Let's see how the update will affect the market demand and supply for ETH and whether it will (or will not) benefit the DeFi ecosystem.

What is the Shanghai Update?

In September 2022, Ethereum completed its switch to a Proof of Stake (PoS) consensus mechanism. As a result of this move, users who want to become network validators can now stake 32ETH rather than solve computational puzzles using mining equipment like in the Proof of Work blockchain.

Since the Merge (transition from PoW to PoS), validators were not allowed to withdraw the funds they staked to become the network validators.  And not the Ethereum developers have finally agreed to implement the upgrade as a network hard fork in March 2023.

Although the Ethereum Shanghai update includes several EIPs (Ethereum Improvement Proposal), the main improvement will be EIP-4895: Beacon Chain Push Withdrawals as Operations.

This proposal gives validators the ability to withdraw staked ETH that has been contributed to the Beacon Chain since December 2020. Ultimately, EIP-4895 plans to provide long-term ETH stakers and HODLers with additional liquidity as they will finally be able to withdraw their ETH after more than two years of being in a staking position with negligible gas fees.

Another important thing about the Shanghai update is that this is a preparation stage before the bigger Ethereum update – Surge. Since Surge is an upgrade path that is aimed to increase the blockchain's maximum transaction per second (TPS) rate, Ethereum developers say that the Shanghai update will ensure minimal delays and issues in preparation for the Surge rollout.

How will the Ethereum Update Affect DeFi?

It is hard to predict the exact effects of the Shanghai update on the players of the DeFi ecosystem. However, we may look at the overall picture and try to think of possible scenarios.

There’s currently 16M+ ETH being staked. This $26B+ worth of ETH helps keep the network secure, process transactions, and store on-chain data.

With billions of dollars worth of ETH unlocked, many are wondering what will happen to prices…

Some say prices will soar because staking on ETH may be more attractive to users due to its improved liquidity. Those who didn't want to use liquid staking protocols will now have the chance to stake ETH directly with Ethereum. This could lead to demand for ETH due to the upgraded staking conditions. More staked ETH means less sell pressure means prices go up.

Others predict prices will crash when people rush to sell their unlocked ETH. Less staked ETH means more sell pressure means prices go south.

Another concern is connected with the recent news about the crypto exchange Kraken closing down its staking service for US users due to the SEC allegations. As mentioned, except for staked ether (ETH), assets enrolled in the on-chain staking program by U.S. clients will automatically be unstaked and will no longer earn staking rewards. Given that Kraken will be forced to unwind this as soon as possible, they will likely withdraw all ETH immediately once the Shanghai upgrade goes live.

Since a large number of Kraken users are based in the US, Kracken will have to unstake a large number of ETH at once. This will immediately add more days to the withdrawal queue.

If the regulators will not stop at Kracken and force Coinbase to shut down their staking program (the rumor goes, they are going to do that), things could worsen. If US-based Coinbase customers had to unstake their ETH at once, the withdrawal queue would skyrocket. ** **

This news should have spread a negative sentiment over the crypto communities. However, we’ve seen quite the opposite. The governance tokens of Lido and Rocket Pool, two of the largest pool staking services went up 11% the day after the Kracken news.

That means the market believes that the centralized exchanges like Kraken and Coinbase,

are at risk, but not the rest of the industry. In fact, the Kraken settlement should be a wake-up call for crypto users and businesses to take control of their funds and push them towards decentralised alternatives.

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As you can see, the Shanghai upgrade is likely to benefit the DeFi ecosystem. Withdrawals from staking facilitate a more efficient ETH market because holders are able to respond to staking demand and supply to maintain market liquidity. This should be seen as a positive effect because it reduces artificial control effects on the price and circulation of ETH.