John Freyermuth | Enigma Securities
On 15 September, Ethereum's validators replaced miners to activate Proof-of-Stake consensus that boosted the network's economic and energy sustainability for the long term. Proof-of-Stake consensus more widely spread the risk and reward of building and securing the network. Additionally, PoS validators consume a fraction of the energy that miners used to process transactions. The Ethereum community and core developers collaborated to research, develop, and implement the Merge since 2015. The scope and schedule represented the largest public decentralized project that prove the viability of decentralized governance and coordination for the industry in general. The Merge was the most important development in digital assets to date.
Proof-of-Work consensus required miner nodes to expend computational power to validate transactions and build the ledger, or blockchain. On 15 Sep. 2022 validator nodes replaced Ethereum miners for good. Instead of computational power, validators pledge, or stake, ETH tokens to vet transactions and build the blockchain and receive for new ETH supply. So, users can pool ETH together to create a validator. A validator increases their chance of participating in blocks and earning ETH rewards as their share of staked ETH grows. So, validators that accept delegated ETH are incentivized to provide the best experience for their users.
Before EIP-1559, ETH token issuance steadily inflated ETH supply through miner rewards. New issuance diluted ETH holders to pay miners, which put downward pressure on token price and network value to fund security. Additionally, miners represented a small proportion of Ethereum users, so ETH issuance concentrated ownership over time.
After EIP-1559, and solidified by The Merge, new ETH issuance more widely spread and usage fees burn ETH to decrease and balance supply over time. After The Merge, validators earn all ETH rewards. Once the staked ETH is released, in Mar 2023, those rewards will pass from validators to users that delegate to them.
Additionally, usage fees are burned in line with Ethereum network usage. ETH demand should increase with network growth because increased usage increases gas and usage fees. While fee burning decreases supply as the network grows, this year proves ETH supply could decrease even while on-chain traffic decreases. Network activity decreased since July 2022, but ETH issuance was nearly zero.
Despite its industry significance, the Ethereum Merge could not overcome macroeconomic headwinds to asset returns. From July through October, while the US Federal Reserve raised the target short-term rate above 3%, ETH and BTC maintained tight correlations to equity market indices. Once expected rate increases slowed in October, digital asset returns trailed equity returns. The digital asset class was the first to sell off during a year of rising rates, but internal crises dragged returns lower.
Sam Bankman-Fried's benevolent eccentric genius persona helped his exchange, FTX, and his hedge fund, Alameda Research, become two of the largest players in their respective spaces until insolvency suggestions plunged them into a meltdown. Before FTX fell, Bankman-Fried attracted the world's top technology investors, including Binance. Their undoing confirmed that centralized exchanges present counterparty risk that contradict trustless and disintermediated blockchain networks.
02 Nov: CoinDesk published an article that indicated FTX-affiliate trading firm, Alameda Research, was more closely financially tied to FTX than previously disclosed. The article showed that FTX's token, FTT, constituted $5.8B of Alameda's $14.6B assets, and $7B of its liabilities, as of June 2022. The trading firm's relationship came under heavy scrutiny that week while Caroline Elison, Alameda's CEO, provided little clarity. Alameda's FTT holdings and collateral represented concentrated risk to FTX, which was one of the world's largest exchanges by daily volume.
06 Nov: Binance CEO, CZ, tweeted that Binance would exit its nearly $2.1B FTT token position it held from a 2019 investment in FTX. Together, the CoinDesk article and CZ's tweet caused users to withdraw from FTX. Simultaneously, users sold FTT holdings, which dropped over 25% to $22.
07 Nov: After FTT price fell, FTX froze withdrawals because it was unable to meet user demand for funds. Throughout the day, SBF tweeted that customer funds were safe, that FTX had just fallen behind due to unprecedented request volume. Despite his reassurances, digital asset markets sold off, with $XXM decline in total market capitalization.
08 Nov: Binance nearly purchased FTX to prop up the exchange and maintain an orderly market. Bankman-Fried announced the transaction via Twitter. Over the next 48 hours, Binance backed out of the deal during its due diligence on FTX. The market reacted negatively after the defunct deal suggested FTX had no alternatives to bankruptcy. Total market cap fell $XXM by the end of the day.
11 Nov: After days of uncertainty, Bankman-Fried tweeted that FTX filed Chapter 11 bankruptcy in the USA. As part of the proceedings, FTX replaced Bankman-Fried with CEO XX to usher the company through the process.
The filings addressed to the XX court confirmed that FTX and Alameda operated as one entity with intermingled finances beyond the FTT token. The documents noted that FTX maintained no accounting or controls on corporate spending.
13 Dec: Bankman-Fried was arrested by Bahamian law enforcement pursuant to the country's extradition treaty with the US. Within hours, the US Commodities Futures Trading Commission filed a civil suit against Bankman-Fried and the combined FTX and Alameda group. Both criminal charges and civil claims allege the firm and its owners committed wide scale fraud and recklessly misused user funds.
Only a few exchanges facilitated more volume than FTX before November. However, this summer's Terra collapse and Celsius bankruptcy created greater shocks by orders of magnitude because they evaporated liquidity. The Terra and Celsius implosions took over 40 days to drop BTC by -47%. The FTX bank run took -21% from BTC's price over seven days. Since then, BTC has performed positively three out of four weeks.
We believe the market will recover through 2023 and beyond, and the Ethereum transition to PoS remains the benchmark for innovation by decentralized development, coordination, and governance. It created a sustainable environment over half of all blockchain transactions to take place. In 2022, users, developers, and investors had more diverse choices for blockchain networks than at any point in the industry's history. Over the long term, Ethereum is unlikely to maintain its market share for smart contract activity as communities build new systems with Ethereum's innovations. Until then, no network presents a credible threat to Ethereum's market position.
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