In recent months, the price of Bitcoin and Ether have been moving with the stock markets. And not in the direction we would like. Bitcoin and Ether are seen as risky in turbulent times - let alone other altcoins. But there's something to be said for the fact that this is going to change. Will they be viewed more as risk-off assets? And could Ethereum even become the 'bond of the internet'? We list the arguments for and against this slightly daring proposition.
Every Layer 1 blockchain, of which Ethereum is one of the most important, has characteristics of a country's economy. The chain has its own rules and its own (monetary) policies. To do anything on it, you need the local currency (for example ETH).
Add to that another similarity. Ethereum rewards people who lock up capital (ETH) by staking with yields: in effect, interest. This is suspiciously similar to the mechanism of government bonds. Can Ethereum staking in the future take on that role of safe haven that government bonds have now?
The comparison between government bonds and Ethereum staking
The comparison between Ethereum staking and government bonds is not as far-fetched as you might think. And just as you can lend money to a government in exchange for interest - a government bond - so you can soon lock away ETH and get interest. That is: after the merge, when Ethereum switches from proof-of-work to proof-of-stake. The validators who put ETH away then help keep the network safe and get a reward for doing so.
Like traditional bonds, staking at its core involves an agreement between the bond issuer (the state or, in Ethereum, the protocol) and the bondholder (or, in Ethereum, the validator).
A small difference is that with ETH staking, the payout is daily. With government bonds, that time frame is monthly or quarterly. The return on government bonds depends on the maturity. If the duration is ten years, the interest rate is higher than in the case of two years. With Ethereum, the expected interest rate is about 6%. This is a conservative estimate: it could well turn out to be higher.
What backs ETH staking rewards?
Back to basics for a moment. Why do people lend money to countries? Let's start with the most creditworthy nation: the United States. People lend that country money because they have confidence that the government will continue to meet its payment obligations: the periodic interest payments. The U.S. has the largest and most robust economy in the world, so it has a lot of power to tax its citizens. That's what backs U.S. government bonds.
Just as a country has certain industries, Ethereum's main industries right now are Decentralized Finance (DeFi) and NFT's. But the economic activity of Ethereum (and other chains) will increasingly integrate with the 'real world'. Think smart contracts for buying houses, intellectual property, insurance, salary payments. Gas fees rise with the growth of the network. So an 'Ethereum bond' will be safe as long as there remains demand for the network, more precisely for block space. That is likely to be a huge market in the future. Who wouldn't want to invest in that and draw interest from it?
There are analysts who believe that traditional investors will never venture into Ethereum staking as an alternative to or complement to their bond portfolio. We see four 'bears on the road' - but some are not as dangerous as you might think at first glance.
Risk 1: Smart contract risk
One train of thought might be: we can't expose ourselves to smart contract risk. That's the risk of software failure due to internal vulnerabilities or external threats like hacks. It is true, of course, that traditional investors are not familiar with this type of risk. So will they not want to take it? Maybe so, but maybe not. In the bond market, it happens often enough that less creditworthy countries are late with a payment. But a hiccup does not mean end of business.
Risk 2: Ethereum dominance
Another risk is whether Ethereum will remain the leading smart contract blockchain. It is not inconceivable that Ethereum could one day be surpassed by other Layer 1s. But even for this scenario, a counterpart can be found in the bond market. It has happened many times in history that countries are overthrown by a war or revolution and the old bonds are thrown in the trash by the new regime. So even in traditional economics, there is no such thing as an investment totally without risk. That risk just has to be compensated for by higher staking rewards. And investors can of course diversify their staking portfolio across other protocols, not just Ethereum.
What the above two risks show is that Ethereum may not gain the reputation among investors of the United States bond market but of a slightly less creditworthy country.
Risk 3: Currency risk
Another risk is price volatility: the price of Ethereum is not fixed. But this is a well-known risk for traditional investors that they can hedge even in today's economy. It is currency risk and financial instruments exist to cover it.
Risk 4: Regulation
Finally, an important risk is regulation. Isn't an agency like the U.S. SEC someday going to designate smart contract blockchains as unregistered securities? If this continues to loom over the market, traditional investors will not jump in.
As mentioned, the whole hypothesis of staking Ether as a future bond of the Internet depends first of all on the success of the merge. Will everything work well after the merge and will Ethereum remain dominant? Either way, it will probably take some time before traditional investors flock in large numbers. But they will have to consider it. According to Fidelity, 70% of institutional investors plan to buy crypto in the near future. They are just looking for a good reason to make the jump. Simply for lack of alternatives: bonds do not yield enough anymore.
To return to the beginning of this article. Through staking, Ether could transition from a risky to a relatively risk-free investment. We could tell a similar story for Bitcoin as a replacement for gold in portfolios. That's worth a separate article.
Now, if you were to tell this to your uncle who has been in finance for thirty years, he might laugh at you. But the fundamental similarities between bonds and staking simply point in that direction.
IF it happens, it would have implications for the correlation between crypto and stocks. The fact that they now move up and down together to a high degree: that could well change.