Scenius Insights: The Ethereum Merge
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The Ethereum Merge
After several tumultuous months for crypto, the market shifted its focus to one of the most anticipated events in the history of digital assets: the Ethereum Merge (“the Merge”). The Merge to Ethereum 2.0 was successfully achieved on September 15th and became the most meaningful upgrade ever made to the Ethereum network. It transitioned the second largest digital asset by market cap (~$195bn at the time) and the most important smart-contract blockchain, from energy-intensive proof of work (PoW) to a proof of stake consensus mechanism. By ending PoW for Ethereum, the upgrade will also usher in a more sustainable and eco-friendly system by reducing Ethereum’s energy consumption by ~99.5%, while also enabling scalability upgrades not possible under PoW. The change is also expected to have a deflationary impact on ETH which, combined with increasing demand, should be positive for ETH holders.
What is the Merge?
The Merge is Ethereum’s change to PoS. It is referred to as the Merge because it represents the joining of the existing execution layer of Ethereum—the PoW Mainnet used up until September 15th—with the new proof-of-stake consensus layer, the Beacon Chain, first introduced in 2020. Consensus refers to the method by which all the computers maintaining a blockchain agree to add new transactions to it. Since July 2015, Ethereum operated under PoW consensus, the same as that pioneered by Satoshi in Bitcoin. PoW involves “mining” where miners use specialized hardware to solve difficult computation puzzles with the winners earning the right to order transactions into a block and earn rewards of newly minted coins and fees. This is the proof of work, and the process that maintains the state of a blockchain. The security of a PoW chain is measured in hash power, or the total amount of computation (energy) devoted to securing the network. Because mining requires often expensive equipment and expertise, the majority of hash power can be controlled by a small number of privately operated mining pools. This historically was the case with Ethereum. Moreover, these mining operations can be very large and consume huge amounts of energy. The Merge solves the energy problem, but critics of PoS argue it is no more decentralized than PoW. This is because token rewards are proportional to how much a user has staked, so ownership can still tend to concentrate in larger holders who earn greater rewards, which the critics equate to the advantage large mining operations have under PoW.
Source: Ethereum.org
Timing of the Merge – Why Now?
The ESG narrative around PoW mining has been a persistent thorn in the industry’s side. Ethereum is the leading smart-contract blockchain and was by far the most notable not to use PoS consensus.
Although it had been on the roadmap for years, preparing for the transition was a major undertaking. People in crypto compared the process to changing the engine of an airplane mid-flight. Engineers and core developers spent years working to prepare Ethereum for a transition to PoS. This includes running shadow forks of existing testnets and Mainnet, merging many PoW testnets to PoS, and undertaking extensive testing and bug bounties to help ensure a safe transition. Implementing the upgrade while simultaneously ensuring there would be no network downtime, proved to be a time-intensive endeavor.
Why The Merge Matters
There are misconceptions that the Merge will increase transaction speeds and reduce transaction (gas) fees. This is generally not true. The Merge’s most significant contributions are the environmental benefit of ending PoW, the impact to token economics, and the promise of further scaling, especially sharding discussed below.
Unlike PoW, in a PoS system there are no miners solving cryptographic problems and mining is not the means of producing valid blocks. Instead, PoS consensus validators are responsible for the validating of transactions and proposing of blocks. Validators stake ETH into a smart contract on Ethereum. This staked Ether secures the network because it acts as collateral that can be destroyed if the validator behaves dishonestly or unreliably. Anyone can operate a validator under PoS as long as they have 32 ETH to stake, so control over the network is distributed to more participants than under PoW. For example, under PoW five Ethereum mining pools accounted for over 65% of all mined ETH in 2021. The PoS network incentivizes staking via yield generation on locked assets and individuals with less than 32 ETH can also enjoy yield by staking in pools such as Lido, Rocket Pool, or on centralized exchanges. Critics argue, however, that these staking services have the potential to control a majority of staked ETH and thus create a centralization vector similar to PoW mining pools. How decentralized PoS Ethereum really is will remain an open question.
It is not debatable that, by eliminating energy intensive PoW mining, the Ethereum network is expected to reduce its carbon footprint by 99.95%. While some industry participants believe that Bitcoin’s energy consumption actually incentivizes a more efficient and clean energy network, others argue that PoW blockchains such as pre-Merge Ethereum and Bitcoin harm the environment by consuming as much energy as small countries. In this regard, Ethereum’s transition to PoS is almost unanimously viewed as a major positive for the industry. Institutional investors, companies, and developers with ESG mandates unable to consider Bitcoin as an investment or a usable technology, may now be able to consider investing in or using Ethereum with this obstacle removed.
As the graphic above illustrates, the effect on emissions of the transition to PoS will be as though, overnight, Chile had been switched off.
The Merge also has a notable impact to Ethereum’s token economics. On the supply side, a significant amount of ETH will be locked up post-merge as over 14 million ETH (approx. 11%) are currently staked. This number is likely to go up after a successful merge as holders seek stable yield. Further, miners were rewarded in new ETH (~13,000 ETH/day) for PoW, which was mostly sold to cover expenses. This will drop to zero after the upgrade when only ~1,600 ETH per day will remain in staking rewards. This represents a ~90% reduction in issuance post Merge and eliminates forced selling from miners. This reduction also follows the implementation of EIP 1559, an improvement to Ethereum that introduced a transaction fee burn mechanism, which has resulted in more than 2.6 million ETH being burned. Depending on network fees, the fee burn could offset new issuance and collectively these factors may result in scarcity that makes ETH a deflationary asset.
The Surge, The Verge & The Splurge
According to Ethereum co-founder Vitalik Buterin, the network’s overall development will only be 55% complete after the Merge. At the EthCC conference in Paris in July 2022, Buterin discussed the Merge, the longer-term future of the network, and its scaling prospects. He joked that the path for the blockchain to further scale and efficiency is first the Merge, followed by “the Surge, the Verge, the Purge and the Splurge.”
The names may be funny, but they refer to real future technical developments. The Surge refers to the addition of Ethereum sharding, a multi-phase upgrade to improve scalability and capacity. Sharding would break the network into separate partitions called “shards” designed to spread the computation load on the mainnet, reduce network congestion, and increase transaction throughput. Instead of settling all operations on one single blockchain, these shard chains will spread operations across 64 new linked chains, in essence creating mini-blockchains. This provides secure distribution of data storage requirements, enables cheaper rollups, makes nodes easier to operate, and will enable layer 2 solutions to offer low transactions fees while leveraging Ethereum’s security. Sharding is planned to begin in 2023.
The Verge phase refers to the implementation of “Verkle trees,” a new kind of mathematic proof that makes “stateless clients” possible. This optimizes data storage for Ethereum nodes by allowing users to become network validators without having to store the entire “state” of the blockchain, an enormous amount of data.
The Purge refers to the removal of old data from the blockchain history, thus cutting down the amount of space required to store Ethereum’s network history. Finally, the Splurge is “all the other fun stuff.”
Ethereum today can process about 15-20 transactions a second. An upgraded Ethereum, including rollups and sharding, should be able to process 100,000 transactions per second according to Buterin. This will be key if Ethereum is to achieve its long-term goal to be the global settlement layer for the world’s internet. The Merge is the first important step in this process.
The successful merge on September 15th to Ethereum 2.0 brings meaningful positive changes to the network. These changes will benefit the developer community (the largest of any blockchain) and usher in the next generation of applications and building on the network. More important still, the achievement illustrates that Ethereum has the capacity for self-improvement and to execute on its roadmap to become an even more powerful technology, opening the door to other more sweeping changes in future.
REFERENCE SOURCES
1.https://ethereum.org/en/upgrades/merge/
2.https://www.theblock.co/post/166708/the-merge-everything-you-need-to-know-about-ethereums-big-upgrade
3.https://www.coindesk.com/learn/ethereum-merge-explained-what-investors-should-know-about-the-shift-to-proof-of-stake/
4.https://www.economist.com/finance-and-economics/2022/09/06/the-future-of-crypto-is-at-stake-in-ethereums-switch
5.https://metaversal.banklesshq.com/p/the-merge-and-nfts-?utm_source=email
6.https://www.veradiverdict.com/p/the-merge?utm_source=email
7.https://blockworks.co/ethereum-ropsten-testnet-successfully-merged-to-proof-of-stake/
8.https://www.cnbc.com/2022/08/10/ethereum-goerli-testnet-merge-goes-live-before-move-to-proof-of-stake.html
9.https://www.coindesk.com/tech/2022/07/06/ethereums-sepolia-testnet-successfully-transitions-to-proof-of-stake/
10.https://ethereum.org/en/upgrades/merge/issuance/
11.https://www.theblock.co/post/167841/how-ethereums-monetary-policy-will-change-after-the-merge
12.https://www.coindesk.com/learn/top-questions-about-proof-of-stake-and-staking-answered/
13.https://www.coindesk.com/markets/2022/07/21/vitalik-buterin-discusses-ethereums-upcoming-merge-and-surge-at-ethcc-in-paris/
14.https://decrypt.co/105707/ethereum-merge-surge-verge-purge-splurge-vitalik-buterin
15.https://www.coindesk.com/tech/2022/08/01/ethereum-after-the-merge-what-comes-next/
16.https://vitalik.ca/general/2021/06/18/verkle.html
17.https://blockworks.co/ethereum-fans-meme-the-merge-with-pandas-and-bats/
18.https://blockworks.co/ethereum-switches-to-proof-of-stake-after-7-years-of-work/
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