July 8, 2022
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today we’re covering ethereum’s latest testnet merge activation, a proposal for aave to launch its own decentralized stablecoin, and reddit integrating with polygon to offer custodial nfts to its users.

also, on this week’s episode of the galaxy brains podcast, we discussed a tornado cash governance proposal to diversify the protocol's dao treasury, new creative licensing rights around clonex nfts made by digital fashion brand RTFKT, and the use of social engineering by hackers from north korea’s lazarus group to steal $540m from axie infinity’s ronin bridge last year. in addition, our friend and former colleague karim helmy joined us on the podcast to discuss developments in bitcoin mining.

have a great weekend,
Market Update
The total implied network value (market cap) of the digital assets market stands at $967bn, up 10.5% from last week (when it stood at $875bn). Bitcoin’s network value is 3.65% of gold’s market cap. Over the last 7 days, BTC is up 12.67%, ETH is up 17.33%, and SOL is up 17.47%. Bitcoin dominance is 43.65%, up slightly from last week.
Data current as of 9:45 PM ET on July 7, 2022. Prices and data via Messari.
Three Big Stories
🐼 Ethereum Merge Upgrade Activates on Sepolia Testnet
On Wednesday, a major Ethereum testnet known as Sepolia underwent the Merge upgrade. As background, the Merge is a long-awaited upgrade on Ethereum designed to replace Ethereum’s core consensus protocol from proof-of-work (PoW) to proof-of-stake (PoS). Given the complexities around activating this upgrade, developers have tested the Merge on several developer networks (devnets) and have recently started to test the upgrade on major testnets. Sepolia is the second major testnet to run through the Merge upgrade after the Ropsten testnet, which took place in early June. The third and final testnet to undergo the Merge before mainnet Ethereum will be the Goerli testnet, which is the testnet out of the three with the most organic user and decentralized application (dapp) activity, and thus is the testing environment with the most similarity to Ethereum mainnet.

The activation of the Merge on Sepolia yielded mixed results. 25% to 30% of validators securing the network were reported to have dropped offline post-Merge due to incorrect software configurations. Specifically, several node operators running Sepolia validators failed to properly configure the total terminal difficulty (TTD) threshold. As background, TTD refers to the total cumulative mining difficulty of the network. The Merge is designed to activate at a specific TTD value as opposed to a block height. Due to the unpredictability of mining difficulty, especially on Ethereum testnets like Ropsten and Sepolia, node operators are required to manually override the original TTD value during the Merge activation process. Failure to do so can result in nodes dropping off and potentially stalling network consensus post-Merge. We described the TTD mechanism in our report last week on execution risks associated with the Merge upgrade.

Most node operators have since fixed their configuration issues related to TTD. The validator participation rate on Sepolia as of Thursday, June 7th has climbed to 94%. The 6% of validators that remain offline, according to one Ethereum developer, is due to lost private keys preventing those validators from upgrading. Having successfully transitioned to a fully PoS consensus protocol, the Sepolia testnet will now be monitored by core developers and undergo a series of exercises including client sync tests to further evaluate the robustness of the network post-Merge. For a detailed step-by-step description of the Merge activation process and related execution risks, read this Galaxy Digital Research report.
OUR TAKE: One of the main learnings from the Merge activation on Ropsten back in early June was the unpredictability of Merge timing due to the TTD threshold. To help mitigate this issue, developers introduced an additional step to the Merge activation process with the TTD override mechanism. With the Merge activation on Sepolia, one of the main takeaways has been the difficulties around ensuring correct client configurations by node operators to handle the TTD. As a result, developers are now focusing on increasing awareness and improving existing guides to help node operators avoid common pitfalls when configuring their machines for the Merge upgrade.
Unlike prior hard forks, the Merge requires most node operators to run two pieces of software known as the execution layer (EL) client and the consensus layer (CL) client. There are four independent client types being built for both the EL and the CL of Ethereum. Up until the Ropsten Merge activation, Ethereum core developers had been working out minor bugs with certain EL/CL client pair combinations. Luckily, no bugs in client pair combinations have been identified so far from Wednesday’s testnet Merge activation.
Instead, there were errors made by node operators following along with the upgrade, which has since been identified to be related to TTD configurations. Node operators can also make several other errors in the Merge configuration process. Node operators running validators must pay careful attention to how they set their fee recipients for earning priority fees post-Merge and how they authenticate the dedicated API, known as the Engine API, for communication between their EL and CL software clients.
Given these potential stumbling blocks, a Merge readiness checklist has recently been created to support node operators in their preparations for the upgrade. In addition, Ethereum Foundation developer Parithosh Jayanthi has floated the idea of building an independent script to automatically check if a node is correctly configured for the Merge. Node operators’ last opportunity to practice running through the Merge activation from start to finish will be the Goerli testnet. Considering learnings from Ropsten and Sepolia, it is clear that the key to a successful Merge activation is not only the absence of bugs and major errors in code but also the ability for node operators to correctly deploy the code. -CK
👻 DeFi’s Second Largest Protocol to Launch its Own Stablecoin
There is a new governance proposal to launch a platform-native stablecoin on Aave. Aave Companies put forward an Aave Request for Comments (ARC) proposing a “native, decentralized, collateral-backed stablecoin” called GHO. If accepted, GHO will be Aave’s first native stablecoin. GHO would leverage Aave’s existing safety and risk parameters used across the lend/borrow protocol. To maintain its peg, GHO would rely on over-collateralization and arbitrageurs to step in when the stablecoin’s price deviates from $1. Interest paid on GHO borrowings would be deposited into Aave’s DAO to “innovate, support contributors in the ecosystem, bolster the treasury during market downturns or anything else the DAO decides.” 

To incentivize adoption of GHO, stakers of AAVE tokens in the Safety Module would be permitted to borrow GHO at a discounted rate through the Discount Strategy Mechanism. This not only incentivizes current AAVE stakers to mint new GHO, but it also helps attract a deeper pool of AAVE tokens that can be used to keep the protocol solvent in case of a Shortfall Event—or an event where the protocol accumulates bad debt.

The proposal also introduces the concept of Facilitators, a role that third-party protocols or entities can apply for to integrate GHO and expand its presence. Acceptance of facilitators would be dictated by Aave governance which also sets the risk parameters around how much GHO each Facilitator can mint. Examples of Facilitators suggested in the proposal include real-world assets, delta neutral positions, or even credit scores for uncollateralized lending.

In the coming weeks, Aave will hold a governance vote among holders to decide whether to proceed with the rollout of GHO. If accepted, GHO would be initially rolled out on Aave v2 on Ethereum before being integrated into Aave v3 markets. 
OUR TAKE: Aave is entering in an increasingly crowded and competitive market of stablecoin providers. Among the major DeFi applications, Maker has been the only one to launch its own stablecoin, and GHO borrows heavily from Maker’s stability mechanisms and growth initiatives (Aave’s eMode shares resemblance with Maker’s Peg Stability Module and Facilitators has similarities to the DAI Direct Deposit Module that integrates with other borrow/lend protocols to allow direct minting of DAI).
The motivations for launching a decentralized stablecoin are both offensive and defensive for Aave. From an offensive perspective, GHO drives additional revenue streams to the protocol and expands Aave’s footprint on other platforms. Defensively, Aave would be building a moat around its application by leveraging its reputation as a battle-tested DeFi lender. With this proposal, Aave has the potential to recapture its title as the largest DeFi protocol by TVL.
GHO complements Aave’s core offerings, including several new v3 features like an Efficiency Mode (eMode) that improves collateral efficiency, especially when used with stablecoins; an Isolation Mode enabling Aave to accept riskier collateral types without endangering the rest of the protocol; and Portals which enables users to migrate liquidity across blockchains without the need for bridging. Aave has unique advantages over Maker because it exists on multiple platforms already whereas Maker’s presence is primarily on Ethereum. Additionally, Aave was built as a generalized borrow/lend protocol unlike Maker which only permits borrowing in DAI. This would allow GHO to be used in a wider range of risk-management applications and would likely make GHO less cyclical than DAI whose demand is largely dictated by the demand for leverage.
The offering could be attractive for current Aave users, who can stake their Aave to earn discounted borrowing rates. However, in its proposed form it does not present any novel features to borrowers that newer borrow/lend protocols are offering, such as Liquity’s zero interest borrow offering or Alchemix’s self-repaying loans. Given Aave has a clean slate to build the reserve profile of its decentralized stablecoin, we would have liked to see the proposal explicitly address the common criticism facing MakerDAO’s DAI stablecoin regarding the centralization and censorship risks of relying on USDC, a centralized fiat stablecoin, for significant portions of its collateral. Still, Aave’s plans for GHO have the potential to accelerate the integration and acceptance of decentralized, over-collateralized stablecoins. -LT
🤖 Reddit Partners with Polygon to Launch a “Collectible Avatar” NFT Store
Reddit joins the ranks of prominent social media companies integrating NFT-focused features. This trend started last year when Twitter debuted NFT profile pictures and heated up in recent months with Meta planning to integrate NFTs into Facebook and Instagram. Interestingly, Reddit stopped short of calling these collectible avatars “NFTs” in their official announcement. Instead, the company is positioning this feature as a natural evolution of its custom avatar builder originally launched 2 years ago. The key differentiator with this new feature is that creators can leverage the key value propositions offered by NFT assets. Specifically, artists who commission limited-edition avatars in partnership with Reddit will be compensated for each avatar sold and will earn royalties on each avatar sold on secondary markets. The user experience will be custodial in nature, with the avatars living inside Reddit’s own blockchain wallet (accessible only inside of Reddit as of the time of this writing). Users can only purchase these custom avatars using fiat currencies, and there is currently no known methodology to take these NFTs “on-chain” to use in other applications or effect self-custody.

Polygon was tapped by Reddit for this endeavor due to their “low transaction fees” and “sustainability commitments” (according to Reddit’s official announcement post). So far, 90 designs have been produced with 50-100 editions available for each design. Reddit plans to make tens of thousands of these collectible avatars available to purchase via Reddit’s avatar builder page for prices ranging from $9.99 to $99.99.
Collectible avatar designs for Reddit's NFT marketplace.
Source: Reddit
For each NFT sold through its avatar marketplace, Reddit keeps 5% of the sale and gives the remaining 95% to the artist. The artist also receives a royalty from each secondary sale, similar to how many other profile picture NFTs operate today. Users who purchase these avatar NFTs will have a license to utilize their avatar NFT outside of Reddit, but this license is very limited in nature (even when compared to the limited licenses that govern marquee NFT collections such as BAYC).
OUR TAKE: Reddit is charting a unique path for its NFT strategy compared to the likes of Twitter and Meta. This starts with their wallet experience which will only be accessible through Reddit’s own application and will only support Reddit-approved avatar NFTs. From the start, it appears this wallet will be custodial in nature. This also means that Reddit’s Avatar NFTs will not be compatible with decentralized marketplaces like OpenSea. Although Reddit has tapped Polygon to power the blockchain side of its avatar NFTs, Reddit’s user experience effectively makes this a permissioned, custodial avatar NFT experience for its users. At the same time, given that the underlying stack is Polygon, there is room for Reddit to potentially expand this experience to be compatible with Polygon-enabled, permissionless NFT protocols in the future.
The artistic direction of the NFTs themselves look very different from popular collections that dominate the PFP space todays. Whereas most popular PFP collections, such as CryptoPunks and Bored Apes, have simplistic backgrounds and consistent base characters with varying traits, Reddit instead has 90 very different designs with varying levels of background and foreground detail. The levels of details seen in some of the sample NFTs shown don’t appear to be particularly well-suited to an avatar use-case given that avatars are typically the smallest image shown on a user’s Reddit page. Regardless, Reddit has committed to its unique artistic vision, and this artistic vision departs substantially from prevailing successful NFT collections today. For that reason, we have some skepticism about the social signaling value for these avatar NFTs from a cultural standpoint. We are curious to see how the market responds once these are available to purchase and if the Reddit community shares our sentiment.
Polygon itself was an interesting choice for underlying blockchain given the lack of popularity of Polygon NFTs in comparison to other alternative (relative to Ethereum), “environmentally friendly” Proof of Stake blockchains such as Solana. This choice speaks to Polygon’s business development acumen in forging strategic alliances with established web2 brands. However, the downside to choosing a blockchain like Polygon is that these NFTs have a low ceiling for liquidity and composability with other permissionless protocols should Reddit open up their wallet to developers in the future.
Clearly, Reddit is seeking to distance itself from the common pain points that have plagued the NFT space over the last year. By doubling down on a custodial, sandboxed vision, by way of Polygon, Reddit is ensuring that its users don’t have to deal with 3rd party wallets, transaction signing, phishing attack vectors, and on-ramping into a cryptocurrency for purchasing the NFTs. This approach ensures that Reddit can maintain a simplified NFT user experience while preserving the option to unlock more crypto-native, permissionless features down-the-line should they choose to do so. It will be interesting to watch this integration unfold over time. -SQ
Other News
  • Polygon partners with phone maker Nothing to bring Web3 tech to mobile users
  • The US Treasury releases a framework for international engagement around crypto as directed by President Biden’s executive order
  • Web3 running app StepN announces the launch of their third in-game realm on Ethereum.
  • Boris Johnson resigns as U.K. Prime Minister raising questions around the future direction of crypto policy and regulation in the country
  • Blockstream co-founder, author of BIP 32 (HD Wallets), BIPs 141 and 144 (Segregated Witness), and BIPs 340, 341, and 342 (Taproot/Schnoor), Bitcoin core maintainer Pieter Wuille steps down as maintainer of the Bitcoin core repository to focus on other bitcoin projects
  • MKR token holders approve a proposal to onboard off-chain loans issued by U.S.-based Huntington Valley Bank as collateral
  • Mining hardware manufacturer Bitmain releases a new ASIC machine for mining ETH.
  • Flow blockchain enables permissionless smart contract deployments
  • Crypto lender Nexo reportedly interested in acquiring competitor Vauld, which halted withdrawals
  • Yuga Labs performs tech demo of its Otherside metaverse
  • Three Arrows Capital files for Chapter 15 bankruptcy protection in New York
  • Voyager Digital files for Chapter 11 bankruptcy protection 
From the Desk
Access our research on the Bloomberg Terminal with ERH GXY <GO>
or visit www.gdr.report
Overview of Ethereum's Merge Upgrade and Associated Risks
Christine Kim and Arunabh Sarkar break down the Merge activation process and shine a light on the upgrade's execution risks.

Galaxy Digital Research Podcast
Listen to our podcast on Apple, Spotify, Amazon, or wherever you listen to podcasts.

In this week's episode, we are joined by former Galaxy Digital Research colleague Karim Helmy to discuss developments in bitcoin mining. We also discuss a tornado cash governance proposal, new creative licensing rights around CloneX NFTs, and the use of social engineering by hackers from North Lorea’s Lazarus group.
Charts of the Week
For the first time ever, Tether (USDT) dominance has declined to under 50% of the stablecoin market with most of the share gains going to USDC, which now controls over 30% of the market. 
The total amount of ETH staked on Ethereum’s proof-of-stake (PoS) blockchain, the Beacon Chain, exceeded 13mn on Wednesday, July 6, the same day of Ethereum’s Merge activation on the Sepolia testnet. Close to 11% of total ETH supply is now locked in the Beacon Chain. 
Thank you!
Thanks for reading this week. Have a great weekend.

Please feel free to contact us at research@galaxydigital.io with any questions or comments.
Alex Thorn
Head of Firmwide Research, Galaxy Digital
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