Ethereum 2.0 — What to Expect?
The long-awaited Ethereum 2.0 is almost here.
The multi-phased upgrade attempts to improve the Ethereum network’s scalability and security by making major infrastructure changes, most notably switching from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS).
This article will discuss Ethereum’s merge and its future potential.
What is Ethereum 2.0?
Ethereum 2.0 is an upgrade to the Ethereum blockchain. The upgrade intends to improve the Ethereum network’s speed, efficiency, and scalability so that it can handle more transactions and alleviate bottlenecks.
To begin with, Ethereum developers have dropped the label “Ethereum 2.0” in favor of “consensus layer.” This was done to minimize misunderstanding and to emphasize the fact that what has previously been dubbed “Ethereum 2.0” is more of a network upgrade rather than a whole new network.
Instead, Ethereum is made up of “Ethereum 1.0” as the execution layer and “Ethereum 2.0” as the consensus layer, with both integrated together.
When is Ethereum 2.0 happening?
Image source: banklesshq.com
Ethereum upgrades are a multi-staged procedure with several phases. The Beacon Chain phase became operational on December 1, 2020. The Beacon Chain adds native staking to the Ethereum blockchain, which is a fundamental component of the network’s transition to a PoS consensus mechanism. It is, as the name implies, a distinct blockchain from the Ethereum mainnet.
The second phase, known as “the Merge,” is set to begin in the second or third quarter of 2022, and will involve the integration of the Beacon Chain with the Ethereum mainnet.
Kintsugi, a public testnet, had a testnet merge in December 2021 to let application developers and clients to become accustomed with the post-merge Ethereum environment. Heavy usage of the test network would allow clients and Ethereum developers to find any potential issues and mitigate them. Although there were few problems to fix, it provided an important preparation for the upcoming Kiln testnet.
Kiln testnet merge was mostly successful. This is the last public testnet before the switch to proof-of-stake, which will happen later this year.
The final phase is shard chains, which will play a key role in scaling the Ethereum network. Instead of settling all operations on one single blockchain, shard chains spread these operations across 64 new chains. Sharding is what will make Ethereum 2.0 efficient and scalable blockchain.
Ethereum 2.0: What to Expect
It’s important to understand that the merge will be an upgrade to a consensus layer. On this layer it will no longer be miners propagating the blocks, but staking validators. The execution layer will remain unchanged.
Image source: consensys.net
- Execution layer: Responsible for transaction bundling, execution, and state management.
- Consensus layer: Responsible for the validating blocks, also known as the Beacon Chain. This consensus-layer has been running smoothly with 329,006 validators collectively staking 11,043,496 ETH to date.
The scalability, which will see Ethereum moving from 30 transactions per second to up to 100,000 transactions per second, will be achieved through the implementation of shard chains. This is because the current Ethereum setup has a blockchain consisting of a single chain with consecutive blocks. This is secure but very slow and inefficient. With the introduction of shard chains, the blockchain will be split up, enabling transactions to be handled in parallel chains instead of consecutive ones. This will speed up the network and scale it more easily.
Ethereum 2.0 will consist of the following:
Image source: Hsiao-Wei Wang and Ethereum
- Beacon Chain: The brand-new, proof-of-stake blockchain. It serves as a bridge between shard chains and the main chain, providing staking incentives. The Beacon Chain will keep track of historical shard chain reference points.
- Shard Chains: Since sharding is used for scalability, each shard chain is obligated to run independently of one another with unique states and independent transaction histories. The principal link between shards will be recorded on the Beacon Chain.
- eWASM: Transition from the Ethereum Virtual Machine (EVM) to eWASM Ethereum 2.0 (Ethereum WebAssembly Machine). eWASM will help create an ecosystem that’s fast, scalable, and flexible, encouraging developers to build complex smart contracts on top of Ethereum 2.0’s protocol.
Tokenomic Implications Post Merge
Currently the amount of Ether issued per year is approx 5.4 Million ETH at the inflation rate of 3.3%. Taking into account Ethereum’s burning mechanism, also known as EIP-1559, whereby a small portion of ETH gas fee, i.e. the base fee, is burned and thus removed from circulation permanently. Currently, such burn rate is 1.5 Million ETH per year. See below:
Image source: ultrasound.money
After the merge, the amount of Ether being issued will drop considerably. Specifically the current annual Ether issuance is 5.4 Million ETH per year which is expected to drop to about 500,000 ETH per year and with fee burning mechanism on top of that, this would make Ethereum deflationary. See below:
Image source: ultrasound.money
This dynamic is significant because, owing to the law of supply and demand, a drop in supply at a constant demand will result in a price increase.
According to the most recent on-chain measurements, 2022 has witnessed some of the highest Ethereum outflows. The quantity of Ether held by crypto exchanges has dropped to its lowest level since September 2018.
According to Glassnode data, almost 550,000 ETH, around $1.61 billion, have departed centralized trading platforms this year alone.
Image source: glassnode.com
Chainalysis showed similar data, revealing that Ether tokens have left exchanges this week at an average of about 120,000 units per day.
When Ethereum is removed from exchanges, it could be used in DeFi protocols or deposited in the ETH staking contract. The latter appears to be the case, since records reveal that Ether holders contributed over 11 Million ETH to the Ethereum 2.0 contract as of today.
Image source: twitter @ultrasoundmoney
Valuing Ethereum 2.0
Image source: launchpad.ethereum.org
Post-Merge Selling Pressure?
What will happen to all of the ETH that has been locked up after the merge? Is it possible validators will sell all of these ETH? To begin with, the exit rate will be limited to 4 validators each epoch, with one epoch lasting 6.4 minutes.
According to Ethereum’s beacon chain explorer, there are currently over 329,000 validators staking over 11 Million ETH, equating to 33 ETH on average per validator (beaconscan.com).
Assuming that every validator decides to sell, 4 validators every epoch means that 900 validators may only exit per day with 33 ETH, resulting in a maximum of 29,700 ETH sold per day. With Ethereum’s current daily trading volume of about 5 Million ETH, this would represent 0.57% of the current daily trading volume and 0.024% of the entire circulating supply of 120.18 Million ETH.
Even if every validator sells, we believe this won’t have a significant impact on the price of Ethereum. In actuality, once the merger is completed successfully, an increasing number of institutions, whales, and miners could begin to stake. This is because, one of the biggest concerns surrounding staking ETH is the lack of visibility on the withdrawal period, as for many institutional investors, it can be a challenge to stake ETH holdings without certainty on when they will be able to get it back, even if the yields themselves are attractive.
Furthermore, because the Ethereum blockchain is migrating from Proof-of-Work (PoW) to Proof-of-Stake (PoS), miners, who were previously compelled to sell in order to pay for operating costs on equipment, would no longer be required to do so, as maintaining a validator node on PoS is significantly cheaper. Consider the following data:
Image source: Coinbase Analytics
According to Coinbase, miners appear to be accumulating ETH since EIP-1559 introduction (ETH fee burning mechanism), as the net ETH inflows into miner wallets have been predominantly positive. This might imply that miners are waiting until the merge to flip over their rigs and migrate over as validators, allowing them to continue safeguarding the network with staking rewards. This means there will be less ETH on the market, which will result in reduced sell pressure and a favorable price action.
Image source: coin68.com
The sharding of the main Ethereum chain will increase the scalability of Layer-2. This is because Layer-2 solutions (Polygon, Arbitrum, Optimism) employ rollups, these roll-up solutions will be able to take full use of increased Ethereum block space. This would be crucial to allow Ethereum network to potentially scale to billions of users in the long run.
Demand Post Merge?
Ethereum and its scaling solutions dominate 55% of the DeFi TVL ecosystem, 90% of the NFT market, and the fast rising Metaverse sector, which Citibank recently predicted to be a $13 trillion market with 5 billion users, which is predominantly being developed and operated on the Ethereum blockchain. This trend is expected to continue, resulting in increased demand for ETH post-merge.
Environmental, Social and Governance
ESG, which stands for Environmental, Social, and Governance, is influencing investing strategies, with largest asset managers increasingly incorporating these non-financial elements into their research process to identify opportunities.
The perception around proof-of-work mining, such as Bitcoin and Ethereum before the merge, being bad for the environment has meant that many large institutional investors stayed away from such cryptocurrencies. Now that Ethereum transitioning to proof-of-stake, which is magnitudes more efficient then proof-of-work, as it eliminates the need for mining rigs, the power Ethereum will require will be a fraction of what it is now. Specifically, the power consumption will reduce by over 99%, making it ‘green’. See below:
Image source: blog.ethereum.org
ESG, together with the diminishing supply outlined in tokenomics, would make it extremely compelling for major asset managers to acquire an asset that would also let them to earn staking incentives. This might attract billions of dollars in institutional capital, especially in a climate of rising inflation and an overvalued stock market.
Furthermore, many SNP500 companies must include ESG into their corporate policies, and if they want to employ Ethereum’s technology in their operations or payments, becoming PoS, or ‘green,’ will be highly advantageous.
The merge is the biggest upgrade that Ethereum is going through. Even though it has been thoroughly tested, there is no assurance that it will operate well on a live switch. Any serious flaws might jeopardize Ethereum’s reputation, and it’s worth mentioning that there are already highly scalable blockchains competing with Ethereum, such as Solana, Avalanche, Fantom, and Cardano, that don’t require “transition” or Layer-2 solutions to be efficient.
Furthermore, there is no certainty that the merger will take place in the next several months, since it has already been postponed on several occasions.
Subject to a smooth transition, favorable market conditions, and the retention of staked ETH in the 2.0 contract, a merge that will result in Ethereum becoming deflationary, combined with the EIP-1559 burning mechanism, and the possibility of major financial entities getting involved due to its ESG, we estimate a possible price range of $5,000 — $7,000 per ETH.
DISCLAIMER: The information contained in this article is for educational purposes only and does not constitute any form of advice or recommendation by Wheatstones, and is not intended to be relied upon by users in making (or refraining from making) any investment decisions.