Understanding DeFi: Ethereum’s Merge to Proof-of-Stake Explained
Later this year, Ethereum is set to complete the most significant update in its history. The world’s most used blockchain will implement “The Merge” from Proof-of-Work to Proof-of-Stake, an important update that’s been in discussion since 2014. Ethereum’s upgrade to Proof-of-Stake marks a new stage in the blockchain’s lifetime and is expected to have a significant impact on the broader ecosystem for many years to come. In this guide, we explain how it works and why it’s such an important update.
Proof-of-Work vs. Proof-of-Stake
Ethereum launched in 2015 with a Proof-of-Work consensus mechanism similar to the one Bitcoin uses to verify transactions. With Proof-of-Work, Ethereum miners are responsible for solving computational problems and adding new transactions to blocks. Miners receive ETH rewards for securing the network.
Although Proof-of-Work has worked for Ethereum over the past seven years, it has some disadvantages compared to Proof-of-Stake. Crucially, energy consumption for Proof-of-Work mining rigs is very high, and the expense of mining hardware excludes people from participating.
Once Ethereum transitions to Proof-of-Stake, it will rely on validators who stake tokens to verify transactions and add new blocks to the chain. Ethereum stakers must deposit 32 ETH to the Beacon Chain, otherwise known as the consensus layer, to run a validator node — or they can deposit a smaller amount of ETH to staking pools such as Rocket Pool or Lido. There are currently 12.6 million ETH worth $25 billion staked, making the amount of funds securing Ethereum larger than the overall market cap of most of its competitors.
One key benefit of The Merge is that it will reduce Ethereum’s energy usage. According to estimates from the Ethereum Foundation, Proof-of-Stake Ethereum will be 99.95% more energy-efficient than Proof-of-Work. Rather than relying on heavyweight ASIC mining rigs, Ethereum will be validated by stakers who can run a node from devices as small as a Raspberry Pi.
Besides reducing Ethereum’s energy consumption, Proof-of-Stake should also change the narrative surrounding the network. In recent months, Bitcoin has come under fire for its reliance on energy-intensive mining, leading to criticisms of Ethereum and specifically NFTs. With a shift to Proof-of-Stake, the fast-rising technology should see more acceptance and position Ethereum as a hub for technological innovation.
As many newer blockchains use Proof-of-Stake and consume less energy than Ethereum, the move to become more energy efficient has been a long time coming.
Reducing ETH issuance
Ethereum currently pays ETH rewards to miners to incentivize miners to secure the blockchain. As a result, the ETH supply increases by approximately 3.5% annually.
With Proof-of-Stake, emissions will reduce to closer to 0%. Ethereum validators can currently expect to earn approximately 4.5% APR in exchange for committing their ETH to secure the chain. But as EIP-1559 burns the base fee in every Ethereum transaction, the overall emissions come in at closer to 0%.
Researchers have calculated that with enough activity on the network, ETH could become a deflationary asset. Such a development would benefit ETH holders and could theoretically increase the price as it becomes more scarce. This would make the network more secure as it becomes more expensive to carry out an attack.
The future of Proof-of-Stake Ethereum
While Ethereum will immediately benefit from The Merge, the update also sets the blockchain up for longer-term success. This is because it will allow for sharding when Ethereum will add 64 new chains to help distribute the traffic on Ethereum mainnet. Sharding is the next major update following Proof-of-Stake. With the help of Layer 2 scaling solutions such as ZK-Rollups, sharding is expected to help increase the availability of Ethereum block space and ultimately move Ethereum closer to mass adoption by making the blockchain more scalable.
Ethereum’s Merge to Proof-of-Stake will likely transform the network and set Ethereum up for long-term sustainability and scalability. This should benefit the entire crypto ecosystem, given the crucial role Ethereum plays in both DeFi and NFTs. However, the update is not without risks. Due to the amount of funds locked in Ethereum today, a mistake could have drastic consequences. A significant issue could also wreak havoc on other networks and DeFi protocols. It’s worth noting that The Merge has already gone through several testnets to ensure that the update runs smoothly. Though the launch date has not been finalised, the Ethereum Foundation has insisted that the update will not ship until it is ready. It’s expected to happen sometime before the end of the year.