September 2, 2022

Dopex Essentials: The Merge

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Our budding economists within the Dopex community would be familiar with the so-called Efficient Market Hypothesis (EMH), whereby the price of an asset reflects all available information. One piece of information that has been heavily publicized is the upcoming “Merge” of the Ethereum blockchain, which will involve the transition of Ethereum from Proof-of-Work (PoW) to Proof-of-Stake (PoS).
Whilst this proverbial Merge is a publicly known event, it is arguable that this event has not been fully priced in. CEO will present two main takes about why this may be:
  1. Uncertainty about the success of the upgrade.
  2. How well informed people are about the economic implications of the PoS transition.
Allow the CEO to take you on a journey through what The Merge is, how this will affect supply and demand of ETH, and the role Dopex can play in hedging your position.

What is The Merge?

As we mentioned above, The Merge is the transition of Ethereum’s consensus mechanism from PoW (a la Bitcoin) to PoS. This means that blocks will be approved by validators that stake their ETH as collateral to verify transactions. This is as opposed to PoW, where miners expend computing power by using expensive equipment to validate transactions.
Both approaches are intentionally economically intensive to penalize malicious actors whilst rewarding good ones. In PoS, malicious actors may have their collateral slashed whilst in PoW incorrect validators will not be given mining rewards and will thus be expending hashrate and utilizing their expensive equipment for no financial gain. This encourages validators in both approaches to act in good faith.

Uncertainty about the success of The Merge

With any major change to a protocol comes the possibility that these changes may create vulnerabilities that were not previously present. This requires vigorous testing on test nets which may create a time sink and delay The Merge itself.
Whilst PoW is a tried and tested consensus model, Ethereum’s transition to PoS would be the largest transfer of value from system of mining to one of staking - whether the same level of security is conferred with this new model at this scale is a test in itself.
Proponents of PoW may want to hard fork Ethereum to stay as a PoW chain and, if they do, there is no guarantee which chain (PoS. vs. PoW) will be dominant.
Each of these narratives raise genuine concerns about the success of The Merge - the common denominator of each is the essence of uncertainty. Despite our faith in the Ethereum foundation to pull off this major upgrade, it is difficult to say categorically that things will definitely go according to plan.
The playout of these uncertainties is the bear scenario, and perhaps the main driver for downward volatility of ETH.

Economic Implications of The Merge*

Now the minute details of the economic implications on Ethereum post-Merge are well below the CEO’s pay grade. As such, I will break it down into some basic components and the impact on ETH this may have if things play out as intended.

Supply Crunch

Pre-Merge ETH is an inflationary asset, with annual issuance of ~5.4m ETH (with nearly 90% going to miners) which represents an annual emission rate of ~4.3%. Recall that pre-Merge ETH is secured by mining where a miner’s capital is locked up in equipment and hashrate.
Post-Merge ETH has a projected annual issuance of ~580k (exact numbers are more complicated but let’s use this as an example) which represents an annual emission rate of ~0.48%. Recall that post-merge ETH is secured by staking where a staker’s capital is locked up in staked ETH
Looking at issuance alone, there is a huge decrease in annual issuance, decreasing the amount of new ETH that may hit the market. In addition, the transition from PoW to PoS means that in order to issue these new blocks ETH must be staked which removes them from circulating supply. These two events have the effect of a so-called “supply crunch” which would be expected to drive positive ETH price action.

Burn Rate

The burn rate of Ethereum is not something that has changed in the transition from pre to post-Merge, but rather a notion interesting to consider in the context of the supply crunch. Of the transaction fees that users of Ethereum pay in gas, 30% of these go to validators whilst 70% will be burned. Whilst transaction fees are a function of network utilization, it is expected that ~580k  ETH will be burned annually. This is pretty much equal to the project annual issuance of ETH in the PoS transition, meaning the burn rate will roughly cancel out new ETH issuance.
The consequence of the supply crunch and continued burn rate is that ETH supply will be stagnant or slightly deflationary. All else equal, if the supply of ETH post-merge is stable or decreasing compared to pre-merge where the supply of ETH is inflationary, we can expect ETH to increase in value purely through supply and demand.
*Information from this section was taken from https://ethereum.org/en/upgrades/merge/issuance/#the-burn

Enter Dopex

Merge Uncertainty and Economic Implications in Context

From the above discussion, it is clear that there is a degree of uncertainty about how smooth the transition from PoW to PoS will be. The accumulation of these uncertainties is embodied in a bearish outlook on ETH. These are things that could go wrong, and if they do go wrong it is not an ideal scenario for Ethereum which will reflect in its token price.
The counter-point is that if all things go smoothly, the transition to PoS has economic implications that will mean ETH supply will become deflationary. As the supply of ETH is deflationary, all else equal we can expect ETH to become more valuable - a bullish outlook on ETH.
There is no single strategy that can guarantee you play The Merge perfectly. What you can do, however, is to look at all these factors in context and consider which scenarios are more likely and which scenarios are less likely. With this in mind, you can position yourself to minimize risk exposure whilst maximizing your gains.
This is where our beloved Dopex can come in.

The Magic of Dopex

Now The Merge is a very polarizing event, with strong arguments for both bull and bear scenarios. A Dopex user’s outlook on how The Merge will unfold may dictate the strategy they choose to employ.

Bear Scenario

If you are bearish on The Merge, you probably expect some aspect of The Merge uncertainty to play out, resulting in ETH to decrease significantly in price. Dopex users could capitalize on this outlook in two ways:
  1. Purchase puts: profit if the price of ETH decreases since you can sell at the strike price.
  2. Write calls: earn from option premiums.
Note that in the Write calls strategy, if the price of ETH were to increase above your written call’s strike price, your deposit will be slashed to pay settlement to call buyers.

Bull Scenario

If you are bullish on The Merge, you think that the uncertainty is FUD and the economic implications of The Merge will driver an increase in ETH price. The Dopex play is the opposite:
  1. Buy calls: profit if the price of ETH increases since you can buy at the strike price.
  2. Write puts: earn from option premiums
Note that in the Write Puts strategy, if the price of ETH were to decrease below your written put’s strike price, your deposit will be slashed to pay settlement to put buyers.

Bear this, Bull that, I don’t know

Now what if you are in the third camp - you know The Merge will be a big event in terms of price action, but cannot gauge which direction the price will go. With Dopex’s new Atlantic Straddles (please see Atlantic Straddles Explainer for a full break down), you will be able to build a position that profits from this in a single click (it will actually take a few clicks but CEO shall keep this statement for dramatic effect). The logic flow is as follows:
  1. Buy ATM ETH AP (this profits if ETH goes down).
  2. Borrow 50% of the stablecoin collateral and buy spot ETH (this profits if ETH goes up).
How this strategy plays out is best explained by this payoff graph (assuming 1500 USD per 1 ETH as the initial price) :
customIf the price changes in either direction by at least the cost of the AP premium, this strategy will be in profit. However, if the market does not move, the premium paid upfront will be lost. This allows any user that thinks ETH will be highly volatile but is unsure of the direction of the volatility to profit in a one-click solution.
 

Parting Poem

customWow Mr. Descartes; what a visionary. Truly a man well ahead of your times.
Until next time, my loyal students.
Warm regards,
CEO (Chief Education Officer)
customWe do a lil' walkerino

About Dopex

Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers and maximize gains for option buyers — all in a passive manner.
Dopex uses option pools to allow anyone to earn a yield passively. Offering value to both option sellers and buyers by ensuring fair and optimized option prices across all strike prices and expiries. This is thanks to our own innovative and state-of-the-art option pricing model that replicates volatility smiles.

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