies were hedging massive amounts of USD exposure back into Yen in currency forward markets.
So what happens to currencies when there is an external shock produced by a sudden change in RFR? If nothing has changed in the market’s existing expectations of future depreciation for a currency, but the priced in future depreciation has mechanically changed because of a rise in RFR, capital floods into the currency whose “priced in depreciation” (higher RFR) doesn’t match market expectations.
As long as this “priced in” depreciation is more than the market expects will happen, then market participants expect a positive return from borrowing in the lower yielding currency, buying the higher yielding currency, and collecting the now higher RFR. This is even a tool used by Emerging Market central banks to defend their currency! In a currency crisis central banks will sometimes raise rates to attract capital into the currency: the Ethereum network is (by happenstance) almost acting like a central bank defending its currency.
When the Ethereum network raises rates from 0% to 10% any marginal trader who did not expect a depreciation per year in ETH equal to the RFR differential between ETH and another currency would now find it profitable to borrow in other currency terms and lend in ETH terms. There are three ways this mispricing can theoretically resolve itself: ETH/USD spot rising, ETH staking yields falling, the other currency’s RFR rising. Until ETH spot rises versus other assets, and staking yields fall vs the RFR of those assets (or their RFR rises) to the point that the market thinks future *depreciation* vs those assets reflects a realistic future, capital will flow from those assets into ETH and from ETH into staking.
How much capital? You can make some assumptions about post-merge network usage, validator queues, etc. and come up with an estimate, but the short answer is a whole lot. There is a lot of concern in the market about the Fed raising rates, but the Ethereum network will actually tighten relative to the Fed over the next twelve months.
Interest rate differentials have a huge impact on currency prices, but the net rate environment over the next year is actually extremely bullish for ETH. Because there is a lag in the ability for staked ETH to compress staking rates, and no amount of ETH buying is going to raise rates at the Fed, a huge external shock like the ETH RFR going from 0% to the 5–10% range will likely have to be almost entirely resolved in ETH spot prices: ETH/USD (1yr RFR on USD = 2.3% at time of writing), ETH/BTC (the RFR of BTC is 0%), etc. Basically, ETH/USD spot is more price flexible than those RFRs (for ETH and USD) are, and the majority of the change should get priced in there: it would make sense for ETH to risk vs USD until the priced in annual depreciation makes sense to market participants.
To use the ETH/BTC cross as an example: if ETH rates shoot up and priced in fixed rates based on staking yields imply say, a 6% 5 year rate, ETH prices should theoretically rise until the market expects a 6% depreciations per year vs BTC from current spot prices.
But what about within the ETH ecosystem? Wouldn’t a sudden 5–10% increase in rates have massive effects on that currency’s native economy?
The ETH Tightening, DeFi Yields, and the Future
As mentioned earlier in this article, RFRs are (more or less as a rule) the lowest yields available for a given currency. Why? Everyone else has to compensate you with extra return, because every other rate is more risky.
So, how do yields everywhere else rise when the RFR goes up? People sell out of other assets, and move their capital into the treasury bonds, staked ETH, or whatever the source of the RFR is. The lower price of the same amount of future payment creates the new higher yield. In the case of ETH, at time of writing, some of the highest TVL money markets like Aave and Compound are offering sub 1% yield on ETH (0.03% and 0.06%, respectively).
10% yielding ETH staking will act like a black hole for ETH, sucking liquidity out of every alternative use until rates everywhere in DeFi look like the the RFR + some premium to compensate the capital allocator for additional risk. This should raise the cost of ETH borrowing, reduce the liquidity available for DEXes, and generally prove the point that “TVL” is, in most cases, not “locked” at all. In short: It will tighten conditions in the Ethereum economy, disincentivizing credit creation, and reducing liquidity. All non-ETH-staking derived sources of yield should lose capital until they offer some credit spread above staking returns.
The big exception to this is staking-derived yield bearing assets like stETH or rETH. These should explode in popularity not only as sources of yields themselves, but as a replacement for straight up ETH in most DeFi protocols. Many of the major protocols have already integrated stETH or rETH as collateral, which makes the resulting yield product quite literally staking yields + some compensation for additional risk (credit spread).
There is some risk of this repricing being…violent. There will likely be not only a giant jump in staking yields around the Merge (which will be slowly compressed by new validators), but also a rapid growth in awareness of staking yields (which up until the point of the Merge cannot be properly considered an RFR, since there is some technical risk around its implementation). Some DeFi stuff might break. Be aware of how DeFi products you use might respond to rapidly drying up liquidity conditions.
The really neat thing about ETH going forward, is that its monetary policy (as expressed through the staking yield RFR) is actually responsive to network activity. It will “ease” during low levels of network activity and “tighten” during high levels of network activity.
Lower activity → lower fees→ lower RFR → more liquidity in the Ethereum economy
Higher activity → higher fees→ higher RFR → less liquidity in the Ethereum economy
ETH is (largely by accident) creating a dynamic central banking policy post merge. But first, it’s going to introduce a policy rate and jack it way, way up.
