Yielding A Volatile Asset
August 21st 2022

As the Ethereum “Merge” approaches I suspect the crypto world will see fireworks in the coming months.

"PoW" = Proof-of-Work

"PoS" = Proof-of-Stake

I’ve long been puzzled by the success of ETH the asset. As I’ve previously written, the value of ETH the asset is fundamentally predicated on its usage as a bandwidth unit in the Ethereum network. I view the Ethereum network as a sort of public good, and public goods typically make for poor investments. I suspect the success of ETH the asset can be distilled down to three major factors.

  1. Growing global liquidity addicted market speculation
  2. A new generation of borderless 24/7 digital market exchanges
  3. The future potential of digital finance

First, the level of global debt in the world today induces a requirement for monetary inflation, which creates massive waves of liquidity. This is the fiat monetary world we find ourselves in, where the path-of-least-pain is to print more money. Any small hint of monetary deflation is sniffed out by market participants, whereafter middle & working class retirement accounts (their life savings) are put in jeopardy. The least worst option is to create monetary inflation, which leads to asset inflation.

Second, the emergence of cryptocurrency exchanges offers a great home for these waves of liquidity. These cryptocurrency exchanges often operate outside the realm of Western judicial systems, which means tax benefits, and of course promotion of pump-and-dump Ponzi schemes without fear of criminal convictions. These exchanges also operate 24/7 around the clock 365 days a year — while BTC is only a little over a decade old, it has something like five decades of trade-time in comparison to equity markets (which are only open 9:30AM-4PM EST Monday through Friday).

Lastly, undeniably, everyone knows we live in an increasingly digital world, and finance is ripe for technological disruption. Finance has an unavoidable digital future. Who would dare promote a luddite agenda and deny the possible value to humanity by digitizing finance. There is real innovation which will, and is currently taking place in digital finance.

ETH the asset emerged at the perfect time to capture the convergence of value from these three contributing factors. If it wasn’t ETH, it would’ve been something else.

We’re on the precipice of the most significant single change to a major cryptocurrency network in history — “The Merge.” During this update, the Ethereum network will migrate the consensus mechanism from Proof-of-Work to Proof-of-Stake. This means, Ethereum will move from using energy to using capital to “secure” the network.

This tweet from Twitter user @Data_Always got me thinking…

“Energy consumption, deflationary, and security are all actually the same point. Because staking provides more efficient security, the energy consumption can drop, meaning you don't need to debase the asset and it becomes deflationary.”

To put the take in my own words, Proof-of-Stake networks don’t have the added cost of burning energy and therefore don’t have the need to debase the currency to pay the cost. Whereas Proof-of-Work systems have the additional cost of burning energy and pay the cost through inflation. Transaction fees are another mechanism for paying the energy cost, but let’s set that aside.

This is a compelling argument. It had me thinking…

There is a mass delusion in the cryptocurrency space regarding the word “security.” We often hear the claim, “Bitcoin miners secure the network” or “Proof-of-Stake validators secure the network.” This is a misnomer which I think yields (pardon the pun) significant consequences. Block creators do not create “security” for the network, but instead create “data integrity.” I’ve written previously about how blockspace is the holy alter of utility for cryptocurrencies. In computer information systems, maintaining immutable data is functionally impossible. Computer hardware devices are designed as generic read/write machines. If a piece of data can be written to a disk drive, then it can also be deleted. There is a galaxy-brain perspective here which goes something like, nothing can ever truly be “written in stone” for eternity. Even stars eventually die. Reality is constantly mutating. The novel innovation of a blockchain is to create an immutable data stream, not through a computer science mechanism, but through economic incentives. The monetary properties of cryptocurrency blockchains create a system where an immutable data stream is the Schelling Point.

“Data Integrity” > “Security”

The normie salespitch for PoS over PoW goes something like, “it’s a more efficient security mechanism.” Of course, as we’ve just proven, it’s not a matter of security but instead data integrity. The language here is important because “security” can be sold to the public for a much higher price. There’s a reason the national defense industry is constantly flush with cash; citizens are willing to pay any price for security. The innovative mind then asks, “how can we reduce security cost?” And the initiative is defended by malthusian values which claim "humans simply use too much energy" (from the wisdom of Doomberg, “energy is life” and “you first”). Along comes Proof-of-Stake which promises to reduce the “security” cost by eliminating the usage of real world energy. The misnomer of “security” here has led to a public obsession over reducing what people call "the security budget."

What if I told you the cost to maintain data integrity is far less than anyone expects? And the current revenue from PoW mining is most pragmatically framed as an arbitrage from a failing fiat monetary system, not a “security budget.”

In other words, what if PoS is a solution to a problem which doesn’t exist?

The problem with PoS over PoW is the increased asset volatility. Offering a yield on an underlying volatile asset increases volatility because of the procyclical dynamics. If the market expects the price of the asset to increase into the future, then speculators will stake their asset to collect yield as an added bonus — it’s a leveraged bet, and leverage induces volatility. Again, the lack of a withdraw mechanism is moot because of synthetic assets like “Staked ETH.” On the counter point, if the market expects the price of the asset to decrease into the future, then speculators will dump their ETH, which requires them to stop staking, which creates upward pressure on the yield, which is more inflationary, which leads to dilution, which leads to further downward pressure on the price.

There is no way to avoid the fact that, offering a yield on a volatile asset increases the volatility of the asset.

The Luna/Terra meltdown is this mechanism on hyperdrive.

I suspect the only mechanism to prevent a death spiral induced by increased volatility from yielding a volatile asset is market regulation. I think distressed debt from emerging markets is an apt comparison here. As we’ve seen time-and-time again, even sovereigns, who are legally capable of physical enforcement fail to prevent death spirals. What makes us think ETH can do better?

So, the migration from PoW to PoS has been initiated because the cost of “security” needs to be made more efficient, but in moving to PoS, the asset becomes more volatile, and creates a higher risk of death spiral. I propose the cost to maintaining data integrity is far less than the public consensus — due to the misnomer of “security” rather than “data integrity” — and therefore the migration to PoS is an unnecessary risk to the future of the asset & therefore the network.

Said differently, Proof-of-Stake is a solution to a problem which didn’t exist in the first place, and the solution has created higher risk market conditions. ETH’s most important ally to its future survival is US regulators.