One of the most anticipated events in the history of the digital asset industry took place on September 15th 2022 – The Ethereum Merge. This is expected to bring about a host of emerging investment narratives for crypto’s second largest asset by market cap and largest smart contract platform. With this letter, we aim to provide key information related to The Ethereum Merge.
- The Ethereum Merge transitioned the Ethereum network’s consensus mechanism from proof-of-work to proof-of-stake.
- With staking, miners are replaced with validators posting collateral and attesting to transactions, and competition is replaced with randomization.
- The Merge is expected to have several potential benefits including decreasing Ethereum’s energy consumption by over 99%, making the ether token (ETH) a yield-bearing asset, reducing the ether issuance rate, and increasing block time consistency.
- This milestone is not the end of Ethereum’s evolution towards an eventual mature state. The next series of upgrades following this event will be centered around transaction speed and cost – known as scaling.
What is The Merge?
The Merge represents the joining of the existing execution layer of Ethereum (the Mainnet we used so far) with its new proof-of-stake consensus layer, the Beacon Chain. It eliminates the need for energy-intensive mining and instead secures the network using staked ETH.
Source: Ethereum Foundation
This will mark the end of proof-of-work for Ethereum, and the full transition to proof-of-stake.
Proof-of-Work vs Proof-of-Stake
Proof-of-work and proof-of-stake are both consensus mechanisms. In this context, consensus is said to be reached when at least 51% of nodes (or miners) on the network agree on the next global state of the network. Consensus mechanisms therefore allow distributed systems (like a blockchain) to work together to find consensus and stay secure.
Under proof-of-work, block creation was facilitated by miners who competed in a cryptographic race to produce the link between the current block and the block that went before. The winner then shares the new block with the rest of the network and earns a reward — some freshly minted ETH. The network is kept secure by the fact that you would need 51% of the network’s computing power to disrupt the chain. This would require such a substantial investment in equipment and energy that an attacker would likely lose more than they gain.
Proof-of-stake on the other hand allows ‘validators’ — those who have staked Ether to participate in the system (by volunteering their Ether as an economic bond for the blockchain’s security) — to facilitate block creation. A validator is chosen at random to create new blocks, share them with the network, and earn rewards. Instead of needing to do intense computational work, you simply need to have staked your ETH in the network. To successfully attack a proof-of-stake based Ethereum, an attacker would need 33% or more of the total staked Ether to disrupt the consensus of the chain (33% is the lower-bound to impact block production).
Why the Change?
There are three key reasons to make the transition:
Reason one: decentralisation. Requirements to participate in Ethereum block production will go down significantly, gone are the days of expensive hardware and exorbitant energy bills. Easier validator requirements should increase network participation, improving decentralisation and security.
Reason two: energy usage. Measured in terawatt-hours per year (TWh/yr), Ethereum used ~112 TWh/yr, comparable to that of the Netherlands. The switch to proof-of-stake will reduce this energy expenditure by more than 99.95%, implying that the total energy expenditure for securing Ethereum will be closer to 0.01 TWh/yr. Source: https://ethereum.org/en/energy-consumption/
Reason three: Ether Issuance/Rewards. Ether issuance will drop from the current 4.3% of total supply (c.$8.5bn per annum at current prices) to 0.43% (c.$850m). This is broadly good for Ethereum and its users as it dramatically decreases sell pressure from the market both in terms of actual new Ether minted and by also issuing them to stakers as opposed to miners that have high fixed costs they must cover (and therefore likely sell rewards).
Ether Token Implications
From an investors perspective, the most interesting aspect of the merge is the symbiosis of the proof-of-stake issuance reduction combined with the burning mechanism introduced with EIP-1159 last year.
The combination of the lower emissions and EIP-1159 means Ether has the potential to become deflationary. Given EIP-1559 burns Ether as the network is used, as The Merge reduces issuance (aka inflation) by ~90%, fewer transactions are need to happen to burn more Ether than there is issued.
Looking Past The Merge
Despite the significance of The Merge, Ethereum founder Vitalik Buterin believes the roadmap is still only ~55% complete post-Merge. There is a lot to do. We therefore thought it would be worth spending some time looking at the implications of The Merge on the short-medium term future of Ethereum.
Shanghai Upgrade: Any staked Ether is currently locked on the Beacon Chain without the ability to make withdrawals. A common misconception with The Merge is that this Ether will immediately become liquid. This is incorrect. Withdrawals are planned for the Shanghai upgrade, the next major upgrade following The Merge. This means that newly issued Ether, accumulated on the Beacon Chain, will remain locked and illiquid for at least 6–12 months following The Merge.
EIP-4844: Central to scalability improvements, EIP-4844 is likely to become the Ethereum team’s key priority following The Merge. EIP-4844 will increase the amount of data available for ‘roll-ups’ (Ethereum scaling solutions) per block — potentially by a factor of 20x. This will make transactions on roll-up protocols such as Optimism or Arbitrum even cheaper, noting that they already provide fees that are ~3–8x lower than Ethereum base layer itself.
There are a number of reasons to be excited by The Merge. At Algo Capital, we follow the Ethereum roadmap closely, and this certainly looks to be a pivotal moment in Ethereum’s history and, looking forward, potentially for the entire Digital Asset sector as well.
Digital Assets technologies are in constant (r)evolution; stay tuned to stay updated.