Decentralized Dev and Shanghai Upgrade
January 2023 Commentary
Investors were certainly glad to put 2022 behind them and enthusiastically embraced the new year. US CPI inflation for December was reported to have risen 6.5% from the prior year, a continual deceleration from the previous month’s reported rate of +7.1%. This whetted investors’ risk appetites to pile into risk assets despite warnings from an increasingly inverted yield curve. US equities gained close to 6.2% while global equities earned +7.5% in USD terms. Digital assets market rallied 32.5%, led by bitcoin gaining a mouthwatering 39.8%.
Early US economic readings in February, however, gave investors pause. The US jobs report indicated that 517,000 jobs were added in January, compared with an expected 185,000. While the Federal Reserve recently moderated their rate increase, raising the Fed Funds rate by 25 basis points to a target range of 4.50 – 4.75%, their communications made it clear that they were looking for sustained signs of decelerating inflation. Any hope for a reversal in the US central bank’s policy was quickly dashed.
More jobs, but not in Tech and CEX
The increase in the number of jobs in January is particularly interesting when considering the number of layoffs technology companies and centralized [crypto] exchanges (CEX) have made over the past 6 to 12 months.
According to Layoffs.fyi, tech companies laid off over 159,000 employees in 2022 and continued to lay off over 94,000 thus far in 2023. To put things in context, the tech industry is huge, consisting of approximately 5.5 million employees as of 2020, as estimated by Deloitte. Layoffs from 2022 to early 2023 make up just about 4.5% of this cohort. Still, a quarter of a million people losing their jobs is no laughing matter.
The digital assets industry has been a microcosm of the tech industry similarly shedding jobs over 2022 and into 2023 due to macro uncertainties and last year’s Terra Luna implosion, Three Arrows Capital’s bankruptcy, and FTX’s collapse. Layoffs have been plentiful, but the exact number has been hard to pin down due to lack of standards of how crypto jobs are categorized. For the one-year period ending January 2023, optimistically, crypto companies have shed over 9,600 jobs, according to a study by CoinGecko. More sobering is a job loss estimate of over 29,600 over a similar time period, as tallied by Coindesk.
Importance of differentiating Ce* versus De*
As is often the case with digital assets and the industry surrounding it, it is important to dig deeper into these job trends to understand whether the industry is coming to a screeching halt or wheat is being separated from the chaff. In particular, it is important to remember that most of the shenanigans in 2022 involved centralized entities and service providers, and that is where we find most of the job cuts.
Based on a study by Electric Capital, the number of full-time developers at the end of 2022 grew by 8% over the prior year to 7,179. While this is a deceleration in its 2-year growth rate of 77%, it is markedly better than the job losses experienced in the broader tech and centralized digital asset services. Much of the activities have been focused on infrastructure development – building out the Layer 0 (“chain-of-chains), Layer 1 (blockchains), and Layer 2 scaling platforms. Refer to our previous discussion on these infrastructure components.
Full Time Developer Count and Growth. Bubble size indicates the number of developers at the end of 2022. Source: Electric Capital, Firinne Capital.
Going to work for Ethereum
Ethereum captures the lion’s share with 1,873 full-time developers. Indeed, it has an ambitious agenda. According to Vitalik Buterin, the Ethereum roadmap, updated in November 2022, consists of the following phases:
Merge – completed in September 2022, Ethereum’s Mainnet merged with the Beacon chain to switch its consensus mechanism from Proof-of-Work (PoW) to Proof-of-Stake (PoS; we discussed it here in more details),
Surge – will introduce blockchain sharding to scale network capacity,
Scourge – introduces proposer-builder separation to tackle risks introduced by Maximal Extractable Value (MEV) to allow for fair transactions inclusion in blocks,
Verge – adds verkle trees to make it easier to verify blocks, for the purpose of promoting decentralization,
Purge – expires the history of unnecessary transactions and eliminates technical debt,
Splurge – “Fix everything else”
Shanghai Upgrade
To tie up some loose ends following the Merge and prepare it for the next phase, a lot of attention has been focused on the upcoming Shanghai upgrade expected around March. The upgrade bundles a series of Ethereum Improvement Proposals (EIP) that together will lower transactional gas fees and be more friendly to validators, key actors responsible for providing security on the blockchain. In particular, much attention has been paid to EIP-4895. As Ethereum switched to PoS, validators have individually staked 32 ETH and collectively staked a total of approximately 16 million ETH to verify transactions, thereby securing the blockchain. Currently, these staked ETH and their staking rewards cannot be withdrawn and are not directly tradable, leaving validators who want to unload their positions, subjected to economic risks with no direct options. EIP-4895 finally unlocks the staked ETH, giving validators the opportunity to withdraw both their staking rewards and staked ETH, if they choose to.
Over 16 million staked ETH (~ 14% of ETH supply) with a staking APY of 4.9%. Source: Dune Analytics
Indirectly, ETH owners have been able to take advantage of liquid staking protocols such as Lido, Rocket Pool, and Frax. These platforms accept and aggregate ETH deposits to set up validator nodes to stake and validate on the behalf of the owners. In return, the individual owners received a derivative token that represents the quantity of ETH that they deposited and their respective share of the staking rewards. These derivative tokens are tradable and provide the owners a liquid alternative while earning staking rewards from Ethereum.
Sixteen million ETH is a lot of ETH, considering the circulating supply of around 122.4 million ETH. The concern is that this unlock would prompt the validators to rush for the exit, akin to insiders selling their shares in a public corporation after their lockup period expires. This concern has been cited as one of the reasons for ETH’s underperformance relative to BTC during January’s massive crypto rally.
But there is plenty of evidence that points to the contrary. For starters, the exit door is quite gated. To preserve the network stability, validators seeking to withdraw their stake must wait in a queue. Looking more broadly, Ethereum has a lower percentage staked relative to other blockchains and this percentage will likely rise, now that staked ETH can be retrieved. Approximately 40% is held by liquid staking derivative protocols which is unlikely to be sold post Shanghai. Furthermore, looking at stETH, the Lido staked ETH derivative, investors haven’t been demanding a premium for the liquidity it has offered. Finally, given that most of the “home stakers” originally locked their ETH up for an indefinite period, they are unlikely to suddenly want to sell.
Source: CoinGecko
Previously, highly anticipated events in both Bitcoin and Ethereum have not resulted in major prices changes at the date of the event, as the market has plenty of time to diffuse this information amongst market actors. However, the effect of supply restriction, such as bitcoin halving events, tends to play out slowly over the course of months and years, suggesting the market is not efficient with respect to the pricing these events. We expect the price of ether to behave similarly for the Shanghai fork, which is that the sudden change of supply will have little impact, at least to the downside. Over time, however, the increase of ether staked and the passing of another successful milestone on the Ethereum roadmap should be reflected positively in price appreciation.
Despite the overall slump in the world economy and doom and gloom on the macro front, we take heart in the knowledge that quietly, developers and innovators continue to labor unabated. The strongest projects are forged in bear markets. Whilst market cycles may come and go, human ingenuity continues forever.