Written By: Marcus Wang
Edited By: Igneus Terrenus and Charmyn Ho
Introduction
With The Merge just around the corner, a prominent Chinese Ethereum miner, Chandler Guo, called for a hard fork of Ethereum, which will continue to adopt proof-of-work (PoW), and thus diverging from the proof-of-stake (PoS) model upon The Merge. The hard fork, dubbed Ethereum PoW (ETHW), is essentially a post-Merge continuation of the PoW Ethereum Mainnet after removing the difficulty bomb, and perhaps revoking EIP 1559.
Ethereum PoW came into the limelight and prompted widespread discussion on whether incumbent players might support post-Merge Ethereum PoS (ETH2) or Ethereum PoW. As the saga evolves, a few centralized exchanges have started offering ETHS tokens for ETH2 and ETHW tokens for Ethereum PoW.
Diving deep into the emergence of Ethereum PoW, it seems that this fork stems from Ethereum miners who are fighting back. With the shift to PoS looming, Ethereum miners risk losing lucrative profits they used to gain from mining activities. The meteoric progress of The Merge caught miners off guard, as HIVE Blockchain (HIVE) initially predicted mid-2023 when Ethereum mining becomes financially unattractive.
Besides forking Ethereum PoW, miners may choose other GPU-mineable PoW chains, including Ethereum Classic (ETC), to compensate for revenue loss.
Against this backdrop, in this report, we explain miners’ dilemma after Ethereum turns to the PoS model, revealing their intentions behind forking the Ethereum PoW. Following this, we explore whether ETC or Ethereum PoW will help to bail them out of the dilemma.
Miners’ Role and Dilemma Following The Merge
Despite its low throughput and emergence of various so-called “Ethereum killers”, Ethereum’s dominance in DeFi and NFTs is tenable thanks to its superior security. The security partly derives from its PoW model, where myriads of miners process on-chain transactions in return for transaction fees and coin rewards.
Miners run mining rigs (consisting of chips and other configurations) and connect them to Ethereum nodes, adding blocks of transactions to Ethereum while consuming significant electricity. Due to the design of mining algorithms, most miners adopt GPUs, and the ones with more substantial computing power (hashrate) are more likely to process the next block of transactions.
Miners have invested in many new mining rigs, contributing to spiraling hashrate in the past two years. With The Merge dissipating the craze, the huge investments and expected revenue loss began to bog down miners’ financials.
Loss of Revenue and Profits
Miner Revenue in ETH and US$
Percentage of Transaction Fee as of Miners’ Total Revenues
Source: Glassnode (data as of Aug. 3, 2022)
Mining has been a lucrative process in the past two years, with average daily revenue amounting to 25K ETH. Miner revenue consists of transaction fees and coin rewards. After The Merge, those processing transactions would be validators instead of miners, which in turn leads to miners losing most coin rewards and, should they choose to join the ranks of validators, only sharing transaction fees with other incumbent validators.
In addition, as on-chain activities on Ethereum wane, fee transactions as a percentage of total miner revenue continue to fall below 10%, suggesting that miners will have lost at least over 90% of pre-Merge mining revenue.
The emergence of Lido and other liquid staking providers lowers the threshold for an average user to earn validating rewards, thus putting further pressure on the already declining mining revenue. More validators mean fewer rewards for each miner.
Source: HIVE annual filings, Bybit Estimate
(Note: around 80% and 50% of HIVE’s mining revenue is from Ethereum for the year ended March 2021 and March 2022, respectively. We neglected the impact of Bitcoin mining on its profitability)
With respect to investment returns, becoming a validator post-Merge is still not as lucrative as mining. Despite the fact that Ethereum’s higher hashrate signifies increasing competition, HIVE’s ROIC still maintained a rate close to 50% as a result of skyrocketing Ether prices. As such, large miners may refuse to become validators because the validating return is not up to par.
GPUs Turn Obsolete
Source: Glassnode (data as of Aug. 3, 2022)
Valuable mining rigs will become obsolete after The Merge. From the graph above, the hashrate more than tripled in 2021, revealing a slew of mining rigs added by miners during the period. If The Merge happens in September, the added new rigs will have only served for 1-2 years. With an estimated useful life of 2-4 years, those mining rigs will become idle if miners cannot figure out how to repurpose them.
Source: 3DCenter.org
You may wonder why miners do not sell GPUs to contain the loss. This is because GPUs purchased in 2021 were at more than a 50% premium from their retail prices; however, now that the premium is almost gone, it spells a potential 35-70% realized loss.
Leverage and Cash Flow
Source: HIVE Blockchain annual filings
Following The Merge, uncertainties in income streams would complicate cash flow management. Take HIVE as an example; the mining company has spent significantly on capital expenditures and raised remarkable debt or equity financing in the past two years. The uncertainties in Ethereum mining will put pressure on the future operating cash flow, and miners may not be able to recover their earlier investments and fundraising.
More notably, most mining companies have outsized purchase commitments, e.g., $65M for HIVE, to buy additional mining rigs. Hence, miners would feel obligated to receive a return on their investments on the rigs, which adds a burden to miners after The Merge is completed.
Conclusion
Miners would have to seek alternative income sources to compensate for revenue loss, repurpose obsolete GPUs, and manage their cash flow carefully. The immediate solution suggests using GPUs to mine other existing PoW chains or the possible Ethereum PoW that went viral recently.
Finding a Safe Haven in Alternative GPU Mineable PoW Chains
Since GPUs will become obsolete in the Ethereum ecosystem following The Merge, Ethereum miners would have to repurpose them for sustainable income and cash flow. The immediate alternative is to mine other GPU-mineable PoW chains, including ETC, RVN, and ERG, among others.
Source: WhatToMine, CoinMarketCap (data as of Aug. 8, 2022)
Unfortunately, mining revenues from other GPU-mineable chains do not live up to the revenue gained from mining ETH. The above table reveals that the daily mining revenues from other GPU mineable coins are nowhere close to Ethereum. Despite taking the second spot, ETC trails far behind ETH. Notwithstanding the fact that ETC jumped 270% from its lows in June due to speculations, ETC mining revenue may still be lower if the token price normalizes.
Source: WhatToMine (data as of Aug. 3, 2022)
To further illustrate the impact of miners migrating to ETC en masse, we perform the below calculation. With one RX 480 GPU, daily ETC mining revenue is $0.61. As the ETH hashrate is 29 times that of ETC, the daily mining revenue is estimated to drop to $0.02 if all Ethereum miners migrate to ETC. We estimate a 0.15/kWh energy cost, equivalent to an everyday energy bill of $0.5. With the above numbers, miners may incur a daily loss of $0.48 per GPU. Barring an exponential jump in market capitalization, ETC would not be a haven for Ethereum miners.
Source: BitInfoCharts, DefiLlama (data as of Aug. 3, 2022)
In totality, it seems that without any radical changes, Ethereum Classic or any other GPU mineable chains will fail to provide a haven for miners to repurpose their GPUs while generating sufficient returns.
Can Ethereum PoW Turn the Situation Around?
If the mining revenue of Ethereum PoW wants to match that of pre-Merge Ethereum, ETHW token price has to be higher than ETC and, hopefully, a higher fraction of ETH.
As of the time of writing, the market capitalizations of ETH and ETC are at $207B and $5B, respectively. We will discuss the intrinsic value of ETHW in reference to that of ETH and ETC based on the following assumptions:
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The Merge will not be delayed
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ETHW will be successfully listed on centralized exchanges
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Assume the current valuation of ETH and ETC are fair, while ignoring ETC’s recent fluctuation due to speculative activities
Is Ethereum PoW Worth More Than Ethereum Classic?
Despite the underlying blockchain of Ethereum, Ethereum POW, and Ethereum Classic being the same, the value of ETH, ETHW, and ETC differ. Since Ethereum Classic separated from Ethereum in 2016, they missed the DeFi Summer and NFT developments, which contributed to the lagging developer and user activities on Ethereum Classic. Comparatively, Ethereum PoW will be a fork of the existing state of Ethereum. Hence, with web3 infrastructure and dpps built in the past few years, it seems that ETHW could potentially be more valuable than ETC should Ethereum miners jointly support this new hard fork.
In addition, should the miners band together in support of the new fork, Ethereum PoW may cannibalize on Ethereum Classic due to their similar nature — Ethereum forks without a plan of shifting to PoS. As there is no widespread consensus and cooperation among miners to build Ethereum PoW, Ethereum PoW would likely split its small community even further. As we look to the future, there may possibly be newer forks that could dilute the value of the incumbent PoW hard fork.
Ethereum PoW’s Valuation Relative to ETH2
Developer and user activities are essential to create value for a blockchain. From the perspective of DeFi and NFTs, we will explore the valuation of Ethereum PoW compared to ETH2.
DeFi
Let’s assume TVL as a gauge of a DeFi protocol’s valuation. Vitalik and other industry players pointed out that centralized players, including stablecoin and wrapped Bitcoin issuers, may be significant deciders in future Ethereum hard forks. These centralized players can’t support ETH2 and Ethereum PoW simultaneously due to the limitation of underlying collateralized assets.
Tether CTO, Circle, Justin Drake, a researcher at the Ethereum Foundation, and Chainlink, the dominant oracle on Ethereum, are currently in support of ETH2 only. On the other hand, Justin Sun, Poloniex, Huobi, MEXC, and Gate.io pledged their support for Ethereum PoW. However, the support of these Ethereum PoW backers is not exclusive, and they are also almost without a doubt in support of ETH2 as well. We may see more DeFi protocols voice out their support on either Ethereum PoW or ETH2 soon, but there have yet to be any industry players exclusively in support of Ethereum PoW apart from miners.
Some analysts suggest that centralized stablecoin issuers will likely back ETH2 only, while major crypto exchanges may list both ETHW and ETH2. With this assumption, we assess how much value Ethereum PoW can keep should USDC, USDT, and WBTC be drained from the liquidity pools.
Loss of TVL for Ethereum PoW after The Merge (In US$ Billion)
Source: DefiLlama (data as of Aug. 4, 2022)
First, most of Lido TVL will likely evaporate (following a secondary merge planned six-to-12 months after The Merge to unlock the staked ETH) since its existence was solely for The Merge. Following this, should issuers turn their backs on the new hard fork, centralized stablecoin USDC and USDT will cease to have value on the potential PoW chain as the underlying fiat collateral cannot be duplicated. The same applies to WBTC, which would be worthless on Ethereum PoW should issuers give their full support to ETH2. Following which, DAI will lose value due to linkage to the above assets. Following the above hypotheses, we reckon that ETHW may at most keep 10% of TVL after The Merge.
Trading Volume Breakdown
Source: Token Terminal (data as of Aug. 4, 2022)
If centralized stablecoins do not support Ethereum PoW, the trading volume of decentralized exchanges (DEXs) on the new hard fork will plunge. As shown above, at least 84% of Uniswap trading pairs and at least 83% of Curve trading pairs involve USDC, USDT, WBTC, or stETH.
The above analyses reveal that conservatively at least 90% of DeFi liquidity might dry up on Ethereum PoW. If most DeFi protocols decide to only support ETH2, the DeFi TVL on the new hard fork will become negligible. On the other hand, decentralized stablecoins, such as USDD backed by Justin Sun, can replace centralized stablecoins and bootstrap the liquidity on Ethereum PoW. In short, when it comes to DeFi, the valuation of Ethereum PoW will be only a tiny fraction of ETH2.
NFT
The future for NFTs following The Merge is a complex issue, and it would be difficult to gauge the valuation of Ethereum PoW in terms of NFTs. All NFTs will be copied once on Ethereum PoW. Since there is no agreement on which fork is the official chain, should one seller sell their NFTs on ETH2 but not on Ethereum PoW, the owner of the same NFT would be different on the two chains. As such, some industry players favor forkless blockchain for NFTs like Algorand. This issue poses a big challenge for PFP projects, whereas, for game NFTs and metaverse NFTs, the circulation of NFTs is muted once project owners halt their operation on the new fork.
However, from our expert viewpoint, Ethereum PoW may hardly retain the NFT community after The Merge. In the community’s best interests, NFT projects will probably favor ETH2 due to its plans to boost throughput with sharding and, in return, reduce the gas fee.
Other Considerations and Summary
From the above discussion, it would be fair to claim its valuation of ETHW may be only at a minuscule fraction of ETHS if The Merge proceeds smoothly and the majority of communities support ETH2.
In the past few years, Vitalik and Ethereum Foundation have steered future roadmaps on behalf of the community. In our view, a significant portion of the valuation of ETH is attributed to the leadership of the Ethereum Foundation. Ethereum PoW is unable to catch this part of the value.
However, it is important to note that for simplification, we omitted the cannibalization effect in the above analysis. With the assumption that the value of Ethereum is a constant, the part allocated to Ethereum PoW indicates a loss for ETH2. In case The Merge brings about many chaotic changes, Ethereum PoW may siphon away more value from ETH2.
We tend to believe Ethereum PoW will be valued more than ETC with more miners’ support, but it is probably just a minuscule fraction of the current ETH market capitalization. With this, Ethereum miners could not compensate for their revenue loss and sustain the existing scale of operations. We have not observed a collective will within the miner community to migrate to Ethereum PoW, dampening its competitiveness against ETC, let alone ETH2.
Final Thoughts and Alternatives for Miners
As we analyze above, the mining revenues from Ethereum Classic or Ethereum PoW pale in comparison to pre-Merge Ethereum. Miners will need to seek out alternative ways to bail themselves out of the trilemma of shrinking revenue, obsolete GPUs, and untenable cash flow.
A few large Ethereum miners may be less affected as they mine both Bitcoin and Ethereum. And some of them have indicated their intention to shift part of GPUs operation to data center business, such as HIVE’s long-term HPC computing strategy.
Smaller Ethereum miners own fewer resources needed to make a shift to data center business, and may instead look for opportunities within web3 space. Platforms such as Render Network, Livepeer Network, and Akash Network allow users to contribute their computing power. For example, allowing users to run a Livepeer Network transcoder node with a reward of 11.4% at the time of writing.
ZK Rollups may pose another opportunity in the future as the evolving roll-up technology demands significant computation power. Scroll recently launched its ZK EVM, which features a Layer 2 mining mechanism. Despite all this, we would have to watch closely to see what choices the miners would take in the coming months and how they plan to solve the question of how to seek alternative income sources with their obsolete GPUs.
Source: Bybit Blog
