Could The Ethereum 2.0 Upgrade Lead To The Flippening?

The second-largest cryptocurrency in the world is implementing a network upgrade, which completely changes its value proposition as a financial asset.

One of the main criticisms of Cryptocurrencies from the investment community has been that they do not generate any future cash flows and hence can’t be considered as an investment.

Due to their deflationary design, most cryptocurrencies don’t lend themselves well to be a currency to denominate income-generating assets (i.e. no one would want to borrow in a currency that is designed to appreciate in value and no company should be willing to pay its employees/denominate its contracts in such a currency).

Would some of these criticisms fall away if cryptocurrencies were to have future cashflows? This question has not had much interest from the investment community so far, but it is worth considering, as that
is exactly what may be happening.

To understand why things may be changing, we need to take a
step back and look at how cryptocurrencies work. Cryptocurrencies are digital assets that are recorded on a blockchain, which is a distributed ledger that holds an immutable record of these assets.

The accuracy of such ledger is maintained by a process called consensus mechanism, that requires each transaction to be verified by a distributed group of validators.

Bitcoin uses a consensus mechanism called Proof of Work (“PoW”). In this mechanism, the validators (known as “miners”) spend energy solving mathematical puzzles. They prove they are genuine entities by committing resources to the task and get rewarded with Bitcoins for the work they have done. This is the most common consensus mechanism used amongst public blockchains today.

This mechanism is commonly criticised for its excessive use of energy for no productive use. The estimates show the Bitcoin network consumes electricity more than individual consumptions of 159 countries
( Graph 1) , including large economies such as Ireland and Nigeria.

Graph 1: Bitcoin Consumes more electricity than these
countries

However, Ethereum, the smart contract platform, and currently the second-largest cryptocurrency by market cap, has been working towards making changes to its consensus mechanism. The release called Eth 2.0 or Casper proposes to introduce Proof of Stake consensus mechanism.

In a Proof of Stake (“PoS”) mechanism, the validators need to be holding some of the relevant cryptocurrency and they stake it to become a validator.

In return, they get rewarded with Ether, the cryptocurrency of the network, equal to a percentage of their stake. Both the mechanisms work on the premise of validators making an investment to help keep the network safe and getting the rewards to compensate them for their investment.

In PoW investors are investing in mining equipment and pay for energy; in PoS they are using their financial resources to buy cryptocurrencies and
stake it instead.

The interesting point financially is this makes the staked cryptocurrency look more like a financial asset with the ability to get a fixed income, thus can change the whole economics of how such assets are supposed to be valued.

The rewards that will be distributed, increase the supply of Ether in existence and therefore is called the inflation rate.   If we assume a final stage where a whole network is being run on a PoS mechanism, the inflation rate will equal the rewards distributed.

If we, therefore, assume a simplified case where any Ethereum bought will be staked forever, this then looks like a financial asset with a future stream of cash flows, all be it in its local currency.

The use of conventional economic terminology by designers of
Ethereum is not accidental. It is a digital ecosystem that has similarities to
a traditional economy. 

Ethereum is a distributed world computer and Ether (“ETH”) can be used to buy Gas, which is the necessary commodity to run this computer. So Ethereum is like an emerging economy where economic activity as measured by the usage of the currency has been increasing (Graph 2)

Graph 2: Ethereum Network Gas Usage

Source: Etherscan.io

Like all other traditional currencies, this currency also has an inflation rate.
Once the PoS comes into effect it will have its own interest rate in the form
of stake rewards. Having a currency with an interest rate curve makes it
possible to have a forward market against other currencies, so hedging can
become possible as well.

There are however large differences to emerging currencies too. In a fiat currency when you generate a fixed return, that is through buying an interest-bearing instrument such as a bond or lending your cash, which will inherently have credit risk.

In the case of staking, there is no credit risk to a counterparty as the return is generated by an algorithmic mechanism, not through a risky economic activity of the counterparty.

The reward rate is therefore the risk-free rate of the Crypto economy. However, at least the initial stage, there can be some other technical risks such as slashing, attacks, and hacks. However technology risks are inherent in existing financial infrastructure as well, so we should assume that as financial institutions become active in this field, they will build the necessary technological defence systems.

The other important factor to consider is the relationship between this return and inflation. The staking rewards are directly linked
with the inflation rate in Ethereum. This direct relationship does not exist for any conventional cash instrument, other than inflation-linked bonds and historical data shows real rates of return for cash can be negative for extended periods of time.

So ETH will be a unique currency that can provide a risk-free rate that comes with security against inflation. In addition, it will not be possible to stake all the currency in existence, as some of the currency will be used for its utility such as paying network fees to run smart contracts.

That should mean in this hypothetical scenario, the rewards that accrue to the staked coins will be higher and hence will guarantee a real rate of return over the inflation. This can not be said for any other asset class currently.   

All considered together this may be perceived as an asset
with no credit risk and offering the possibility of inflation-adjusted real return.

This makes it likely to be considered a financial asset with familiar financial
characteristics, instead of a “tulip” like phenomenon with no way to value. This is a complete game-changer for financial investors and it comes at a very opportune time.

Currently, the main reserve currency of the world, USD, is under immense pressure as holders are financing trillions of dollars of debt of a government for almost zero return, which is an increasingly difficult position to defend. In addition, the holders are increasingly at the whim of the US government’s hard to predict actions.

The alternatives such as EUR and JPY have negative rates and are backed by economies sitting on the top-up of various political and demographic time bombs. The CNY which is touted as the emerging alternative requires
one to trust the Chinese regime, which itself is reluctant to any capital
flows.

While Bitcoin requires a complete leap of faith to the “digital gold” rhetoric, Ethereum represents the currency of a fast-growing, decentralised, and open economy with extremely attractive and understandable properties for money managers.

As the Ethereum based economy grows, in long term one can expect to see Ethereum gaining its place as a unique asset on institutional portfolios and even central bank reserves.

While there are many technical hurdles on the way to implementation of the PoS mechanism, leaving aside uncertainties about the eventual state of the ecosystem that use it, the potential means Ethereum is becoming too risky to ignore as a financial asset.

Notes: The author owns ETH, Bitcoin, and other cryptocurrencies. Opinions expressed are the author's own.