Ethereum (ETH) Merge Could Impact Blockchain-Based Stablecoins, DeFi Applications: Report

The crypto market and its stakeholders worry that an upcoming Ethereum (ETH) merge could adversely impact the blockchain-based stablecoins and DeFi applications

Global DeFi app store DappRadar and other stakeholders have expressed concern over Ethereum’s imminent “merge” as it could adversely impact or destablise several decentralised applications on the ETH blockchain network during the upgradation process.

In a report titled ‘DeFi’s Stablecoins Battle Fallout’ on August 27, DappRadar highlighted that it is one of the most anticipated events in the crypto industry as it could potentially destablise the stablecoins.

Expressing similar views, crypto investment firm Grayscale has tweeted that the ETH merge could impact the native tokens on the Ethereum blockchain.

Ethereum is currently the predominant blockchain network on which DeFi protocols and other applications function. It is one of the reasons why the ‘merge’ has been viewed with a pinch of salt.

Grayscale data shows that blockchain-based stablecoins like Tether (USDT) make up 28 per cent of Ethereum’s total market cap. Also, according to crypto market data provider Coinmetrics, the value locked in various Ethereum-based DeFi smart contracts is about $40 billion. 

Grayscale tweeted that “Already, issuers like Tether and CirclePay have stated that post-fork, only the tokens on the PoS (proof of stake) network will be redeemable.” 

Therefore, Grayscale said, if the PoS-based Ethereum fork goes “live with a parallel DeFi ecosystem, collateralized with unredeemable stablecoins, users and smart contracts may attempt to liquidate positions on the new chain, contributing to sell pressure on the new token.”

Pedro Herrera, data analyst at DappRadar, said in an interview with CoinDesk, “If the Merge fails to successfully be launched, we will have delays on DeFi protocols that will affect stablecoins. But from the supply dynamics perspective, this can also take a toll on how stablecoins will be used for liquidity pools, in the DeFi space and beyond.”

According to Shailendra Singh Rao, MD and founder of Creduce, a sustainable blockchain company, "It is a common fear that Ethereum Merge could affect the stability of stablecoins simply because of the majority of DeFi applications. However, the developers have made provisions and apportioned actions to prevent any damage."

Relation Between Stablecoins And DeFi

According to DappRadar, “Stablecoins are central to the functioning of DeFi, as they are often used in DeFi arrangements to facilitate trading or as collateral for lending and borrowing.” 

Stablecoins, it said, are one asset in a pair of digital assets and are often used in automated market maker (AMM) arrangements. “The AMM is designed to create liquidity for others seeking to effectuate trades,” said DappRadar.

Citing another example, DappRadar said, “Stablecoins are frequently ‘locked’ in DeFi arrangements to garner yield from interest payments paid by others borrowing those stablecoins from the arrangement for leveraged trading or other activities.”

"Considering the fact this merger will affect only the base layer there is a high chance that the network will not be affected. Most studies are opening all that may happen with the transition to proof-of-stake is the decrease in stable coin values and contract lending protocols. This only adds to the woes of the already beleaguered future of stablecoins for the DeFi sector," added Rao.

Impact of Ethereum Merge 

The crypto market and its stakeholders worry that the imminent Ethereum (ETH) merge might adversely impact the stablecoins and DeFi applications on its network.

Nonetheless, Circle’s USDC, the largest dollar-backed stablecoin on the Ethereum blockchain and whose audited reserves have been held at BlackRock, a US-based financial institution, said it will support the upcoming event. Tether (USDT), another stablecoin provider, has also assured its support. 

On the other hand, MakerDAO (MKR), the builder of the stablecoin DAI, expressed concern on Twitter stressing that the “merge could lead to perpetual contract backwardation and negative funding” and “potentially trigger selling pressure across various chains” on ETH proof-of-work version. MKR believes the possibility of assets becoming worthless on staked Ethereum assets could not be ruled out.

“Staked Ethereum is likely to become worthless on any PoW Ethereum fork. This is because further chain upgrades would be required to unlock staked ETH from the deposit contract, and there is arguably little economic incentive for the fork chain to accommodate this,” said MKR on Twitter. 

Responding to MKR’s comments, DappRadar added that the lending protocol risks could get higher due to the increase in “ETH deposit rates and liquidity due to the merger fork.”

“There’s also the potential of network downtime because not all Ethereum-based protocols would move to proof of stake with the Ethereum chain. Maker noted that this could affect users and transactions alike. Similarly, a replay attack on DAI-fork or MKR-fork was not left out of the options,” DappRadar said in the report.

According to Grayscale, the merger might produce unexpected, unfavourable outcomes. Grayscale also expressed concern that the event could trigger a panic sale.

Also, “the Merge might create a scenario where stablecoins and tokens locked in smart contracts might not be redeemable,” said the DappRadar report. 

In concluding remarks, DappRadar noted that the concerns of Grayscale and MakerDAO are genuine; however, “Ethereum developers have likely taken them into account. The ‘Merge’ will presumably transfer proof of work Ethereum data and serve as a handoff. A parallel chain would inevitably result in duplication. However, the strategy and measures for addressing such concerns remain.”

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