The Ethereum Merge: What’s changing and what’s yet to come?

Posted: 25 August 2022 5:00 pm
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theMergeLarge-min (2)

The next major Ethereum upgrade is just around the corner. Here’s everything you need to know about the Merge.

The Merge upgrade launches on September 15. It marks a significant milestone in the Ethereum (ETH) roadmap, which will see the Beacon Chain replacing the mainnet. The Merge upgrade will transition Ethereum to a proof-of-stake (PoS) blockchain, significantly reducing energy consumption and lowering ETH issuance.

How did we get here?

Decentralization is a vital component of a successful blockchain. It involves the blockchain achieving consensus and authorizing transactions without a central governing authority, instead relying on a peer-to-peer trustless system.

The two most prominent consensus mechanisms are proof-of-work (PoW) and PoS. The former is often referred to as mining, while the latter involves participants locking up their crypto to help secure the network.

Ethereum operates as a PoW blockchain. However, come Merge day, this will no longer be the case. The PoW model operating on the mainnet will be switched off and will be replaced by the Beacon Chain’s PoS consensus mechanism.

The Beacon Chain has been running in parallel with the Ethereum mainnet since December 2020. This period has allowed the PoS chain to be tested in production, helping ensure a smooth transition when the PoW chain is finally decommissioned.

What’s changing?

The Merge upgrade will see two notable changes to the Ethereum blockchain: consensus and issuance.

Consensus. PoW mining is an expensive task, often overlooked by retail investors and left to institutions. PoS breaks down this barrier to entry and opens the door for retail investors to act as consensus participants, easily staking ETH from any computer.

The Beacon Chain already has over 13 million staked ETH, secured by more than 400,000 validators. This increase in validators will go a long way towards further decentralizing the Ethereum blockchain. It ensures network security at the time of the Merge and makes it more resistant to malicious attacks.

Institutions will likely benefit from this change too. The Ethereum Foundation estimates that the transition to PoS will see a 99.95% reduction in network energy consumption. This means that institutional investors can stake ETH and participate in the broader Ethereum ecosystem while adhering to environmental, social and governance guidelines (ESG) – a task that was impossible via mining.

Issuance. Aside from the environmental benefits, the most notable takeaway from the Merge is how it will impact Ethereum issuance and supply. ETH issuance post-Merge will plummet from approximately 4.3% to 0.43% – an inflation rate reduction of about 90%.

Ethereum developers also implemented a burn mechanism in the previous milestone release, the London hard fork. This introduced a base fee of ETH being taken from all transactions and burned (removed from circulation).

This burn mechanism plus a lowered inflation rate may result in deflationary periods for ETH where supply is reduced instead of increasing. This is expected to have a positive impact on the price of ETH over the long term.

What comes next?

The Merge is just a piece in the puzzle of a multi-stage Ethereum upgrade. Although it does fill in some of the gaps, there are still flaws that developers aim to solve.

Scalability. A major issue with the Ethereum blockchain involves a cryptographic problem known as the scalability trilemma. This theory states that a blockchain can’t achieve three key characteristics at a single time: scalability, decentralization and security.

As Ethereum operates, it is both decentralized and secure. However, it lacks scalability. The entire blockchain ledger needs to be read and approved by every network validator for consensus to be achieved. As the ledger grows and takes up more memory, validation and transaction processing times increase.

Competitor layer-1 blockchains have tried to improve Ethereum’s speed and scalability by cutting back on validator nodes. By confirming transactions based on the consensus of a few “trusted” validators, the network can increase transactions per second (TPS). However, this leads to the blockchain being far more centralized and prone to attacks.

Ethereum developers aim to tackle this problem and solve the scalability trilemma with a solution known as sharding. Sharding partitions the blockchain and distributes these partitions or “shards” to a group of randomly selected validators. Each validator is responsible for verifying a small portion of data, as opposed to the entire blockchain history.

If the sharding update is successful and scalability is solved, this enables higher throughput and drastically reduces transaction times.

The Ethereum vision states:

“Ethereum needs to support thousands of TPS to make applications faster and cheaper to use.”

Thousands of TPS does sound great, especially considering Ethereum’s current TPS rate of about 10–13. However, sharding is a complex solution and far from completion. The development team estimates the update to be shipped in 2023. Although if history is anything to go by, development delays should not be discounted.

Staking

Since the release of the Beacon Chain in December 2020, ETH validators have flocked to lock up their coins and receive rewards for securing the network. More than 13 million ETH has been staked across 400,000 validators.

While this is overwhelmingly positive for the decentralization and security of the blockchain, some investors have raised concerns about large quantities of staked ETH being unlocked once the Merge goes live. Mass unlocks have the potential to oversaturate the market if investors decide to sell their assets in bulk.

Fortunately, this will not be the case as the Merge is not an unlock event.

Upon staking ETH, investors have committed to act as long-term validators. This means all ETH staked directly on-chain is subject to a locked staking period and cannot be withdrawn or transferred until Ethereum says so.

This ensures a simultaneous sell-off does not occur and a sufficient number of validators remains in place. While it is uncertain exactly how long this lock-up period will last, it is estimated to be at least 6–12 months post-Merge, at which time validators can opt to join an unstake queue. Pending Ethereum’s approval, these nodes will be removed as network validators and have their ETH returned.

There is also substantial motivation to keep ETH staked as returns are expected to increase. While it is not certain exactly what the rewards for stakers will be post-Merge, Ethereum researcher and developer Justin Drake has released a report stating a “best guess” of an 8% annual percentage rate (APR). This is approximately double what is currently being issued to Ethereum validators.

ETH projections from Justin Drake's report

ETH projections | Source: Justin Drake | Image: Supplied

It should be noted that to act as an Ethereum validator, you must stake at least 32 ETH. For many investors, this amount is not feasible especially given the uncertainty surrounding the unlock schedule.

Fortunately, there are alternatives available. Through the Lido Finance platform, you can participate in ETH staking with no minimum required balance or lock-up period. You will not be acting directly as a network validator. Instead, you will receive staking rewards paid daily in the form of stETH.

stETH is a token that represents ETH on a 1:1 basis. It is minted upon depositing your ETH and burned once withdrawn.

How to stake Ethereum – three ways compared

Summary

The Merge is one of the most anticipated events in the history of blockchain. If the Ethereum development team manages to make the transition from PoW to PoS without a glitch, it will mark a significant milestone in the advancement of decentralized technologies.

The Merge also lays the groundwork for further updates such as sharding, which will help improve the network’s scalability issues and reduce gas fees.

Whether you’re a long-term HODLer or a speculative investor watching from afar, all eyes will be on Ethereum.

Trying to get a handle on the markets? Cut through the noise with our overview of the best cryptos to buy right now, explore some strategies for how to trade crypto or see if there's a better platform for you with our guide to the best crypto exchanges.

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Billy Endres owns cryptocurrencies as of the publishing date.

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