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May 05, 2022

A Take On “The Merge”

Almost seven years after inception, Ethereum remains the flagship smart contract platform in the crypto space. A “victim of its own success”[1], it has been consistently facing scalability issues, with users having to pay high transaction fees when interacting with decentralized applications (DApps), which range from decentralized finance (DeFi) and NFTs to blockchain-based games.

 

Because the Ethereum network has security and decentralization as its two main features, scalability cannot be easily attained without resorting to more complex technologies. So far, improved scalability for Ethereum has been mainly driven by sidechains—parallel chains capable of running Ethereum applications—which allow faster and cheaper smart contract execution and data storage, leveraging the Ethereum mainnet[2] as a registry of cryptographic proofs,[3] and providing a safe haven for storing governance tokens, stablecoins, and NFTs. This has paved the way for a better user experience for several important applications in the Ethereum ecosystem. Polygon, for example, is helping the continued growth of several DeFi applications, like AAVE, Curve, and Uniswap[4]. Another example is Ronin, which allowed Axie Infinity to scale considerably and reach two million daily active users in late 2021[5]. 

 

However, sidechains have some drawbacks. They lack the kind of interoperable security that has long been a core function of the Ethereum network[6]. This is particularly relevant in light of recent major hacks involving bridges[7], which are responsible for transposing crypto assets native to the Ethereum blockchain to sidechains. While sidechains have given breathing room to Ethereum developers to test the series of network updates  to create more scalability and sustainability to the Ethereum mainnet (previously known as “Ethereum 2.0”)[8], two other key technologies — sharding (discussed below) and roll-ups [9] — have more potential to enable Ethereum to support tens of thousands of transactions per second (TPS). 

 

“The Merge” is the major event when Ethereum will fully transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS), making mining obsolete and substantially decreasing the environmental impact of the network. This event alone will not lead to less congestion and lower transaction fees, but serves as a cornerstone for future updates to bring the much-anticipated higher scalability Ethereum has always purported to have[10]. This switch to a new consensus mechanism will enable a more distributed Ethereum network with a very low computational cost. This will allow most users to participate in the validation and execution of transactions, targeting a future where Ethereum may indeed become the large-scale decentralized world computer it has aspired to become.

 

This report covers how The Merge will be pivotal for the Ethereum network, addressing:

  • The huge reduction in power consumption (~99.95%) [11] brought by the change in consensus mechanism from PoW to PoS, and how this migration alone cannot provide higher scalability to the Ethereum network, but establishes the infrastructure for sharding to become a reality;

  • Mid- and long-term effects of recent updates to Ethereum’s monetary policy, with the potential to decrease in up to ~90% [12] the current issuance velocity of new ETH, the network’s native token, while also removing most of the selling pressure from miners today;

  • How staking yields will increase from ~5.0% to ~10.0% [13], propelling the demand for staking and further reducing the liquid supply of ETH in the market, and how Staking-as-a-Service will allow most users to earn rewards on their ETH holdings;

  • The main risks related to The Merge, and how the market is dealing with the uncertainties revolving around this event.

Part of a series of upgrades that aim to solve a fundamental conundrum in blockchain networks—the blockchain trilemma—[14] The Merge has the potential to be the starting point for much more adoption of the Ethereum network in the coming years. If successful, this may start burying deep concerns about other Layer-1s[15] outshining Ethereum’s position as the leading smart contract platform, bringing a new wave of value accretion for the network.

 

Before The Merge

After The Merge

Consensus Mechanism

Proof-of-Work

Proof-of-Stake

Mining

Yes

No

Network Energy Consumption

~112 TWh/year

~0.056 TWh/year

Annual ETH issuance

~5.25M ETH

~525,000 ETH[16]

Scalability

Low

Low (with The Merge only)

Infrastructure for sharding

No

Yes

Staking Yield

~4.6% (on the Beacon Chain)

~9.4%[17]

 

 
   

 

  1. Creating basic infrastructure for higher scalability and more environmental friendliness

 

Since its launch, Ethereum has been operating under the Nakamoto consensus, where Proof-of-Work (PoW) establishes how network participants determine the correct candidate for the next block on a blockchain. Under PoW, miners use electricity to solve a computational puzzle by brute force. The miner that first solves the puzzle becomes eligible to include the next block of transactions on the chain, earning a profit equal to a combination of a number of newly issued tokens and transaction fees paid by the users. Ethereum provides rewards in ether (ETH) and transaction fees are called gas fees. 

 

The energy consumption of PoW has been a subject of scrutiny and criticism by external observers and major players within the Ethereum community. The development team, including co-founder Vitalik Buterin, started considering a novel consensus mechanism for improved scalability of Ethereum as early as 2016,[18] debating efficiency versus security for different frameworks. Proof-of-Stake (PoS) was the resulting solution,[19] which—in addition to creating a solid groundwork for later updates to improve scalability on Ethereum—significantly reduces the network’s power consumption. In contrast to PoW, in PoS, validators take turns proposing and voting on the next candidate block, and the weight of each validator’s vote depends on the size of their deposit (their stake).[20]

 

The Beacon Chain,[21] a chain parallel to the Ethereum mainnet (the current PoW-based blockchain) introduced PoS to Ethereum on December 1, 2020[22] as a testnet to experiment and develop the new consensus mechanism on Ethereum. To get involved in staking, and start validating in this new PoS chain, a user must stake a total of 32 ETH to activate validator software (i.e., lock 32 ETH on a smart contract deployed on the current Ethereum mainnet) [23]. As of April 2022, there is a total of ~11.4M ETH staked in the Beacon Chain, with a total of 340,000 validators and rewards providing an annual percentage rate (APR) of 4.6% [24].

 

The computational infrastructure based on PoS will allow for a process known as sharding to be implemented, scaling the Ethereum network by splitting data availability and code execution into a huge number of nodes [25] running in parallel [26]. Attacking the whole network under PoW demands a lot of computer resources, making it infeasible on a network with the computational power that Ethereum has today (~1,000 TH/s) [27]. However, acting maliciously on a single shard is significantly less costly, since the resources needed to attack one of them (Ethereum is expected to support 64 shards) are only a fraction (1/64) of the total computational power of the whole network. This could impair the security of shards operating under PoW, and is one of the main reasons behind the switch in consensus mechanism. 

 

Under PoS, validators will not be able to choose the shard they want to work on, but instead will be randomly assigned to a shard by the network software. Shard assignments will occasionally be reshuffled to avoid validators working on a single shard for a sustained period of time, which limits their attacking ability and prevents collusion among groups of validators. Because PoS removes the necessity for mining hardware and its high electricity costs, the operation of shards will be feasible on consumer hardware, removing barriers for new players to enter the Ethereum network. It is important to note that the switch to PoS is, therefore, a necessary condition for shards to be implemented in the future. However, the switch alone will not impact Ethereum scalability for now [28]. The Merge is the event where the Beacon Chain merges with the Ethereum mainnet, forming a new consensus layer operating under PoS.

Figure 1: Schematic representation of The Merge between the Beacon Chain (PoS) and today’s Mainnet (PoW), resulting in an upgraded Mainnet operating under PoS.

 

In addition to enabling higher scalability in the future and likely increasing the decentralization of block validation (since it will no longer be performed through a computational power arms race), the switch to PoS will make mining obsolete, removing the high energy expenditure associated with PoW. Today, the Ethereum network consumes as much as 112 TWh a year in electrical energy (currently comparable to the power consumption of the Netherlands), with a carbon footprint of 62 Mt CO2 a year (comparable to Belarus) [29]. Since validators do not need to solve any mathematical puzzle, PoS on Ethereum will result in a significant drop in energy consumption, with validators operating the Beacon Chain estimating up to a ~99.95% reduction [30].

 

Figure 2: Ethereum’s energy consumption has grown by tens of TWh/year since early 2021, with the increased profitability of miners operating a highly congested network [31,32]. For the sake of illustration, we consider a scenario where The Merge happens on July 1, 2022.

  1. Updated monetary policy, miner selling pressure, and the long-term supply

 

The London hard fork, which took place on August 5, 2021[33], marked the activation of EIP-1559, a new transaction-pricing mechanism that includes fixed-per-block gas fees that are burned and dynamically expands/contracts block sizes to address Ethereum network congestion. This is a major effort to make transaction costs more predictable to the end-user, while also creating a burning mechanism that discounts part of newly issued ETH on a daily basis.

 

Figure 3: Number of ETH burned daily since EIP-1559 [34].

 

After The Merge, Ethereum will no longer include a two-ETH reward for every new block mined under today’s PoW consensus mechanism. Instead, ETH will be awarded to validators based on a dynamic issuance schedule that is adjusted every staking epoch (a bundle of 32 blocks) based on how much ETH is staked at each point in time. For perspective, consider a scenario after The Merge where there are 20 million staked ETH. This implies a staking APR of 3.79%[35] and about 2,100 newly minted ETH daily. Assuming 50% of the current average daily burn becomes the new burn rate post-merge (8,400 ETH/0.50 = 4,200 ETH) [36], there will be a net daily supply decrease of 2,100 ETH (2,100 - 4,200 = -2,100). This might lead to the ETH supply slowly decreasing, and the network to become deflationary over time. 

 

This scenario is dependent on network parameters such as staked ETH and the number of tokens being burned. But regardless, if the current level of staked ETH (11.4M) [37] were to be kept constant after The Merge, the annual rate of emission will change from today’s ~5.25M ETH to ~525,000 ETH, a reduction of ~90% in the supply expansion rate.

Figure 4: Scenarios for the supply of ETH over time. We assume The Merge happens on July 1, 2022, providing four different scenarios for the average number of daily burned tokens post-merge: 10%, 25%, 50% and 100% of the average daily burn since the activation of EIP-1559 (~8400 ETH), assuming 20M ETH are staked [38]. We fill in the missing data between the current date and The Merge with the average daily issuance under PoW since Jan/20 and a bit of random noise using the standard deviation within the same time window.

 

Figure 5: Scenarios for the new daily issuance of ETH. We assume The Merge takes place on July 1, 2022, providing four different scenarios with different APRs: 10M Staked ETH (5.4%), 20M staked ETH (3.8%), 40M staked ETH (2.7%), and 80M staked ETH (1.9%) [39]. We fill in the missing data between the current date and The Merge with the average daily issuance under PoW since Jan/20 and a bit of random noise using the standard deviation within the same time window.

 

Because mining will become obsolete after The Merge, it is likely the liquid supply of ETH will also decrease due to: (i) the operational cost of validating blocks under PoS being drastically lower, reducing the natural selling pressure that miners exert on the market to cash out profits and pay for electricity and hardware expenses; and (ii) since staking is the mechanism allowing one to mint new blocks on the chain, once PoS is working at full steam, there is potential for much more ETH to be taken out of circulation and locked by validators in their validation node.

 

  1. The attractiveness of ETH staking

 

The staking APR for validators in the Beacon Chain follows a yield curve that dynamically allocates rewards depending on the number of staked ETH. Currently, the Beacon Chain is not validating transactions on the Ethereum mainnet. After The Merge, the validation network will receive the APR of newly issued tokens from staking (the base rewards that replace the current two ETH emitted per block mined)—currently at 4.6% [40]—and the sum of transaction fees per minted block. Since EIP-1559 launched, there is a daily average tip (gas fees on top of a block’s base fee) paid to miners of roughly 1,470 ETH/day[41], which — if kept constant — amounts to around 4.8% additional APR to be added to the revenue of validators post-merge. 

 

We are also seeing the emergence of a novel Staking-as-a-Service (STaaS) [42] business model. This is a product already appearing on some platforms that allows any user to delegate their ETH holdings to a third party and earn rewards proportional to their share of that staking pool. By design, Ethereum developers chose not to allow users to run a validator with less than 32 ETH (~US$100,000) [43] being committed for the activation of validator software. However, as little as 0.01 ETH (~US$30) [44] is needed to stake ETH in platforms like Rocket Pool or Lido, which use ETH synthetics. Lido’s synthetic, stETH, currently has one of the most liquid pools (on the stETH/ETH pair) available on Curve, a major decentralized exchange on the Ethereum ecosystem [45]. This means staking on Ethereum will actually be quite accessible to any ETH investor, reassuring the idea of staking as an activity that every ETH holder should consider engaging with. 

4. Risks

 

The Merge is a major update to the inner-workings of Ethereum, with the potential to trigger a “quantum leap” [46] in how the network operates and to establish the foundations for a high TPS and environmentally friendly future. Nonetheless, we understand there are a few risks associated with these complex changes to the Ethereum architecture. 

 

First, The Merge is still only a promise. The staked ETH in the Eth2.0 contract [47] is currently locked with no estimated date for enabling users to withdraw their funds. For example, Lido currently has the largest staking pool in the Beacon Chain [48], and issues a synthetic and freely tradable ETH (stETH). In theory, if there were no merge-related risks, stETH should trade at a premium with respect to conventional ETH, since stETH is a yield-bearing asset on the new PoS chain. However, given the uncertainties around The Merge, stETH has traded mostly at a discount since staking became available. Judging from the recent trend of stETH/ETH converging, the market is already pricing in the fact that The Merge is basically a matter of  “when,” not “if.” 

 

Figure 6: stETH price with respect to ETH since early 2021. Most of the time, stETH has traded at a discount with respect to ETH, recently coming closer to unity [49].

 

Second, changing the consensus mechanism is somewhat similar to changing a car’s engine while the car is running. As a result, there is the possibility of major unseen/untested implementation bugs and undesired outcomes being discovered only after The Merge, which may impact the functioning of the Ethereum network and eventually trigger a fallback to the original PoW-based blockchain. For this reason, the Ethereum development team has been very cautious to dry-run The Merge on testing environments first, with a successful merge taking place in the Kiln testnet as of mid-March 2022 [50]. These tests have demonstrated some undesired outcomes that have only later been identified [51], raising again concerns that the migration to PoS will have to wait a few more months to occur. 

 

Lastly, The Merge alone does not imply improved scalability for Ethereum. The network still lags in this respect when compared to other (less decentralized) smart contract platforms like Solana, Avalanche, and Terra, which collectively have seen a relevant rise in user adoption, total value locked, and market capitalization over the course of 2021 [52]. If sharding—currently expected to be shipped by 2023 [53]—still takes some time to be fully implemented, there is room for Ethereum to keep losing market share in the coming months and years. Since the switch to PoS precedes sharding, further delays with The Merge signals that higher scalability still remains in the queue. 

The Merge Wrap-Up

 

We believe The Merge is the biggest upgrade in the history of blockchain technologies. It is a very important step towards delivering an Ethereum framework that is highly-scalable and environmentally friendly, allowing users to interact with DApps living on a very secure and decentralized platform, while also paying low transaction fees and experiencing a less congested network.

 

PoS will enable sharding to be run on consumer hardware in the near future [54], which will likely drive the validation network toward more decentralization and improved resiliency. This change will decrease the power consumption of the Ethereum blockchain by as much as ~99.95% [55], while also reducing the emission of new ETH by around ~90% through a new issuance policy [56]. The staking yield curve, aided with transaction fees that will become additional rewards to PoS validators, makes staking a very attractive activity for every ETH holder, even for the ones that cannot run their own node, which may leverage STaaS providers and participate in the operation of the network.

 

In our opinion, these factors combine to make The Merge a game changer for Ethereum, likely driving a huge decrease in liquid supply of the network’s native token, which has the potential to go through a next leg of price appreciation. More importantly, The Merge undoubtedly creates new value for Ethereum as it seeks to maintain its position as the flagship smart contract platform in the crypto economy. The road ahead still includes several other upgrades that will bring the full Ethereum vision into reality [57]. However, The Merge is certainly the dawn of a new era that will be remembered as a key milestone enabling the next wave of Ethereum-based innovations.

References

[1] Tech Radar, Ethereum: A victim of its own success, accessed April 7, 2022.

[2] A mainnet is a fully developed and released version of a blockchain network. This stands in contrast with a testnet, which is generally used to perform tests and experiments on a blockchain before a mainnet is released. Testnets are used while a blockchain is live for experimentation and development as to not disrupt the main chain. Source: Gemini, Cryptopedia – Glossary, accessed April 19, 2022.

[3] Cryptographic proofs enable authentication or validation of information without storage of the actual information. For instance, in user databases, one does not store the password of each user, but a cryptographic hash, a set of alphanumeric characters generated from a user’s password. Since reverting a cryptographic hash is a very difficult endeavor, but taking a password as input, generating its hash and comparing it to the stored hash is very easy, the cryptographic hash provides a cryptographic proof of user authentication without the database storing users’ sensitive information.

[4] Polygon Ecosystem, accessed April 7, 2022.

[5] CoinDesk, Axie Infinity Nears 2M Daily Active Users as Creator Raises $152M Series B, accessed April 7, 2022.

[6] Vitalik Buterin, My argument for why the future will be “multi-chain”, but it will not be “cross-chain”, accessed April 7, 2022.

[7] The Washington Post, Hackers hit popular video game, stealing more than $600 million in cryptocurrency, accessed April 7, 2022.

[8] The Ethereum Foundation announced in January 2022 it would no longer use the term “Ethereum 2.0.” Instead, it now refers to this upgrade as the merge of the “consensus layer” and “execution layer” (Ethereum 1.0) to stress that these are upgrades to Ethereum, not an entirely new network. Source: Ethereum Foundation Blog, The great renaming: what happened to Eth2?, accessed April 11, 2022.

[9] Roll-ups are an off-chain—off the Ethereum mainnet—aggregation of transactions inside an Ethereum smart contract. Roll-ups are used to combine and process smart contract transactions off-chain before settling the final state on-chain—on the Ethereum mainnet. This is done to lower transaction fees and makes roll-ups a throughput solution, not a scaling solution, as they usually require additional hardware to settle transactions on-chain. Source: Gemini, Cryptopedia – Glossary, accessed April 19, 2022.

[10] Fortune, 3 misconceptions about the ‘merge,’ Ethereum’s next big upgrade that will affect its supply and environmental impact, accessed April 11, 2022.

[11] Ethereum Blog, Ethereum’s energy usage will soon decrease by ~99.95%, accessed April 7, 2022.

[12] Bitwise, A (Mostly) Jargon-Free Guide to Ethereum’s Quantum Leap – Part I: The Merge, accessed April 12, 2022.

[13] Bitwise, A (Mostly) Jargon-Free Guide to Ethereum’s Quantum Leap – Part I: The Merge, accessed April 12, 2022.

[14] Ethereum Wiki, Sharding-FAQs, accessed April 7, 2022.

[15] Blockchain networks that execute general purpose smart contracts on their mainnets.

[16] Assuming current 11.4M staked ETH. Source: beaconcha.in, Open Source Ethereum 2.0 Beacon Chain Explorer, accessed April 11, 2022.

[17] Assuming current staking yield (with 11.4 staked ETH) and current mining tips. Source: beaconcha.in, Open Source Ethereum 2.0 Beacon Chain Explorer, and Watch the Burn, Insights, accessed April 11, 2022.

[18] Vitalik Buterin, A Proof of Stake Design Philosophy, accessed April 7, 2022.

[19] BeInCrypto, Official Ethereum Proof-of-Stake Algorithm Proposal Published, accessed April 17, 2022.

[20] Ethereum Wiki, Proof-of-Stake FAQs, accessed April 7, 2022.

[21] Ethereum Docs, The Beacon Chain, accessed April 11,  2022.

[22] CoinDesk, Ethereum 2.0 Beacon Chain goes live as “World Computer” begins long-awaited overhaul, accessed April 11, 2022.

[23] Etherscan, Eth2 Deposit Contract, accessed April 12, 2022.

[24] beaconcha.in, Open Source Ethereum 2.0 Beacon Chain Explorer, accessed April 11, 2022.

[25] In blockchain technology, a node is a computer that is connected to a blockchain network that serves a number of purposes essential to the maintenance of a distributed system. Some nodes validate transactions, while others observe activity on the blockchain. Nodal network structure is also a key aspect of maintaining security on a blockchain. Source: Gemini, Cryptopedia – Glossary, accessed April 19, 2022.

[26] ethos.dev, The Beacon Chain Ethereum 2.0 explainer you need to read first, accessed April 7, 2022.

[27] Etherscan, Ethereum Network Hash Rate Chart, accessed April 22, 2022.

[28] Fortune, 3 misconceptions about the ‘merge,’ Ethereum’s next big upgrade that will affect its supply and environmental impact, accessed April 11, 2022.

[29] Digiconomist, Ethereum Energy Consumption Index, accessed April 7, 2022.

[30] Ethereum Blog, Ethereum’s energy usage will soon decrease by ~99.95%, accessed April 7, 2022.

[31] Digiconomist, Ethereum Energy Consumption Index, accessed April 7, 2022.
[32] Statista, Ethereum mining revenue from August 2015 to December 2021, accessed May 6, 2022.
[33] Glassnode, Ethereum Issuance, accessed April 13, 2022.
[34] CNBC, Ethereum just activated a major change called the ‘London hard fork’ — here’s why it’s a big deal, accessed May 6, 2022.
[35] Glassnode, Ethereum Issuance, accessed April 13, 2022.
[36] Glassnode, Ethereum Issuance, accessed April 13, 2022.
[37] beaconcha.in, Open Source Ethereum 2.0 Beacon Chain Explorer, accessed April 11, 2022.
[38] Data from Glassnode, Ethereum Issuance, and yield curve formula is given by Vitalik Buterin, Quick Python code for computing staking reward rates from total ETH staked, accessed April 13, 2022.
[39] Data from Glassnode, Ethereum Issuance, and yield curve formula is given by Vitalik Buterin, Quick Python code for computing staking reward rates from total ETH staked, accessed April 13, 2022.
[40] beaconcha.in, Open Source Ethereum 2.0 Beacon Chain Explorer, accessed April 11, 2022.
[41] Watch the Burn, Insights, accessed April 12, 2022.
[42] Messari Research, What’s at Stake in Staking-as-a-Service?, accessed April 12, 2022.
[43]  CoinMarketCap, accessed April 12, 2022.
[44] CoinMarketCap, accessed April 12, 2022.
[45] The liquidity pool for stETH/ETH has the fifth largest average daily volume (US$37.5M) and the highest TVL on Curve. Source: Curve Finance, Curve pools, accessed April 12, 2022.
[46] Bitwise, A (Mostly) Jargon-Free Guide to Ethereum’s Quantum Leap – Part I: The Merge, accessed April 12, 2022.
[47] Etherscan, Eth2 Deposit Contract, accessed April 12, 2022.
[48] Nansen, ETH2 Deposit Contract, accessed April 12, 2022.
[49] Dune Analytics with data from Curve, ETH:stETH price hourly, Accessed April 13, 2022.
[50] Ethereum Foundation Blog, Announcing the Kiln Merge Testnet, accessed April 12, 2022.
[51] Marius van der Wijden, The mainnet shadow fork already found an issue we could’ve easily missed on the devnets, accessed April 12, 2022.
[52] Money Training Club, The 5 blockchains of 2021: Solana, Cardano, Terra, Avalanche and Polygon, accessed May 06, 2022.
[53] Ethereum Docs, Shard chains, accessed April 12, 2022.
[54] ethos.dev, The Beacon Chain Ethereum 2.0 explainer you need to read first, accessed April 7, 2022.
[55] Ethereum Blog, Ethereum’s energy usage will soon decrease by ~99.95%, accessed April 7, 2022.
[56] Bitwise, A (Mostly) Jargon-Free Guide to Ethereum’s Quantum Leap – Part I: The Merge, accessed April 12, 2022.
[57] Bankless, Endgame | Vitalik Buterin, 2022.

 


 

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