Ethereum censorship debate and investment opportunity with the Merge | Weekly Insights

Aug 19, 2022

Ethereum is facing a big challenge from OFAC

Ethereum is moving from its current proof-of-work (PoW) blockchain to a proof-of-stake (PoS) mining consensus. With the sanctioning of Tornado Cash several days ago, Twitter user @lex_node pointed out that more than 66% of validators on the Beacon Chain (Ethereum PoS chain) will adhere to the United States Department of the Treasury's Office of Foreign Assets Control (OFAC) regulations.

OFAC, The Office of Foreign Assets Control, is the US Department of the Treasury administers and enforces economic and trade sanctions based on US foreign policy and national security goals, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United States.

In detail, if OFAC needs to sanction an Ethereum account, OFAC could control whether or not an Ethereum account is allowed to make transactions. Because once your Ethereum account is sanctioned by OFAC, the verifier nodes will not execute the related block packing according to the policy.

The fact is that more and more companies have jumped to comply with the sanctions by OFAC. As Daniel Kuhn, the editor covering the cryptocurrency industry at Coindesk, talked earlier this week, “It is perfectly reasonable, and possibly preferable, for Ethereum blockchain-based apps to block users with exposure to Tornado Cash, following the sanction of that anonymizing service last week. The alternative would likely open large parts of the Ethereum network to criminal liability. And that would include founding teams who are building the nascent, alternative economy of decentralized finance (DeFi).” He showed that U.S. Institutions trended to let the U.S. control and censor the blockchain industry.

Merge is just a change from POW to POS but the anti-censorship storm is shaking the foundation of the entire blockchain. Once the anti-censorship storm is on the table, it will inevitably cause the blockchain consensus to split. The debate is still on the way, and the only thing we can do now is to find out what will happen next.

Investment Opportunities Under the Ethereum Merge

The Ethereum Merge is approaching, and it will bring significant changes to the Etheruem economy, as well as shorter-term chaos on-chain. What are the investment opportunities for investors to take advantage of the Merge?

Liquid staking service
Liquid staking service providers, from such as Lido (LDO), Rocket Pool (RPL), and Stakewise (SWISE), might be the most direct beneficiaries of the Merge. Since Ethereum can eliminate previous technical and execution risks through the Merge. Staking risk is greatly reduced, and the non-custodial protocol is expected to experience a significant increase in the months of transition to proof-of-stake (POS).
As yields are expected to increase, there may also be an increase in collateral in liquid staking protocols. Right now, beacon chain validators only get block rewards, while after the Merge, stakers earn transaction fees and revenue from MEV. This is projected to dramatically increase the staking yield from roughly ~4%, where it sits today, to anywhere from 6-12%.
Event-based DeFi Investment
One way in which a user can do this is by lending ETH on money markets like Aave, Compound, and Euler. There will likely be a considerable increase in demand to borrow ETH around the time of the Merge, as investors will want to accumulate as much of the asset as possible in order to farm the “airdrop” from a potential PoW-based Ethereum fork (ETHPOW).
A second way to use DeFi to express a view on Merge-related events is to use Voltz Protocol, an AMM for interest-rate swaps to bet on the LSD staking yields. Since staking returns may increase after the Merge, market participants can use Voltz to amplify their returns by using ETH as margin and buying variable-rate stETH or rETH tokens. It should be noted, however, that this brings greater liquidation risk.
Other impacts of the Ethereum economy
One of these opportunities are Layer-2s (L2), as the transition to PoS will pave the way for scalability upgrades (e.g. EIP-4844) which will dramatically reduce transaction fees for end-users on rollups by decreasing the cost of storing call data on-chain. This fee reduction should serve to catalyze L2 adoption by increasing the number of users that can transact on the network and unlocking the capability to build new, novel dapps.
Another industry that is set to change after the Merge is MEV. There are numerous projects within the MEV stack with publicly traded tokens that could provide a way to gain exposure to this shift, such as Manifold Finance (FOLD) Rook Protocol (ROOK), and Cow Protocol (COW).