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Complete Guide to Ethereum Shapella Upgrade and Beyond

Updated: Apr 22

On 12th April 2023, 15% of Ethereum’s market supply, worth roughly $33bil, that was locked up as a part of Ethereum’s transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS), will become liquid and withdrawable in the year’s most important market-moving event: Ethereum’s Shapella upgrade.


What are its impact on Ether the asset and Ethereum the network you ask? Read on to find out more. Subscribe to my newsletter for more weekly content on crypto adoption trends and stats.


How We Got Here (2020 Nov -2023 Apr)

In recent years, Ethereum has undergone multiple network upgrades, shifting from energy-intensive mining (PoW) to a more secure network that relies on ETH itself (PoS). The process of participating in consensus on the Ethereum network is now referred to as "staking," which involves locking up ETH voluntarily to have the ability to participate in the network. Those who adhere to the rules will receive rewards, while those who attempt to cheat will have their stakes slashed.


Since the launch of deposit contract in Nov 2020, brave souls on Ethereum network have chosen to lock up their funds in order to activate "validators," which are accounts that have the privilege to formally attest to and propose blocks in accordance with network rules. If you want to learn more about how Ethereum blocks are built by its execution layer’s block builders and finalized by its consensus layer’s validators you can read the Crypto Infrastructure Highway section of my previous article here. It’s a 30s adventure.


Staked Amount + Rewards

As of 2nd April 2023, there are 18.1mil ETH staked, amounting to roughly 15% of total ETH supply, through 565k validators. At a price of $1820 per ETH, the staked ETH equates roughly to $33bil in value. You can think of this as the deposit amount backing economic activities on Ethereum but unlike bank deposits, rewards for staked ETH are directly proportional to the economic activities executed on the Ethereum and distributed automatically. The current annualized yield for ETH stakers according to the official Ethereum website is 4.7%



If you believe the future of social, gaming, finance and commerce will be more digital with transactions between people and businesses moving onto a credibly neutral and seizure-proof network, then that 4.7% number will become highly relevant to you as more economic activities expands on Ethereum, the busiest and most developed blockchain highway of the future. There are a number of factors influencing that number such as fee burn, MEV and issuance. Subscribe to my newsletter for future articles breaking it all down for you.


Shapella = Shanghai + Capella

The Ethereum network will undergo two simultaneous upgrades to enable ETH reward withdrawals and validator exits. The Shanghai update will take place on the execution layer and Capella upgrade will take place on the consensus layer. Once the upgrade goes live users can:


  • Stake their ETH

  • Earn ETH rewards that will be distributed automatically

  • Un-stake their ETH to regain full access to their entire balance


What does this unlock mean for Ether the asset?

The fact that 15% of the Ether supply or $33bil in value will become available to be sold could put a lot of sell pressure on the Ether the asset in the short term.


Using the latest data from Kaiko, ETH has a market depth of 64k ETH within 2% of the market mid price.


Assuming a price of $1800 per ETH, this roughly equates to $110mil. A potential $33bil additional sell pressure could prove problematic for the market to digest. Of course, not all of the staked ETH is likely to be sold.


How much of the staked ETH is likely to be withdrawn and sold?



According to onchain data, approx. 28% of the total staked ETH is currently in profit. Assuming these stakers all plan to sell, that means roughly 5.04mil ETH or $9.24bil in sell pressure, assuming $1800 per ETH. For the sake of argument, let’s assume those with a cost basis of $2200 or lower will sell to get liquidity. That means an additional 1.8mil ETH or $3.3bil sell pressure. Add on top an assumption that 10% of all remaining stakers will prefer instant liquidity to holding their positions underwater, we get another 1.1mil ETH sell pressure. So adding everything up, in total we get 7.94mil ETH, or $14.3bil assuming an ETH price of $1800, as a possible upper bound number for immediate sell pressure. Of course I do not actually expect all validators in this category to exit but this number serves as an upper bound estimate of aggressive assumptions.


Although $14.3bil certainly is a very large number for market to digest, there are a few mitigating factors in place preventing a single large dump crashing the market.

  1. the number of validators entering the exit queue every 32 Ethereum blocks to fully unstake and withdraw their stakes is limited by the churn limit. The churn limit is calculated as the full number of validators / the churn limit quotient (65,536), rounded down to the nearest whole number. Currently only 8 validators can exit every epoch (565000/65536 = 8.6) Coinbase expects the Ethereum network to take weeks if not months to process unstaking request following the upgrade.

  2. once validators have gone through the exit queue, they will need to wait a withdrawal period which is either 27hrs for unslashed stakers or 36days for slashed validators.

  3. for those staked through Liquid Staking Derivatives (LSD) such as Lido’s stETH, if they wanted to sell, they already would have.

This likely means that the actual sell pressure is going to be lower than $14.3bil.


There have been many threads on the factors impacting the exact exit and withdrawal time periods. To avoid unnecessary regurgitation, you can read this excellent thread on the topic here.


What does Shapella mean for the future of Ethereum?

With illiquidity risk of staked ETH removed following the Shapella upgrade, I expect three trends to follow:


1) ETH staking rate to increase as binary upgrade risk is removed

Comparing the current staking rate of Ethereum to that of top 10 PoS chains, Ethereum’s 15% staking rate is uncommonly low.

Of course, this is not surprising given staked ETH cannot be withdrawn unlike other PoS network currently. However, once this risk is removed, I expect Ethereum staking participation rate to converge to industry average of 50%+ or exceed that given Ethereum’s dominance in revenue generation, earnings and economic value captured. You can refer to my daily post here for details.


2) LSD market to grow as more ETH look for a way to earn a yield while keeping liquidity

A central part of Ethereum’s network security going forward is liquid staking. Liquid Staking was invented in 2021 to unlock the liquidity of the staked ETH. Liquid Staking providers take in users’ ETH to stake on their behalf while simultaneously issue a receipt token which stakers can use in DeFi (decentralized finance) to earn additional yield on top of the base ETH staking yield that accrues to stakers.


As more ETH looks to be staked, the path of least resistance is to stake with one of the LSD providers such as Lido, Rocket Pool and Frax. I expect the total value of staked ETH commanded by these projects to grow.


Collectively LSD providers command $14.5bil worth of staked ETH right now. Given Ethereum’s future road map and current $220bil market cap, I expect the total market size of LSD to grow to hundreds of billions in the medium term.


3) LSD market to decentralize as Ethereum's credible neutrality and censorship resistance come under thread from market concentration in Lido

As you can see from the onchain data table above, the LSD market share is highly concentrated in the hands of Lido. With 5.5mil staked ETH, Lido commands close to 30% of the total staked ETH and more than 74% of all LSD ETH. Since the majority of the staking power is currently concentrated in Lido, a centralized attack on the Ethereum network would be possible if Lido’s network control exceeded 33%, Ethereum Foundation researcher Danny Ryan cautioned in a recent essay.


Increasing node operator numbers by either making running a node easier or by leveraging the new staking primitive called Distributed Validator Technology will become more important and urgent than ever to ensure Ethereum network’s censorship resistant nature.


Post Shapella and Beyond

According to Vitalik’s tweet, with the Shapella upgrade, Ethereum will finally complete its Merge upgrade phase and transition to focus on upgrading its scalability in the next phase called the Surge. The first part of a series of upgrades, named Cancun, is expected for early next year.



Summary:

Ethereum has seen its staking participation rate steadily climbing since the launch of staking contract in 2020 Nov. Brave souls had deposited their ETH without knowing when they would be able to get their them back. With the upcoming Shapella upgrade, a total of 18mil ETH or $33bil will be unlocked. While the market depth is ill-equipped to absorb all of this additional supply, more and more ETH are likely to find home at one of Liquid Staking providers once network stabilizes following the upgrade. I expect LSD market to scale proportionally with Ethereum’s market cap. Decentralization and by extension new staking primitives such as Distributed Staking Technology should become urgently important to keeping Ethereum censorship resistant.


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Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.

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