A major Ethereum blockchain software upgrade was successfully completed earlier today, marking a landmark event for the digital assets industry. The upgrade, known as the “merge,” changes how transactions are verified on Ethereum’s blockchain and dramatically improves its energy efficiency. While this is welcome news, we doubt this means the rout in digital assets prices is over in the near term, as macro headwinds continue to be the most important factor driving prices.
The merge is an exciting development for the digital assets industry because it marks a shift toward sustainability. Indeed, digital assets are often criticized for the massive amounts of energy consumption they require. Blockchains use consensus mechanisms to verify transactions, and, up until this point, Ethereum—like bitcoin—has used an energy-intensive “proof-of-work” mechanism for that purpose. The White House recently estimated that digital assets account for 0.4% to 0.9% of annual global energy usage, driven mostly by the intensity of the proof-of-work mechanism. Of that energy consumption, bitcoin accounts for 60% to 77%, while Ethereum accounts for 20% to 39%. Today’s merge shifts Ethereum to a “proof-of-stake” mechanism effectively ending its proof-of-work mining model, which is estimated to cut Ethereum’s energy consumption by 99.95%.
Despite the positive Ethereum developments, digital assets prices remain under significant pressure. The Bitwise 100 Total Market Crypto Index has lost 60% of its value year-to-date. This week, digital and other risk assets were challenged by a US inflation report, which showed broad-based inflationary pressures. This report increased interest rate expectations and led to a sell-off in equities. Both developments put pressure on digital assets, as fixed income and equity prices are now slightly more compelling for the marginal buyer. That dynamic has resulted in an increased correlation between digital assets and equities this year, particularly high-growth, long-duration tech names.
As the Federal Reserve continues to grapple with rampant inflation, policy rate expectations have steepened, and markets are bracing for economic weakness. While digital assets prices are highly speculative, we suspect prices will remain under pressure until the macro headwinds have eased. Still, longer term, it seems likely the merge will benefit Ethereum after these macro headwinds clear.