Mergers: What to Expect From Ethereum’s Biggest Update


The long-awaited The Merge update is still a few months away, and it will be a major milestone in Ethereum’s development. Not only will the consensus algorithm change, Ethereum will also become more environmentally friendly and deflationary, which will have a positive impact on its price in the medium to long term.

ForkLog figured out the features of the upcoming upgrade and its potential impact on the investment attractiveness of the second-largest cryptocurrency by capitalization.

During the activation of The Merge update, Ethereum has final preparations to switch to the Proof-of-Stake consensus algorithm.
The upgrade will significantly affect the fundamental qualities of encryption, making it deflationary and more environmentally friendly.
The rate of ether emission that affects the price will depend on the number of validators and on-chain activity.

seven year journey

The transition from Proof of Work (PoW) to Proof of Stake (PoS) is the most important and complex upgrade in Ethereum history. This process has been going on for seven years and has reached its end.

In the past, upgrades have been called by various names: Serenity, Casper, Shasper, Ethereum 2.0, and finally The Merge.

This update will change the consensus mechanism that determines the principles of transaction verification and block production.

eth_merge_sch-1024x464.pngHistory of Ethereum hard forks on the way to merge activation. Data: Galactic Digital Research.

Since 2014, developers have been exploring the possibility of PoS as an alternative to PoW systems. Due to the novelty and lack of knowledge of the new algorithm at the time, Ethereum was launched in 2015, based on the proof-of-work based Ethash technology.

That same year, the developers came up with an ambitious roadmap, with the final stage of development dubbed Serenity. He assumes a complete transition from Ethash to a stable PoS algorithm.

One of the main motivations is to improve the energy efficiency of Ethereum. Developers expect The Merge to reduce energy costs by more than 99.9%. Validators will play a central role in the network instead of miners, and each validator needs 32 ETH in the form of collateral.

According to Galaxy Digital Research researchers, the upcoming upgrade will not in any way change the algorithm by which users interact with dapps. Exchange clients, custodial services, and regular ETH holders don’t need to move their tokens anywhere.

From inflation to deflation

Currently, most new ethereum issuances take place on traditional PoW blockchains – the execution layer. Miners earn 2 ETH per mined block, totaling over 12,000 ETH per day.

Miner reward 1024x262.pngData: IntoTheBlock.

A small portion of ETH is issued on the beacon chain. This PoS-based network is called the consensus layer.

Beacon Chain (or Phase Zero for Ethereum v2) was launched on December 1, 2020.

The amount of ETH issued at the consensus level depends on the number of validators and the number of coins staked. Another factor that affects emissions is the transaction fee for burning a portion, depending on network load. The mechanism (EIP-1559) was activated during the London hard fork, and more than 2.4 million ETH has been burned since then.

Ultrasonic money 1024x484.pngInformation on Ethereum inflation and the number of coins burned since EIP-1559 was activated. data as of June 8, 2022.

With a current pledge of 12.7 million ETH (about 10% of the ether market supply) and a daily burn rate of 7,900 ETH, the inflation rate is 2.1%. In other words, the new emissions are about 5.4 million ETH each year.

ETH-Supply-Distr-1024x507.jpgETH supply distribution map: funds, ETH2 Staking, DeFi, foreign exchange reserves. Data: Cryptocurrency.

The screenshots below are heatmaps. It shows how changes in consensus-level burn rates and staked ETH affect the daily supply of Ethereum.

Projected-Daily-Iss-of-ETH-Post-Merge.jpgData: Galactic Digital Research.

With The Merge activated, the emission mechanism no longer means a fixed reward for miners per block. The amount of ETH awarded to validators will change dynamically, with each epoch lasting 6.4 minutes.

Suppose the consensus level involves 11 million ETH. The heatmap above shows that with this parameter, 1511 ETH will be issued per day.

When coin burns are taken into account – say, 4000 ETH per day – Ethereum becomes deflationary. Supply with such parameters will decrease by 2489 ETH per day or 0.77% per year.

The amount of ETH burned is directly dependent on on-chain activity, which is falling after the hype around DeFi and NFTs ended. The chart below shows that the number of transactions in the Ethereum network has fallen significantly relative to its peak levels in May 2021. The daily average is below the 1 million mark, which is in line with the value in early 2018.

trans number 1-1024x683.pngData: IntoTheBlock.

According to Galaxy Digital Research: “If user adoption of ethereum picks up in the coming months and years after the Merge upgrade, the ethereum supply will shrink even faster.”

Then, according to them, the value proposition of the second-largest crypto by capitalization will increase, especially in the context of store of value.

As mentioned earlier, the security of a PoS network is not provided by energy-intensive miners, but by validators who block the supply of ETH in the network. The more coins are staked, the harder it is for a potential attacker to take control of the system and alter transaction history.

The Ethereum consensus level is designed to automatically adjust validator rewards based on the amount of Ethereum involved.

eth_p1-1024x517.pngThe annual supply of ETH and the annual rate of return for validators. Data: Galactic Digital Research.

When the amount of ETH in stake increases and there are many active validators in the network, the latter’s profitability falls. In the opposite case, when validators and tokens are few, the yield increases to encourage them to participate more actively in the network.

As of June 8, 2022, there are 399,554 validators.

glassnode-studio_ethereum-total-number-of-validators-2-1024x576.pngGrowth dynamics of the number of accounts depositing 32 ETH in the Ethereum 2.0 deposit contract. Data: Glassnode.

The algorithmically altered issuance rate ensures that no matter how much ETH is staked, validators always have enough incentive to work.

“However, this dynamic approach is fraught with difficulties when predicting Ethereum’s long-term monetary policy,” stressed experts at Galaxy Digital Research.

In addition to the amount of ETH staked and the number of tokens burned, analysts should also consider less important metrics: online validators and slashed validators.

eth_p2-1024x517.pngData: Galactic Digital Research,

The chart above illustrates the expected drop in ETH supply following the activation of The Merge. According to the Ultra Sound Money service, with 2.9 million ETH burned per year (or about 8,000 ETH per day, which is the average since the activation of EIP-1559), the number of coins in circulation will decrease by 2% per year.

Other factors can also affect the income structure:

Priority fees currently received by Ethereum miners will be transferred to active validators once the merge is activated. According to Coin Metrics, the total volume of such “hints” is just over 1,000 ETH per day, roughly the same as the daily income of validators. As a result, the latter’s revenue will double.
In addition to the prompt, validators will also receive a maximum extractable value (MEV). Flashbots researcher Alex Obadiah calculated that MEV revenue can increase revenue by 75%.

Liquid staking and centralization risk

An increasing share of the beacon chain is falling on platforms operating in a staking-as-a-service (SaaS) model. The clear leader in this space is Lido, a liquid staking service.

The chart below shows that large exchanges also have a large weight: Kraken, Binance, and Huobi.

Address of the highest depositor.pngData: Etherscan.

The popularity of SaaS providers is largely due to the fact that such platforms greatly simplify and democratize staking due to the possibility of delegation. Users do not need to own 32 ETH – a small amount can be used. No deep technical knowledge is required.

Additionally, many SaaS providers offer cut insurance to users. Additionally, liquid staking services can help improve capital efficiency—for example, Lido issues derivative tokens that represent funds locked in staking contracts. Such tokens can be used in DeFi protocols to generate additional income.

“Given that the profitability of ETH derivatives is higher than ETH itself, tokens like rETH and stETH may at some point become competitors or even surpass Ethereum in terms of liquidity and acceptance as the dominant currency for DeFi operations,” Galaxy Digital Research representatives shared their thoughts.

The chart below shows that Cosmopolitan is far ahead in its segment.

LidoAnalytical-1024x179.pngDynamics of funding volume in popular staking protocols. Data: Dune Analysis (@LidoAnalytical).

Bankless co-founder Ryan Sean Adams speculates that, over time, ETH will become something like a perpetual internet bond, whose holders will be both creditors and network owners. Therefore, as the underlying asset, ether will be less and less involved in dapps.

Given the wide range of interesting options offered by SaaS providers, we can expect further growth in their popularity and therefore further value in assets under management (TVL).

There is a trend towards decentralization in this field. For example, Lido is implementing distributed validator technology. The newer service Rocketpool is gradually gaining momentum, positioning itself as a decentralized staking platform.

When is the merge activated?

Testing at The Merge is in full swing: On June 8, Ethereum developers switched the Ropsten network to PoS. The Goerli and Sepoila testnets are expected to migrate within a few weeks.

In May 2022, Preston Van Loon, one of the main developers, announced that the transition of the mainnet to PoS would take place in August. Vitalik Buterin also called the last month of summer the most likely date, but allowed the event to be pushed back to September-October to avoid “potential risks”.

Under Messari’s conservative scenario, The Merge will be fully activated in November-December.

5/ Fundamental improvements to long-term attractiveness include:

+ less protocol energy + less issuance + net deflation + bond-like yields + increased decentralization + slight increase in throughput

— Messari (@MessariCrypto) June 7, 2022

Analysts expressed confidence that after the upgrade, Ethereum will no longer be seen as a “utopian experiment.” Instead, cryptocurrencies will attract long-term investors.

Messari assumes that staking rewards will be in the range of 7%-13%.

future development

After The Merge is launched, the Shanghai hard fork will be an important event. It aims to improve the scalability of the network, make the withdrawal of pledged funds available, and upgrade the Ethereum Virtual Machine (EVM).

In March, Vitalik Buterin shared the idea of ​​Proto-danksharding, a data validation script focused on transactions that carry so-called blobs that the EVM cannot execute.

My own EIP-4844 (aka proto-danksharding) technical FAQ:

— Pigbayashi vitalik.eth (@VitalikButerin) March 19, 2022

Proto-danksharding aims to replace danksharding, a sharding technique where only one author of a proposal chooses all transactions and data that fall into one slot or the other. This approach was introduced in February 2022 by Ethereum Foundation researcher Dancrad Feist.

The founders of Ethereum proposed to automatically delete blob data every 30 days, so that the network would not make excessive demands on data and memory storage.

There is also EIP-4488, which aims to expand the use of Ethereum-based rollups. Initially, this relatively simple solution was planned to be implemented before The Merge was activated. EIP-4488 reduces the cost of sending bulk transactions from the Layer 2 network to the Ethereum blockchain by a factor of five.

“While The Merge is the most complex upgrade in Ethereum’s history, it will not be the last upgrade for the network,” stressed Galaxy Digital Research.

After that, the researchers are sure, developers will focus on other pressing issues developed over the years, such as scalability and statelessness.

Galaxy Digital Research researchers predict other consequences of Ethereum’s transition to PoS:

The popularity of mining crypto on GPUs will decline. Some miners will move to other coins like Ethereum Classic or Ravencoin. Many will simply sell video cards and then sell to gamers and designers. This will lower the price of the device in the market and affect the manufacturer’s revenue.
Bitcoin, still the largest PoS cryptocurrency, will receive more criticism for the high energy intensity of the network.

in conclusion

According to optimistic forecasts, The Merge is expected to launch in August. However, given the technical complexity of the merger process and the developer’s tendency to delay upgrades, the event is likely to take place in late fall.

One of the most important consequences of the transition to PoS is to remove miners from the game. This could significantly affect market conditions in the short term. Selling pressure is likely to ease and the hash rate of altcoins like Ethereum Classic will rise.

In the medium to long term, Ethereum may become a more attractive crypto to invest in. First, the project will demonstrate its antifragility. Second, the asset will align with the trend towards being environmentally friendly.

Finally, deflation will definitely play a role. However, its level will depend on the user’s activity.

The merger is far from the last major Ethereum update. It will help solve scaling problems where sharding and rollup play an important role.

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Source of information: compiled from FORKLOG by 0x information.The copyright belongs to the author Алекс Кондратюк and may not be reproduced without permission

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