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The Ethereum Merge: Everything You Must Know

For quite some time, the term ‘Merge’ has piqued the interest of many in the crypto community. The Ethereum Merge has been a subject on the lips of important players in the crypto sector, and many have given their thoughts and viewpoints on one of the most significant moves in the short history of blockchain technology.

What Exactly Is The Ethereum Merge?

On September 14, 2022, the Ethereum blockchain will move from proof-of-work (PoW) to proof-of-stake as its consensus method (PoS). Vitalik Buterin, the inventor of Ethereum, pondered this upgrade in public blogs during Ethereum’s ICO in 2014, far before the network’s debut in July 2015. The testnet for the upgrade went live at the beginning of May 2019, and the new 2.0 chain began operating in parallel in December 2020. Since then, frequent delays have dimmed enthusiasm, despite the fact that Ethereum has successfully surmounted more testing obstacles.

PoS works when validators “stake” the native cryptocurrency of the blockchain network by depositing it into a private smart contract. Then, random validators are chosen to verify each new block and receive the delegated reward.

From ETH 2.0 → The Merge

The Merge is part of what was formerly known as “ETH 2.0,” a series of improvements that restructure the fundamental aspects of the blockchain. And it’s considered phase two of Ethereum’s multi-part upgrade, to improve scalability, security and energy efficiency. It will accomplish this through sharding and rollup updates to improve scalability.

Since late 2020, when a testing configuration of the Ethereum PoS blockchain called the Beacon Chain was introduced, Ethereum has been continuously developing. Since ETH2 is the next version of Ethereum, the transition from ETH PoW to ETH PoS was given the term “The Merge.” with The Merge, the PoW chain and Beacon Chain will merge to create a single blockchain.

The PoS consensus method is more eco-friendly than the PoW consensus mechanism, in which miners fight to verify new blocks by wasting enormous computational power and energy. In addition to the environmental effect, many feel that the conversion to PoS will lessen the danger of over-centralization by making the validator function accessible to everyone with Ether to stake, instead of just those with costly mining equipment.

What Will Change Post-Merge?

More people and businesses who aren’t already active in the cryptocurrency industry will be able to enter the Ethereum market, especially institutional investors. The DeFi protocols, NFTs, and Web3 ecosystem are now accessible to millions (and eventually billions) of users. For the Ether price, this is almost certainly good news.

It will revolutionize Ethereum and make it the industry-leading Proof-of-Stake (PoS) blockchain, but it hasn’t been without its lengthy and costly period of development.

Below, we will examine a few potential impacts of The Merge and the on-chain indicators that observers might use to monitor these consequences.

How Does Staking Secure the Network? And Why Is It So Expensive?

Billions of dollars are being spent to protect the Ethereum PoS network to make it secure, stable, and scalable. The total value of Ether invested so far exceeds 13 million ETH. In other words, before the Merge, users (also known as Validators) already staked their Ethereum and contributed over $29 billion to the network’s security.

The amount of Ethereum staked even topped the market value of the largest PoS network at this time — Solana. However, not all of these validators are genuinely decentralized since some are held by centralized exchanges, custodians, and staking pools such as Lido and Rocket. The Validators’ payout may not seem appealing as of right now, but it will climb from 4% to 10%.

However, it is not all a walk in the park for validators considering possible technical issues with such a significant transition. A Validator’s stake may be decreased for bad behavior. Validators, for example, may be penalized for dishonest work. They can also potentially be expelled from the network due to duplicate proposals, competing proposals, or double voting are examples of slashable offenses, as is downtime (offline penalty when more than 1/3 of the nodes are offline).

The Rise of Ultrasound Money

The removal of miners from the Ethereum ecosystem is also something to consider since the necessity to pay huge block rewards will no longer be a problem, substantially lowering the production of new ETH. During the process, user fees are partly burned and partially distributed to the validators. This is the Ether burn technique used in the London hard fork — EIP 1559 — which burnt over 2.25 million ETH, or more than $5.6 billion.

It will reduce the inflation rate from 4% to -1%, thereby making Ether deflationary everywhere network activity grows. This leads to the term Ultrasound money,” which some in the community have already nicknamed Ethereum.

To address scalability difficulties, the initial plan intended for sharding operations to be undertaken prior to The Merge. However, with the introduction of layer 2 scaling solutions, the focus has shifted from proof-of-work to proof-of-stake through The Merge.

Sharding strategies are constantly changing. However, layer 2 technologies are becoming more popular for scaling transaction processing; thus, this may not be necessary. Today, sharding methods are more concerned with determining how to split the task of storing compressed call data from rollup contracts equally. The implementation of proof-of-stake is a necessity for exponentially expanding network capacity.

What About the Ethereum Merge Myths?

Not everything you hear about the merge is true. Here are a few of the common myths debunked.

“Staking 32 ETH is required for node operation.” This is not the case. There is no restriction on who may sync their own verified copy of Ethereum (i.e., run a node).

“Gas fees will be significantly more affordable after the merge” is also untrue. The Merge is a change in the consensus method, not an augmentation of network capacity, and it won’t lead to cheaper gas prices.

“Transactions will be substantially quicker following The Merge” is also incorrect. Despite some minor adjustments, the transaction speed on layer 1 will stay the same.

“You may withdraw staked ETH after The Merge happens.” This is still incorrect. The Merge does not currently support staking withdrawals. Staking withdrawals will be permitted in the forthcoming Shanghai update.

“Until the Shanghai upgrade, validators will not get any ETH rewards when withdrawals will be authorized.” False. Fee tips/MEV will be credited to a validator-controlled Mainnet account and will be accessible instantly.

“When withdrawals are authorized, stakers will all leave at once.” Also incorrect. Validator exits are rate controlled for security reasons.

“There will be a threefold increase in the staked APR after The Merge.” False. More recent estimates expect a 50% rise in APR after the Merge, rather than a 200% increase.

“The Merge will cause chain downtime.” This is false. The Merge update is intended to allow for a seamless transition to proof-of-stake.

Staking and the Future of Ethereum Network Upgrades

One of the first issues is whether The Merge will increase Ethereum blockchain staking activity.

More than $30 billion in Ether has been staked on the PoS Beacon Chain, making it the biggest PoS blockchain by value staked, even before it replaces the Ethereum PoW Network. Staking requires installing specialized software and hardware, which may be purchased from other parties. Many others have staked by adding ETH to a staking pool. Staking pools function similarly to mining pools in that several users may pool their resources to increase their chances of being selected to propose a new block and divide the rewards.

After The Merge, staking will become an even more appealing option for a number of reasons. Once PoS is formally implemented, and PoW is relegated to the past, users will likely feel more comfortable staking. The fact that Ethereum PoS will be more environmentally friendly might reassure investors with a dedication to sustainability. This is particularly true for institutional investors.

The Merge also lays the groundwork for future Ethereum enhancements. ETH placed directly on the beacon chain cannot be withdrawn from the contract. Some staking platforms offer liquid, synthetic assets that act like a receipt to users’ staked ETH, although these synthetics may not necessarily retain a 1:1 peg with ETH. While The Merge will not instantly alter this, a future update called the Shanghai upgrade will let users withdraw staked Ether, offering greater liquidity for stakers and making staking a more appealing proposition overall. Other scalability improvements like sharding, which aim to decrease gas costs and speed up transactions, are also on the horizon after The Merge.

Collectively, these modifications, beginning with The Merge, should make ETH a more desirable asset to have and, by extension, to stake.

Ethereum Positioning Itself As A Viable Institutional Investment

In addition to a general rise in staking, we will be on the lookout for institutional investors like JP Morgan to start or boost their Ethereum staking activities.

We have previously discussed how the values of crypto assets such as Bitcoin have grown more connected with those of tech stocks and other high-risk, high-reward assets. ETH’s price may decouple from other cryptocurrencies after The Merge since its staking incentives will make it comparable to instruments that carry a premium, like bonds and commodities. It has been speculated that validators may anticipate yearly yields of 10–15% in ETH from staking incentives and transaction fees without even factoring in the possibility that the price of ETH could climb, which would raise profits in terms of fiat currency.

These returns might make staking Ethereum an attractive alternative to bonds for institutional investors. Although it has risen over the last 12 months, the one-year U.S.Treasury bonds yield is 3.5% as of September 2022.

The data indicates that the number of wallets staking at least $1 million worth of ETH, which can be referred to as institutional stakers, has been rising significantly.

It would be fascinating to watch whether the number of institutional-sized stakers grows at a quicker pace after The Merge, as Ethereum proves itself as a viable PoS yield-generating opportunity.

Ethereum Miners Will Have To Move, but Bitcoin Is Unlikely To Be an Alternative

The transition from PoW to PoS will entail adjustments in mining activities. Currently, a large number of miners and mining pools mine assets across many blockchains, dynamically dividing their hash rate depending on market patterns. The majority of mining, however, is concentrated on Bitcoin and Ethereum.

Several Ethereum blockchain-based services use the power of distributed GPUs to perform specific computational tasks in a decentralized way, rewarding GPU owners with ETH or ERC-20 tokens in exchange. So, does this imply that millions of once-productive GPUs will suddenly stop processing transactions, depriving their owners of the opportunity to profit from cryptocurrency? Perhaps not necessarily. Consider the two situations below:

  • Livepeer is a decentralized video streaming service that compensates GPU owners with money for transcoding content.
  • Render network offers a similar service for generating 3D graphics and lets GPU owners make money by sharing their hardware with others.

GPUs have several non-cryptographic applications, including processing for data centers, gaming computers, and other heavy-duty equipment. Despite the recent fall in on-chain activity, it will be worthwhile to see if these and comparable networks experience an uptick due to an inflow of GPU owners seeking yield options after The Merge. There is a possibility that some miners may sell their GPUs to industry players.

Meanwhile, as application industries flourished during the bull market of 2020–1, the Ethereum network grew overloaded with a large transaction volume, and transaction costs skyrocketed. This enabled other protocols, such as Binance Chain, Solana, and Avalanche, to steal Ethereum’s market share.

Announcing the anticipated launch date for the update eliminated ambiguity and increased anticipation that Ethereum would regain market dominance. Since then, the price of Ether has doubled, and the volume of Ether options has overtaken that of Bitcoin options for the first time, with the ratio of calls (bullish posture) being around 4 to 5 times that of Bitcoin.

What Are The Benefits?

Here are the main advantages a successful merge will unlock:

  • Improve the efficiency of the Ethereum network
  • Reducing energy usage by more than 99%
  • Less expensive to operate since validators will not be required to make significant hardware investments.
  • Issuance of Ether will decrease by nearly 90% since a percentage of transaction fees are burned (destroyed).
  • Becomes easier to engage in network security
  • All you have to do is stake your assets and earn transactions fees

In light of these benefits, it’s reasonable to assume that Ether will outperform Bitcoin in the near future. Ether’s price in BTC is now just 45% behind its all-time high and 10% below its yearly high reached in December.

If the second largest blockchain system can successfully switch to proof-of-stake, it will have an impact on the ongoing debate over the relative merits of proof-of-stake vs. proof-of-work methodologies. This might sway public opinion even further against proof-of-work blockchains (including Bitcoin) due to their high energy consumption. If Ether can “flip” Bitcoin and become the dominant cryptocurrency, Bitcoin’s dominance will inevitably decline.

And although Ethereum’s careful approach to the update has created major delays, it also gives confidence that the technical risks will have been substantially addressed by the time the upgrade goes live.

What Are The Dangers?

Despite Ethereum’s development team’s careful approach to deploying the proof-of-stake update, new technologies always carry the possibility of flaws and problems.

Ether’s price performance may be most susceptible to a broad misunderstanding of what The Merge would achieve. The transition to a proof-of-stake network is only the first stage on Ethereum’s road map. And although the date is definite and the possibility of future delays is minimal, an unexpected delay would have a negative impact on the price of Ether.

After the update, there is a tiny chance that regulators may see Ether as a security. This is improbable, considering the majority of blockchain systems are now proof-of-stake. Therefore Ethereum is not the first to provide this functionality. Furthermore, such a damaging regulatory action would be inconsistent with Western regulators’ generally accommodating and supportive stance. However, the legal justifications are somewhat hazy, leaving the door open for arbitrary regulatory action.

The most considerable risk in the immediate future is the possibility that The Merge will not make transactions quicker, cheaper and that this improvement will not take full effect for at least a year. On the other hand, the medium-term potential presented by a well-considered, complete upgrading of the (by a significant margin) most extensively used smart contract platform is enormous.

Market Trends Surrounding The Merge

Ethereum futures with expiration beyond the scheduled Merge go-live date have been trading at a discount to the market price — the most significant deficit since the March 2020 meltdown. This may be regarded as market players positioning themselves for “buy the rumor, sell the news” type deals, indicating that the favorable news has already been priced in.

However, it is more likely that the downtrend of Ether futures is the outcome of an arbitrage transaction (long spot/short futures) aimed at profiting from an anticipated fork of Ethereum’s proof-of-work version. Prominent miners want to keep the original system and give out a new currency to Ether holders for free.

Conclusion

Finally, the Merge is equivalent to replacing the engines of a flying aircraft, which sounds inconceivable to the human mind. However, the Merge success would be a victory for every person, institution, and organization in the blockchain ecosystem since it would open up even more opportunities for the good of humanity in unimaginable ways for most people.

This Merge is regarded as one of the most meaningful and awaited occurrences in the cryptocurrency sector. It is scheduled for September 14th. The countdown has begun, and the anticipation is palpable. The question remains, “Are we ready for it?

The effect of The Merge on crypto markets begins with on-chain data. The Merge might have significant effects on ETH’s price and general desirability as an asset, which in turn affects staking, mining, and institutional adoption of cryptocurrencies. Although it’s hard to forecast the precise market responses or how pronounced they’ll be, the on-chain measures outlined above may assist in tracking them after The Merge.

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Renato Zamagna

Renato Zamagna

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Finance, Blockchain, Cryptocurrency, and Data Security researcher, writer, and educator. www.linkedin.com/in/rzamagna