Update on ETH Merge & Tokenomic Changes
Recent Test
For all of us anxiously waiting for an update on the much-anticipated Ethereum Merge, the news that a recent run of the merge on the Ropsten testnet executed as of June 8th, 2022, must have resulted in a collective sigh of relief. As the first of three test nets on which the merge must be executed on prior to launching, the update has given Ethereum users hope that the merge is in fact, just around the corner.
Key to note that Ropsten supports a significant number of projects and protocols on the Ethereum network such as MetaMask and EtherScan among many others. This aspect of the Ropsten testnet is unique compared to all shadow fork tests conducted by the Ethereum development team prior. As such, the effective execution of the Ethereum merge on the Ropsten network would allow protocols to ensure their code and tools efficiently function when the merge on the Ethereum mainnet goes live.
Note: I use the terminology “The Merge” to refer to the now retired previous name of the merge project “ETH 2.0”. This rebranding decision was taken by the development team to reduce the common misconceptions non-technical ETH users experienced, such as the issuance of a new ETH token named “ETH 2.0” and the dissociation of ETH 2.0 from Ethereum itself. — Ethereum Foundation Blog Post
All transactions on the Ethereum blockchain will still require Ethereum (ETH) to execute, no new tokens have been created. Ethereum users should be wary of any malicious individuals attempting to pitch them a new token or investment related to “ETH 2.0”.
Wen Merge?
Assuming all Test nets go live and all issues experienced have been resolved. As of the current timeline, the merge on the main net is expected to go live in August of 2022; however, it is important to note that to be consistent with the timeline, we need to assume that all merges on the test nets go through without fail and that no other black swan events occur that would result in a shift in Ethereum development team priorities. A more likely timeline would be more towards the end of the year.
What the point?
To better understand the reasoning behind the merge, we must first understand the benefits of shifting from a Proof of Work to a Proof of Stake mechanism. Essentially, the Ethereum blockchain has 3 different layers, the Execution Layer, Consensus Layer, and Data Availability Layer. The Merge itself is an update to the existing consensus layer, which at the current point in time utilizes a Proof of Work mechanism. Post merge, the consensus layer will operate via a Proof of Stake mechanism where stakers rather than miners earn rewards for propagating blocks on the Ethereum blockchain.
This shift poses many benefits from an energy efficiency perspective as the shift to Proof of Stake (PoS) changes the hardware requirements to run an Ethereum validator on the consensus layer. Proof of Work (PoW) requires miners to deploy a set of high core GPUs each of which requires significant electrical input to operate and cool, whereas PoS only requires stakers to have a simple dedicated computer connected to the internet 24/7. In fact, as per the information outlined on a blogpost by the ETH foundation in May of 2021, the merge is expected to decrease overall energy consumed by the Ethereum blockchain by approximately 99.95%.
You may be wondering why this is important from an investor perspective, it may be beneficial overall for the environment sure but what implications if any does it have on the price of ETH? For one, it contributes positively to the likelihood that traditional institutional investors will adopt an Ethereum position in their portfolio since Environmental, Social, and Governance (ESG) elements have become dominant factors considered by said investment professionals when making allocation decisions. Additionally, one can look no further than the EU and its overall stance on adopting regulation whose sole objective is to significantly diminish the utilization of PoW based blockchains like Bitcoin. This is mainly due to the environmental concerns cited by the EU government in their (now rejected) proposed bill. The rise of regulation against PoW mechanisms would be additional backing as to why the merge may be beneficial as individuals flock to PoS based blockchains should the risks of a PoW ban increase substantially.
So, what about users of the blockchain itself? Other than price appreciation of the transacting token, what changes would the merge bring to transacting on the Ethereum blockchain? Unfortunately, despite the common misconception, the merge has no effect on the gas fees associated with transactions as said fees are determined by the execution layer not the consensus layer. However, that is not to say there are no alternatives to optimize and save on certain gas transactions, many layer 2 Protocols have the current capability to provide such services on Ethereum. Additionally, post merge, the Ethereum development team will be working on a scaling fix in which upgraded shard chains on the main net, coupled with layer 2 execution layers work in conjunction to reduce gas fees.
Tokenomic Implications: Is this good for the price?
In the end of the day ETH’s price is driven by the availability of the token on exchanges (supply) as well as the overall need for ETH (Demand). Demand isn’t necessarily expected to change much due to the merge itself; however, as pointed out above, the resulting energy efficiency of the merge may result in increased adoption of the token.
Supply is where things get interesting. Firstly, to run a PoS system you require stakers willing to lock in a specified portion of tokens (in ETH’s case: 32 ETH) to obtain a VARIABLE yield or APY. It’s important to note that the yield is variable based on certain factors such as total amount of ETH staked. As such, we can expect there to be outflows of ETH from exchanges so that holders benefit from staking rewards, which in turn would reduce supply of ETH available to trade. As observed on the Ethereum staking subdomain, the current amount of ETH staked is approximately 13.5M, earning an APY of 4.2%. What is important to note here is that the 13.5M ETH staked is locked in the staking contract, with the ability to withdraw only available once the development team updates the main net post the merge.
Another important aspect we must consider is new ETH minted and burned. For those unaware of Ethereum’s core tokenomics, ETH is a cryptocurrency that in effect has no cap on circulating supply. For anyone new to the crypto market, you might have been told from certain sources that an uncapped market supply is something to be concerned about and in effect it should be; yet we must also consider the inflation rate (I.E. new tokens minted relative to current supply) in order to get a broader view on how supply may change long term.
At the current point in time, ETH has an inflation rate of approximately 2.1% a year according to data from UltraSound.Money. See screenshot below.
We can see that as per the data, prior to the merge, the amount of ETH issued is expected to increase by approximately 5.4M ETH / Year. Additionally, due to the EIP-1559 Burn Mechanism which burns a certain portion ETH with every transaction, approximately 2.9M ETH is burned / Year. Coupling both issuance and burn mechanisms we can conclude that approximately 2.5M ETH is the NET amount created and acts as input to our inflation rate calculation.
If we adapt the data to simulate post merge tokenomic functioning, we see from the new screenshot below that ETH issued decreases significantly from approximately 5.4M/year to only 0.5M/year, representing a decrease of over 90%!
What about the burn rate though? Well, the data indicates that the amount of ETH burned will not change post merge. This is primarily due to the burn mechanism purely existing on the execution layer which itself is not affected by the merge. As such, due to the decrease in ETH issued and the expected constant amount of ETH burned post merge, ETH would experience an inflation rate of NEGATIVE 2.0% a year. Yes, you read that right, the merge may effectively turn an inflationary token into a deflationary one. The implications of this shift in ETH’s core tokenomics on price can be understood by referring back to the token supply factor. The less ETH available in the market the higher the price of ETH assuming demand remains constant, and with the likelihood of ETH becoming a deflationary token, we can assume that new potential supply constraint will be heavily factored in by market participants when pricing the token post merge.
Yes, it’s exciting, and yes, this could be very good news to holders of ETH; however, we must not get too excited as we have historically seen many setbacks delay the merge by months on end. Certainly, anyone would hope for a smooth road ahead to get the merge deployed on the Ethereum mainnet, but the Ethereum development team have taken the mindset of wanting a bumpy transition. I personally am all for this approach, better to iron out all the wrinkles before deploying on the main net rather than risk crashing the blockchain and all the protocols build onto it.
Additional Resources:
Coin Bureau — “Ethereum: Merge INCOMING!! ETH Predictions & Analysis!”
Inspiration for this Article
Bankless Podcast — “ Ethereum Merge Updates! | Tim Beiko” (Ethereum Developer)
Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing
