Pain Relief and Merge Musings

July 31, 2022

The crypto markets received a much-needed relief rally in July, but a ¾ point interest rate hike, inflation at 9.1% and GDP at 0.9% points to the fact that we’re not quite out of the woods yet – but we may be getting closer.

The Final Shoe

It’s great that we had a rally this month given the punishing state of the markets over Q2. It showed an important support level held in BTC. We’re cautious right now, however, because while nothing is guaranteed, we suspect that we’ve got one more painful drop in these markets. This “Final Shoe,” if you will, could be much like the March 12, 2020 deflationary event, where all asset prices go down as investors flee into the US Dollar; we believe that will be the death knell for this bear.

We’ve been anticipating the Fed turning dovish sooner rather than later and markets responded quite favorably to this last rate hike, noting that there was more dovish sentiment coming out of Chairman Powell’s announcements – but there is debate about that. What we do know is that the ¾ point rate hike to fight inflation points to two back-to-back rate hikes, the likes of which we’ve not seen for years.

Inflation in July crested a whopping 9.1% YoY which is the real number we need to keep an eye on. Comments come and comments go, but once that number pulls back – even a little – we should see the real dovish direction come from our friends at the Fed and, at that point my friends, the Bull is on.

We’re still at bottoms and present to huge value in these marketplaces and, though we could have one more drawdown, we would argue that these prices are the likes we may never see again. We expect the real rally in Q4. We’ll see.

Blockchain Battles

As last month, rather than spend too much time trying to predict when the bear will end, I think it’s worth talking about the thing that gets us most excited about the world of blockchain and crypto assets, and that is the technology.

Technology is, to some extent, market proof. Of course, there’s always some impact as markets move, but over the long-haul sound technology, like sound money, wins the day. Bitcoin is an exercise in sound money principles. It is a money use case of blockchain tech and the only one that, in our opinion, we really care about. The battle for new money is over, and Bitcoin won.

The value of other blockchains is then given by their technology. Remember, outside of Bitcoin the crypto world is really not about money. It’s about effective implementation of blockchains, which is a function of technology implementation. Blockchains give us an entirely new way to operate in the digital world and stand to impact every industry. We see it as the infrastructure that is going to carry the day over the next 50+ years and, importantly, smart contract platforms are going to be the foundation of that foundation.

Smart contract platforms, as we’ve noted before, are the platforms upon which other blockchain applications can be built. DeFi, Metaverse, NFTs and oh so many others are all created on a foundational layer. This is often referred to as a Layer 1 protocol and a lot of players are vying to be king of this hill.

Ethereum, which launched in the summer of 2015, has been the dominant player since its inception. Though continually besieged by speed and cost issues, no other player has been able to knock it off its perch. Solana has made possibly the strongest inroads, taking 30% of the DeFi market from Ethereum in 2021, but they aren’t the only player at the table. Solana, Cosmos, Polkadot, Avalanche, Cardano and so many others are making the argument to be the key players in this space. Some we really like. Some we don’t. That is for a different blog. What is important here is to understand that this is the holy grail of the blockchain space. Whichever platform(s) gain – and hold – market share will be the platform(s) that truly have value and therefore stand the test of time.

I use the growth of the internet analogy quite a bit so let’s go back to our search engine example. In the late ’90s, there was a massive battle for search engine dominance and, as we all know, Google won. This doesn’t mean that there aren’t other engines out there, but the fact is for the vast majority of humans, when looking for something on the web, we “Google” it. There were engines out before Google such as Altavista, Lycos, etc. and, as we noted last time around, Altavista went from market dominating internet darling to the black sheep of the search world in a very short period of time.

So, the question that I’m postulating here is, “Will Ethereum be Google or Altavista?”

A big portion of answering this question has to do with the upcoming Ethereum enhancement called “The Merge”, which is perhaps the most important part of the rollout of Ethereum 2.0.

The Merge

I was recently asked what “The Merge” is by a good friend and successful investor in traditional markets. Though this is well known by those who swim in the blockchain ocean, it occurred to me that those that don’t may not be aware of this seminal event, so here’s a bit of a precis of this upcoming milestone and why we care. If you’re already clear on this topic, I encourage you to skip to “The Punchline,” but if the concept of “The Merge” is new to you I encourage you to read on.

Ethereum has market share and is the dominant chain, but it’s (generally) slow, expensive and doesn’t scale well. Ethereum currently processes about 13 transactions a second, which is a woefully inadequate number considering that there are over 1M+ transactions a day demanding attention on the chain. The Merge intends to solve this problem by setting the stage for future enhancements by moving to a new consensus mechanism.

Consensus is the process of all the nodes on a blockchain agreeing that a transaction is valid. Bitcoin and, currently Ethereum, use a proof-of-work (PoW) consensus mechanism which, in summary, means that there is a network of machines (miners) that have to spend a lot of computational processing power (energy) to confirm transactions. This is a woefully inadequate description, but I don’t want to tangent, so for more details on PoW I encourage a review of this Wikipedia page.

Ethereum’s proposed new consensus mechanism is called proof-of-stake (PoS) which, again simplified, has each computer running on the network (validators) pledging a certain amount of Ethereum (staking) which gives them the right to participate in the confirmation of transactions. This new methodology will be vastly more energy efficient – some speculate it will reduce the carbon footprint by as much as 95%.

This efficiency opens the door for the next steps. It will NOT immediately impact the transaction fees and speed, but this new consensus mechanism will set the stage for sharding, which is processing transactions off chain in a faster manner, as well as other enhancements.

The Merge is the next major Ethereum upgrade, which migrates to PoS, and it could happen as early as middle of Sept 2022.


The Punchline

So, the question is, “Why do I care?”

Why this is important is that many other platforms exist which currently have this PoS consensus mechanism. They don’t have the market share that Ethereum does, but better products tend to win over time, so this is a crucial juncture for Ethereum.

For those of you looking at investing in blockchain technology (yes, I’m looking at you), this is a seminal event, because it sets the stage for the landscape for years.

Ethereum is set to rule the world as the premier Level 1 blockchain technology IF they can successfully continue to upgrade their technology. This will allow them to not only keep market share, but also address the cost/scalability dragon. The Merge is the first step to that. This puts them on the path of being like a Google to the search engine world.

If they do NOT, however, and The Merge is not successful, it opens the door wider for contenders and – yes, you’re already there – Ethereum then becomes more vulnerable to progressing on an Altavista-ish path. We do not expect this to happen, but it is a risk to factor in.

In Closing

The important point here is that The Merge may or may not go well, which means Ethereum may or may not be set to continue to be the dominant player, which means it may or may not be a fantastic long-term investment.

Notably, a successful merge does not mean they will dominate (still lots of moving parts to go) and a failed merge does not mean they will flounder (the game is far from over), but it is a major milestone, and we’re all watching it carefully.

I’ve waxed long in many other blogs so I’m going to keep this one mercifully short and pause here. For a more detailed discussion I encourage you to reach out and let’s dialog!

Until next time, be well, stay safe, and I’ll keep Decrypting: Crypto for you!

About the author James Diorio

James is a Principal and Chief Executive Officer of Tradecraft Capital.